State electricity boards are turning innovative in an effort to keep attracting investors with their numerous forays in the market.
State electricity boards (SEBs) have begun tapping the financial markets with increasing frequency to raise resources for both new and expansion projects. Banks, financial institutions, mutual funds and non-banking finance companies have traditionally been the major subscribers to SEB bonds. However, these subscribers are slowly becoming cautious about their increasing exposures to the electricity boards. Because of this, the electricity boards have found it necessary to offer innovative products to the subscribers.
In fact, with exceptions like Jammu and Kashmir and the north eastern states where electricity boards depend on the budget for their requirements, all other SEBs have made forays into the market. They have raised resources either by directly borrowings through bond issues or through sale and lease back of assets. Their entry into the markets has been prompted by the fact that the states are constrained by Article 293 of the Indian Constitution from making direct borrowings. As a result, states have been using electricity boards and special purpose vehicles to raise funds to meeting critical capital expenditure.
But clearly, the days of plain vanilla packages have gone. Almost all SEBs have started structuring their packages and all the recent methods have involved structured obligations.This method allowed financiers to have a primary charge on predetermined portion of the SEBs' most consistent revenue flows. This meant that this portion of the revenues would have to be transferred to a separate escrow account with additional security in the form of a state government guarantee built into the structure.
Till early this year, the only security for financiers was the state government guarantee. But after the ITC Classic Finance episode, the escrow account mechanism has become a standard practice. In the case of ITC classic, a large portion of the losses came from sale and lease backs to the Bihar state electricity board. First, the rentals stopped coming and then there was no way for the NBFC but to write off this huge amount. Escrow accounts thus became a common thing since then.
Yet, despite such safeguards only some states like Punjab, Rajasthan, Maharashtra and Karnataka have been able to build the confidence in the market for repeated forays. KEB is not a newcomer to the market. Till August 1997, it had resorted to sale and lease back (SLB) methods for raising funds. So far it has raised about Rs 218 crore through this method of funding at rental rates ranging from 12 per cent to 16 per cent.
The main attraction of resorting to these transactions is that the financier is able to take advantage of the depreciation allowance. As for the lessee, the transfer of the assets to the financier also allowed it to cut fixed costs, as it did not have to provide for depreciation on these assets. This helped it boost the bottom line. This is precisely the reason SEBs became favoured candidates for SLBs, since the high rates of depreciation is one of the major reasons for SEB losses.
But SLBs are no longer an attractive source for raising funds, because sale and leasebacks cannot be resorted to repeatedly un-less there is a continuous asset build up. Besides, leasebacks of second-hand assets is no longer re-cognised for tax exemption purposes.
And in the case of new assets, the leases would be big ticket, where the fund requirement would be large and therefore would have to be done on a syndication basis. This is because the bulk of the lessors so far have been leasing companies. Besides, banks are also constrained by a limit of 5 per cent on their incremental deposits to invest in leasing companies.
But any syndication has some inherent drawbacks. While sharing of depreciation is permissible with effect from September last year, this may still entail the formation of a special purpose vehicle.
Enter, the SPV
Accordingly only the special purpose vehicle (SPV) will benefit from the depreciation allowance, and not the bank or the non bank finance company who would want to show the asset in their books.
Moreover, with the liquidity overhang in the markets and the slide in interest rates, states like Karnataka are finding that, given their track records, borrowings can be made at extremely competitive rates.
This is precisely what the KEB has chosen to do so. The current tranche of Rs 100 crore has a seven year tenor and carries a coupon of 13.40 per cent payable half yearly. This is just about 75 basis points above the maximum sovereign yield. This is despite the fact that the issue has been rated only 'LAA minus' by ICRA. The bond offers neither a call nor a put option. And unlike past offerings in the market by public sector companies and SEBs, there are no bullet repayments. Instead it is staggered over the fifth, sixth and seventh years.
However, the rating itself is not on the electricity board but effectively on the mechanism. Bankers say that on a standalone basis none of them would prefer to invest in such securities. In fact, ITI Limited, the public sector telecommunication company that had made a foray into the bond market with a plain vanilla issue early this year, could not find takers given the huge losses on its balance sheet.
