Structured finance—the struggle against innovation
It appears that we are very good at replicating the western approaches in finance. No wonder soon after liberalisation terms like red herring prospectus, road shows, hair cuts became common words in financial services.
However, when it comes to meet home grown challenges the financial services industry is rather shy of innovating. Most persons familiar with the real estate market in Mumbai would be aware about the tenancy system and the associated pagri system. Under this system, a tenant pays the landlord the equivalent of a market value of the property as premium (called Pagri) and gets a tenancy right which is irrevocable and also transferable. While transferring the tenant in turn would collect a Pagri. Variants to the scheme would include a lower Pagri to start with but the landlord shares one third of the subsequent pagri for confirming the transfer of tenancy.
Recently, an SME entrepreneur was exploring ways to raise resources for a new venture to manufacture power plant equipment, mainly boiler and boiler house. He was to start as a subcontractor and subsequently graduate into a main contractor. The initial capital required for the project was in the range of `15 crore. His own equity required was `5 crore.
Falling short of resources to contribute his own equity, he thought it would be easy to raise money against the security of his commercial office admeasuring about 2,000 sq ft held under the aforesaid pagri system. To his surprise there were no takers. When pushed for a reason to reject the same, most potential lenders said "tenancy property cannot be mortgaged." To meet all objectives an innovative structure was devised.
In this, the entrepreneur will form a SPV (a private company) and transfer the tenancy right to the company which will be confirmed by the landlord. The landlord will enter into a new tenancy agreement with the company which will specify that tenancy is irrevocable and transferable. Since the tenancy right is being transferred to the company the same will be valued and equity shares in the company issued.
The mode of transfer itself would be tax optimal. Further, the company will not have any other asset or business. The shares will be pledged with the lender as security for the loan. The property may then be given on rent by the SPV to the new company executing the power business and earn rental income. The rental income will be escrowed and used first for payment of maintenance and other regulatory charges and then for repayment obligations. The surplus if any to be used by the company as considered appropriate.
Any layman can easily understand that the structure protects the lender completely. In case of default in payment of instalments for three months or so (as may be specified) the lender can exercise his right under the pledge and get the shares transferred in his name, effectively becoming the owner of the company.
That in turn makes the lender the tenant. He can sell the shares to any person interested in taking over the premises. Thus, the lender has the same rights as he would in a mortgage property. In fact, exercising his right under the pledge is far easier than exercising the right under mortgage. Still there are no takers. The entrepreneur is still scouting the market for a suitable lender.
All had the same defence - "that they are not allowed to lend against tenanted property." No discussion with their legal team, no willingness to innovate. It is not familiar territory. Such structure is neither seen in the US nor in text books originating from the west. It was as though America has patented the right to innovate financial products or services. It is possible that the regulator would turn innovative and issue a circular permitting such structure motivating the lender to jump in.
In yet another case, a company was keen to purchase agricultural land and develop the same into gated farm house community project. The total funding requirement to develop the entire land area of about 50 acre was not more than `5 crore, factoring in cash inflow from those who book land in the project.
Obtaining funding for the project was near impossibility from regular lenders. For one lending against agricultural land was restricted only for agricultural activity. Buyer of the subdivided property can get a loan for building the farm house but not buying the land. Again an innovative structure was suggested.
The company executing the project would create bonds, with each bond representing one acre (the lowest denomination in the project). Assuming that targeted selling price for the developed land is `45 lakh per acre, each bond representing one acre would have a face value of `45 lakh. The issue conditions would include:
i) The bonds would be issued as zero coupon bond structured to pay a return of 14% compounded half yearly
ii) On mauturity at the end of 3 years it will pay the face value of `45 lakh. Thus, the issue price would be Rs. 29.9854 lakh
iii) The borrower to have a right to prepay the loan without any penalty at any half yearly intervals. The prepayment amount at each half yearly interval would then be after 6 months `32.08 lakh, 12 months `34.33 lakh, 18 months `36.73 lakh, 24 months `39.30 lakh, 30 months `42.05 lakh and 36 months `45 lakh.
iv) If the borrower gives a notice of prepayment the lender can opt to take one acre at the end of three years instead of taking the prepayment
v) Land underlying the bond cannot be sold without consent from the lender
vi) If the land is sold the bond must be foreclosed
vii) if there is default in repayment then the lender can take possession of the land earmarked.
As can be seen the structure provides an opportunity to gain more for the lender if he perceives that the selling price of the land would be much higher than the indicated `45 lakh. All structuring was of no avail. No lender was willing to consider the same. It looks like if you are small, you still struggle to raise finance, no matter what the government or Reserve Bank wills. Happy hunting.
