FINANCE COST OPTIMISATION A presentation by Mr. Devendra Kumar Vyas Chief Executive Officer Srei BNP Paribas 2 Finance Cost Optimisation Key Points Since the 2008 crisis, the role of treasury has evolved into a more strategic one with primary focus on de-risking the balance sheets and optimising the finance costs It is important to have an ideal capital structure which proffers a balance between debt and equity and minimizes the firms cost of capital The choice of source of finance plays a pivotal role in optimising the cost and reducing asset liability mismatches. A modern treasurer has to be aware of both the traditional sources of finance, as well as the un-conventional sources Today, treasury department has gone global and risk management has become a necessity for survival and a key driver in the diverse, competitive, and fragile marketplace Post the crisis, a majority of CEOs around the world view increasing regulations as the key challenge to the funding environment Ralph Waldo Emerson (May 25, 1803 April 27, 1882) was an American essayist, lecturer, and poet who led the Transcendentalist movement of the mid-19th century. 3 Finance Cost Optimisation Key Enablers Risk Framework Technology Business Model Ralph Waldo Emerson (May 25, 1803 April 27, 1882) was an American essayist, lecturer, and poet who led the Transcendentalist movement of the mid-19th century. 4 Traditional sources of finance 5 Indian Financial Market Money Market Call/NoticeT. BillsTerm Money Certificate of Deposits Commercial PaperWorking CapitalCommercial Bill Debt Market G-Secs Central Govt. State Govt. Bonds Foreign Institutional Bonds PSU Bonds Corporate Securities Forex market FuturesOptions Higher Order Derivatives Capital Market EquityFuturesOptions Higher Order Derivatives 6 On Balance Sheet Methods 7 Retained Earnings Retained earnings is a fundamental tool for financing future growth without having to leverage Readily Available First in pecking order Least Costly Complimentary to dividends paid out Current Scenario Companies leveraging debt to pay dividends ?? A 2013 survey of top 419 BSE 500 companies for leveraging Debt for Dividends Payout On Balance Sheet Methods PAT Dividend Payout Retained arnings Debt for Dividends Payout YearDebtNo of Companies Taking DebtDebt/EBITDA > 5X 2013Rs Bn5714 BSE 500 Companies excluding Banks and NBFCs (419 out of top 500) OR Retained EarningsDividend Payout No Interest or Tax PaymentsDividend Distribution Tax Earnings get cumulatedPressure to maintain track record Direct funding for future plansLeft with less reserves for future funding 8 Current Assets/Working Capital Financing (WCF) Current assets consist of cash or anything that can easily be converted into cash (eg Stock holdings in other companies, Inventory, Cash etc.) Useful for short term financing Need to be kept above current liabilities to avoid going in loops Supplier Financing WCF is a growing trend amongst the top CFOs and Treasurers. According to a BCG and BNP Paribas survey, 25% of treasurers plan to increase the use of supplier financing in the near term. Factoring One of the oldest forms of business financing Transfers the risk of payments Looks at customers financials, rather than creditors Can be costlier than traditional sources of finance Receivables Financing According to the same survey, 20% of the large corporations indicated increase in use of receivables financing On Balance Sheet Methods.. contd.. IF CA < CL -ve WC Short term funding required Internal Funding through CA 9 Commercial Paper CP With RBI slashing rates Top CPs saw fall of 150 bps Preferred by NBFCs and Manufacturing companies CPs Yield (7.4%) < Banks base rate (9.3%) Trade Credit New Rupee denominated trade credit (for resident importers) IRDAI to allow trade credit insurance policy The ratio of trade covered under credit insurance to the GDP is only 5 per cent while in most other countries, it is in double digits. Bill Discounting Tighter norms needed in light of recent frauds Exposure to each buyer limited Bill discounting is part of contingent liability Bankers need to take care in the ratio analysis Authorized Dealer Cat - I permit upto USD 20 mn/ transaction Indemnity cap increase to 85% from 80% Rs 350 Crs fraud by BOB client in Ahemdabad Another fraud of Rs 4,000 Crs involving various banks On Balance Sheet Methods.. contd.. 