Structured Debt Transaction (Non-Securitisation Transaction)
- Credit Rating Agency in India
- Credit Rating
- Structured Debt Transaction (Non-Securitisation Transaction)
Introduction
Debt instruments / facilities of an entity may be backed by collateral / security (e.g., shares, mutual funds, government securities, etc.), escrow mechanism, DSRA (Debt Service Reserve Account) or explicit support from a third party/ parent/ group company. This additional comfort may enhance credit quality of the debt instrument/facility.
As per Securities and Exchange Board of India (SEBI) circular No SEBI/HO/MIRSD/ DOS3/CIR/P/2019/70 dated June 13, 2019, ratings in such cases are assigned with the suffix (CE) which indicates that the rating is based on an explicit external Credit Enhancement and not solely on the standalone credit quality of the issuer.
Infomerics’ criteria for rating such debt instruments / facilities are elaborated below.
In compliance with SEBI guidelines, disclosure of both the unsupported and the supported (CE) ratings is made by Infomerics in its Press Release (PR). The PR also contains a detailed explanation of all the covenants of the instrument/facility. Adequacy of credit enhancement structure under various scenarios including stress scenarios is also carried out by Infomerics and such assessment is disclosed in the PR.
I) Infomerics’ rating criteria under different forms of credit enhancement for instruments which fall under the purview of SEBI
a) Debt backed by third party explicit support
An ‘explicit credit support’ is a promise made by a third-party to fulfil the debt obligations of the borrower in case the latter fails to do so on its own, in accordance with the terms and conditions of the agreement with the lenders or investors. Explicit support can be in different forms as follows:
The extent of credit enhancement of a debt instrument (on the basis of explicit support from a support provider) over its base unsupported rating could range from an equalization of the rating of the debt instrument with that of the support provider (a case of credit substitution) to limited or no credit enhancement from the base unsupported rating level (for example a partial guarantee).
Evaluation mechanism:
Enforceability: The support extended should be legally enforceable at any time during the tenure of the rated instrument.
Irrevocability: The support should not be revocable till all obligations under the rated instrument are fully paid.
Un-conditionality: The support extended should be unconditional in nature.
Amount and tenure covered: A support which covers all the obligations that may arise with respect to the debt instrument during its entire tenure is stronger, as compared with a support which covers either only a partial amount or is not valid for the entire tenure of the debt instrument. The support should cover the entire instrument being rated, including principal, interest, or other payables as per the terms of the instrument. In case of partial guarantees, the rating comfort derived shall be restricted to the extent of partial guarantee provided.
Guarantee for payment: The obligation of the support provider should be to pay the guaranteed amount without demur as per the term sheet in case of default by the borrower and nor merely to ensure repayment by the borrower.
Payment mechanism: The guarantee deed should specify timelines for invocation of the guarantee by the lender, and for subsequent payment by the support provider.
Payment on first demand: The support provider should make the payment under the guarantee on receipt of the first demand/ notice from the lender as per the guarantee terms.
Payment without deduction: The guarantor must make all the guaranteed payments without any deductions.
Rights of support provider to be waived: The Indian Contract Act, 1872 provides certain rights to the guarantors, including automatic termination of the guarantor’s obligations under certain situations (such as change in the terms of contract without the guarantor’s consent as per Section 133). Hence, in case of any change in the terms of the original loan contract affecting the guarantee, then the same needs to be reaffirmed by the guarantor for it to be treated eligible as a valid support for deriving the CE rating.
Guarantor is primary obligor: The lender is entitled to proceed against the support provider without waiting to exercise all its remedies.
Payment should happen in the event of insolvency: The support provider should agree to make payments even in case of any insolvency, liquidation, dissolution, or any other analogous proceedings against the rated entity.
Overseas guarantees: In case of overseas support provider (foreign parent) in respect of subsidiaries/ group entities/ affiliates operating in India, the foreign guarantor should continuously hold a rating from at least one of the international rating agencies (viz. S&P, Fitch Ratings and Moody’s Ratings), which corresponds to a lower risk weight than the standalone rating of the borrower. Infomerics will map the external rating by the international rating agency to Infomerics’ domestic rating scale. In case no external rating is available, Infomerics will assess and arrive at an internal rating of the support provider which will be monitored continuously. Further, apart from the other features of guarantees, Infomerics shall also examine whether there are any regulatory or legal issues in the guarantor making remittances under the guarantee as per the existing legal/ regulatory framework in the jurisdiction of the guarantor.
