Stretching The Credit Risk

What exactly is a financial guarantee and how can corporates benefit from it?

Explains Sadashiv Rao, vice president, Infrastructure Development and Finance Company (IDFC), A guarantee is a sort of credit enhancing mechanism available to companies. The financial guarantees we talk about today owe their existence to the deferred payment guarantees (DPG) which the central and state governments, or certain financial institutions used to extend to foreign lenders for industrial loans. In the recent past, Krishna Bhagya Jal Nigam and the Krishna Valley Development Corporation projects have been assisted by state DPGs.

Consider a project vehicle started by a company or promoters who do not have any international presence. For a foreign institution willing to finance it, partly or wholly, there are various risks associated with such ventures. Apart from the country risk and the industry risk, the biggest risk it has to contend with is the default risk. This uncertainty arises primarily out of the lack of awareness of the company's style of functioning. So despite the fact that a company may have a good rating within the country, the foreign investor will still be wary to invest, because this company is an unknown entity abroad.

 

To prevent funds being denied to certain genuinely viable projects, the centre or state governments or certain credit institutions used to extend guarantees to the foreign investor against default risk. The repayments of such loans were usually not in a single bullet form but had an amortised schedule and as such, the guarantees extended to the foreign institutions were called deferred payment guarantees.

In a similar fashion, today we have an entity, usually a financial institution with very good credit rating, extending guarantees to investors for investments in certain project vehicles.

Let us take the case of RTL. Marketmen opine that for its recently concluded private placement of secured non-convertible redeemable debentures worth Rs 200 crore, the company would have on its own merit got at best a BBB rating. This would have made it very difficult for the company to raise funds at less than 12 per cent, which in turn would have seriously impaired its operational efficiency and the bottomline.

So Reliance Telecom approached ICICI to act as an intermediary between the company and the prospective investors and extend financial guarantee to these investors, in return for a guarantee commission.

Says Shikha Sharma, general manager, ICICI, "By entering into such an agreement, RTL in a way got the ratings of the guarantor and this enabled it to tap the market at rates ranging from 9.75 to 10.5 per cent. And though the guaranteeing institution does not dictate the coupon rates at which the company enters the market, their ratings do influence the final coupon rates."

In case of default by the company the institution extending the financial guarantee is liable to make the guaranteed payments to the investors. This insures investors against any default risk and consequently they are willing to settle for lower returns.

But Rao extends a word of caution here. The financial guarantee can mitigate the commercial risk for the investors, but not the structural risk. The investors can be sure that the project is inherently viable because the due diligence has been performed and the repayments have been guaranteed by an institution in which they have more confidence; but other risks like interest rate risks etc. still remain."

But the ICICI guarantee is important on a larger scale as well. "ICICI has taken the lead in facilitating the inflow of private capital into inherently viable infrastructure projects. Simultaneously the financial institutions now have a new tool for enhancing their fee-based income from this off-balance sheet product, says Rao.

But how can the financial institutions safeguard their interests in case the company defaults in making the requisite payments? "In the first case," says Rao, "there is a need to redefine 'default'. Investors should not have a myopic view on short-term defaults and should refrain from enforcing the guarantee unless they feel that the company is either unwilling to make payments or the vagaries of business have made it incapable of living up to its commitments in the long term."

But what happens to the bottomlines of the guaranteeing institution if a company defaults on its obligations? "The financial guarantee extended by the institutions is secured pari-passu on the fixed assets of the company, on pledge of shares and on assignments of all project contracts," Rao counters.

This way the guaranteeing institution gets a lien on the assets of the promoter too but this will automatically lead to a reduction in the guarantee commission. Additional precautions include suitably discounting the future cash inflows of the company. The financial institutions may share the risk by seeking counter guarantees from other institutions, for a part of the total amount. This is usually possible if this second institution does not enjoy the same level of confidence of the investors but the guaranteeing institution is more comfortable with it.

But in the first case, how is the guarantee commission worked out? According to Sharma, "the guarantee commission is worked out in much the same way as we work out the loan spreads and to a large extent depends on the outcome of negotiations with the company and the cost savings achieved by it."

Financial guarantees form a part of the contingent liabilities for the FIs and the institutions therefore keep a small fraction of the guaranteed amount as idle funds in case of defaults. This amount is proportional to the quality of assets. It is usually based on some risk weightages arrived at by the financial institutions when doing the due diligence of the company. But what has been the experience of players in the international financial markets? "Internationally, the financial guarantee business is the forte of monoline entities handling nothing but the guarantee business. These firms are highly leveraged firms (some leveraged to the extent of 100 times) and have ratings equivalent to AAA ratings," explains Rao. Drawing from their experience, ICICI has disclosed its intentions of forming a Special Purpose Vehicle (SPV) for the financial guarantee business. It has entered into parleys with Cap Mack, USA for the purpose of setting up a 100 per cent financial guarantee company.

The financial guarantee business is a non-cash business and therefore this SPV will not require huge cash and will be highly leveraged. As such, it should be allowed to have a capital adequacy requirement much lesser than the 8 per cent applicable to other credit institutions. Also since the risks in this business are different, the capital adequacy requirements should be based on the quality of the asset, she adds. There is another unique aspect to the business of financial guarantees. In case of undersubscription of the bond issue guaranteed by any institution, it may just convert its guarantee into a loan depending upon their due diligence, despite the fact that they have not specifically underwritten the issue.

ICICI expects the guarantee business to exceed Rs.10,000 crore in the next ten years. Besides infrastructure projects, it may also extend the guarantees to the securitisation business. And with the financial markets coming of age in India, the demand for such uniquely structured financial products is sure to rise.

Can financial guarantees help companies investing in infrastructure raise cheaper funds?

Tax benefits in financial guarantee

The Income Tax Act, 1961, under section 10 (23G) has the following provisions:

In computing the total income of a previous year of any person, the income falling under the following clauses shall not be included-

(23G) "any income by way of dividend, interest or long-term capital gains of an infrastructure capital fund or an infrastructure capital company from investments made by way of shares or long-term finance in any enterprise carrying on the business of developing, maintaining and operating any infrastructure facility."