10 Need for stronger bond market Reduces reliance on bank financing Reduces the risk of currency and funding mismatches, particularly for projects with long gestation periods Required Funding The funding gap in just renewable energy and urban infrastructure is estimated at Rs 20 lakh crs in the nest 5 -6 years In MSME: funding gap Rs 4.8 lakh crs Corporate bond market Corporate Bonds form a very small percentage (7%)of the total debt market in India Trading of corporate debt securities is still much lesser when compared to government securities The spread between the government and corporate bonds need to be justified Rating of the issue (and not the issuer) should drive the prices Bonds help to reduce the cost of capital with the tax benefits associated with them The cost of debt has always been less then cost of equity Source NSE Indian Bond Market Source NSE 11 Securitization Regular tracking by credit agencies Timely identification of loss drivers Better protection against credit quality risks Loads off the poor assets of the balance sheet of the issuer Indian Scenario Pass Through Certificates (PTC) Securitization Overall PTC Securitization decreased from Rs 28,300 crs in FY 14 to Rs 17,000 Crs in FY 15 Asset Backed Securities have been able to increase their share from 85% to 90% in FY15 In ABS CE, CV, PV accounted for Rs. 100 Bn in FY15 Disadvantage Tax (on SPV) disadvantage Underwriting Cost Off Balance Sheet Methods 12 Direct Assignment (DA) (Specific to NBFCs) Mainly driven because of priority sector lending norms No mark to market for investors Receivables bought treated as loans Regulatory Changes As per new guidelines, there is permanent extension of PSL status to medium enterprise With introduction of Small and Micro Farmers (SMF), RBI is been off with distinguish between direct/indirect agriculture SMF are included in agriculture and weaker sections making it difficult for private banks to meet the targets and easier for public banks (due to NBFC Business Correspondence model) Disadvantage Investors exposed to delinquencies, direct exposure to credit quality risks has increased No credit enhancement by originators Off Balance Sheet Methods in Rs Crs Year Total Securitisation VolumePTC VolumeDA Volume DA as % of Total Securitized Assets ,50017,00026,00060% ,30028,30021,00042% PSL Targets for Banks % Agriculture 18% SMF* 8% Micro Enterprises (FY16) 7% Weaker Sections 10% *included in agriculture How Cost Effective? Reduces Layers of Transactions and mitigates transactional costs No SPVs, no extra taxation 13 Un-conventional sources of finance -Rupee Denominated Global Bonds (Masala Bonds) -Leasing as a tool for asset creation and de-risking the balance sheet -Covered Bonds -REIT and InvIT Masala Bonds 14 Helps in reducing borrowing cost by bps due to transfer of risk In 2013, the IFC launched the first ever Rupee Linked Offshore Bond programme in various maturities of 3,5 & 7 Yrs. Subsequently, IFC was permitted to expand the issuance program and it issued a 10-year, 10 billion Indian Rupee bonds in 2014 These bonds described as Masala bonds marked the first rupee bonds listed on the London Stock Exchange What give these bonds the name and flavour is that they are issued to foreign investors in INR and settled in US dollars Hence the currency risk lies with the investor and not the issuer, unlike ECBs The Reserve Bank of India in its bimonthly monetary policy state for presented on April 7, 2015 proposed the introduction of a draft for the issuance of Rupee linked bonds overseas Besides IFC, ADB has also issued such bonds while NTPC and the Indian Railway Finance Corp are planning to be amongst the first domestic issuers Rupee Denominated Global Bonds Key Considerations for Investors 15 Global INR Bonds is a important investment route for Offshore investors who do not have access to domestic market through FII / FPI license and are not able to currently take exposure in INR denominated credit risks Limitation of Access T here is a section of Institutional Investors overseas who cannot access domestic market as they are required by mandate to buy into papers only settled through Euroclear / Clearstream since the INR Bond currently are only settled through NSDL / CDSL. Global INR Bonds will provide them an opportunity to take India credit exposure through INR Bonds Settlement Investors who have a view on the currency (USD INR) and India Credit would be best placed to invest in Global INR Bonds This product become very attractive as the current