RATING METHODOLOGY


RATING METHODOLOGY

Overview

The rating exercise undertaken by Infomerics is based on information provided by the issuing entity, in-house database and data from other sources that Infomerics considers reliable. Infomerics undertakes only solicited ratings. The primary purpose of the rating exercise is to evaluate the future cash generation capability and their adequacy to meet debt obligations in the future. The analysis therefore attempts to examine the key determinants of the business and the probabilities of change in these fundamentals, which could affect the repayment capacity of the borrower. The analytical framework of rating methodology adopted by Infomerics is broadly classified into two inter-dependent segments. The first deals with the operational factors and the second with the financial characteristics. Besides quantitative factors, qualitative aspects like assessment of management capabilities play a very important role in arriving at the rating for an instrument. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Rating determination is a matter of experience and holistic judgement, based on the relevant quantitative and qualitative factors affecting the credit quality of the issuer.

The rating methodologies adopted by Infomerics for manufacturing entities begins with the evaluation of the industry in which the entity operates, followed by the assessment of the business risk factors specific to the entity. This is followed by an assessment of the financial and project-related, if any, risk factors as well as the quality of management. Assessing liquidity and financial flexibility of the issuer/obligor gains more prominence while arriving at ratings of short-term instruments/facilities apart from the analysis of the basic fundamentals of an issuer/obligor. The key determinants covered in the manufacturing entities are enumerated below:

Industry Overview: The industry overview brings out the characteristics of the industry in general and various key factors, its performance, linkage with the global front, its strategic position in the economy and its near-term and long-term outlook. It captures, in nutshell, all the prospects and concerns.

Business Risks: The business risks broadly cover geographical diversity and regional demand-supply scenario, locational economics, market structure, extent of competition, product diversity, scale of operations, market share, capacity utilisation, cost efficiencies, level of technology, sourcing of major input, power & fuel sensitiveness, export potential, logistics, brand development, fiscal incidence, Government policies & intervention, pending litigations, industrial relation, environmental issues, ongoing and/or proposed projects, if any, etc. The business risks, in general, attempts to capture all the major risks associated with the industry and how the entity being rated is positioned in the market.

Financial Risks: The financial risks broadly cover revenue growth, profitability, working capital management, leverage & capital structure, matching of cash flow vis-a-vis maturity of debt/loan obligation, risks relating to interest rates & refinancing, debt servicing track record, foreign currency related risks, if any, contingent liabilities & off-balance sheet exposures, consolidated financial analysis, if applicable, financial prudence & accounting policies, quality of auditors & their observations, etc. Deviations from the Generally Accepted Accounting Practices are noted and the financial statements of the entity are adjusted to reflect the impact of such deviations. The financial risks attempt to capture the various risks associated with the financial position of the entity and also the capability of the entity to meet its debt/loan obligations as per the debt servicing schedule. It is also seen as to how the entity being rated is placed vis-a-vis its peers in terms of financial parameters.

Management Risks: The management risks cover the quality & experience of promoters & management, past track record, status of group companies, prevailing corporate governance practices, continuity in the management, employee attrition rate, regulatory sanctions/prosecutions, succession policy, etc. The management risks attempt to capture the capability, transparency and integrity of the promoters and the top managerial personnel.




Overview

In India, trading businesses have traditionally been dominated by a wide number of small unorganised players, largely in the form of family run businesses. Barring a few sectors such as oil & gas and energy, most of the trading business segments are extremely fragmented. However, the participation of organised players has been increasing gradually with relaxation in Government’s trade and investment policies. Some of the organised players have strong parentage, including large global players, that has recognized India as an important emerging market and its positioning in the global commodity trade. Besides having benefits of diversification, such players benefit from the strong risk management practices, deep understanding of global commodity markets and ability to withstand inherent business risk, given the considerable parentage support.

Key Determinants

Business Risk

  • Nature of Activity(ies)/Product(s)
  • Scale & Market Position
  • Level of Diversification
  • Level of business integration
  • Market Risk
  • Material Sourcing
  • Marketing Network
  • Regulatory Risk
  • Counterparty/Credit Risk
  • Systems & Processes

Financial Position

  • Accounting Quality
  • Revenue growth & Profitability
  • Working Capital Intensity
  • Leverage, Cash Flows and Coverage Indicators
  • Tenure Mismatches and Risk Relating to Interest Rates and Refinancing
  • Liquidity Position & Adequacy of Future Cash Flows
  • Financial Prudence

Management Profile

  • Promoters and Management Quality
  • Past Track Record
  • Capability Under Stress
  • Resourcefulness

Industry Scenario (for major industries, if the entity is in multiple products)

  • Characteristics
  • Key Factors
  • Linkage with Global Market, if any
  • Performance
  • Outlook


Each of these key determinants are explained below for the issuers, investors and other key market participants to understand the approach adopted by Infomerics in assessing various risks associated with the entities in the Industry. This methodology does not include an exhaustive treatment of all factors that are reflected in ratings, but enables to understand the rating considerations that are most important.

Business Risk

In line with the rating methodology for most of the other corporate sectors, assessment of a trading company’s scale, market position and business diversification play an equally important in reflecting a company’s competitive strength in the markets it serves, its bargaining power with suppliers and customers. The line of business the company is engaged in and whether the company is in multiple products – that also assumes considerable significance. In India, trading has traditionally been a fragmented business.

In India, most of the trading businesses have traditionally been managed by family run businesses. Such business outfits, though have vast experience in their fields, but generally lack strong market position and even diversification. Such business traits may however vary from business to business. For instance, the share of organized segment in trading of agricultural commodities, especially rice has attained a reasonable share of the market over the years, while some of the businesses especially metal trading etc. continue to remain highly fragmented. With significant export opportunities, many of the players have gradually attained meaningful scale and market position in agricultural commodity trading and have also explored both backward & forward integration measures to strengthen their business profiles.

Nevertheless, given the unorganized and fragmented nature of trading business in India, the importance of scale and market position may command different weighting across sectors and qualitative factors such as experience of the promoters and their understanding of the business may be acknowledged while assessing the business risk. Some of the key parameters analysed include:-

  • Level of trading volumes;
  • Relationship with suppliers (producers, farmers etc.);
  • Relationship with customers, share of business & bargaining power;
  • Presence – Regional or Nationwide;
  • Customer concentration;
  • Presence in backward supply sources or front-end marketing/distribution.

Companies that score highly on the above parameters are often able to source products at competitive prices, spend less on logistics and provide quicker delivery of products. As a result, companies with larger market share are able to generate higher margins over time by exploiting any regional discrepancies in price and short-term imbalances in supply and demand.

Apart from enjoying strong market position and diversification, trading businesses also strengthen their business profile by vertically integrated their operations. While backward integration measures prima facie add strength to a company’s business model, the extent of investments required in backward integration and the ability of a company gain critical importance in an attempt to transform a business model. As a result, certain businesses by their very nature have limited vertical integration opportunities. Thus, the approach will depend on the sector the business belongs to and follows a comprehensive benchmarking evaluation with peer group, while assigning ratings.

One of the key risks which trading companies face is the market risk arising out of volatility in commodity prices which may be influenced by trends in international commodity prices, demand-supply dynamics and macro-economic trends. Exposure to a commodity is either taken through physical possession or through financial derivatives and the risk may be hedged through back-to-back transactions or through counter purchase agreements on local/global exchanges. In assessing market risk, the evaluation is done on the company’s trading and hedging strategies, management’s track record in the business, volatility in earnings from its core business segments and longevity of the company’s operations in each of its major market segments. In addition, the extent of market risk in a business is also influenced by inventory holding period.

After market risk, the other prominent challenge that trading companies face is the potential change in regulations related to commodity trading. In India, the regulatory environment is fairly stringent, restricting free trade, sourcing, warehousing and even pricing of essential commodities. In an attempt to strike a balance between the welfare of the agricultural community and ensuring supplies at competitive rates, the Government also engages directly in sourcing and pricing (by setting minimum support prices) of essential commodities. Besides, the Government also implements restrictions in imports/exports from time-to-time depending upon the prevailing market conditions. Import duties are often altered to align with the interest of the local industries. Such risk expose companies engaged in trading of essential commodities to regulatory risk further emphasizing the importance of diversification. Given these considerations, detailed analysis of the regulatory framework is carried out and appropriate adjustments are made to the analytical framework for trading companies.

Involvement of multiple counterparties in trading transactions also exposes a company to credit risk, and necessities a comprehensive credit risk management system for identifying, assessing and monitoring credit risk with respect to their customers and suppliers. Credit risk can be mitigated through managing counterparty exposure through risk weighted limits and customized credit terms determined. Additional risk mitigants may include third party guarantees, collateral agreements, margin deposits and trade insurance measures. The implementation of such measures in a tightly monitored environment is favourably considered.

The trading companies are exposed to multiple other risks across the supply chain, including but not limited to, risk of loss or damage during storage or transit, foreign exchange risk or events of political risks. In addition, political risk insurance provides cover for events such as war, export restrictions, seizure or blockage of funds, prohibition of transfers in foreign currency, among others. The evaluation is based upon the importance given by a company to these risks and is reflected by its insurance and forex policies.

Financial Position

In trading business, the accounting quality assumes high significance as most of the players in this segment are from unorganised sector. Given that, it is necessary to assess the typical financial parameters like growth in revenue & profit level, profitability & trend, capital structure & leverage, liquidity position & adequacy of cash flow with reference to debt servicing and meeting other financial obligations. In assessing a company’s credit profile, analysis is made on the financial leverage on both unadjusted and adjusted basis. The two material adjustments applicable to the calculation of adjusted ratios include a) impact of operating leases (related to warehouse leases, vessel chartering etc.) and loans from promoters/group companies.

These companies are generally working capital intensive, given the nature of operations, and hence, how they manage the working capital plays a very dominant role for the purpose of assessing the liquidity position. In India, trading firms generally rely on banking system to meet their working capital requirements and have limited access to capital markets. Given the stringent lending norms, access to bank funding at times becomes a time consuming process, especially for start-up or fast-growing companies, resulting in liquidity issues or even delays in timely servicing of debt obligations. Further, as the importance given to financial planning & financial management is not very formalised, it is necessary to critically assess the financial prudence of the management. It is observed that most of trading businesses in India being family run tend to rely on promoter funding (usually in the form of loans) in addition to bank borrowings. As part of working capital management, companies also discount receivables. In most cases, such trade receivable financing is not recognized on a company’s balance sheet. Thus, such financing arrangements are considered as part of debt.

Given the critical importance of liquidity in this industry, we consider management’s approach and track record on proactively maintaining sufficient excess liquidity to absorb any reasonable increase in commodity prices or other events that could stress liquidity.

Management Profile

All debt ratings necessarily incorporate an assessment of the quality of the issuer’s management, as well as the strength and weaknesses arising from an issuer being part of a conglomerate or large group. In case, the issuer is among the stronger entities within the group, its past track record and future plans in supporting other group companies are analyzed. Resourcefulness of promoters also plays a key role in assessing the creditworthiness of the entity. Usually, a detailed discussion is held with the management to understand the business objectives, plans and strategies, besides the outlook on the issuer’s industry. Some of the other points assessed are:-

  • Experience & Commitment of the promoter/management in the line of business
  • Management’s policies on leveraging and hedging commodity & foreign exchange risk
  • Growth plans, investments/acquisition plans in new areas/projects
  • Business & Financial strengths of other companies within the group

Apart from quality and experience of management, assessment of corporate governance, quality of financial reporting and information disclosures are given considerable weightage while assigning ratings. The assessment of these factors can be highly subjective and variable over time. Ratings may include additional factors that are difficult to quantify or that only have a meaningful effect in differentiating credit quality in some cases.

Industry Review

  • Characteristics
  • Key Factors
  • Linkage with Global Market, if any
  • Performance
  • Outlook

Depending on the entity’s participation, whether in single product or multiple products, the major industries are evaluated in terms of characteristics like whether fragmented or being managed by few players and the key factors in terms superiority or limitations. It is also evaluated as to whether the particular industry is domestic oriented or it has linkage with the global market, in which event the demand-supply situation and its implications in the overseas front impact the particular industry. Infomerics also evaluates the performance of the industry in terms of growth, profitability & trend, price volatility and so on. Infomerics also tries to assess the outlook of the industry in the near-term and the long-term depending on the nature of debt instrument/borrowing facility being rated.

Rating Methodology for Service Sector Entities

Overview

The services sector is not only the dominant sector in India’s GDP, but has also attracted significant foreign investment flows, contributed significantly to exports as well as provided large-scale employment. India’s services sector covers a wide variety of activities such as trade, hotel & restaurants, transport, storage and communication, real estate, business services, community, social & personal services.