It appears that we are very good at replicating the western approaches in finance. No wonder soon after liberalisation terms like red herring prospectus, road shows, hair cuts became common words in financial services.
However, when it comes to meet home grown challenges the financial services industry is rather shy of innovating. Most persons familiar with the real estate market in Mumbai would be aware about the tenancy system and the associated pagri system. Under this system, a tenant pays the landlord the equivalent of a market value of the property as premium (called Pagri) and gets a tenancy right which is irrevocable and also transferable. While transferring the tenant in turn would collect a Pagri. Variants to the scheme would include a lower Pagri to start with but the landlord shares one third of the subsequent pagri for confirming the transfer of tenancy.
Recently, an SME entrepreneur was exploring ways to raise resources for a new venture to manufacture power plant equipment, mainly boiler and boiler house. He was to start as a subcontractor and subsequently graduate into a main contractor. The initial capital required for the project was in the range of `15 crore. His own equity required was `5 crore.
Falling short of resources to contribute his own equity, he thought it would be easy to raise money against the security of his commercial office admeasuring about 2,000 sq ft held under the aforesaid pagri system. To his surprise there were no takers. When pushed for a reason to reject the same, most potential lenders said "tenancy property cannot be mortgaged." To meet all objectives an innovative structure was devised.
In this, the entrepreneur will form a SPV (a private company) and transfer the tenancy right to the company which will be confirmed by the landlord. The landlord will enter into a new tenancy agreement with the company which will specify that tenancy is irrevocable and transferable. Since the tenancy right is being transferred to the company the same will be valued and equity shares in the company issued.
The mode of transfer itself would be tax optimal. Further, the company will not have any other asset or business. The shares will be pledged with the lender as security for the loan. The property may then be given on rent by the SPV to the new company executing the power business and earn rental income. The rental income will be escrowed and used first for payment of maintenance and other regulatory charges and then for repayment obligations. The surplus if any to be used by the company as considered appropriate.
Any layman can easily understand that the structure protects the lender completely. In case of default in payment of instalments for three months or so (as may be specified) the lender can exercise his right under the pledge and get the shares transferred in his name, effectively becoming the owner of the company.
That in turn makes the lender the tenant. He can sell the shares to any person interested in taking over the premises. Thus, the lender has the same rights as he would in a mortgage property. In fact, exercising his right under the pledge is far easier than exercising the right under mortgage. Still there are no takers. The entrepreneur is still scouting the market for a suitable lender.
All had the same defence - "that they are not allowed to lend against tenanted property." No discussion with their legal team, no willingness to innovate. It is not familiar territory. Such structure is neither seen in the US nor in text books originating from the west. It was as though America has patented the right to innovate financial products or services. It is possible that the regulator would turn innovative and issue a circular permitting such structure motivating the lender to jump in.
In yet another case, a company was keen to purchase agricultural land and develop the same into gated farm house community project. The total funding requirement to develop the entire land area of about 50 acre was not more than `5 crore, factoring in cash inflow from those who book land in the project.
Obtaining funding for the project was near impossibility from regular lenders. For one lending against agricultural land was restricted only for agricultural activity. Buyer of the subdivided property can get a loan for building the farm house but not buying the land. Again an innovative structure was suggested.
The company executing the project would create bonds, with each bond representing one acre (the lowest denomination in the project). Assuming that targeted selling price for the developed land is `45 lakh per acre, each bond representing one acre would have a face value of `45 lakh. The issue conditions would include:
i) The bonds would be issued as zero coupon bond structured to pay a return of 14% compounded half yearly
ii) On mauturity at the end of 3 years it will pay the face value of `45 lakh. Thus, the issue price would be Rs. 29.9854 lakh
iii) The borrower to have a right to prepay the loan without any penalty at any half yearly intervals. The prepayment amount at each half yearly interval would then be after 6 months `32.08 lakh, 12 months `34.33 lakh, 18 months `36.73 lakh, 24 months `39.30 lakh, 30 months `42.05 lakh and 36 months `45 lakh.
iv) If the borrower gives a notice of prepayment the lender can opt to take one acre at the end of three years instead of taking the prepayment
v) Land underlying the bond cannot be sold without consent from the lender
vi) If the land is sold the bond must be foreclosed
vii) if there is default in repayment then the lender can take possession of the land earmarked.
As can be seen the structure provides an opportunity to gain more for the lender if he perceives that the selling price of the land would be much higher than the indicated `45 lakh. All structuring was of no avail. No lender was willing to consider the same. It looks like if you are small, you still struggle to raise finance, no matter what the government or Reserve Bank wills. Happy hunting.
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