1 STRUCTURED FINANCE DEALS HOW DO THEY WORK AND WILL THEY WORK? by David Hew Tel:(65) 2501211; Fax:...

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STRUCTURED FINANCE DEALSHOW DO THEY WORK AND WILL THEY WORK?

by David HewTel:(65) 2501211; Fax: (65)2501277; E-mail: [email protected]

© David Hew 2000. All rights reserved

The information contained herein should not form the basis of any decision as to a particular course of

action; nor should it be relied on as advice or regarded as a substitute for detailed advice in individual cases. The services of a competent

professional adviser should be obtained in each instance.

2

PRELIMINARIES

• Definitional incongruity;

• UNCTAD’s definition;

• Structured Finance pre Asian Crisis; and

• Situation post Asian Crisis

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DEFINITIONAL INCONGRUITY

• “Structured financing operations {include} a wide array of instruments: leveraged buyouts, management buy-outs, restructuring, industrial projects, infrastructure projects; secured debt;term loans, operating loans and asset-based secured lending” - A major U.S. financial institution– Comments: Vague. Excludes project finance, does not deal

with import or export of commodities as well as non-banking operations such as securitisation

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DEFNITIONAL INCONGRUITY

• “Structured Commodity Finance refers to the sum of banking operations pertaining to an import or export of commodities which are not plain vanilla” - A major French bank.– Comments: Vague. Implies that anything a bit complex will qualify as

structured.

• “Structured Commodity Finance provide working capital in difficult environments by mitigating the risk through mortgaging an export flow” - Branch of an Austrian bank.– Comments: What about structured commodity financing for commodity

importers?

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DEFINITIONAL INCONGRUITY• “{Include} asset-based financing, limited recourse project financing,

cross-border financing and structured/hybrid debt products” - A leading South African bank.– Comments: Definition too broad.

• “Commodity linked financing, also known as asset-backed securitisation or structured finance, makes the use of commodity or asset to improve the credit quality of financing” - Managing Director of the International Commodity Division of a major U.S. commercial bank– Comments: Commodity financing can be structured for use by the banking

market and for non-banking investors as well.

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UNCTAD’S DEFINITION

“A technique whereby certain assets with more or less predictable cash flows can be isolated from the originator and used to mitigate risks (eg. transfer of foreign exchange, contract performance and sovereign risk), and thus secure a credit”.

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UNCTAD’S DEFINITION DISSECTED

• “A technique …” – A methodology implying certain requisite skills or knowledge.

• “… certain assets … with (1) more or less predictable cash flow … (2) isolated from the originator and used to mitigate risk ...” – (1) Suggests that structured finance is financing based on future

receivables which are IDENTIFIED and more or less ASSURED.

– (2) Suggests that assets to support the financing must be AVAILABLE, ISOLATED and USED to mitigate risk. This implies that there are 2 ESSENTIAL PARTS in a structured finance transaction.

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2 ESSENTIAL PARTS

• (1) Arrangements which ensure that if a transaction proceeds normally, the financier is automatically reimbursed. The loan is therefore self-liquidated.

• (2) Arrangements further ensure that, if anything goes wrong, the financier has recourse to some assets as collateral.

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UNCTAD’S CONCLUSION

Overall “this form of finance allows for wider possibilities than other forms of short-term financing, which are normally limited to companies with acceptable credit risk or conditional upon onerous security, and gives access to financing on better terms”.

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UNCTAD’S CONCLUSION

• Why “ … wider possibilities …” apart from the 2 reasons?– “Bankability” increased because transaction economics improved.

– Can be used in both trade and project finance.

– Can be used in credit structures by bank or non-bank entities

• How “ … financing on better terms …” ?– From the financier’s perspective, better pricing can be offered since credit

is either enhanced or the risk shifted to a strong off-taker and all other risks identified and mitigated.

– From the borrower’s perspective, better costing achieved, longer maturity periods and more favourable balance sheet treatment.

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PRE-ASIAN CRISIS STRUCTURED FINANCE

• Two types of structured finance techniques prevalent before the Asian Financial Crisis.

• Asset Backed Securitisation (ABS) – Fixed income debt instrument whose principal and interest payments are governed by cash flow generated by underlying asset. By convention ABS is backed by non-mortgage assets.