Key Determinants

Business Risk Profile

  • Market Position
  • Revenue and Client Diversification
  • Contract Mix and Billing Rates
  • Geopolitical Risk associated with Outsourcing
  • Manpower Utilisation, Attrition and Training
  • Systems, Processes and Compliance
  • Event Risk

Financial Soundness

  • Revenue growth& Profitability
  • Foreign Currency related Risk
  • Working Capital Intensity
  • Leverage, Cash Flows and Coverage Indicators
  • Tenure Mismatches and Risk Relating to Interest Rates and Refinancing
  • Debt Servicing Track record
  • Adequacy of Future Cash Flows
  • Accounting Quality

Management Strength

  • Promoters and Management Quality
  • Past Track Record
  • Capability Under Stress
  • Financial Prudence
  • Resourcefulness

Industry Scenario

  • Characteristics
  • Key Factors
  • Strategic Position in the Economy
  • Linkage with Global Market, if any
  • Performance
  • Outlook

Each of these key determinants are not exhaustive by themselves, but enables to understand the rating considerations that are most important. The credit ratings assigned by Infomerics are a symbolic representation of its opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at following a detailed evaluation of all the aforesaid factors with major emphasise on issuer‘s business and financial risks, its competitive strengths, its likely cash flows over the life of the instrument being rated and the adequacy of such cash flows vis-à-vis its debt servicing obligations.


Rating Methodologies - Banks

The rating methodologies developed by Infomerics for evaluation of banks comprise of qualitative and quantitative factors, the details of which are described below.

The Qualitative Factors that are found critical in the rating process are:

a) Operating Environment

The assessment of a bank’s operating environment is one of the most important parameters for the credit risk evaluation of a bank, as it could affect growth, asset quality and its earnings. The operating environment of a bank is studied through an analysis of the prevailing economic conditions, growth prospects (GDP growth rate), the likely deposits and credit growth, structural constraints in the economy (such as a large fiscal deficit and the necessity of banks to invest in Statutory Liquidity Ratio [SLR] instruments) as well as the impact of economic and regulatory environment on the credit risk profile. Infomerics also evaluates the likely policy changes to combat these challenges. Additionally, political risks and the legal system of the country are also evaluated to assess the asset quality of banks as well as their ability to recover from delinquent accounts. An evaluation of the structure of the financial market, stages of development and intensity of competition forms an important part of the evaluation of a bank’s operating environment.

b) Ownership Structure and Government Support

The Indian banking system consists of public sector banks, private sector banks, foreign banks, cooperative banks and regional rural banks. While comfort is drawn from the sovereign ownership of public sector banks, the credit view on some of the private sector banks would depend on the ability of the bank to raise capital from promoters / other key shareholders, as and when required. Also viewed positively is public sector bank with GOI shareholding well in excess of 51%, as it would have greater flexibility to raise capital by diluting GOI‟s shareholding.

c) Management Quality

Infomerics lays special emphasis on governance issues, quality of management, systems & policies, shareholder expectations, the strategy followed to manage these expectations and accounting quality, as these aspects form the foundation of a bank’s credit risk profile. The composition of the board, frequency of change of CEO/MD and the organisational structure of the bank are critically examined. The bank's strategic objectives and initiatives in the context of resources available, its ability to identify opportunities and track record in managing stress situations are taken as positives. In addition, evaluation is done on the quality, depth, timeliness and relevance of information available to the banks management. The analysis of system adequacy encompasses the quality of the communications network, level of computerisation & integration within the bank, systems for accounting control, management information for monitoring performance, business development and statutory reporting. The extent of frauds committed in the bank is viewed as an indication of the inadequacy of the control system. The evaluation focuses on the adoption of modern banking practices and systems, capabilities of senior management, personnel policies and extent of delegation of powers. The track record of labour relation is also examined.

d) Risk Management

A careful evaluation of the risk management policies of the bank is conducted, as it provides an important guidance for the future liquidity, profitability, asset quality and capitalisation of the bank concerned. The risk management of the bank is evaluated for credit risk, market risk, operational risk, foreign currency risk and interest rate risk. Credit risk management is evaluated by examining the quality of appraisal, monitoring & recovery systems and the prudential lending norms of the bank. The bank's balance sheet is examined from the perspective of interest rate sensitivity and foreign exchange rate risk. Interest rate risk arises due to varied maturity of assets and liabilities and mismatch between the floating and fixed rate assets and liabilities. Also being examined is the extent to which the bank has assets denominated in one currency with liabilities denominated in another currency. The analysis is also done on the derivatives and other risk management products used in the past and implication of these deals are also examined. The evaluation of a bank’s risk management focusses on its ability to assess, control, mitigate and disclose the aforesaid risks. This is done by evaluation of norms &^ tolerance limits, roles & responsibilities, relative importance and independence of risk function as compared to operating lines and systems to implement the risk management framework.

e) Compliance with statutory requirements

A well regulated and supervised system is the backbone for credibility and stability of banks even when the operating environment is unfavourable. The track record of the bank in complying with regulatory compliances like SLR/CRR and priority sector lending norms as specified by the RBI are examined.

f) Accounting Quality

The rating is based on the audited financial data submitted by the issuer. Consistent & fair accounting policies are a pre-requisite for financial evaluation and peer group comparisons. Further, the RBI has also issued prudential norms for Banks specifying the accounting methods to be used for income recognition, provisioning for bad and doubtful advances, and valuation of investments. In evaluating Bank’s accounting quality, the review is made with regard to the Bank’s accounting policies, notes to the accounts, and auditors’ comments in detail. Deviations from the Generally Accepted Accounting Practices are noted and the financial statements of the Bank are adjusted to reflect the impact of such deviations.

g) Size and Market Presence

The scale of branch network of a bank determines its capacity & ability to grow, while maintaining reasonable risk adjusted returns and sustenance of earnings with resilience. Hence, the strength of a bank in terms of scale of operations vis-à-vis branch networking and market share for various activities at the pan-India level alongwith business niche, positioning with reference to competition are evaluated. Brand recognition, complexity of key areas of work and special government support or privileges as compared to other banks are also captured.

Quantitative Factors

as enumerated below cover a detailed review of key financial performance parameters and stability.

a) Asset Quality

Asset quality holds the potential to impact earnings (higher NPAs could dilute the yields and necessitate higher credit provisions) and capital (lower earnings could slow down the internal capital generation or in extreme situations [loss] could weaken the capital). The evaluation of asset quality begins with the examination of the bank’s credit risk management framework. The quality of credit administration as reflected in design and implementation of appraisal and loan pricing methodologies and adherence to periodic review are examined. The overall asset quality is examined by evaluating the sector by sector loan and off-Balance Sheet exposures. The bank's experience of loan losses and write off/provisions are studied carefully. The percentage of assets classified into standard, sub-standard, doubtful or loss and the track record of recoveries of the bank are examined closely. The portfolio diversification and exposure to troubled industries/areas is evaluated to arrive at the level of weak assets. The extent of diversification is also an important indicator of a bank’s asset quality. In assessing diversification, the common factors include loan mix, portfolio granularity, geographical diversification and borrower profile. Restructured assets in banks total exposure are closely examined to arrive at the potential NPAs of the bank. Also evaluated the risk of devolvement of obligations on a bank from its underperforming subsidiaries, if any. The devolvement may arise legally or due to the publicly perceived moral obligation of a parent to support a subsidiary organisation.

b) Funding sources

Resource base of the bank is analysed to assess the cost & composition. Deposits constitute core funding source of a bank. Higher proportion of low cost deposits in total deposits is viewed as positive and also examined is retail-wholesale deposit mix. Deposit growth rates and their rollover rates are also analysed. Average as well as incremental cost of funds is examined in the context of prevailing interest rate regime. Ability of the bank to raise additional resources at competitive rates is examined critically.

c) Liquidity Management

Liquidity plays an important role in the stability of the bank. Lack of liquidity can lead to a bank’s failure, while strong liquidity can help even an otherwise weak institution to remain adequately funded during difficult times. The internal and external sources of funds to meet the bank's requirements are examined. The degree of the bank‟s reliance on volatile funds in relation to total assets is examined. Some short-term funding sources are more sensitive than others to adverse developments. Infomerics views inter-bank funding by domestic banks and domestic deposits by non-bank depositors in descending order of confidence The liquidity risk is evaluated by examining the assets liabilities maturity (ALM) profile, deposit renewal rates, proportion of liquid assets to total assets and the degree to which core assets (those which are relatively illiquid) are funded by core liabilities. The short term external funding sources in the form of refinance facilities from RBI and the inter-bank borrowing limits available along with CRR and SLR investments are important sources of reserve liquidity.

d) Earnings Profile

A bank’s ability to generate adequate returns is important from the perspective of its shareholders as well as debt subscribers. The purpose of the evaluation here is to assess the level of future earnings and quality of earnings of the Bank concerned by analysing its interest spreads, fee income, operating expenses and credit costs. The income composition of the bank is examined by segregating it into those generated from fee based and fund based activities. A large fee income allows greater diversification, which, in turn, can improve a bank’s resilience of earnings and earning profile. The trading income of the bank is also evaluated to assess the sustained level of income / losses under an adverse interest rate scenario. Core earnings are also identified by excluding non-recurring income from total income. Each business area that contributes to the core earnings is evaluated for risks as well as for its earning prospects and growth rate. Profitable operations are essential for banks to operate as an ongoing concern. Yield on business assets and on investments are viewed in conjunction with cost of funds to arrive at the spreads earned by the bank. Net interest income (NII) and Net interest margin (NIM) are evaluated to arrive at the spread available to the Bank. Operating efficiency is also examined in terms of expense ratios. Quality of bank's earnings is also impacted by the level of interest rate and foreign exchange rate risks that the bank is exposed to. The overall profitability is reviewed in terms of return on assets (ROA), return on net worth and return on equity (ROE).

e) Capital Adequacy

Capital provides the second level of protection to debt holders (earning being the first) and, therefore, its quality and adequacy (in relation to the embedded credit, market and operational risk) is an important consideration for ratings. Capital Adequacy is a measure of the bank’s ability to meet its obligations relative to its exposure to risk and also relates to the degree to which the bank's capital is available to absorb possible losses. It also indicates the ability of the bank to undertake additional business. The evaluation by Infomerics factors the conformity of the bank to the regulatory guidelines on capital adequacy ratio. Higher proportion of Tier I (core capital) in the overall capital is viewed favourably. During the rating process, the expected erosion of capital and its impact on the capital adequacy is examined factoring additional provisioning for NPAs, possible losses from restructured assets and possible losses from other weak assets.

f) Peer group analysis

Infomerics carries out peer group comparison on each of the above discussed parameters with the bank’s performance. Detailed inter-bank analysis is done to determine the relative strengths and weaknesses of the bank in its present operating environment and any impact on it, in future. All relevant quantitative and qualitative factors are considered together, as relative weakness in one area of the bank's performance may be more than adequately compensated for by strengths elsewhere. However, the weights assigned to the factors are different for short term ratings and long term ratings. The intention of long term ratings is to look over a business cycle and not adjust ratings frequently for what appear to be short term performance aberrations. The quality of the management and the competitiveness of the bank are of greater importance in long term rating decisions.

Conclusion

The rating process ultimately determines the likelihood of the rated debt obligation being serviced in full and on time. The assessment of management quality, the bank's operating environment and its role in the nation's financial system are used to interpret current data and to forecast how well the bank is likely to be positioned in the future. While several parameters are used to assess the risk profile of a Bank, the relative importance of each of these qualitative and quantitative parameters can vary across banks, depending on its potential to change the overall risk profile of the bank concerned. The final rating decision is made by the Rating Committee after a thorough analysis of the bank's position over the term of the instrument with regard to business fundamentals.

Financial & Operating Ratios Considered

In order to evaluate the aforesaid quantitative factors, various financial & operating ratios are calculated to see how a particular bank is placed over a three years time horizon on a standalone basis, as also with reference to its peers:


Growth

(i) Total Income

(ii)    Total Interest Income

(iii)    Treasury Income

(iv)    Profit After Tax (PAT)

(v)    Deposits

(vi)    Advances

(vii)    Total Assets

Profitability

(i)    Operating Margin (%)

(ii)    PAT Margin (%)

(iii)    Return on Investment (RoI)

(iv)    Interest Spread (%)

(v)    Net Interest margin (%)

(vi)    Net Spread (%)

(vii)    Return on Total Assets (ROTA - %) - before provisions

(viii)    ROTA (%)

(ix)    Return on Net Worth (RONW - %)

(x)    Treasury Profit/Profit Before Tax (PBT)

(xi)    Interest income /Average interest earning assets (%)

(xii)    Interest exp/Average interest bearing liabilities (%)

(xiii)    Operating Expenses/Average Total Assets (%)

(xiv)    Interest coverage - before provisions (times)

(xv)    Interest coverage - after provisions (times)

(xvi)    Cost of deposits (%)


Gearing

(i)    Total Debt / Networth (times)

(ii)    Capital adequacy (%)

Asset Quality

(i)    Gross Net Performing Assets (NPAs - %)

(ii)    Net NPAs (%)

(iii)    Net NPAs/ Networth (%)

(iv)    Provision Coverage/br> (v)    Credit Deposit Ratio

The trend of a bank’s performance may be measured in terms of its year-to-year growth majorly in respect of its revenue, profit volume and business level (which is defined by aggregate of its deposits & advances). Although these parameters are interlinked, they have also standalone bearing on bank’s performance. Nowadays, the investment/treasury activities also play a dominant role, besides the traditional lending function, and hence, they impact the overall asset level and the revenue of a bank. Therefore, there is a need to assess the growth pattern of treasury income and total assets.