Board Resolution: Guarantee / Shortfall Undertaking / Letter of Comfort / Letter of Intent / Letter of Support should be duly backed by a Board Resolution. These forms of support should be documented in the sanction terms and conditions/ term sheet of the instrument.
Further, in case of rating comfort derived from support extended through multiple layering of group entities, in addition to the evaluation of the rated entity and the first layer supporting entity, Infomerics shall independently evaluate the financial flexibility, resource raising ability, prevailing governance systems, management capability etc. of the major group entities on whom ultimate reliance will fall in the event of default.
b) Debt backed by collateral / security
Infomerics shall consider the collateral/ security if a third party provides them. If the collateral/ security provided is owned by the borrower itself, then the financial flexibility of such instrument, if any, is already built in the standalone rating of the entity and will not lead to any enhancement.
The primary feature of collateral/ security to be considered for credit enhanced rating is the ready marketability/liquidity, including cash, marketable (listed) securities, fixed deposits etc. The following factors are considered for rating the debt instruments/facilities backed by collateral/security(ies):
Movement of price & volatility is studied along with the current value of the security and asset cover. Higher value of asset cover provides greater credit comfort.
Infomerics derives comfort from the availability of unencumbered collateral with the borrower or the promoter. This enables the borrower to provide top up when the collateral cover declines below the pre-designated level.
Monetizing the value of a security depends on its liquidity. Liquidity is assessed through a security’s collateral/traded volume movement and volatility of the same. Higher the liquidity, better is the likelihood of realizing the assessed value in times of stress.
The presence of well defined, time-bound mechanism for mandatory monetization of the security, in case the entity fails to deposit the money by a specific date, provides comfort. In the absence of such a mechanism, the monetization of the security remains at the discretion of the lender or trustee, which may result in delays in debt servicing.
The cushion between the date when the monetization of the security is contractually stipulated to be initiated by the lender or trustee and the due date for debt servicing should be such that it provides adequate time for enforcement of the lender(s) or trustee(s) right to monetize the security. The adequacy is assessed considering the nature of the security and its liquidity, besides taking into account the procedural timeline expected for its monetization. Thus, higher is the above cushion, greater is the likelihood of the structure being able to support timely debt servicing.
Any structure is encapsulated through several legal documents e.g., Deed of Guarantee, Trustee Agreement and Power of Attorney from the Guarantors, as applicable. Infomerics will require a legal opinion from its internal legal counsel or a reputed law firm on the legal soundness and enforceability of the structure.
The credit support in the structure is linked to the quality of the collateral. Apart from the price and volume movement of the collateral, the credit quality of the entity whose security is provided as collateral is also important.
Equity capital market, by its nature, are volatile due to developments taking place on the multiple fronts. Despite a particular security continuing to remain fundamentally strong, the market price of such security may get adversely impacted due to the market behavior. Higher the volatility, higher would be the quantum of credit enhancement required to arrive at a particular rating.
c) Debt backed by escrow mechanism
The following factors are considered for rating the debt backed by escrow mechanism:
If the escrow structure is not bankruptcy remote to the rest of the operational, financial creditors including labour and statutory dues, then no significant credit enhancement can be achieved.
To assess bankruptcy remoteness, Infomerics shall depend on an unqualified legal opinion from its internal legal counsel or an external credible legal counsel.
Infomerics believes that more the operational intervention of the issuer required to generate/ produce/ deliver the finished product/service to create the transaction cash flow, the more closely is the (credit enhanced) rating linked to that of the issuer. Infomerics assesses the degree of linkage between the originator’s ability to deliver the promised goods/services (which will generate the cash flows) and the originator’s normal operation. The complexity of ‘performance’ will also be assessed, and less complex operations will be viewed favorably compared with complex operations.