• Mortgage Backed Securitisation (MBS) – Specific type of ABS where the debt instruments are backed by a pool of mortgage loans.

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ASSET SECURITISATION STRUCTURE

Originator

SpecialPurposeVehicle

Investor

ThirdParties

Proceeds Proceeds

(3) SPV issues assetbacked & rated securities

(1) Transfers right toreceive future receivables

Payments Principal andInterest

Initial cash flow Future cash flow

Obligors

(2) Enhancements added to the Structure to improve credit quality

(4) Investors look to future cash flows and credit enhancement for repaymentRather than to the originator.Originator risks eliminated.

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ASSET BACKED SECURITIES

• Process of distributing risk by aggregating debt instruments or assets in a pool, then issuing new securities back by the pool.

• Asset pool being securitised has a lower default risk than the company itself and therefore if financed discretely, commands a better rating and tighter pricing. Ratings improvement can also occur relative to the issuer or the sovereign ceiling rating if the issuer is resident in a non-investment grade country.

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MORTGAGE BACKED SECURITIES (MBS)

• MBS in Asia emulates the United States’ success in securitising housing loans mortgages (where fees and interest received are not liquid and loans not negotiable), making them liquid and marketable– “Fannie Mae” of the Federal National Mortgage Association and

“Freddie Mac” or the Federal Home Farm Mortgage Corporation

• Asia’s equivalent– Indonesia – SMF (secondary mortgage facility); Malaysia –

Cagamas; Hong Kong – Hong Kong Mortgage Corporation

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HOWEVER, ABS or MBS requires

• Good credit ratings – Examples of AAA rating– Thai Cars, LIBOR+22bps, average life – 1.5 years

– ASF 1, LIBOR+17 bps, average life – 0.9 years

• Attractive coupon rates;

• Stable cash flow;

• Liquid secondary market; and

• Range of maturities

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SITUATION POST ASIAN CRISIS

• ABS and MBS activities to sustain pre-crisis rapid growth momentarily halted by Crisis;

• Funding still needed (in fact even more needed) but financiers’ risk tolerance considerably reduced;

• Asian companies still experiencing difficulty to access capital markets and still needing to diversify funding sources;

• Therefore greater need for structured finance solutions because of the risk mitigating characteristics.

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TERMS OF REFERENCE

• How do they work? Project which link trade and investment

– Structured finance deals for trade finance

• How much of a solution?

• Conditions for their wider use

• Links to underlying markets, which markets and their robustness

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Project which links trade and investmentOBJECTIVE:

To illustrate a structured finance

transaction embedded in a project

financing structure linking

trade and investment.

KARNAPHULI US$423 MILLION FERTILISER

PLANT DEAL

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KARNAPHULI DEAL - THE BACKGROUND

• Funding of US$423 million sought by the Bangladesh government to finance the engineering, procurement, construction, operation and maintenance works of a fertiliser plant in Bangladesh.

• Typical project financing structure with payment of the loan to be by way of the proceeds of the future sale of urea and ammonia produced from the plant.

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KARNAPHULI DEAL - THE CONSIDERATIONS

• How to link the borrower’s commercial activities to its financial obligations; again using the commodities not yet physically available as collateral and payment.

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KARNAPHULI DEAL - IN SUMMARY

Transammonia(Switzerland)

Marubeni(Japan)

Karnaphuli FertiliserCompany limited

Equity investors (of whichGovernment of Bangladesh

holds 41%)

Banksyndicate

Export Credit Agency

Bakrabad GasSystems (BGSL)

Government

EscrowaccountPayment for purchases

Government guaranteeon performance of

BCGL&

Guarantee to approveescrow account and

make foreign exchange available

Contractto buy

full ureaoutput,

atmarket

price

Contract to buy full ammoniaoutput, at market price

20-year gas supply contractat price linked to urea output

Security over plant, site, property, equipment

7-10 year loan of US$ 423 millionInvestment of US$130 million

Investmentinsurance

cover

Payment

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KARNAPHULI DEAL - POINTS TO NOTE

• Debt/Equity ratio is high. Would conventional loan be possible?