The ultimate success of a bank, its cash flow, long-term sustainability and ability to absorb shocks in case of adversities depends upon its ability to generate profit. Although the usual profitability parameters like Operating Profit Margin and PAT Margin throw significant light towards that, much more meaningful evaluation is possible if various derivative based ratios are looked at. As perennially and even now, the major activities of bank centre around raising money from public and deployment of the same by way of advances, it is important to ascertain the overall borrowing cost and the overall earning percentage, the difference of which indicate the Interest Spread. In ascertaining the overall borrowing cost, the cost of deposit as well as the profile of deposit of a particular bank also assume significance as deposits are the main source of funds to a bank. But in order to evaluate the net interest earning on assets which are deriving such income, Net Interest Margin is perceived to be more candid indicator. While these two items like overall borrowing cost and the overall earning are, to a great extent, the outcomes of market forces, the bank is left with the option to contain the overhead to improve overall bottomline which is represented by Net Spread. Various other parameters are also calculated to ascertain the overall return with reference to total assets and capital employed. As the provision made for non-performing assets is more on account of legacy and generally not the result of the particular year’s lending policy and/or decisions, so the ROTA is assessed both before provisions and after provisions. RONW indicates the net earning ability of a bank on best use of its networth. If the company is highly leveraged, then the PAT will be lower due to higher interest expenses. Interest coverage implies the interest servicing ability of a bank.

As for ascertaining the capital structure and the leverage of a bank, more than the traditional gearing ratios the Capital Adequacy is looked at to measure the adequacy of capital vis-a-vis its risk weighted assets. The minimum Capital Adequacy ratio is stipulated by the central bank based on its empirical analysis considering the domestic economy and the global best practices. Banks being the financial outfits with funds are main input, they are expected to have higher gearing ratios as compared to manufacturing companies.

The asset quality of a bank is the major broad parameter indicating the performance of a bank, These are measured in terms of proportion of gross NPAs to gross advances and net NPAs to net advances. While gross NPA percentage indicates the real asset quality of a bank, the net NPA percentage is calculated after factoring the provision made for NPAs. However, the Net NPAs to Networth signifies the ability of the company to absorb the impact of NPAs, while Provision Coverage indicates the extent of provisions made in respect of Gross NPAs. The credit-deposit ratio stands for deployment of deposits in the form of advances.




Rating Methodology – Financial Institutions/NBFCs

The rating methodologies developed by Infomerics for evaluation of banks comprise of qualitative and quantitative factors, the details of which are described below.

Qualitative Factors

a) Overview and Operating environment

Non-Banking Finance Companies (NBFCs) play an important role in the Indian financial market. While the Reserve Bank of India (RBI) regulates both NBFCs and banks, there are some significant differences in the regulatory treatment, with NBFCs being given greater flexibility in governance structure and operational matters, and being allowed to lend independent of priority-sector targets and of statutory reserve requirements. However, at the same time, there are regulatory restrictions on the bouquet of services that NBFCs can offer and on their funding options. Normally NBFCs lend for vehicle loans, personal loans, loan against property/shares, corporate loan, etc.

The operating environment has a significant bearing on an NBFC’s credit rating as it can impact its growth prospects and asset quality quite considerably. In assessing the operating environment, also looked at is the overall economic conditions, prospects of the industry related to the asset class being financed, and the regulatory environment. For instance, in the case of a commercial vehicle (CV) financing NBFC, the level of economic activity and freight rates are very important, just as the outlook on real estate is important for a home finance company, from the perspective of both asset creation and asset quality.

For an NBFC, regulatory changes can significantly impact (either positively or negatively) credit losses. For instance, the establishment of the credit information bureau has helped lenders take informed credit decisions, while The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI) has helped them recover real estate backed loans more efficiently; at the same time, recoveries from unsecured asset classes and vehicle loans have been hit with the regulator taking a strict view of the recovery procedure followed by some financiers. Intensity of competition has a significant bearing on the credit profile of an NBFC, given that the prevailing or anticipated competitive intensity would influence the company’s growth prospects, earnings and management strategy. Our evaluation focuses on the current level of competition as well as the attractiveness of the segment for potential competition by assessing several factors including growth potential, entry barriers and risk-adjusted returns

b) Promoters

Ownership structure could have a key influence on an NBFC’s credit profile in that a strong promoter and strategic fit with the parent can benefit an NBFC’s earning, liquidity and capitalisation, and hence its credit profile. In assessing an NBFC’s ownership structure, the parameters examined include, among others: the credit profile of the promoter, shareholding pattern of the NBFC, operational synergies of the NBFC with its promoter, level of involvement of promoter in the NBFC and level of commitment, and track record of the promoter in providing fund support.


c) Management quality

Quality of management, systems and policies, shareholder expectations and the strategy followed to manage these expectations, and accounting quality are the foundation stones on which an NBFC’s credit risk profile is built. The importance of these factors is even higher for a new NBFC, one with a shorter track record, or one with a changing business profile. The composition of the board, frequency of change of CEO and the organisational structure of the company are critically examined. The company's strategic objectives and initiatives in the context of resources available, its ability to identify opportunities and track record in managing stress situations are taken as positives. The extent of digitisation of the operations and adequacy of the information systems used by the management are evaluated. The evaluation focuses on the adoption of modern practices and systems, capabilities of senior management, personnel policies and extent of delegation of powers.

d) Risk Management

A careful evaluation of the risk management policies of the NBFC is done as that provides important guidance for assessing the impact of stress events on the liquidity, profitability, and capitalisation of the company concerned. Also compared is the underwriting policies of the NBFC concerned with the best practices in the industry to make an assessment of the company’s risk profile. The process of risk profiling also involves evaluating the NBFC’s business sourcing practices (in-house vs. outsourced), besides its recovery and monitoring systems.

e) Compliance with statutory requirements

The track record of the company in complying with regulatory requirements of RBI are examined.

f) Accounting Quality

Consistent and fair accounting policies are a prerequisite for financial evaluation and peer group comparisons. By virtue of being incorporated under the Companies Act, 1956, NBFCs are required to follow the Accounting Standards prescribed by the Institute of Chartered Accountants of India. Further, the RBI has also issued prudential norms for NBFCs specifying the accounting methods to be used for income recognition, provisioning for bad and doubtful advances, and valuation of investments. In evaluating an NBFC’s accounting quality, the review is made with regard to the company’s accounting policies, notes to the accounts, and auditors’ comments in detail. Deviations from the Generally Accepted Accounting Practices are noted and the financial statements of the NBFC adjusted to reflect the impact of such deviations.

g) Size and Market Presence

For an NBFC, its franchise strength determines its capacity to grow while maintaining reasonable risk- adjusted returns, and to maintain resilience of earnings, thereby facilitating predictability of its future financial performance. It may be noted that an NBFC with a significant market share and a niche player can both have a defensible franchise (The bigger company on the strength of its standing in the overall market and the smaller one on account of its unique offering or its strong relationship with the key participants in the credit chain of the target segment), which could in turn benefit their credit profile. As for size, typically it is seen in relation to an NBFC’s loan mix and has a bearing on the company’s competitive position, diversity, credit risk concentration, stability of earnings, and financial flexibility.

Qualitative Factors

a) Asset Quality

Asset quality plays an important role in indicating the future financial performance of an NBFC. Asset quality holds the potential to affect earnings (higher NPAs could dilute the yields and necessitate higher credit provisions) and capital (lower earnings could slow down the internal capital generation or in extreme situations (loss) could weaken the capital).The evaluation of asset quality begins with the examination of the NBFC’s credit risk management framework. Assessment is also made of credit risk concentration, trend in viability of customers, trend in delinquencies, Gross NPA percentage, Net NPA percentage, and Net NPAs in relation to Net Worth. The NBFC's experience of loan losses and write off/provisions are studied carefully. The percentage of assets classified into standard, substandard, doubtful or loss and the track record of recoveries of the NBFC is examined closely. The portfolio diversification and exposure to troubled industries/areas is evaluated to arrive at the level of weak assets. In assessing diversification, the common factors include loan mix, portfolio granularity, geographical diversification and borrower profile. Restructured assets in NBFC’s total exposure are closely examined to arrive at the potential NPAs of the NBFC.


b) Resource Profile

Resource base of the NBFC is analysed in terms of cost and composition. Proportion of deposits /loans/bonds in funding mix is examined. Deposit growth rates and their rollover rates are also analysed. Average as well as incremental cost of funds is examined in the context of prevailing interest rate regime. Ability of the NBFC to raise additional resources at competitive rates is examined critically.


c) Liquidity Management

It is important for an NBFC to maintain a favourable liquidity profile for the smooth functioning of its funding activity (fresh asset creation) and to honour its debt commitments in a timely manner. It is also important that an NBFC manage its interest rate risk, as the same could impact its future profitability. In assessing an NBFC’s liquidity profile, the evaluation is done on the company’s policy on liquidity, the maturity profiles of its assets and liabilities, the asset-liability maturity gaps, and the backups available to plug such gaps. The evaluation also focuses on the diversity of the NBFC’s funding sources and their quality (i.e. availability of these sources in a stress situation). The short term external funding sources in the form of unutilized lines of credit available from banks, etc along with directed and other investments if any are important sources of reserve liquidity.


d) Profitability

The purpose of the evaluation here is to assess the level of future earnings and the quality of earnings of the NBFC concerned, which is done by looking closely at the interest spreads, fee income, operating expenses, and credit costs. The evaluation of an NBFC’s profitability starts with the interest spreads (yields minus cost of funds) and the likely trajectory of the same in the light of the changes in the operating environment, the company’s liquidity position, and its strategy. The ability of the NBFC to complement its interest income with fee income is also assessed. A large fee income allows greater diversification, which in turn can improve the resilience of earnings, thereby improving an NBFC’s risk profile. After assessing the income stream, the evaluation is done on the NBFC’s operating efficiency (operating expenses in relation to total assets, and cost to income ratio) and compares the same with that of its peers. Finally, the credit costs are estimated on the basis of the company’s asset quality profile, and the profitability indicators compared across peers. Importantly, a very high return on equity may not necessarily translate into a high credit rating, given that the underlying risk could be very high as well, and being so it could be more volatile or difficult to predict.


e) Capital Adequacy

Capital Adequacy is a measure of the NBFC’s ability to meet its obligations relative to its exposure to risk and also relates to the degree to which the NBFC’s capital is available to absorb possible losses. It also indicates the ability of the NBFC to undertake additional business. Riskiness of the product and granularly of the portfolio are factors that have a significant bearing on the amount of capital required to provide the desired degree of protection to an NBFC’s debt holders. The evaluation by Infomerics factors the conformity of the NBFC to the regulatory guidelines on capital adequacy ratio. Higher proportion of Tier I (core capital) in the overall capital is viewed favorably. During the rating process, the erosion of capital arising out of additional provisioning for NPAs is examined. Also factored impact of mark to market gains/losses from investment portfolio on capital adequacy.


f) Peer-group analysis

Infomerics also carries out peer comparison on each of the above discussed parameters with the NBFC’s performance. Detailed inter-company analysis is done to determine the relative strengths and weaknesses of the NBFC in its present operating environment and any impact on it, in future.

All relevant quantitative and qualitative factors are considered together, as relative weakness in one area of the NBFC's performance may be more than adequately compensated for by strengths elsewhere. However, the weights assigned to the factors are different for short term ratings and long term ratings. The intention of long term ratings is to look over a business cycle and not adjust ratings frequently for what appear to be short term performance aberrations. The quality of the management and the competitiveness of the NBFC are of greater importance in long term rating decisions.