Mingling of an entity’s cash flows stemming from multiple sources is prevented by an escrow mechanism. A defined sequence in which the cash flows can be utilized further limits the discretion available with the borrowing entity, with regard to utilization of cash flow. The escrow account is monitored by the lender or trustee and withdrawals by the borrower are allowed only after the former’s consent.
While an escrow mechanism is characterized by the presence of a pre-determined sequence for the utilization of cash flow (cash flow waterfall) such that these are first utilized for incurring the necessary operating expense / debt servicing, etc., followed by replenishment of reserves such as DSRA, before being available for other purposes, escrow in itself is not a credit enhancement but only brings in discipline in usage of cashflows.
d) Debt backed by DSRA
The following factors are considered for rating the debt backed by DSRA:
The likelihood of timely funding coming from the DSRA guarantor to meet the shortfall is dependent on the credit profile of the DSRA guarantor, in cases where the DSRA is in the form of a DSRA cover guarantee from a financial institution or a corporate entity. Thus, the credit quality of the DSRA guarantor has an influence on the rating of the debt backed by DSRA.
The strength of the DSRA cover depends on the period and extent of debt servicing covered by DSRA. A longer tenure DSRA will be able to withstand cash flow pressure over a longer time period and thus provides greater support.
The invocation mechanism of the DSRA needs to be such that it ensures timely availability of liquidity as DSRA is meant to be utilized whenever there is cash flow shortfall to ensure that debt servicing happens in a timely manner. Presence of an invocation mechanism to ensure that the DSRA is utilized, in case of any shortfall, is necessary for DSRA to be effective apart from the first lien of the lender or trustee on the DSRA. Maintenance of DSRA in the form of a fixed deposit or cash balances with a well-defined operating instruction (such as utilization of the DSRA at ‘T-n’ if the debt servicing account is not funded by ‘n’ business days before the due date ‘T’) provides greater comfort.
The strength of the replenishment mechanism which ensures that the DSRA is replenished sufficiently in advance of the next debt servicing date provides greater comfort. Replenishment can be from the surplus cash flows of the entity, which in itself does not provide any significant enhancement, while timely funding support from a third-party rated better than the entity being evaluated provides credit support.
II) Infomerics Ratings’ CE rating criteria for facilities under the purview of the Reserve Bank of India (RBI)
Basis RBI directive to Credit Rating Agencies (CRAs) DOR.CRG(STR).No.S408/21.06.008/2022-23, dated April 22, 2022, Infomerics has amended the Credit Enhancement policy with respect to Bank Loan Ratings (BLRs). The broad guidelines while assigning BLRs are as follows:
Debt backed by third party explicit support
An ‘explicit credit support’ is a promise made by a third-party to fulfil the debt obligations of the borrower in case the latter fails to do so on its own, in accordance with the terms and conditions of the agreement with the lenders or investors. Explicit support considered while rating facilities under the purview of RBI are as follows:
Guarantee: It is a promise made by the support provider to fulfil the debt servicing obligations of the borrower in case the latter is unable to service on its own. Unless otherwise provided in the contract, the obligations of the support provider are generally co-terminus with that of the borrower. Only a legally enforceable, unconditional, and irrevocable guarantee is considered good for the purpose of credit enhancement.
Shortfall Undertaking issued by Central/State Government: It is a promise made by the government to fulfil the debt servicing obligations of the borrower only to the extent that the latter is unable to fulfil i.e., only to the extent of the shortfall. In order to provide credit enhancement, such shortfall undertakings need to be legally enforceable, irrevocable, and unconditional.
Letter of Comfort issued by Central/State Government: These are promises made by the government to take appropriate steps to ensure timely servicing of the debt obligations of the borrower. The borrower’s obligations are not transferred to the support provider and the support provider’s responsibility is generally limited to facilitate the borrower in servicing its obligations. The ‘Letter of Comfort’ can be considered only if it is legally enforceable, irrevocable, and unconditional.
Evaluation mechanism:
While factoring in the support, Infomerics shall inter alia evaluate the credit profile of the support provider including its financial risk, business risk, management risk etc. over the tenure of the rating to ascertain the ability to honor the supported obligations. The extent of credit enhancement over its base unsupported rating could range from an equalization of the BLR with that of the support provider (a case of credit substitution) or to a limited or no credit enhancement from the base unsupported rating level (for example a partial guarantee). Any rating downgrade in the support provider’s rating will require an immediate reviewing of the CE rating of the borrower.