• The fertiliser company sold its production forward. A Swiss and Japanese company agreed to commit themselves to buy this entire production for an extendible period of at least 7 years starting from the commencement of plant operations. These 2 companies also agreed to deposit their payments for the fertilisers in an offshore account, from which the debt would be served. The banks took additional security over the plant.

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• Agreement for offshore escrow account needed to be approved by the government of Bangladesh, which it did. The government also agreed that it would not limit the amount of foreign exchange available to this escrow account, eg. by forcing the fertiliser plant to directly repatriate its foreign exchange earnings.

• Financiers obtained insurance from a number of export credit agencies which would be triggered if the government interfered in the escrow account arrangement or otherwise expropriate the plant.

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• A 20 year agreement was signed between Bakrabad Gas Systems, a government parastatal, for the delivery of gas, the main input to the fertilizer production process. The gas company promised the delivery of minimal annual amount (which will ensure that the fertilizer company has sufficient inputs to produce the required amounts of urea and ammonium) and in addition agreed to tie the payments for this gas to regional bulk market urea prices. As a result, the fertiliser company automatically hedged one of its major price risks, locking in a minimum profit and a certain operational efficiency.

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• The government in turn, guaranteed the gas company’s performance.

• The banks ensured that their loans were indeed used for constructing the fertilizer factory and not diverted for other uses by using an independent third party to approve all project expenditures.

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• Further comfort over the operational efficiency of the fertilizer plant was given by the fact that those constructing the plant were willing to take part of the equity. The Bangladeshi government retained 41.2% of the equity, but more than half of the equity was held by foreign companies (with a small part in the hands of local investors). These foreign companies thus kept a strong control over the future day-to-day management of the facility, once it becomes operational.

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TERMS OF REFERENCE

• How do they work?– Project which link trade and investment

Structured finance deals for trade finance




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Structured Deals for Trade Finance OBJECTIVE:

To illustrate use of structured

finance techniques in trade finance.

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COMPOSITION OF ASIAN EXPORTS

Economy Year Primary Produce

(%)

Textiles and other labour

intensive items (%)

Electronics and machinery (%)

Other manufactures

(%)

1970 98.6 0.2 0.0 1.2 Indonesia

1994 60.7 22.8 4.8 11.7 1970 94.7 0.9 1.0 3.4 Malaysia

1994 29.4 8.3 44.4 17.9 1970 71.2 6.8 8.0 14.0 Singapore

1994 17.1 4.9 57.7 20.3 1970 35.2 39.6 6.3 18.9 South Korea

1994 8.1 22.2 34.5 35.2 1970 94.0 1.4 0.1 4.5 Thailand

1994 31.1 23.8 27.7 17.4 SOURCE : EMERGING ASIA – CHANGES AND CHALLENGES

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THREE MAIN TYPES

• Export receivables backed financing

• Inventory financing

• Prepayments

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EXPORT RECEIVABLES BACKED FINANCING

• DEFINITION: A loan is made with recourse to the exporter whereby the security is provided by the assignment of export sales contracts and receivables, and the repayment comes from the export proceeds paid by identified buyers directly to the lender.

• Is the basic form of structured commodity finance. The other two namely, inventory financing and prepayments are variants of the same theme – the future sale of the commodity will provide the borrower with the means to repay the financing.

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EXPORT RECEIVABLES BACKED FINANCING

• Sale contract between exporter and importer

• Sales proceeds assigned to bank

• Against assignment, bank advances loan to exporter

• Export made by exporter to importer

• Importer makes payment to escrow account controlled by bank

• Loan is repaid from escrow account

• Excess after agreed deductions released to exporter

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INVENTORY FINANCING

• DEFINITION: A loan is made with recourse to the exporter whereby the security is provided by an assignment of the commodity stored (or about to be stored) in a warehouse and the repayment comes from export proceeds paid by future buyers directly to the lender.

• It is the only structured finance solution, if the exporter has not identified a buyer yet.

• Can be used by importer to obtain pre-shipment finance to pay for a portion of the cost of imported commodities pending re-imbursement from its sale.