Conclusion

The rating process ultimately determines the likelihood of the rated debt obligation being repaid in full and on time. The assessment of management quality, the NBFC's operating environment and its role in the nation's financial system are used to interpret current data and to forecast how well the NBFC is positioned in the future. The final rating decision is made by the Rating Committee after a thorough analysis of the NBFC's position over the term of the instrument with regard to business fundamentals.


Financial & Operating Ratios

In order to evaluate the aforesaid quantitative factors, various financial & operating ratios are calculated to see how a particular NBFC and/or FI is placed over a time horizon of three-five years on a standalone basis as also with reference to its peers:


Growth

(i)    Total Income

(ii)    PBT

(iii)    Profit After Tax (PAT)

(iv)    Total Assets

(v)    Total Capital Employed

(vi)    Tangible Networth


Profitability

(i)    PAT margin (%)

(ii)    PBT margin (%)

(iii)    Interest income / Avg. interest earning assets

(iv)    Interest expenses / Avg. borrowed funds

(v)    Interest spread (%)

(vi)    Net Interest margin (%)

(vii)    Operating expenses (before prov. & write-offs) / Average capital employed

(viii)    ROCE (%)

(ix)    Cost of capital (%)

(x)    Net spread (%)

(xi)    RONW (%)

(xii)    ROTA (%)

(xiii)    Return on Total Assets (ROTA - %) - before provisions

(xiv)    Interest coverage (before prov. & write off)

(xv)    Interest coverage (after prov. & write off)


Gearing

(i)    Capital adequacy (%)

(ii) Overall debt equity (incl. guarantees for securitisation)

(iii)    Overall debt equity (excl. guarantees for securitisation)


Asset Quality

(i)    Gross Net Performing Assets (NPAs - %)

(ii)    Net NPAs (%)

(iii)    Net NPAs/Networth (%)

In order to assess the performance of an NBFC/FI with respect to its growth trend, we look at Total Income, PBT & PAT, Total Assets, Total Capital Employed and Tangible Networth. While the level of business, as reflected in terms of Total Assets and Total Capital Employed, indicates the ability of an NBFC/FI to generate revenue, these are not exhaustive by themselves. This is so because proper deployment of assets also play an important role in enhancing the total income. While, to an extent, the profit trend is the fallout of trend in revenue, the ability of the entity to contain its overhead & establishment expenses and to source and deploy the funds go a long way in driving the profit.

The ultimate success of an NBFC and/or FI in terms of adequacy of cash flow, long-term sustainability and ability to absorb shocks in case adversities depends upon its ability to generate decent level of profit on continuous basis. Although the usual profitability parameters like PBT Margin and PAT Margin indicate a direction, many other profitability related ratios are assessed. For an asset-financing and lending NBFC and/or FI, the usual activity centres around competitive sourcing of funds and effective & gainful deployment of the same. In that context, it is important to ascertain the overall borrowing cost and the overall earning rate, the difference of which indicate the Interest Spread. But to evaluate the net interest earning on assets which are deriving such income, Net Interest Margin is considered as one of the most important parameters. However, the final assessment of net earning for an NBFC and/or an FI can be made in terms of net spread, being the difference between ROCE and Cost of Capital. While the overall borrowing cost and the overall earning rate are considerably driven by market forces, the capital structure of the NBFC and/or FI and the level of administration expenses play important roles in earning the Net Spread. Various other parameters are also calculated to ascertain the overall return with reference to total assets and networth. As the provision made for non-performing assets is more on account of legacy and generally not the result of the particular year’s lending policy and/or decisions, so the ROTA is assessed both before provisions and after provisions. Interest coverage implies the interest servicing ability of the NBFC and/or FI and it is the function of Profit Before Interest and Interest expense.

As for assessing the soundness of capital structure and the leverage position of an NBFC/FI, more than the traditional gearing ratio, the Capital Adequacy is looked at to measure the adequacy of capital vis-a-vis its risk weighted assets. The minimum Capital Adequacy ratio is stipulated by Reserve Bank of India based on its empirical analysis. Generally for NBFCs/FIs, the overall gearing ratio is higher vis-a-vis that of manufacturing companies in view of their business centering around funds. While computing the same, contingent debt on account of any guarantee provided for securitisation transactions as a matter of credit enhancement is also considered as debt as a matter of more conservative evaluation.

The asset quality of an FI and an NBFC (which is predominantly engaged in lending and/or asset financing activities) is a very critical performance parameter. These are measured as a proportion of gross NPAs to gross advances and net NPAs to net advances. While gross NPA percentage indicates the real asset quality, the net NPA percentage is calculated after factoring the provision made for NPAs. However, the Net NPAs to Networth signifies the ability of the company to absorb the impact of NPAs after provisions.



Rating Methodologies - State Finance

Introduction

Infomerics’ analysis of the credit worthiness of a State Government is carried out on a “stand alone” basis and centres on the ability and the willingness of the State Government to honour its financial obligations in a timely manner without the benefits of any additional external support. However the rating will reflect the degree of Central Government support, whether implicit or explicit, or if the form of support is fiscal (e.g. budgetary transfer) or financial (e.g., debt guarantees or credit enhancements).


The Case for rating Indian State Governments

The development of Indian capital markets is fast removing the notion of State Government debt being risk free in nature. The recent past has seen various State Governments walking on the edge of severe liquidity constraint. There also have been instances where State Governments raised money through special purpose vehicles set up for infrastructure projects, but channelled the resources to meet revenue expenditure. In its annual study on State Government Budgets, the Reserve Bank of India has reiterated that State Government guarantees are not substitutes for an effective credit appraisal and monitoring mechanism. In addition to the SPVs, there are many state government enterprises which borrow funds, mostly through public issue and/or private placement of Bonds.

In view of the above, there is a need for credit rating of State Governments in the Republic of India, which is more in the nature proxy/shadow rating; although the rating process and methodology are same with rating of direct borrowing programme of state government.


Rating Factors: Criteria

The rating analysis of State Government comprises both qualitative and quantitative factors. Generally, the qualitative factors include the characteristics of the institutional framework, political factors associated with inter-governmental relations, socio-economic profile, geographical superiority and other elements that offer an insight into the fundamentals of the state.

In terms of quantitative factors, Infomerics analyses States in relation to the trends and projections of public finances and debt level. The quantitative analysis offers mainly a prediction of the ability or capacity to pay financial obligations. Nevertheless, Infomerics recognises in its methodology that both the quantitative and qualitative factors can influence, either jointly or singly, state’s ability to pay its financial obligations.


The Administrative Factors

A study of the administrative framework is a fundamental and necessary beginning to Infomerics’s rating process. With a clear view of the inter-governmental relations, the processes will shift to other factors, including the socio-economic profile of the area, public finances, and debt position.

A detailed description of the state’s administrative hierarchy and types of public services available, quality of state officials will enable Infomerics to assess the degree of autonomy, demand for capital, and other fundamental credit factors.


Economic and Social Profile

Infomerics assesses the economic base of a state to evaluate the long-term potential for stability of its revenue structure during economic cycles, job-losses, employment shift in key industries and other situations. A diverse economy is a positive credit factor. Infomerics would evaluate any dominant employer or industrial sector, as its performance may potentially jeopardise the creditworthiness of the state.

Infomerics will view an state’s strategic importance such as the major commercial centre, proximity to ports, consumer and financial markets favourably. It will also include the availability of basic infrastructure resources such as power, transportation systems, health and waste water treatment facilities and modern telecommunication services.

Demographic trend is also a significant component of the rating analysis, especially for fund allocation for elementary & secondary education and public health. In addition, population characteristics can be decisive in terms of the magnitude of certain liabilities such as pension, the debt of hospital system run by the state, and fresh borrowings to finance substantial capital investments to meet the demands of growing population.


    Key Economic and Social Profile Indicators

  • Per Capita NSDP (Net State Domestic Product)
  • NSDP Composition
  • Literacy Rate
  • Rural Electrification Density
  • Density of roads and railways
  • Proximity to all-weather ports
  • Population growth rate
  • Population mix
  • Poverty Level
  • Urban Concentration
  • Per Capita sanctions & disbursements by Financial Institutions/Banks
  • Geographic advantage


Budgetary Factors

Infomerics evaluates the financial of the state to measure the degree of flexibility during times of economic stress. The ongoing liquidity of a state in meeting current obligations and debt servicing is a critical credit consideration. Other credit elements include revenue diversity, autonomy to raise taxes, ability to balance financial operations over the economic cycle, willingness to control expenses, cash flow management and the weight of capital investments on the fiscal performance of the entity. Consistent financial management and a tradition of conservative budgeting usually indicate a growing local economy.

In analysing the credit profile of State Governments, Infomerics acknowledges the nuances of Indian public finance and the dynamics of a federal economy. The presences of formulae based tax revenue sharing arrangement as enshrined in the tenets of the constitution imply a certain degree of robustness to state finances.

    Key Budgetary Indicators

  • Per Capita NSDP (Net State Domestic Product)
  • NSDP Growth Rate
  • Gross Fiscal Deficit / NSDP
  • Primary Deficit / NSDP
  • Debt / NSDP
  • Interest Payment / Revenue Receipts
  • O/s Guarantees / NSDP
  • State’s Own Revenues / Aggregate Expenditure
  • Capital Outlay / Gross Fiscal Deficit
  • State’s Own Tax Revenues / Revenue Expenditure
  • Internal Debt / Revenue Receipts
  • (Interest Payments and Pensions) / Revenue Receipts
  • Non Developmental expenditure / Revenue Receipts
  • Trends in Revenue and Expenditure


Economic Management

Strong budgetary numbers and a sound socio-economic base should translate into better economic performance for a State, either in the present or in the near expected future. This is partly the goal of any development oriented economic policy. This bears great importance in a federal democracy where economic results are the tools for the electorate to judge the performance of the legislature.



    Key Economic Management Indicators

  • Industrial Policy & Investor conduciveness
  • Deviation from Budgetary Targets
  • Trend in recourse to Ways-and-Means advances (WMA)
  • Performance of State level PSUs
  • Proportion of sick industrial units
  • History of defaults on guaranteed debt
  • Political and quasi-economic stability


Credit Rating of State Governments

It has been stated that both quantitative analysis and qualitative judgement are used to gauge the credit profile of State Governments. The qualitative judgement will take the quantitative analysis to its logical conclusion by including,

1.    Forecasting the Revenue and Capital account of State Government and performing a stress analysis on the budgetary indicators.

2.    Analysing the strength of the senior administrative team and its view towards crucial fiscal responsibility measures.

3.    The stability of a well defined economic policy.

4.    Adherence to the FRBM parameters.

Apart from this, the rating exercise will place great importance to key indicators and their behaviour under stress.


    Key Rating Indicators

  • Debt / NSDP
  • Interest Payment / Revenue Receipts
  • O/s Guarantees / NSDP
  • State’s Own Revenues / Agg. Expenditure
  • State’s Own Tax Revenues / Revenue Expenditure
  • (Interest Payments and Pensions) / Revenue Receipts
  • Non Developmental expenditure / Revenue Receipts
  • Trends in Revenue and Expenditure
  • Political and Quasi-economic instability

​Rating Methodology – Infrastructure Companies

Road Projects

Overview

The road projects under the Public Private Partnership (PPP) model are being awarded on Built Operate Transfer (BOT) basis. BOT is further segmented into BOT-Toll and BOT-Annuity basis. The projects are implemented through project specific Special Purpose Vehicles (SPVs) in which the debt is raised to fund part of the project cost. The main source of revenues for these SPVs is the toll revenue, which is used to meet the contractual obligations including operational and maintenance expenses, payments to NHAI (in case of negative grant/revenue share) and servicing of debt obligations.

The rating methodology developed by Infomerics for debt issues of road projects (RPs) is designed to facilitate appropriate credit risk assessment, keeping in view the characteristics of the Indian road sector. The methodology examines the broad parameters of the project based on the Information Memorandum (IM) submitted by the client. The following key risk areas are covered:


Sponsor Risks

Despite the non-recourse nature of the SPV, the financial strength of the sponsor is a key credit determinant given that apart from contributing promoter’s share in the form of equity capital and/or subordinated debt, the sponsor is also directly or indirectly responsible for ensuring financial closure of these projects. Further, during the pre-COD stage, most of the toll projects involve recourse to the sponsor for debt servicing as termination payments from the project owner are not available during this period. The presence of financially strong sponsor(s) lends comfort, basing on their ability to provide support to the SPV in case of any contingency or short-term cashflow mismatches.


Project implementation risk

The nature of the project and its scope in terms of By-pass, Lane expansion, additional bridge, road modernisation, etc are examined as the risks vary depending upon the scope of the work. Also of importance is location of the project which will determine the viability. A key component of the completion risk is the permitting risk which refers to a project’s ability to acquire all statutory clearances prior to the commencement of construction activity. Typically, for a road project this would include right-of-way acquisition, rehabilitation and resettlement, clearances from the Ministry of Environment and Forest (MoEF), Pollution Control Board and Railways, and clearances for shifting all utilities that lies in project area. The permitting risks are usually low where the project involves upgradation of an existing operating stretch, however such risks are significant where projects involve bypasses or involve construction of entirely new stretches, where considerable amount of land needs to be acquired.