The various parameters that are assessed by Infomerics to analyze the strength of the explicit guarantee are discussed below. In addition to internal assessment, in certain cases, Infomerics may also seek an independent legal opinion with respect to these parameters.
Enforceability: The support extended should be legally enforceable at any time during the tenure of the rated facility.
Irrevocability: The support should not be revocable till all obligations of the borrower under the rated facility are fully paid.
Un-conditionality: The support extended should be unconditional in nature.
Amount and tenure covered: The support should cover the entire facility being rated, including principal, interest, or other payables as per the terms of the facility. In case of partial guarantees, the rating comfort derived shall be restricted to the extent of partial guarantee provided.
Guarantee for payment: The obligation of the support provider should be to pay the guaranteed amount without demur as per the sanction terms in case of default by the borrower and not merely to ensure repayment by the borrower.
Payment mechanism: The guarantee deed should specify timelines for invocation of the guarantee by the lender, and for subsequent payment by the support provider.
Payment on first demand: The support provider should make the payment under the guarantee on receipt of the first demand/ notice from the lender as per the guarantee terms.
Payment without deduction: The guarantor must make all the guaranteed payments without any deductions.
Rights of support provider to be waived: The Indian Contract Act, 1872 provides certain rights to the guarantors, including automatic termination of the guarantor’s obligations under certain situations (such as change in the terms of contract without the guarantor’s consent as per Section 133). Hence, in case of any change in the terms of the original loan contract affecting the guarantee, then the same needs to be reaffirmed by the guarantor for it to be treated eligible as a valid support for deriving the CE rating.
Guarantor is primary obligor: The lender is entitled to proceed against the support provider without waiting to exercise all its remedies.
Payment should happen in the event of insolvency: The support provider should agree to make payments even in case of any insolvency, liquidation, dissolution, or any other analogous proceedings against the rated entity.
Overseas guarantees: In case of overseas support provider (foreign parent) in respect of subsidiaries/ group entities/ affiliates operating in India, the foreign guarantor should continuously hold a rating from at least one of the international rating agencies (viz. S&P, Fitch Ratings and Moody’s Ratings), which corresponds to a lower risk weight than the standalone rating of the borrower. Infomerics will map the external rating by the international rating agency to Infomerics’ domestic rating scale. In case no external rating is available, Infomerics will assess and arrive at an internal rating of the support provider which will be monitored continuously. Further, apart from the other features of guarantees, Infomerics shall also examine whether there are any regulatory or legal issues in the guarantor making remittances under the guarantee as per the existing legal/ regulatory framework in the jurisdiction of the guarantor.
Board Resolution: Guarantee from a non-government entity should be duly backed by Board Resolution. This form of support should be documented in the sanction terms and conditions/ term sheet of the facility.
Further, in case of rating comfort derived from support extended through multiple layering of group entities, in addition to the evaluation of the rated entity and the first layer supporting entity, Infomerics shall independently evaluate the financial flexibility, resource raising ability, prevailing governance systems, management capability etc. of the major group entities on whom ultimate reliance will fall in the event of default.
Last Updated: September 2022
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Introduction
Debt instruments / facilities of an entity may be backed by collateral / security (e.g., shares, mutual funds, government securities, etc.), escrow mechanism, DSRA (Debt Service Reserve Account) or explicit support from a third party/ parent/ group company. This additional comfort enhances credit quality of the debt instrument/facility.
As per SEBI circular No SEBI/HO/MIRSD/DOS3/CIR/P/2019/70 dated June 13, 2019, ratings in such cases are assigned with the suffix (CE) which indicates that the rating is based on an explicit external Credit Enhancement and not solely on the standalone credit quality of the issuer.
Infomerics’ criteria in rating such debt instruments / facilities are elaborated below.
Even in case of explicit credit enhancement, elaborate standalone credit assessment of the issuer is also carried out by Infomerics to arrive at the unsupported rating. In compliance with SEBI guidelines, disclosure of both the unsupported and the supported (CE) ratings is made by Infomerics in its Press Release (PR). The PR also contains a detailed explanation of all the covenants of the instrument/facility. Adequacy of credit enhancement structure under various scenarios including stress scenarios is also carried out by Infomerics and such assessment is disclosed in the PR.