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INVENTORY FINANCING• Exporter puts goods in warehouse

• Bank takes security interest over goods in warehouse

• Goods inspected and security interest perfected

• Bank makes loan to exporter

• Exporter sells goods

• [If necessary Bank obtains top-up goods and gives order to warehouse for sold goods to be delivered to buyer]

• Buyer pays sale proceeds into escrow account

• Bank is repaid from escrow account and excess after agreed deductions release to exporter

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PREPAYMENT

• DEFINITION: A loan is made without recourse to the buyer for prepayment of the commodity sold by the exporter whereby the security is provided by an assignment of the prepaid export sales contract and by an assignment of the commodity stored (or to be stored) in a warehouse and whereby the repayment comes directly from the buyer.

• Used when relationship between the buyer and the exporter is strong eg. when the exporter is a subsidiary of the buyer. Is generally with limited recourse and buyer is responsible to service loan only if commodity is delivered.

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PREPAYMENT

• Sale contract between exporter and importer providing for prepayment by the importer assigned to Bank

• Bank inspects goods for purposes of loan to importer to enable importer to prepays goods to exporter.

• Bank takes security over goods stored in warehouse upon prepayment. Can make advance without security over goods.

• Importer sells goods to sub-buyers with sub-sale proceeds from sub-buyers assigned to Bank

• Goods released from warehouse against payment paid to Bank with excess split between exporter and importer.

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TERMS OF REFERENCE



How much of a solution?



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HOW MUCH OF A SOLUTION?

• Trade & project finance perspective

– By comparing characteristics of traditional vs. structured trade & project finance

• Asset backed securitisation perspective

– Seen from the borrower or seller of the assets for purposes of a securitisation program;

– Seen from the financier or investor in a securitisation program; and

– From the perspective of other participants

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TRADE & PROJECT FINANCE PERSPECTIVETRADITIONAL vs STRUCTURED FINANCE

• Traditional financing rely heavily on creditworthiness of borrower and not the payback from the borrowed funds. Structured Financing relies heavily on the payments to be received from the transaction being financed. The transaction is structured such that the repayment of the loan is automatically made via the transaction proceeds– NB: Traditional financing may require the purpose of the loan to be

approved but is generally not concerned with the profitability of the transaction. In Structured Finance performance of the transaction is key and must be carefully evaluated and controlled.

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TRADE & PROJECT FINANCE PERSPECTIVETRADITIONAL vs STRUCTURED FINANCE

• Traditional financing require a strong balance-sheet. In Structured Finance the reliance is on the soundness and merits of the transaction and not the balance sheet.

• Borrowers must provide chargeable assets to give financiers the comfort they need in event of a default. Borrowers must equally provided chargeable assets in Structured Finance. The assets however are limited to and usually related and specific to the transaction.

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TRADE & PROJECT FINANCE PERSPECTIVETRADITIONAL vs STRUCTURED FINANCING

• All direct and indirect (in varying degrees, depending on the financier, country and borrower concerned) factors relating to the borrower taken into account in Traditional Financing. In Structured Financing all direct and indirect factors relating only to the transaction in question and not the borrower are taken into account.

• Country risks can be a deal-breaker in Traditional Financing. Country risks is surmountable in Structured Finance provided the performance and risk of the transaction is acceptable.

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TRADE & PROJECT FINANCE PERSPECTIVETRADITIONAL vs STRUCTURED FINANCING

• Expertise required in Traditional Finance are relatively straightforward. Specialised and broad-based expertise required in Structured Finance deals and degree of difficulty higher compared to Traditional Finance.

• Cost of Traditional Finance can be high compared to Structured Finance because both direct and indirect factors are taken into consideration. Up-front cost is high in Structured Finance, but because of the lower cost of funding, overall cost can be lower than that in Traditional Finance.

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STRUCTURED FINANCECOFFEE IN KENYA – 3 MONTHS CREDIT

No Structured Finance With Structured Finance

Value of Goods US$7,000,000 US$7,000,000

Advance Rate 50% 80% (increased utilisation of assets by 30%)

Loan Proceeds US$3,500,000 US$5,600,000 (Extra credit US$2.1 mil)

Interest rate pa LIBOR + 15% LIBOR + 2.5% (Savings in interest charged over US$ 3.5 mil = US$120,000)

Storage/insurance/inspection & other professional fees

1.7% 2.55% (Additional upfront fees US$ 59,000)

Total storage etc. etc. & interest costs

US$304,000 US$298,000 (Savings achieved, US$6,000)

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ASSET BACKED SECURITISATION PERSPECTIVE BORROWER/SELLER

• Off balance sheet funding and removing assets allows borrower/seller to achieve better financial ratios.