Infomerics examines the extent of tie-up for finance. Also being evaluated is the vulnerability of the project cost and time overruns, and the promoter’s capability to raise additional resources to fund these over-runs. Further, factors such as difficult terrain, inadequate investments in construction equipment, weather and labour problems also contribute to construction delays and cost escalations. These risks are partially mitigated through strong fixed-price fixed-time EPC contracts with strong counterparties with adequate liquidated damage provisions for non-performance. Also being assessed is the financial and operational capabilities of the EPC contractor and its ability to meet the contractual commitments.

Also being evaluated is the quality of construction and robustness of the project design. Project owners usually lay down the design and quality parameters in the concession agreement. These parameters would need to be adhered to by the concessionaire and certified by the independent engineer before the stretch can be opened to the traffic. In many NHAI owned BOT road projects, there is a clause of provisional COD if at least 75% of the project stretch is completed and the remaining work is pending due to reasons attributable to the authority. Provisional COD gives the concessionaire the right to start partial tolling and protects the revenue loss in case of delays in project completion. Further, in many cases the authority also has to provide atleast 80% of the RoW before the commencement of the concession of the project. These provisions protect the concessionaire from loss of revenues on account of delays in handing over of the required RoW and mitigate the project execution risks to that extent.


Demand analysis, Competition and Toll pricing

The debt investors in toll road projects are primarily exposed to the risks associated with the build-up of traffic volumes and the user’s willingness to pay tolls as per the prescribed rates. The analysis especially focusses on traffic demand and potential variation of demand due to economic changes and competition. The linkage of demand to toll pricing and the users’ willingness to pay is also examined critically.

Demand analysis involves analysis of the toll road region in terms of economic strength and diversity. The projects which serve a captive demand, such as stretches which connect to port or city bypasses which relieve congestion levels, carry relatively lower levels of traffic risks. The regional wealth indicators like level of industrialisation, availability of facilitating infrastructure etc are examined. The analysis examines the level of commercialisation, level of business travel traffic which would be the mainstay for revenue generation. The viability of the project depends upon the assessment of demand which is critical as wrong estimation of demand or deterioration in the economic base would adversely affect viability and debt servicing capability of a project. Infomerics relies on independently conducted traffic studies to assess the future potential of the projects. The traffic studies are however suitably sensitised to assess the cash flow protection available to debt investors in case of shortfall in traffic levels. The nature and composition of traffic as well as volatility of traffic due to business cycles, natural factors (floods, landslides, etc), social unrest and escalation in fuel prices is studied critically.

A balance between commercial and private vehicle traffic is viewed favourably though commercial traffic tends to serve as a stabilising force. In case of commercial traffic, the toll burden is passed on to the customers and hence it is less sensitive to toll increases than private traffic. Normally, a diverse traffic mix cushions the impact of a decline in any one segment.

Toll roads are generally developed in areas with high traffic density to ease traffic congestion or cut down on distance between destinations. This justifies levy of tolls, either on account of savings in distance or time, or both. Toll roads in the initial years face little competition. The availability of alternate freeways and other competing modes of transport (such as railways) could lead to traffic diversion. Also development of toll-free roads can divert traffic away from a toll facility and disturb the projected traffic growth and subsequent revenues. It is therefore critical to examine the capital programmes of the appropriate state, regional and local authorities to factor in any possible competing facility. Covenants in the Concession Agreement (CA) which explicitly prohibit the government from setting up competing facilities up to a stipulated period will mitigate ‘diversion risk’ of the project to a large extent.

The toll pricing based on user’s ‘willingness to pay’ is criticall for the success of any road project. Typically, a toll road project would result in benefits in form of (i) savings in vehicle operating costs (VOC), (ii) savings in time and (iii) savings in distance covered. Savings in VOC is considered as the most important criteria in determining the users’ willingness to pay. The composition of traffic along the stretch and the sensitivity of various user segments towards payment of tolls are also being examined.

A Concession Agreement providing for an ‘automatic’ revision with pre-defined formula for revision in toll rates e.g. linkage to inflation index along with requisite authority to the project directors to implement toll rate revisions is considered as a positive for the project. An important prerequisite in this regard is favourable socio-political climate for revision of tolls and such decisions being shielded from normal political processes.


Evaluation of Concession Agreement (CA)

Concession Agreement (CA) between the project owner and the concessionaire defines the framework within which such projects operate. Such projects are usually implemented through special purpose vehicles (SPVs) which enable legal separation of the credit risk profile of the project from that of their sponsors. The concession period for such projects usually ranges between 15 and 30 years, dependent on the projected toll collections along the stretch. CA provides the mandate to implement the project and to levy and collect tolls. Hence, the terms of the CA are carefully examined, especially those relating to:

  • Tenor of concession and provision of extension of concession period in case of shortfall in revenues.
  • Levy of tolls and their periodic revision
  • Termination of CA.
  • Issues relating to land acquisition.

CA is examined to check whether it contains sufficient safeguards to provide disincentive to any of the contracting parties to default. Quantum of Compensation payments in the event of termination of the CA and their adequacy to repay outstanding debt servicing obligations of the SPV is analysed critically. Provision of assignability of the CA in the covenants in the event of non-completion or non-satisfactory progress would be viewed favorably by Infomerics. Some CAs provide the SPV an option for seeking property development rights in case of insufficient revenue generation. This would have a positive impact from a credit perspective.


Operating Risks

Operating risk is the risk of the project not conforming to the required performance parameters over the period of the concession agreement. Typically, performance parameters specified in the concession agreement are driving quality of the carriageway, safety standards, adherence to maintenance schedule, and road availability standards. Non-compliance with some of the performance parameters may be an ‘event of default’ and impinge on the developer’s ability to collect tolls. The concessionaire’s ability to fairly assess operating expenses and lay down a proper maintenance schedule is important to protect future revenue streams. Operation and maintenance (O&M) expenses cover periodic maintenance, involving relaying the asphalt-concrete once every five to seven years. The O&M estimates would be highly sensitive to inflation and would therefore be difficult to budget over a 15 year period.


Financial analysis

Similar to other infrastructure projects, road sector are also characterised by fairly high levels of capital intensity. Infomerics carries out in-depth analysis of the projected operations to get a clear indication of the SPV’s ability to service debt. The analysis would include critical examination of the underlying assumptions, location of possible stress points and the extent of flexibility to tide over difficulties. A key element of the analysis is an assessment of the sufficiency of revenues for meeting operating expenses and debt service obligations. The key sensitivity scenarios include variability in traffic volumes and toll rates, time and cost overruns during the construction phase and variability in operations and maintenance expenses post completion. Stress tests are all the more important if it emerges that significant traffic and revenue growth is necessary for meeting contractual obligations. Other factors being taken into consideration are as follows:


Structural Risks

Apart from assessing the economic viability of the project, Infomerics also reviews certain structural aspects of these projects, which include the process by which these revenues streams are aggregated in collection accounts and subsequently transferred to the debt service reserve accounts (DSRA) after funding the O&M and major maintenance reserve account (MMRA). Presence of strong escrow mechanism and ring fencing of cash flows to prevent any leakage of funds are some of the structural considerations. Availability of adequate funds in DSRA so as to cover at least six months of debt servicing obligations also provides structural support for ratings.


Credit Enhancement

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.


Quality of investments

Pending redemption of debt obligations, surplus funds would have to be appropriately invested by the SPV. The proposed investment policies of the company for deployment of surplus funds are examined to ensure the safety of such investments. Liquidity aspects of the proposed investments also are considered. Each of the above factors and their linkages are examined to arrive at the overall assessment of credit quality. The reduction in credit risk due to any credit enhancements provided is carefully evaluated before assigning the rating.

Management evaluation

All ratings necessarily incorporate an assessment of the quality of the issuer’s management, as well as the strengths/weaknesses arising from the issuer’s being a part of a “group”. Also of importance are the issuer’s likely cash outflows arising from the possible need to support other group entities, in case the issuer is among the stronger entities within the group. Usually, a detailed discussion is held with the management of the issuer to understand its business objectives, plans and strategies, and views on past performance, besides the outlook on the (issuer’s) industry. The management capability is evaluated from different perspectives like financial capabilities, track record in implementing and operating projects of similar nature and size and availability of technical manpower.


Conclusion

The rating process ultimately determines the likelihood of the rated debt obligation being repaid in full and on time. Infomerics analyses each of the above factors and their linkages to arrive at the overall assessment of credit quality of an issuer. The credit rating is an overall assessment of all aspects of the issuer factoring comprehensive technical, financial, commercial, economic and management analysis.

Power Generation

Overview

Power sector following the liberalisation process has encouraged private investment and such investment is expected to go up substantially in the near future. Power projects are capital intensive and for funding them, recourse to publicly issued debt would be necessary. The rating methodology developed by Infomerics for debt issues of power projects (PPs) is designed to facilitate appropriate credit risk assessment, keeping in view the characteristics of the Indian power sector. The methodology examines the broad parameters of the project based on the Information Memorandum (IM) submitted by the client. The following areas are covered:

Project implementation Risk

New Projects generally entail higher risks than operational projects. The gestation period for thermal plants is around 3-4 years, while that of a hydel plant is higher because of delays caused by political and regulatory disruptions. The focus here is to determine the risks faced by the company in completing the projects. Infomerics examines the pattern of financing employed by the company for approved and ongoing projects, and whether the financing has been tied up. The financing mix in terms of market debt and internal accruals/ government support is indicative of the company’s financial policy. Infomerics conducts sensitivities on time and cost overruns to assess the company’s ability to meet debt-servicing obligations. Projects nearing completion are viewed more favourably than green field projects because they represent a relatively lower construction risk. Also given due weightage to the company’s track record in setting up projects. Fixed-price, fixed time contracts, with adequate clauses for liquidated damages (LD), are usually the mitigants against construction risk. During project implementation, progress would be monitored vis-a-vis the initial cost and time estimates to determine the effect of variations from schedule on the ability to meet debt servicing obligations.


Funding Risk:

The ability to meet debt service obligations in time depends critically on the financing plan of the project. The capital structure of an IPP is evaluated to assess whether the debt-equity ratio is in conformity with that of power projects of similar size and complexity. The technical aspects of the project, financial structure, the funding profile in terms of maturity, proportion of foreign currency loans & rupee loans and the hedging strategies to be used for covering exchange risk are examined in detail. The strength of the promoter would also impart financial flexibility in funding shortfalls for equity tie-up as well as funding for cost overruns or other contingencies. Any covenants in the debt documents or PPA, which can impair debt servicing capability, are also evaluated critically.


Evaluation of Power Purchase Agreement:

Power Purchase Agreement (PPA) is a crucial document outlining the rights and responsibilities of the power producer and evaluation of the same forms a critical part of the rating exercise. The minimum off-take of power committed by the purchaser and the incentives and penalties based on the cut-off Plant Load Factor (PLF) to be achieved are some of the factors being critically examined. The demand-supply situation in the area to be serviced is assessed. Also being evaluated is the terms and conditions to be met before commissioning of the project, clearances and agreements with different agencies and consequences of non-fulfillment of stipulated conditions. The funding pattern, construction schedule, penalties for late completion, achievement of projected capacity and the role of the operating company with regard to plant operation and fuel arrangements are studied. The tariff rates are critically analysed to determine their adequacy to ensure the profitability and debt servicing capability of the PP at the minimum performance level and at higher levels of performance. The focus here is to evaluate the adequacy of both the fuel cost pass-through available in the terms of PPA as well as that of tariff compensation mechanism if approved by SERC. Projects with competitive bid based PPAs where the fuel cost is largely a pass-through based on quoted heat rate, are relatively less risky


Counter party credit risk:

In assessing counter-party credit risk, evaluation is done on the counter-party and the extent of capacity contracted through a long term PPA. Most long term PPAs with state owned distribution utilities provide for a three-tier payment security mechanism (PSM) consisting of Letter of Credit, Default Escrow agreement and Right for third party sale of power, which is a source of comfort. While the structure of the PSM provides comfort, the focus is to assess the past performance record of such mechanisms for operational projects. Revenue generation for a PP depends on the financial strength of the buyer(s) of power and often determines the maximum rating a PP can obtain. The assessment of the power purchaser is, therefore, an integral part of the rating of a PP. While credit quality of state owned distribution utility is linked with the intrinsic credit quality of State Government, the analysis is done on the distribution utility’s financial position in terms of trends in cost coverage ratio (Cost Coverage Ratio = Annual Revenue Realisation (ARR) less Average Cost of Supply (ACS); ARR = Cash Collection inclusive of subsidy receipts / Units Input ; ACS = Total expenditure / Units Input) , adequacy of subsidy release by State Government, extent of cost reflective tariffs and ability to improve the efficiency levels & keep actual costs in line with regulatory targets.