Infomerics’ rating criteria under different forms of Credit Enhancement
a) Debt backed by Collateral / Security
The primary feature of collateral/ security to be considered for credit enhanced rating is the ready marketability/liquidity, including cash, marketable (listed) securities, fixed deposits etc. The following factors are considered for rating the debt instruments/facilities backed by collateral/ other security(ies):
Movement of price & volatility is studied along with the current value of the security and asset cover. Higher value of asset cover provides greater credit comfort.
Infomerics derives comfort from the availability of unencumbered collateral with the borrower or the promoter. This enables the borrower to provide top up when the collateral cover declines below the pre-designated level.
Monetising the value of a security depends on its liquidity. Liquidity is assessed through a security’s collateral/traded volume movement and volatility of the same. Higher the liquidity, better is the likelihood of realising the assessed value in times of stress.
The presence of well defined, time-bound mechanism for mandatory monetization of the security, in case the entity fails to deposit the money by a specific date provides comfort. In the absence of such a mechanism, the monetization of the security remains at the discretion of the lender or trustee, which may result in delays in debt servicing.
The cushion between the date when the monetization of the security is contractually stipulated to be initiated by the lender or trustee and the due date for debt servicing should be such that it provides adequate time for enforcement of the lender(s) or trustee(s) right to monetize the security. The adequacy is assessed taking into account the nature of the security and its liquidity, besides taking into account the procedural timeline expected for its monetization. Thus, higher is the above cushion, greater is the likelihood of the structure being able to support timely debt servicing.
Any structure is encapsulated through several legal documents including e.g., Share Pledge Agreement, Deed of Guarantee, Trustee Agreement and Power of Attorney from the Guarantors, as applicable. Infomerics may require a legal opinion from reputed law firm on the legal soundness and enforceability of the structure.
The credit support in the structure is linked to the quality of the collateral. Apart from the price and volume movement of the collateral, the credit quality of the entity whose security is provided as collateral is also important.
Indian capital market, by its nature, is volatile due to many developments taking place in the social and economic fronts both at the national and international levels. Despite a particular security continuing to remain fundamentally strong, the market price of such security may get adversely impacted due to the market behaviour. Higher the volatility, higher would be the quantum of credit enhancement required to arrive at a rating.
b) Debt backed by Escrow Mechanism
The following factors are considered for rating the debt backed by escrow mechanism-
As the generation of cash flow for debt repayment is linked to the future activity to be carried out by the issuer, the ability of the issuer to generate these cash flows over the life of the rated instrument assumes paramount importance.
Infomerics believes the more the operational intervention of the issuer required to generate/ produce/ deliver the finished product/service to create the transaction cash flow, the more closely is the (credit enhanced) rating linked to that of the issuer. Infomerics assesses the degree of linkage between the originator’s ability to deliver the promised goods/services (which will generate the cash flows) and the originator’s normal operation. Rent revenue (in respect of commercial real estate) and toll revenue are examples of weak linkages where minimal performance, such as maintenance or upkeep of the facilities, by the issuer is sufficient to generate the revenue. These cash flows are likely to become due just with passage of time. On the other hand, airline ticket revenue is an example of revenue that has a strong linkage to the operation of the issuer. The airline company will have to continue operating its flights and be able to attract customers for generation of ticket sales. The complexity of ‘performance’ will also be assessed, and less complex operations (for example, maintenance of a static gas pipeline) will be viewed favourably compared with complex operations (for example, supply of forged automotive components of specified quality).
Mingling of an entity’s cash flows stemming from multiple sources is prevented by an escrow mechanism. A defined sequence in which the cash flows can be utilized further limits the discretion available with the borrowing entity, with regard to utilization of cash flow. The escrow account is monitored by the lender or trustee and withdrawals by the borrower are allowed generally only after the former’s consent.