view is positive on the Indian growth story going forward Risk Due to market dynamics, different markets could be pricing same credit differently and this provides a window of opportunity to investors to take exposure in Global INR Bonds Arbitrage Investors would prefer liquidity in secondary market to manage their exposure based on their views on credit and currency rate, thus size of the offering will an important parameter for investors Fungibility of Offshore INR bonds with onshore bonds will help induce liquidity Liquidity Key Benefits for Issuers and Market 16 Helps in raising cost effective funding Facilitates longer tenure funding. Funding of upto 10 Yrs or more Funding Issuer does not have to bear the hedging cost for cross currency conversion its an INR borrowing for them It further diversifies the investor base for INR denominated offerings beyond existing local investors and FPI investors (ECB restricts it to bi-lateral banking channels) Risk Innovative Bonds helps the participants manage their risks better Systematic Risks Good instrument for external investors to cash in on their positive outlook on India Enhances financial inclusion, helps RBI objective of internationalization of Penetration ISSUERS BOND MARKET Leasing Global Scenario 17 For a borrower, Leasing is the most popular alternative off balance sheet tool to credit finance Worldwide Leasing has emerged as an important tool for asset creation It had allowed to craft out a real distinction between the benefit of ownership and the benefit of use. United States, China, Germany and United Kingdom accounts for 60% of the worldwide annual leasing volumes of USD 884 Bn # Over a third of all assets are created through lease in the US More than three-fourth of the companies lease some or all of their equipment in US. # World Leasing Yearbook 2015 World Leasing Yearbook 2015 18 Indian Lease Regime Despite being amongst the top 10 economy the Indian leasing volume is less than 3% of global volumes. We are ranked outside the top 50 nations while our BRICS peer are all within top 20. The penetration of leasing is less than 3% only which reduces further if the transactions between Indian Railway Finance Corporation (IRFC) and its parents is discounted # Potential of Indian Leasing Marketing Power and roads are crucial pillars of infrastructure and account for the largest planned outlays. With up to 50% of infrastructure creation going to the private sector, leasing will play a pivotal role Increasing cost pressures has resulted into behavioral change in corporate spending from capex to opex model which shall burgeon the lease market by 25-30%, albeit from a low base. Leasing Indian Scenario # White Clarke Group, Ram Sreekantaiah,CALMS2,ProductQualityAssuranceManager 19 Multiplicity and Disparity of taxes add to the cost of Leasing. CENVAT credit to be liberalised and clarified with enlightenment of competent tax officers. High (composite) rates under GST regime to existing Lease contracts will adversely impact cash flows of the customers and make lease proposals unviable. TDS deduction is applicable on Lease rental which effectively means applicability of TDS on the principal cost of the equipment There is subjectivity on the part of tax authorities in allowing depreciation benefits to the lessor. Tax officers often perceive lease as a tool for tax avoidance whereas it is simply tax deferral. Multiple Regulators - Lack of Comprehensive Legislation Qualification criteria for Lease is subjective and not clarified Leasing Challenges - India Leasing Recommendations 20 Fiscal incentive for leasing in terms of higher depreciation and tax holidays especially for infrastructure assets/equipment This will give rise to higher asset creation and catapult the Make-In-India initiative Reduced multiplicity and simplification of tax related regulations The levy of Service Tax as well as Sales Tax on the same transaction should be annulled to avoid multiplicity of taxes and compliances. The term Transfer of Right to use without transferring right of possession and effective control should clearly be defined in the Finance Act, 1994 for the purpose of levy of Service Tax. Also the term Transfer of Right to use with transferring right of possession and effective control should be defined in the CST Act, 1956 for the purpose of levy of Sales Tax/ VAT. The benefit of exemption available U/s 5(2) [Sale in Course of Import], and 