Operating Risk

The operating risks for a power plant arise from two sources: uncertainty over fuel supply and possibility of plant performance being lower than the normative parameters as specified in the PPA. An assessment of fuel supply risks involves evaluation of the sources of supply, locational proximity to the sources, reserve availability, contractual obligation of the seller, and price of supply. Operating risk for a power plant also involves assessment of fuel price risk exposure in PPA. Unlike cost plus based projects where the cost is a pass-through subject to achieving the normative level, the extent of pass-through of costs in a competitively bid based PPA varies depending on the bid structure. For projects bidding for coal blocks through auction route any aggressive bidding approach would be viewed cautiously, especially with most bidders having limited experience in mining operations. Also being examined technology used, plant availability, plant efficiency, administrative efficiency, environmental issues and billing and collection.


Financial Risk

Infomerics carries out in-depth analysis of the projected operations to get a clear insights into the PP’s ability to service debt. The analysis would involve critical examination of the underlying assumptions, location of possible stress points and the extent of flexibility available to tide over difficulties. The financial analysis takes into account the following factors:


Accounting quality

Some accounting policies that significantly influence the genco’s profitability include depreciation, capitalisation of interest and expenses, provisioning for receivables and bad debts, prior period expenses, contingent liabilities and the like. If required, financial statements are adjusted to provide an accurate picture of the genco’s financial position.


Past performance

The focus here is on analysing the genco’s past performance. The parameters assessed include trends in revenue from operations, costs and profitability analysis, management of receivables and payables, capitalisation, analysis of loans and borrowings, payment track record, coverage ratios and return on capital employed.


Profitability

The profitability for power project is critically dependent upon nature of PPA and the mix of PPAs for capacity tie-up which determines net realisation. A PPA can be cost-plus based, competitively bid or bilateral short term based / spot tariff based. In case of cost-plus based PPA, profitability depends upon the issuer’s ability to declare the plant availability and maintain the actual costs within the normative benchmarks. In case of competitively bid based PPA, actual returns for a company would be dependent upon its ability to keep actual operating and cost parameters within the tariff bid levels. In case of PPA based on mutually negotiated short term tariff, the company’s profitability remains exposed to volatility in the fuel price level. Further, vulnerability of profitability remains the highest in case of merchant sales on power exchange where power tariffs are volatile. All the above mentioned factors are critically analysed to review the performance.


Gearing & Coverage Indicators

Given the capital intensity of a power project and the normative debt:equity ratio allowed by CERC of 2.33 times, leveraging levels (Total Debt / Tangible Net Worth) in the sector are inherently high. Generally, a conservative leverage ratio is viewed favourably as it reflects a lower quantum of committed outflows, while a long maturity profile and lower cost of borrowing can partially offset the risk associated with a high financial leverage. Also, a back ended or ballooning structure of debt repayment can partially mitigate the risk of cash flow mismatches in the initial period, post commencement of operations.

Infomerics compares a genco’s key debt-protection ratios such as debt-service coverage ratios (DSCR), Interest coverage and net cash accruals to total debt with other gencos and companies across other industries. Also scenario analysis is done to assess the average DSCR over the debt repayment period as well as the project IRR, with the key sensitive variables being project cost overrun, plant efficiency (heat rate and auxiliary consumption), receivable days and cost of debt (only for average DSCR). Further in case of projects with competitively bid based PPAs, additional sensitivity factors include the actual cost of fuel, fuel price escalation in the PPA and exchange rate (in case of projects with foreign currency debt as well as projects using imported coal).


Future cash flows and financial flexibility

Infomerics focuses on the genco’s operational and financial forecasts to assess the degree of certainty in cash flow projections. Future cash flows are projected after taking into account the tariff structure, PLF, O&M cost, interest cost, debt repayment schedule, working capital funding requirements, other funding requirements related to expansion capital expenditure and available funding options. These cash flows are then used to determine the company’s future debt servicing capability. In the cash flow projections, also being analysed is other ratios such as Fund Flow from Operations to debt coverage and Retained Cash Flows to debt coverage, as inputs to the credit rating.

Also being evaluated is the issuer’s relationships with banks, financial institutions and other intermediaries, its financial flexibility—as reflected by its unutilised bank/credit limits, liquid investments – as well as financial strength of the promoter group to infuse funds (either equity capital or unsecured debt ) to meet cash flow shortfall, if any.


Management Evaluation:

All ratings necessarily incorporate an assessment of the quality of the issuer’s management, as well as the strengths/weaknesses arising from the issuer’s being a part of a “group”. Also of importance are the issuer’s likely cash outflows arising from the possible need to support other group entities, in case the issuer is among the stronger entities within the group. Usually, a detailed discussion is held with the management of the issuer to understand its business objectives, plans and strategies, and views on past performance, besides the outlook on the (issuer’s) industry. The management capability is evaluated from different perspectives like financial capabilities, track record in implementing and operating projects of similar nature and size and availability of technical manpower.


Conclusion

The credit ratings assigned by Infomerics are a symbolic representation of its current opinion on the relative credit risk associated with the instrument being rated. This opinion is arrived at following a detailed evaluation of the issuer’s business and financial risks, its likely cash flows over the life of the instrument being rated, and the adequacy of such cash flows vis-à-vis its debt servicing obligations. Even though the financial projections assesses the adequacy of cash flows from the debt servicing perspective, the final rating assigned is also critically dependent upon the strength of the sponsors and the track record of the sponsor group in power project development and operations.


Issuer Rating - Methodology

Introduction

Issuer Rating (IR) is issuer (corporate) specific assessment of credit risk and is not confined to any specific debt instrument and/or borrowing programme. While the scope of IR is similar to long term instrument ratings, the main difference between IR and other ratings is that IR is not instrument specific but issuer-oriented. Issuer rating factors in expected performance of the entity over an intermediate time horizon of around three years and reflects the capability of the entity in servicing its entire financial obligations. The coverage of IR is much more wide vis-a-vis that of any debt instrument and the user of this rating can form an overall opinion on the credit worthiness and financial capability of the entity. Like for any other traditional debt instrument/borrowing programme, once the rating is accepted, the same shall be subject to periodic surveillance/reviews.


Methodology

The IR exercise mainly focuses on the entity's future cash generation capability and consequently its ability to honour its financial obligations. The analysis therefore attempts to determine the fundamentals of the business and the probabilities of change in these fundamentals, which could affect the creditworthiness of the borrower.

The framework of Infomerics' rating methodology is divided into two interdependent segments. The first deals with the operational characteristics and the second with the financial characteristics. Besides quantitative factors, qualitative aspects like assessment of management capabilities play a very important role in arriving at the IR. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Rating determination is a matter of experienced and holistic judgement, based on the relevant quantitative and qualitative factors affecting the credit quality of the issuer.


Applicability

IR is applicable for wide range of entities across varied industry segments ranging from manufacturing to banks, NBFCs, HFCs, etc. Relatively larger players prefer this product as IR can be used for participating in tender, engaging with new vendor(s) and so on.


Rating Scale & Definition

IVR AAA (Is) Issuers with this rating are considered to offer the highest degree of safety regarding timely servicing of financial obligations. Such issuers carry lowest credit risk.

IVR AA (Is) Issuers with this rating are considered to offer high degree of safety regarding timely servicing of financial obligations. Such issuers carry very low credit risk.

IVR A (Is) Issuers with this rating are considered to offer adequate degree of safety regarding timely servicing of financial obligations. Such issuers carry low credit risk.

IVR BBB (Is) Issuers with this rating are considered to offer moderate degree of safety regarding timely servicing of financial obligations. Such issuers carry moderate credit risk.

IVR BB (Is) Issuers with this rating are considered to offer moderate risk of default regarding timely servicing of financial obligations.

IVR B (Is)Issuers with this rating are considered to offer high risk of default regarding timely servicing of financial obligations.

IVR C (Is) Issuers with this rating are considered to offer very high risk of default regarding timely servicing of financial obligations.

IVR D (ls) Issuers with this rating are in default or are expected to be in default soon in servicing of debt obligations.

Rating Methodology – Securitisation Transactions

Introduction

Investors in securitisation transactions rely primarily on the underlying asset pool securing the transaction for repayment of interest and principal. The effective isolation of securitised pool from the credit risk of the assets of the originator can allow securtisation transaction to achieve a rating higher than that of the originator itself, if the securities are adequately protected from risk of loss at the originator level.

Infomerics will evaluate a securitisation transaction on a five-point criteria to assess whether the debt security (generally represented by PTC – Pass Through Certificate) will be fully repaid in accordance with the terms of the transaction: (i) legal structure, (ii) asset quality, (iii) credit enhancement by way of collateral coverage, (iv) financial structure; and the (v) quality of originator and servicer. All of these criteria are the principal elements that shape the credit profile of the transaction and, thereby, the determination of a rating opinion on the transaction.


Legal Structure

A securitised transaction is distinguished from the corporate credit risk of the original owner, or “originator,” of those assets through isolation, or “de-linking” by way of an underlying pool of cherry-picked assets. The aim is to correlate the primary credit risk of the transaction to that of the pool quality; rather than the idiosyncratic credit risk of the originator. This is achieved in securitisation transaction, either directly or indirectly, by the sale of an identifiable and specific pool of the originator's assets, to a special purpose vehicle (SPV) which will lead to neither the assets nor their proceeds to be consolidated as part of the bankruptcy estate of the originator/seller in the event of its insolvency.

The SPV acquires cash generating assets by issuing PTC and using the proceeds of that issuance. The cash and all the benefits associated with such assets are passed through to the SPV to service the debt.

As bankruptcy of the SPV is rendered remote through various structural features, SPVs are often described as “bankruptcy remote”. SPVs do not assume debt other than rated debt or subordinated debt as they are not operating businesses unlike the originator. SPVs have a separate independent and legal structure than their parents as they are established for a specific and limited purpose, i.e. for issuing the PTCs. Thus, relative to corporate credit, the SPV provides improved outcome predictability as the risk factors associated with a securitisation transaction are ensconced primarily within the asset pool transferred to the SPV.

An organisation’s legal form will be determined and regulated by local law in the jurisdiction where the SPV is created. An SPV in a securitisation transaction is mainly in the form of a limited liability company, a trust, limited liability partnership, or other form of body corporate (depending on the local law in the place of establishment).


Asset Quality

Loss expectation under a base scenario is analysed through the assets’ credit characteristics by Infomerics. This assumption is stressed further through each successive rating category, such that securities rated in the high investment-grade categories have loss expectations that are consistent with low probability, high-severity stress scenarios.

A broad spectrum of financial assets collateralises securitisation transaction. Mortgage loans secured by residential and commercial properties, consumer assets such as credit card receivables and auto loans, and corporate loans are the most common assets that are securitised. Securitisation transactions are broadly classified by Infomerics into four main categories: RMBS (Residential Mortgage Backed Securitisation), CMBS (Commercial Mortgage Backed Securitisation, ABS (Asset Backed Securitisation) and structured credit. Within these categories, there is a variety of sub-categories; for example, the ABS category encompasses consumer (e.g., auto loans, credit cards and educational loans, among others) and commercial assets (aircraft leases, franchise loans and corporate-linked future flows, among others), as well as Asset-Backed commercial Paper (ABCP) conduits.

The rated PTCs in securitisation transactions are serviced out of the underlying loan portfolio and collateral, if required. The assets' credit characteristics are analysed to derive a loss expectation under a scenario that reflects Infomerics' current macro-economic expectations. This is commonly referred to as the base case scenario. The base case scenario is a description of expected asset loss only, without the reflection of potential loss-reducing structural features of the transaction. The Independent Rating Committee provides a rating opinion on base case loss expectations based on values derived by one of the approaches listed below before assigning the final rating:

  • Default probability and loss severity are imputed to each individual loan based on loan-level characteristics through the output of analytical models developed by Infomerics. The underlying pool's loss rate is calculated using default models. This approach is typically used in the analysis of RMBS and CMBS multi-borrower transactions.
  • The asset portfolio is analysed based on the originators' historical performance for the Rating Committee to derive an expected loss. This approach is often used in the rating of consumer ABS transactions.
  • The aggregate portfolio loss rate is estimated through simulation. Correlated portfolios of corporate exposure sectors such as CDOs (Collateralied Debt Obligation) and CMBS are analysed through this approach. Separate adjustments or stresses are applied for individual simulation models. For example, the CMBS analysis often employs stressed values for rental income decline and capitalisation rates.