Thus, an escrow mechanism characterised by the presence of a pre-determined sequence for the utilisation of cash flow (cash flow waterfall) such that these are first utilized for incurring the necessary operating expense / debt servicing, etc., followed by replenishment of reserves such as DSRA, before being available for other purposes, provides greater credit comfort.
An overriding principle of credit enhancement would be the legal position of the account, whether it is insulated from the entity itself and validity of these waterfalls in the event the entity itself is in financial stress.
Greater comfort is derived if the cash flow waterfall ensures that there is no leakage of cash/appropriation of cash for other purposes such that the surpluses are utilized either for mandatory pre-payment of the loan or creation of a reserves for meeting any future contingency. This allows the escrow mechanism to provide liquidity support. Such a cash flow waterfall mechanism which also traps the surplus is stronger than a cash flow waterfall that only ensures that the cash flows are utilized in a pre-determined sequence.
c) Debt backed by DSRA
The following factors are considered for rating the debt backed by DSRA-
The likelihood of timely funding coming from the DSRA guarantor to meet the shortfall is dependent on the credit profile of the DSRA guarantor, in cases where the DSRA is in the form of a DSRA cover guarantee from a financial institution or a corporate entity. Thus, the credit quality of the DSRA guarantor also has an influence on the rating of the debt backed by DSRA.
The strength of the DSRA cover depends on the period and extent of debt servicing covered by DSRA. A longer tenure DSRA will be able to withstand cash flow pressure over a longer time period and thus provides greater support.
The invocation mechanism of the DSRA needs to be such that it ensures timely availability of liquidity as DSRA is meant to be utilized whenever there is cash flow shortfall to ensure that debt servicing happens in a timely manner. Presence of an invocation mechanism to ensure that the DSRA is utilized, in case of any shortfall, is necessary for DSRA to be effective apart from the first lien of the lender or trustee on the DSRA. Maintenance of DSRA in the form of a fixed deposit or cash balances with a well-defined operating instruction (such as utilization of the DSRA at ‘T-n’ if the debt servicing account is not funded by ‘n’ business days before the due date ‘T’) provides greater comfort.
The strength of the replenishment mechanism which ensures that the DSRA is replenished sufficiently in advance of the next debt servicing date provides greater comfort. Replenishment
can be from the surplus cash flows of the entity or funding support from a third-party / other source(s).
d) Debt backed by third party explicit support
An ‘explicit credit support’ is a promise made by a third-party to fulfil the debt obligations of the borrower in case the latter fails to do on its own in accordance with the terms and conditions of the agreement with the lenders or investors. Explicit support can be in different forms as follows-
The extent of credit enhancement of a debt instrument (on the basis of explicit support from a support provider) over its base unsupported rating could range from an equalization of the rating of the debt instrument with that of the support provider (a case of credit substitution) to limited or no credit enhancement from the base unsupported rating level (in case of a weak form of explicit support). The various parameters that are assessed by Infomerics to analyze the strength of the various forms of explicit credit support mechanisms are discussed below. In addition to internal assessment, in certain cases, Infomerics may also seek an independent legal opinion with respect to these parameters.
invocation of the support is discretionary without any defined timelines or the date by which the payment is to be made by the support provider is not defined.
Credit Enhancement in case of Infrastructure Entities
Example: Road Projects
Private road projects in India so far have been either without recourse or with limited recourse to the sponsors. To the extent the project has some form of recourse to a strong sponsor, it serves as a source of credit enhancement. Forms of support may include undertaking to cover cost overruns, cash support in case of any shortfall in repayment of loan, undertaking to provide funds to SPV to maintain a level of DSCR etc. A debt service reserve fully funded can provide significant protection to bondholders, especially if chances for delays in implementation of increase in toll rates exist. Guaranteed take-out financing via repurchase of bonds by highly rated entities has been used in India to serve as credit enhancement for the initial investors in the bonds. Traffic guarantees and Partial/ full exchange risk cover offered by the government has been used as a source of credit enhancement internationally. At times the relevant state, regional or local authority budgets may also provide for meeting shortfall in debt servicing requirements.
The mitigation in credit risk due to any credit enhancements provided is carefully evaluated before assigning the rating.
*Policy on Credit Enhancement (Version II) is approved in the BM dated 02nd February 2022
Last Updated - February 2022