6(2) [Sale in Transit] of the CST Act, 1956 should also be made available to a lease transaction treated as deemed sale. TDS rate should be removed for lease rentals so that impounding impact of charge on asset cost is not severe Reduce disparity in Companies Act and Income Tax Act w.r.t. rates of depreciation and rights to claim depreciation Accounting Standards should clearly state criteria for lease qualification 21 Covered bonds are one of the safest instruments to source finance. Here there is a pool of high quality assets created by the issuer (as security) which remains on the issuers balance sheet Similar as Asset Backed Securities Assets remain on issuers balance sheet (variants with off balance sheet exist) Investor has recourse to against issuer and collateral (Dual Recourse) They are placed above unsecured debt in the securization tranche Covered bonds are a means for banks to raise long-term funding at a lower cost than if they issued unsecured debt Benefit to the investor The underlying security of the issue is rated higher than issuer of the bonds Bankruptcy remoteness of the security ensures payback in case of issuers default Benefits to the seller Low priced bonds due to higher rating of the securities Long term finance source Credit Enhancer Less than AAA rated issuer to reduce borrowing costs by getting an improved rating For AAA cost can be decreased by 3 rd party instruments Covered Bonds 22 Structures are predominantly fixed rate (floating rate possible) and bullet maturities are predominant. Cover pool assets are generally restricted to prime residential mortgages, public or other high quality debt that revolve and are actively managed. The pool can also include other strong asset class like Construction Equipment, Commercial Vehicles etc. as securities. Bankruptcy remoteness of covered bonds essentially ring-fences the assets to safeguard investors preferential position and ensure payments to covered bond investors continue. An Asset Coverage Test ensures that sufficient overcollateralization is available to meet repayment obligations, and this is monitored by an independent party. Why India needs CB Indian NBFCs struggle with Asset Liabilities Mismatches Lack of access to long term funding Lending on wafer thin spreads while taking risk of longer duration Covered Bonds will be win win instrument for both the investor & issuer The issuer will have access to low cost long term funds Less risky nature of the underlying forms a safe bet for the investor Total Covered Bonds Outstanding as of 2014 in EUR Bn and top five nations - ECBC Fact Book 2015 Covered Bonds Covered Bonds act as less risky broad basing of sourcing of funds for issuer and portfolio diversifier, even for a risk averse investor REIT & INVIT 23 REIT Mutual Fund Like Entities; pooled money from large number of individual investors. An investment vehicle that invests in rent-yielding wide range of completed commercial real estate properties According to FICCI, ReIT industry globally amounts to $1Trn, and opportunity in India can be upto $10-$12Bn. (As per Q3, FY14-15) Regulatory Changes required for REIT to be effective Abolish MAT (payable by the sponsor) Removal of DDT Exemption of stamp duty payment InvIT Infrastructure Investment Trust A dedicated Infrastructure funding trust Pooling of funds from multitude of investors Sponsors need to hold just 10% of the units issued by the trust IRB will be the first to issue InvIT in India As on Oct 2014, India has rent yielding office space of up of USD 52 Bn A lot of this can be used as collateral in REIT 24 Risk Management Challenges Market Risk Treasury can be (and will have to be) integrated in every step of the cycle Market risk can range from change in any macro-economic variable to counterparty risk. Treasury needs to give its own inputs on Value at Risk (VAR) testing, Stress testing, or any other metric Treasury needs to have a two way communication with the risk and management teams, about the possible outcomes of different scenarios, and needs to be able to supplement any action taken. Risk Management Challenges for Corporate Treasury Define Risk Parameters Aptitude for Risk Identify Risks Monitor Solutions Control Processes Manage Risks Risk Management Approach Risk AvoidanceLoss ControlDiversificationRisk TransferRisk SharingRisk Retention Concentration of funds needs to source diversified. Treasury needs to integrate with the activities