• Cheaper funds given the higher credit quality of the segregated and credit enhanced assets.

• Allows access to capital markets which may otherwise be unavailable, therefore providing alternate funding source.

• Provides liquidity and cash for otherwise illiquid assets

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ASSET BACKED SECURITISATION PERSPECTIVE BORROWER/SELLER (con’t)

• Allows efficient matching of maturity profile and interest rate of segregated assets charged with principal and interest payable to investors.

• Possibility of fee-income to borrower/seller since borrower/seller is likely to be retained as manager of assets sold of assets not recognised in the balance sheet.

• Risks in assets transferred to others who can better managed risks.

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ASSET BACKED SECURITISATION PERSPECTIVE FINANCIER/INVESTOR

• Permits diversification to new asset class which is liquid and which may not otherwise be available.

• Allows institutional investor to match assets and liabilities by acquiring assets which suits its cash flow and maturity requirement

• Securities issued pursuant to a securitisation program offers higher returns than other corresponding rated securities.

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ASSET BACKED SECURITISATION PERSPECTIVE OTHER PARTICIPANTS

• Fee income

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ASSET TYPE BY COUNTRY

Asset

Type Country

Auto

Loans

Credit

Cards

Mort-gage

One

Proper-ty

Toll

Road

Trade

Receiv-ables

Proj

-ect

Finan-ce

Oth-ers

Hong Kong X X X XIndonesia X X X X X X XMalaysia X X XPhilippines X X XThailand X X XSingapore X

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DISADVANTAGES OF STRUCTURED FINANCE

• Complexity; and increased transaction costs.

• Therefore an appropriate alternative to traditional secured finance if lower cost of funding and other benefits achieved (eg. where financing would not otherwise be available or increased quantum of loan).

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TERMS OF REFERENCE




Conditions for their wider use


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CONDITIONS FOR THEIR WIDER USE

• Available of Good Collaterals– Therefore the question what are the attributes of a

good collateral

• Conditions specific to trade and project finance

• Conditions specific to asset securitisation

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ATTRIBUTES OF A GOOD COLLATERAL

• Standard and quality which can be independently certified to ensure marketability. Reputation of the certifier is important.

• Market transparency to enable real value of collateral to be determined and to allow for price risk management. Ideally collateral is quoted on an exchange.

• Deliverability to an organised market place to prevent deterioration in quality and price and other liquidation costs. (NB: In a forced sale situation, discount can be large.)

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• Good and safe location ensuing that appropriate and good storage facilities and that if the bank needs to liquidate, it can obtain and sell the collateral and receive the currency it requires.

• Good durability providing security that, if the bank has to liquidate, delays do not have a negative impact on its value.

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• Reasonably low price volatility providing security that the value of the commodity, even if not hedged, will continue to be sufficient to cover the loan. The more perishable and volatile the price of a commodity is, the riskier it is to store. If a distributor cannot know what the price is when a sale is made, he may have to cover part of this risk by futures or options.

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TRADE & PROJECT FINANCE CONDITIONS

• The Right Financier

• Available and Reliable Information & Know-how AND

• Good Risk Analysis AND Control

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THE RIGHT FINANCIER

• One who is able to identify quality recurring trade flows and the participants to these trade flows.

• Has global connections of suppliers and buyers.

• Is well positioned on both sides of the trade flow.

• Has good information sources (accurate information can be more important than the collateral)

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THE RIGHT FINANCIER

• Has the appropriate appetite for risk, the necessary knowledge & expertise and the use of special techniques.

• AND who is able to support these trade transactions by making use of – Normal trade finance instruments

– Futures and derivative markets.

– Expertise to keep financing close to the trade flow.

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THE CONCERNS OF THE RIGHT FINANCIER

• Are returns interesting enough?

• Is the financier comfortable with all the risks and are there good collateral to back-up the risks involved ?