Loss expectations are generated under increasingly severe assumptions in addition to the derivation of a base case. The loss expectation is higher for each successive rating category, such that securities rated in the high investment-grade categories have loss expectations that are consistent with low probability, high-severity stress scenarios.

The higher rating categories loss expectations are often expressed as a multiple of base case loss estimate. For instance, an asset pool may be expected to experience 2% losses in a base case scenario, but in an Infomerics AAA(SO) scenario, the collateral pool may be expected to experience losses 4.0 times(x) greater than the base case, or 8% of the collateral pool's balance.


Credit Enhancement

The mechanism that provides PTC holders with protection from losses on the underlying pool is termed as credit enhancement. The rating for each bond is a reflection of the bond having sufficient credit enhancement to withstand default given the expected losses on the underlying collateral pool (determined by Infomerics under the rating stress scenario associated with the relevant bond rating).

Infomerics’ ratings for each bond is a reflection of whether the bonds have sufficient credit enhancement available to withstand default given losses on the underlying collateral pool that is expected under the rating stress scenario associated with the relevant bond rating. Credit enhancement can be sourced internally through various forms as subordination, excess interest or over-collateralisation (OC) or cash collateral or externally by a third-party provider in the form of a provision of reserve fund account, external equity, financial guarantee or a combination of the above. Credit-linked securitisation transaction typically do not have additional credit enhancement; rather, the rating is dependent on the underlying entity or guarantee provider.

In a simple two-class senior-subordinated (senior/sub) structure, all losses on the asset pool are allocated first to the subordinate class until its balance is reduced to zero (assuming that the proceeds of the subordinated note were applied to purchase performing receivables). Thus, the subordinate class provides credit enhancement to the senior class. Generally, whatever cash is remaining is paid to the subordinated tranche post repayment of interest and principal due to the senior tranche. A subordinated bond can be written down each month by an amount equal to realised losses on the underlying collateral or incur shortfalls if collections are insufficient to repay the full due amount. In case, the size of the credit enhancement is consistent with Infomerics’ loss expectation derived under its AAA(SO) stress scenario and if the bond is able to make timely interest payments, then the senior bonds can achieve an AAA(SO) rating from Infomerics.

Many a time, securitisation transactions are “tranched” into multiple senior/sub classes with ratings ranging from AAA(SO) through B(SO). Losses are generally allocated in reverse sequential order commencing with the most junior and lowest rated tranche. The junior tranche’s protection is generally provided either by excess interest, OC, an unrated class that is allocated losses first until it is reduced to zero, or a cash reserve fund fully funded at closing (or with monthly excess interest) that will be utilised first to cover losses. The adequacy of the total credit enhancement or other forms of protection given the loss scenarios for the rating category concerned is reflected in the rating of the junior tranche. Generally, the credit enhancement available to the junior tranche coupled with the subordination of the junior tranche reflects the protection available for the most senior tranches.


Financial Structure

Infomerics will analyse any counterparty dependencies, such as provision of derivatives, bank accounts, or financial guarantees, as these represent credit exposures beyond the securitised asset pool. In the absence of any structural mitigants, securitisation transactions which are dependent on the credit quality of an underlying entity or guarantee provider are credit-linked to those entities.

The senior classes have priority in payment of interest and repayment of principal over the subordinated class in senior/sub SF transactions. However, AAA(SO) rated tranche, which is typically the most senior class, is often split into multiple PTCs with varying maturities or payment schedules. The manner in which principal collected on the asset pool is distributed among PTCs varies; though the amount of loss protection for a rated tranche provided by subordination, excess interest, or OC is generally unaffected by the financial structure.

The specific structure of the transaction concerned in assessing the adequacy of credit enhancement at each rating level is covered by cash flow modelling. A number of stress assumptions that are applied at different rating levels is included in the cash flow criteria. Stresses may include, but are not limited to:

  • High and low prepayment stresses;
  • Asset coupon compression to stress revenue levels;
  • Front- or back-loaded (or other) timings for when defaults and losses occur;
  • Interest rate stresses to assess the materiality of unhedged exposures, as well as carrying costs associated with defaulted assets;
  • Basis risk stresses to assess unhedged exposures regarding different interest rate bases for assets and liabilities;
  • Foreign exchange stresses to assess exposures to unhedged currency risks.

The asset class and type involved and the financial structure of the transaction concerned will influence the extent and nature of cash flow stresses.


Originator and Servicer Quality

The securitisation transaction and performance of the underlying assets can be affected by the originator, servicer, and CDO asset manager. The operational processes for each originator, servicer, or asset manager participating in a securitisation transaction rated by Infomerics is reviewed by Infomerics’ operational risk team or asset-specific rating analysts

The assessment indicated by an internal score, opinion or public rating may lead to adjustments to a transaction's base case expected loss and credit enhancement levels, application of a rating cap or cause Infomerics to decline to rate a transaction.


Surveillance:

After assignment of rating, Infomerics monitors the performance of the portfolio in accordance with its prescribed surveillance process, until the PTCs are paid in full or the rating is withdrawn. Out of the five key rating factors as discussed above, asset quality, credit enhancement and the quality of originator & servicer often evolve over the term of a transaction. In contrast, legal structure and financial structure are usually stable and affected only by specific events.

Corporate Governance Rating – Methodology

Background

Corporate Governance Rating (CGR) is an opinion on relative standing of an entity with regard to adoption of corporate governance practices. It provides information to stakeholders about the level of corporate governance practices of the entity. It enables corporate entities to obtain an independent and credible assessment of the quality and extent of their corporate governance. The rating process would also determine the relative standing of the entity vis-à-vis the best practices followed in the domestic as well as international arena. Companies can also use these ratings as reference and set benchmarks for further improvements. Investors and other stakeholders get benefited as they are able to differentiate companies based on degree of corporate governance.


Corporate Governance Rating (CGR)

is an opinion on the relative position of an organisation in respect of adoption of corporate governance practices. It indicates to the stakeholders about the level of corporate governance practices prevailing in the organisation.


Benefits

Corporate Governance Rating enables corporate entities to obtain an independent and credible assessment of the quality and extent of their corporate governance. The rating process also determines the relative position of the entity vis-à-vis the best practices followed. Organisations can also use these ratings as reference and set bench marks for further improvements. Investors and other stakeholders benefit as they are able to differentiate companies with varying degree of corporate governance.


Limitations

CGR is not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity. CGR should not be construed as implying any direct correlation with the rating of debt instruments of the organisation.

While compliance with the provisions of Clause 49 of the Listing agreement is an important factor for assessing an entity for CGR, Infomerics goes beyond this and evaluate the organisation’s compliance ‘in spirit’ with the Listing agreement as well.


Methodology

The CGR process of Infomerics involves perusal of various documents like agenda papers and minutes of Board and Board committees, Annual return and other documents filed by the bank with ROC, SEBI, stock exchanges (domestic and international) and all other regulatory bodies, prospectus (if applicable), offer documents, minutes of the Annual General Meeting and Extraordinary general meeting. It also involves meeting with top management including CEO, independent directors & whole-time director(s), bankers, Statutory Auditors, Internal Auditors and so on.


Key Parameters

  • Board composition & functioning;
  • Ownership structure;
  • Quality of Management Information System;
  • Shareholders’ profile;
  • Disclosure & transparency;
  • Financial prudence; and,
  • Statutory and regulatory compliance.

Good Corporate governance also helps ensuring that corporations take into consideration the interests of a wide range of constituencies, as well as of the communities within which they operate. Good corporate governance aims at value creation for its stake holders.

Rating Scale & Definition

IVR CGR 1: The organisation with this rating represents highest comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.

IVR CGR 2: The organisation with this rating represents high comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.

IVR CGR 3: The organisation with this rating represents adequate comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.

IVR CGR 4 : The organisation with this rating represents moderate comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.

IVR CGR 5 : The organisation with this rating represents inadequate comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.

IVR CGR 6 : The organisation with this rating represents poor comfort to the stakeholders on the degree of corporate governance. This rating is however not a certificate on statutory compliance and is not a recommendation to buy or sell securities issued by the entity.



Rating Methodology – Real Estate Projects

Background

The real estate Industry being highly fragmented with regional dynamics and smaller players is marred with a low level of Investor trust. Although the emergence of large corporate houses into this sector is bringing some level of transparency, there are no set benchmarks to differentiate one from another


Rating Criteria

In order to evaluate the quality of a real estate developer from the view point of its quality of construction, conformance to committed specifications and adherence to time schedule, Infomerics Ratings has brought out this product for enabling the customers to take an informed decision while purchasing any property. This is a city-specific rating encompassing all types of real estate properties. Broad areas covered are:-

  • Financial Resourcefulness of the Builder;
  • Track record of the project sponsor;
  • Quality of Management;
  • Quality of Technical Personnel, including Architects and Engineers;
  • Technology;
  • Quality Control Mechanism;
  • Procedures & Systems;
  • Quality of Legal Documentation and Land Status;
  • Risk Management System & Mitigation Process;
  • Project Profile and Financial Flexibility/Viability of the Project;
  • Marketing & Pricing Procedures.


Rating Scale

The Star Ratings are assigned on a city-specific, seven-point scale; for example, 'Mumbai One Star' to 'Mumbai Seven Star being the highest. The lowest rating will be 'non-deliverable' project. The assigned rating will thus be a benchmark against other rated projects

The ratings are available for the proposed, ongoing and recently completed commercial and residential projects. Once the rating is assigned, the project will be monitored/reviewed constantly, providing timely updates on project progress. The rating will be valid until the project is completed

City 7-star
City 6-star
City 5-star
City 4-star
City 3-star
City 2-star
City 1-star


Mutual Fund Rating Methodology – Infomerics

INFOMERICS’ fund credit quality ratings are based on evaluation of the fund’s investment strategy and portfolio credit risk. It also involves evaluation of credit quality of individual assets, diversification of portfolio, management quality and operational policies. INFOMERICS uses the concept of credit scores, assigned to individual securities, as per credit scoring matrix developed by INFOMERICS.


INFOMERICS’ credit scoring matrix


In INFOMERICS’ credit scoring matrix, a credit score is assigned to each rating category. The score is essentially a function of the credit quality/rating of the security and its residual maturity. INFOMERICS’ credit scores are arrived at using historical data on defaults adjusted for data limitations. Credit score is higher for higher rating categories and vice versa. The credit score of a rating category is weighted by the proportion of exposure to that rating category. The aggregate of such scores (i.e. the fund credit score) reflects the credit quality rating of the fund. In order to retain the rating, the fund credit score has to be maintained within the benchmark fund score of the rating category.


Qualitative factors


Qualitative factors also play an important role in arriving at the final rating. The qualitative factors examined by INFOMERICS are: Management quality

Infomerics assesses the Asset Management Company (AMC) in terms of organisation set up, qualifications and experience of senior management team. The AMCs track record in fund management is also examined. Infomerics also examines the credentials of the AMC sponsors and Board of Trustees.


Operations and Risk Management Systems

Infomerics examines MIS and risk management systems in various operational areas. Systems for regular monitoring of the portfolio as well as transactions with custodians and registrars are examined. The accounting systems, disclosure levels and the regulatory compliance record of the AMC as well as systems to ensure such compliance are also studied. The quality of trading and back office systems, control systems for segregation of trading and back office operations is also examined.


Ongoing Review, Surveillance and Withdrawal of the Rating

Infomerics reviews the rated mutual fund scheme on an ongoing basis to support its published rating opinions. As such monthly reports of the fund are examined as well as detailed annual review of the fund is also undertaken. While the fund has to maintain the fund credit score within the benchmark fund credit scores, in a particular month, if the fund credit score breaches the benchmark, Infomerics provides one month to the AMC to realign the score. If the fund credit score is not corrected in that period, Infomerics would consider revising the rating opinion. Infomerics would withdraw the rating of a mutual fund on request by the AMC with a notice period of one year.


Infomerics Mutual Fund Rating Scale


Rating Scale Definition
IVR AAAmfs Schemes with this rating are considered to have the highest degree of safety regarding timely receipt of payments from the investments that they have made.
IVR AAmfs Schemes with this rating are considered to have the high degree of safety regarding timely receipt of payments from the investments that they have made.
IVR Amfs Schemes with this rating are considered to have the adequate degree of safety regarding timely receipt of payments from the investments that they have made.
IVR BBBmfs Schemes with this rating are considered to have the moderate degree of safety regarding timely receipt of payments from the investments that they have made.
IVR BBmfs Schemes with this rating are considered to have moderate risk of default regarding timely receipt of payments from the investments that they have made.
IVR Bmfs Schemes with this rating are considered to have high risk of default regarding timely receipt of timely receipt of payments from the investments that they have made.
IVR Cmfs Schemes with this rating are considered to have very high risk of default regarding timely receipt of timely receipt of payments from the investments that they have made.