of other departments so that it can take any counter or complimentary action to avoid unnecessary costs 25 26 Liquidity Risk Liquidity management ensures that the right amount of cash is available, at the right time and in the right place Efficient cash pooling structures are vital to cost effective liquidity management Every investment has cost to the organization Therefore it becomes imperative that there is proper sourcing and utilization of funds Where does treasury come in? Treasury needs to collaborate with business and risk at the testing level Treasury needs to help decide the optimal use of funds. It can help decide whether to use it for short term investments or for working capital needs etc. Stress/Scenario Testing In Stress testing, first it needs to perform a firm wide test, and check upon the liquidity measures Then market testing needs to be done accounting for both seen and unforeseen events All the while there should be a continuous monitoring of the deviation of the forecast from the actual Risk Management Challenges for Corporate Treasury 27 Currency Risk With globalisation corporates cant be insulated to currency risk any more Corporations need to gauge the direction of market pricing Corporates seek currency forecasts from their banks and currency specialists Treasury needs to collaborate with currency forecasters with better track records over periods Solution Dedicated, Robust currency Risk Hedging Team Some products to hedge currency Risk Spot Contracts Forwards Contracts Futures Contracts Options Contracts Risk Management Challenges for Corporate Treasury Corporate Treasury: Economic Scenario + Cash Flows Senior Management: Stock Price + Earnings Effective Hedge Strategy: Cash Flows + Earnings 28 Interest Rate Risk Interest rate risk defines the largest and most connected of risk gamut Almost all businesses are affected directly or indirectly by the fluctuations in interest rate The most important of them is the RBI repo rate Major rates movements van be linked to the movement in RBIs lending rates Methods to Manage Interest Rate Risk Treasury has to integrate with the risk department at the testing levels rather than executional levels to provide better inputs to these procedures Risk Management Challenges for Corporate Treasury Sensitivity Analysis SimpleMeasurement of small changes on interest rates Advanced Multiple changes in interest rates and other variables impact on financial health Stress Testing Large changes in interest rates on borrowings or investments in accounting terms or risk outcomes Repricing Graphical representation of interest reset of assets and liabilities over time Derivatives Interest Rate Caps and Floors, Interest Rate Swaps, Swaptions etc 29 How regulators can help - An example of how a level playing field can help NBFCs 30 Access to long-term funds for Infrastructure Finance Companies/Infrastructure Companies (IFC/IC) Long Term Financing is a major challenge for IFC/ICs; gestation for projects is high while funding horizon is low Banks have been the principal source of debt Pension Funds and Provident Funds have long term funds to invest, but are limited by stringent guidelines Not allowed to invest in any debt instrument having a credit rating lower than AA. As per IRDAI guidelines, Insurance Companies are: Allowed to invest in infrastructure companies with credit rating of A category and above Access to long-term funds A step like this will not only go a long way in addressing the asset-liability problem for financing infrastructure, but will also provide a spurt to entrepreneurial initiatives in the infrastructure sector 31 The guidelines are limiting as most infrastructure companies have weak ratings on account of: Long gestation period Regulated revenues (e.g. power sector) / highly competitive environment (e.g. telecom) Large capital investment and hence high gearing (approximately 4:1) Asset life generally ranges between years post-construction Significant stress on cash generation to service huge debt thereby leading to low debt service coverage ratio (DSCR) during initial years of operations Options Contracts Suggestion IRDAI and PFRDA to suitably amend their guidelines so that Insurance Funds, Pension Funds and Provident Funds can allocate 10% of their corpus to finance: Infrastructure related instruments with credit rating of A category and above (A- rating and above) Access to long-term funds THANK YOU