Innovative project financing to reduce cost of capital : Case of L&T

Larsen & Tourbo has recently concluded a Rs.4.06 billion securitization deal to finance the
construction of a cogeneration plant to be leased to IPCL. This is the first time a large
securitization deal has been executed for project financing and through the capital market.
The entire funds for the power plant were raised as borrowing without either IPCL, the
solitary off taker, or L&T, the EPC contractor, taking any liabilities on their balance sheets.

In mid-1997, IPCL was in the process of expanding its Gandhar Petrochemical Complex. It
invited bids for leasing a 2x45 MW, 240 tonnes per hour of steam, captive combined cycle
cogeneration plant to feed the petrochemicals complex. L&T clinched the deal. It quoted a
price which basically included the cost of EPC and the financing cost.

But as L&T started negotiating the financial lease agreement with financial institutions in
early 1998, it found that the cost of financing had gone up by almost 100 to 200 basis
points. This was due to the Southeast Asian economic crisis and the down turn in the
petrochemicals sector. IPCL’s rating too was downgraded from AA+ to AA- by Crisil. That
affected the lease transaction as the borrowing was essentially to be raised on the credit
risks of IPCL.

In October 1998, L&T floated a 100 percent subsidiary company India Infrastructure
Developers Limited (IIDL) for the purpose of financing the power plant. It was decided that
L&T would construct the plant for IIDL which would own and lease it to IPCL. The future
lease receivables by IIDL from IPCL could than be securitized to raise finance for the
construction of the plant. Transferring the ownership of the plant to IIDL would also help
availing of depreciation benefits. L&T was already taking full depreciation benefits on its
balance sheet. By shifting this asset to IIDL, these benefits could be raised to minimize the
income tax out flow of IIDL.

All project risks, which include completion risks, performance risks and operating risks, were
fully divorced from the financial risks and suitably allocated. What remained was only the
credit risk of IPCL receivable. This is how it was structured.

The project completion risks were taken care of by providing two comforts. One, a
completion guarantee was provided by L&T to cover EPC delays. L&T would bear all cost
overruns, if the delays were attributable to the EPC contract. Two, a standby financing
support for six months was arranged which would be available to address the issue of
servicing the debentures if the project got delayed and affected the commencement of the
lease rentals.

A portion of the operations risks has been taken care of by IPCL, the lessee. The lease
rentals from IPCL will continue to remain payable to IIDL irrespective of the performance
parameters achieved by the plant and also irrespective of whether or not the plant operates.

A debt service in the form of liquidity support account has been created out of the leased
receivables which would be drawn down in case there are delays in receipt of lease rentals
from IPCL. This account will cover three months of debt servicing at all items and will be in
a place by January 31, 2000, the date when debt servicing commences.

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Lastly, L&T also agreed to make good any shortfall in lease rentals received from IPCL
owing to interest rate variations, changes in tax rates, depreciation rates, any variation in
LIBOR and the rupee-dollar exchange rate. These risks have been mitigated through a
hedging agreement and make up guarantee from L&T. The transaction contemplates routing
the lease rentals through an escrow account.

Having convinced the investors to the fullest, it was L&T’s chance to negotiate with them. It
kept the transaction at a low cover and debt service cover of just one. Normally, bankers
insist on an asset cover of 1.25 and debt coverage in the range of 1.35 -1.50.

A preliminary market survey was done soon after. Subsequently, an underwriting

commitment was given to the lead arrangers. Initially these were three – ANZ grindlays,
Citibank, DSP Merril Lynch. I-Sec joined in later. The lead arrangers were appointed based
on past relationships, expertise in structuring and executing the transaction and distribution
capability. Finally, the deal was launched on March 12, 1999.

The bonds were placed by IIDL at a coupon rate of 14.25 percent yearly for a maturity of 8
years and 10 months. The syndication oversubscribed by over two times and had to be
closed within 24 hours of being opened. Prominent amongst the participants were UTI, Bank
of Baroda and Bank of India. Many who committed later to invest was being turned down.

Discussion Points

1. What is the need for floating a SPV on the part of L&T and how it helps in reducing
the cost of capital?
2. What is the risk-sharing model developed by L&T? How best this can be emulated in
any company/ organization?
3. What are the benefits of “leasing”? How can it be applied to a project scenario? How
would be take a decision between buy or lease?
4. What is securitization? What are the benefits of the same?