• (For bank financiers) Does the “reserve requirement” permit doing the deal?

• (For bank financier) Does the bank have enough “lines” to take the “country risks”?

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INFORMATION

• Product and market information

• Country information

• Information on the relevant parties (producers, buyer and seller and all intermediaries involved in the entire chain) in terms of – Management team of the relevant parties, their knowledge, abilities

& experiences

– their reliability, ability to deliver the right goods on time & payment track record

– Risks control systems

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KNOW-HOW

• Inventiveness and creativity

• General knowledge of traditional financing methods

• Specialist knowledge of non-traditional financing techniques

• Experience (can be more important than qualifications)

• Contacts, network & knowledge of capabilities of contacts and network, a differentator

• Documentation skills

• Good risks analysis & transaction management skills

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ASSET BACKED SECURITISATION CONDITIONS

• Same factor of right financiers, availability & reliability of information and know-how

• Presence of legal/regulatory framework

• Availability of data

• Depth of investor bases

• Availability of good rating agencies familiar with markets

• Appropriate Central Bank policies

• Seller system capabilities

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TERMS OF REFERENCE





Links to underlying markets, which markets and their robustness

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THE UNDERLYING MARKETS

• The markets involved bond market, money and foreign exchange market, commodities, energy and transport market and the equity market

• Above all the derivative markets in each of these markets

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MARKETS IN TERMS OF PLACEMENT

• International Private Placement Market

• International Public Bond Market

• Bank Loan Market

• Asset Backed Commercial Paper Market

• Local Markets

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HOW ROBUST?

• Matured or emerging market and their efficiency?

• Challenges of emerging markets – Historical sectoral data for benchmarking asset performance does not exist or

is not disclosed;

– Historical portfolio data for estimating performance on a securitised pool does not exist or is not disclosed;

– Macro-economic change is volatile with possible adverse financial impacts to the seller or the portfolio;

– The legal framework does not resemble what investors are familiar with

– The regulatory and political model is different, with unexpected consequences

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THE APPROPRIATE CONSIDERATION

• The robustness of the specific deal AND NOT the market.

• To achieve robustness all aspects of a specific deal and its structure must be examined specifically.

• A deal from a matured market can possess “emerging market” characteristics whilst a deal from an emerging market can possess “matured” market characteristics.

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WHAT ASPECTS OF THE DEAL?

TransactionAnalysis

PerformanceMonitoring

DocumentationRiskAnalysis

PhysicalAspects

Key PlayersInvolved

Fund FlowProcess

DocumentsProcess

PhysicalAspects

DocumentsProcess

Fund Flow Process

Key PlayersInvolved

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CONCLUSION - THE WAY AHEAD

• Structured finance is the way ahead - HOWEVER

• One needs knowledge, experience and skills which are broad-based as well as specialised.

• Thus the need in most cases, for a team.

• The start-up effort and cost for the formation of such a team is beyond most private entities (especially the SME or developing countries)

• Therefore the need for a special unit or agency at a national, regional AND international level.

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CONCLUSION - THE WAY AHEAD (con’t)

• The national agency would serve the specific interests of its exporters and nationals which competes with others.

• Countries can opt to share expenses of the regional agency to address their common needs peculiar to the Asia Pacific region, like – Gathering and disseminating information;

– Providing education;

– Gathering and making available expertise to countries sharing costs of agency at a cost not otherwise available commercially;

– Building network specific to the region.

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THE END.THANK YOU FOR LISTENING.

by David HewTel:(65) 2501211; Fax: (65)2501277; E-mail: [email protected]

© David Hew 2000. All rights reserved

The information contained herein should not form the basis of any decision as to a particular course of

action; nor should it be relied on as advice or regarded as a substitute for detailed advice in individual cases. The services of a competent

professional adviser should be obtained in each instance.

1 STRUCTURED FINANCE DEALS HOW DO THEY WORK AND WILL THEY WORK? by David Hew Tel:(65) 2501211; Fax:...

Documents

Transcript of 1 STRUCTURED FINANCE DEALS HOW DO THEY WORK AND WILL THEY WORK? by David Hew Tel:(65) 2501211; Fax:...