Another SEB, the Kerala State Electricity Board (KSEB) , which had made a Rs 200 crore bond issue last year also used the structured obligation route, which was rated AA by CRISIL. KSEB then had to offer a coupon of 17 per cent with a 2.5 per cent front end discount, taking the effective cost of raising the funds to 18.5 per cent. But then, on account of a severe 90 per cent power cut, the revenue flows to the board were severely hit, and the interest payments during the first half had to be met by the state government.
KEB has drawn extensively from these experiences to arrive at a structure that would make the bond palatable to institutional investors like mutual funds, non bank finance companies and provident funds. KEB's structure provides for three escrow accounts with the State Bank of Mysore, Syndicate Bank and the State Bank of India.
These banks are expected to transfer the cash receipts on behalf of the board or the state to their designated escrow accounts in a ratio of 45:35:20 to meet the interest and principal payments due to bondholders at any point of time. This ratio implies that 45 per cent of the payments falling due would be met by the State Bank of Mysore from the escrow account being maintained by it, while the State Bank of Mysore and Syndicate Bank would take care of 35 and 20 per cent respectively.
And in the event of a shortfall, standby funds maintained by the Canara Bank and the State Bank of Hyderabad would be invoked to meet the deficit. And to complete the security for the bond holders, the state government guarantee has also been brought in.
Yet despite such arrangements, the bonds are expected to be subordinated to the lease rental payments made by the state. That means that in effect, the lessors would have the first charge on the revenues in the event of a shortfall. This is contrary to the current practice in the Indian markets, where lease rental payments receive the lowest priority, lower than even unsecured borrowings.
The investors do not appear worried on this account, though. According to a banker, "With inflows approximately around Rs 230 crore every month into KEB from billings alone, there is not likely to be any kind of a shortfall. But this mechanism makes the arrangement virtually watertight - almost like a counter guarantee."
Still, without doubt, it is the timing of the entry that gave KEB the most favourable rate. Two other electricity boards that had preceded the KEB, the Punjab State Electricity Board and the Orissa Power Generating Corporation, in tapping the markets through the bond route had to offer coupons of 16 per cent and 16.5 per cent respectively. Along with front end discounts, the effective costs of raising funds then went up to about 17.5 per cent and 18 per cent respectively.
Shifting target
But KEB's delayed entry into the financial markets knocked out five hundred basis points of the cost straightway, which was a substantial saving. Besides the current coupon rate is about 60 basis points below the prime lending rates of most of the nationalised banks. That raises the crucial question as to the target subscribers for the bond issue.
Says a merchant banker, "The target subscribers are obviously not the banks or the financial institutions, who would have preferred a call or put option for such low rates." KEB offers neither of these options, and the only subscribers who would prefer to hold on to such securities over a long period of time are provident funds. Provident funds are allowed to invest a maximum of 40 per cent in public sector bonds. And the PFs have been hamstrung by the low rates on bond offerings during the last few months especially in a situation when they themselves are expected to offer a minimum of 12 per cent.. Consequently any offering considerably above 12 per cent makes it an attractive investment proposition for most of them.On the other hand, despite attractive packaging bankers are becoming wary of picking up such issues, despite the shortage of good quality risk weighted assets. Instead several of them have begun looking very closely at the ability of the states and the electricity boards to absorb additional debt.
The board for instance has signed several power purchase agreements (PPAs) with independent power producers (IPPs). And each of these PPAs involves take or pay contracts assuming a minimum plant load factor of 68.5 per cent. It means that the board has to buy power from the producer to the extent of 68.5 per cent of the producer's installed capacity, and pay for the power even if it can not take it. These arrangements also involve escrowing of the KEB's revenues to meet IPP payment dues, with state government guarantees. In addition, Karnataka has also raised Rs 400 crore last year for the Krishna Jala Bhagya Nigam Limited, an irrigation project on a structured obligation basis and is expected to again tap the markets using the same mechanism.
But Karnataka is not the only state that has built up such debts. Maharashtra, Gujarat and Tamil Nadu also have doneit. And with debts building up without a concomitant increase in revenues, financiers have become aware of the pitfalls in these issues. And as they put each issue under the magnifying glass, their honeymoon with the states is beginning to lose all excitement.