Alternative Investment Fund (AIF) – Rating Methodology

Preface

AIFs are established to mobilise funds from domestic & foreign investors for  investment as per pre-defined criteria & guidelines. In May, 2012, Securities Exchange Board of India had prescribed regulations for AIFs, replaced the then existing SEBI (Venture Capital Funds) Regulations,1996.As per such regulations, there are three types of AIFs which mentioned below:

CategoryI- VCFs,Small and Medium Enterprises (SME) funds, infrastructure funds and social venture funds.

CategoryII - Private equity funds, and debt funds.

Category-III Funds in the nature of domestichedge fund structures.

The AIF Regulations are an attempt to extend the perimeter of regulation to hitherto unregulated funds, so as to ensure systemic stability, increase market efficiency, encourage formation of new capital and provide investor protection. Based on the above, Infomerics has formulated the rating methodology for rating of AIFs. The AIF rating methodology encompasses detailed evaluation of Sponsor, study of Investment Manager’s track record & expertise in the respective segments or asset classes they manage, risk management mechanism, investment processes and operations & technology preparedness.


What is AIF Rating

AIF Rating is an opinion on the asset selection ability and asset management capabilities in the relevant segment i.e., the industry / sector / asset class in which AIF desires to deploy the fund.

What AIF Rating is not?

AIF ratings is not a recommendation to buy, sell or hold a security / units in a fund. Also it does not comment on the future performance of the fund in terms of appreciation, fluctuation in net asset value (NAV), or yield of the fund. The rating does not indicate the ability of the fund to meet the payment obligations to the unitholders.


Rating Methodology

Detailed Evaluation of Sponsor

a) Business model & objectives of Sponsor.

b) Qualification & experience of the senior management.

c) Stature of the group and market position.

d) Growth.

e) Profitability.

f) Capital structure gearing.

g) Asset quality.

h) Liquidity position.

i) Resource mix and raising ability.

j) Sponsor’s financial commitment to AIF.

k) Strategic importance of AIF to Sponsor.

l) Business linkage with segments/sectors AIF proposes to deploy.

m) Sponsor’s track record & experience in the targeted segments/sectors.


Study of Investment Manager’s Track Record & Expertise

a) Board of Directors & composition.

b) Presence of independent directors.

c) Investment Committee & composition.

d) Any independent member in Investment Committee.

e) Other Committees like Risk Management Committee, Investment Committee,and Valuation committee.

f) Experience of the key managerial personnel in fund management in different segments/sectors/asset classes, including the segment the AIF proposes to invest.

g) Investmentplans & policies.

h)  Geographical spread.

i) Clientprofile.

j) Asset class in which fund proposes to invest.

k) The size of the AMC in relation to it speers.

l) Amount of funds under management for a particularsegment in which the AIF proposes to deploy funds.

m) Qualityofthirdpartyvendors.

n) AMC’s ability to cover expenses, sufficiency of cash in hand to meet unexpected contingencies and operating expenses in a period of severe stress, in case of open-ended schemes.


Risk Management Mechanism

a) Frame work for identifying & measuring various risks like market risk, credit risk, operational risk and liquidity risks.

b) Risk estimation techniques like value at risk,scenario analysis, stress test, default risk,etc.

c) Risk monitoring processes.

d) Internal limits in terms of exposure by obligor, geography, industry and sector.

e) Key Man Risk covering the number of key personnel in the AMC, their responsibilities,in centive structure and whether they have any investment in the AIF.

f) Level of acceptable risk & measures taken to mitigate, if necessary.


Investment processes

a) Investment objectives.

b) Internal investment appraisal system – quality & soundness.

c) Investment limits to contain concentration risk.

d) Periodicity of Investment Committee Meetings.

e) Research support - captive or outsourced or both.

f) Regulatoryguidelines– compliance status.

g) Maturity profileof the investments vis-a-vistenureofthefund and the proposed maturity profile incaseof newly launched AIF.

h) Analysis of portfolio - periodicity&methods of valuation of illiquid investments, credit rating of the investments & external ratings and rating migrations.


Operations & technology preparedness

i) Internal controls and adequacy of theinformation system.

j) Quality & timeliness of information system.

k) Thequalityofback officesystems.

l) Checks & balances.

m) Segregation of trading and back office operations.

n) Compliance withdefinedpolicies.

o) Organization Structure.

p) Disclosure and Transparency.

q) Pendinglitigation, if any.

r) Level of statutory and regulatory compliance.

s) Adequacy of staff and the existence of separate department/wing for different activities like front office activities, operations ,investmentteam and risk management.

t) Timelinessand quality of the investor reporting.

u) Adequacy of the physical and IT infrastructure with respect ofstorage & data integrity, data back-up, mitigation of business continuity risk, etc.

Rating Scale and Definitions

Rating Definition
IVR AAA (AIF) The asset selection ability and asset management capabilities in the respective segments/sectors for these funds are expected to be very good.
IVR AA (AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be good.
IVR A (AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be adequate.
IVR BBB(AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be moderate.
IVR BB (AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be to be inadequate.
IVR B(AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be poor.
IVR C (AIF) The asset selection ability and asset management capabilities in their respective segments/sectors for these funds are expected to be weak.


Overview

The real estate sector is highly fragmented & unorganised. This apart, the regional dynamics also play a significant role in the functioning of this sector. Further, there are many small players in this sector which leads to a low level of Investor trust. Despite the above, there are quite a few large corporate houses which have entered into this sector and the same is bringing some level of transparency. Pricing of properties, existence of informal market, quality of construction, level of adherence to committed specifications of both materials & designs, presence of actual users & investors – all have significant bearing in this sector requiring thorough evaluation of all the relevant parameters.

For the purpose of rating of any debt instrument and/or borrowing programme of a real estate entity, various parameters are looked into to facilitate appropriate credit risk assessment. While each parameter is important, on a standalone basis, different parameter has different level of criticalities. The parameters evaluated for the purpose are described below:

(A) Promoter(s)/Promoter Group

The stature & standing of promoter/promoter group are evaluated, in general, and in the real estate sector, in particular. As it is quite customary in the real estate business that the umbrella company forms a number of small companies (SPVs and JVs) for execution of various real estate projects, the project completion track record and the financial resourcefulness of the promoter group are looked into. If the parent entity of the group, irrespective of the sector it operates, is the main revenue earner for the group, then the financial soundness of such entity is examined. The major group companies are analysed with reference to performance & financials, business synergy, group support, mutual dependence, exposure to group companies, if any, and so on.

(B) Quality of Management

All ratings necessarily capture an assessment of the quality of the issuer’s management, as well as the strengths/weaknesses arising from the issuer’s being a part of a group. Usually, a detailed discussion is held with the management of the issuer to understand its business objectives, plans & strategies and views on past performance. The management capability is evaluated from different perspectives like
experience of the top management in the real estate sector, overall experience, past accomplishments, track record in managing medium to large sized projects. The quality of technical personnel, including architects and engineers, is also examined.

(C) Operating Risk

The areas of business like whether the company is in all facets of real estate business like residential, commercial, retail or not need to be seen. The geography/geographies in which the entity is present are considered. The project completion track record of the entity being rated is seen. The projects in hand with particular reference to size, location – diversified or in same territory, project execution arrangement (like joint venture model or not), means of financing & extent of financial closure are factored in. Also the proposed projects, land bank, etc. are taken into consideration. The quality of technology being used, quality control framework being in place, procedures & systems being adhered to and project implementation process (encompassing land identification & acquisition, project execution, costing & pricing and project manning) are evaluated in detail

(D) Industry Evaluation

As stated earlier, the real estate business is a regional game and hence, regional demand-supply dynamics is very important. While evaluation of this sector starts with pan-India situation, the demand-supply scenario of the territory(ies) where the entity is operating is also critically analysed. The effect of new Real Estate Bill and other government pronouncements are considered. The overall sector evaluation essentially covers all the major segments like residential, commercial and retail.

(E) Financial analysis

Similar to other infrastructure segments, the real estate is also characterised by fairly high level of capital intensity. Infomerics carries out an in-depth analysis of the projected operations to get a clear indication of the entity’s ability to service the debt after taking into account the past trend. For this purpose, the projected cash flow coverage assumes significance. The analysis would include critical examination of the underlying assumptions, location of possible stress points and the extent of flexibility to tide over difficulties. A key element of the analysis is an assessment of the sufficiency of revenue for meeting operating expenses and debt service obligations. 

The key sensitivity scenarios include delays in project implementation, cost overrun, fall in prices, etc. Pending redemption of debt obligations, surplus funds, if any, would have to be appropriately invested by the entity. The investment policies of the company for deployment of surplus funds are also examined to evaluate the safety of such investment and the liquidity thereof.

Each of the above factors and their linkages are examined to arrive at the overall assessment of credit quality. The reduction in credit risk due to any credit enhancements provided is carefully evaluated before assigning the rating.

Other factors taken into consideration are as follows:

Structural Risks

Infomerics also reviews certain structural aspects of debt instrument/facility. Presence of strong escrow mechanism and ring fencing of cash flows to prevent any leakage of funds are some of the structural considerations. Availability of adequate funds in Debt Service Reserve Account (DSRA) so as to cover few months’ debt servicing obligations also provides structural support for ratings.

Credit Enhancement

The credit enhancement in a real estate project can be in the form of DSRA or guarantee of a strong entity of the group/external entity or letter of comfort or escrow mechanism with waterfall arrangement and so on. In case of guarantee/letter of comfort, examination of guarantee deed/letter of comfort, evaluation of the provider of guarantee/letter of comfort and soundness of the waterfall arrangement are carried out in detail.

Conclusion

The rating process ultimately determines the likelihood of the rated debt obligation to be repaid in full and on time. Infomerics analyses each of the above factors and their linkages to arrive at the overall assessment of credit quality of an issuer. The credit rating is an overall assessment of all aspects of the issuer factoring comprehensive operating, financial, promoter, management and sectoral analysis.

Perennially, the ULBs has been dependent on the State government for financial support. Infomerics believes that because of weak fiscal position of the State governments generally, budgetary allocations to municipal bodies cannot be expected to increase substantially and may even decrease, with fiscal deficit becoming a critical area of economic management. Concessional funding from financial institutions may also be ruled out. Access to multilateral and bilateral funding is also going to be difficult, as there is increasing pressure from the donor countries to bring greater accountability and market orientation in the projects financed by them. Accordingly, Infomerics feels that it becomes very imperative for the ULBs to explore alternative sources of funds to meet their funding requirements. ULBs in India generally issue General Obligation Bonds and Revenue Obligation Bonds. In this backdrop, an independent assessment of the creditworthiness of the ULBs has become vital from point of view of the lenders.

In rating of debt instrument/facility of Urban Local Bodies, many factors are considered and looked into encompassing various qualitative and quantitative parameters. A brief synopsis of the rating parameters is furnished below:

Management & Administration

  • Policies & Procedures (if SoPs are available).
  • Organisation structure & Personnel Policy.
  • Division of responsibilities between the Administrative and Political wings.
  • Quality and continuity of management.
  • Depth of management - extent of delegation.
  • Extent of autonomy enjoyed by the ULB.
  • Track record in project/programme implementation.
  • Billing for taxes & other user charges and enforcement mechanism.
  • E-governance system.
  • Industrial relations.
  • Management Information System.
  • Relationship with the State Government.

Operations

  • Structure of the ULB macro-economy
  • Coverage of street lighting, piped water supply, underground sewerage, etc.
  • Frequency & regularity of water supply.
  • Per capita expenditure on public health and primary education.
  • Adequacy of sewerage treatment plants.
  • Adequacy of storm water drainage system.
  • Effectiveness & the depth of Public – Private Partnership projects.
  • Level of discretionary services.
  • Grievance Redressal Mechanism.
  • Labour dependency of the industrial and service sectors.
  • Demonstrated leadership of the ULB in charting a growth course.

Financials

  • Systems of accounting.
  • Compliance with applicable Accounting Standards.
  • Nature and quality of audit.
  • Budgetary and planning processes.
  • Tax base and past trends.
  • Composition and timing of revenue and expenditure - past trends.
  • Trends in tax rates and user charges.
  • Extent of cost recovery on various urban services.
  • Financial flexibility to meet unforeseen contingencies.
  • Revenue surplus/deficit.
  • Revenue buoyancy.
  • Extent of State budgetary support.
  • Operating and collection efficiency for taxes and user charges.
  • Sources and allocation of capital expenditure – trend as well.
  • Extent of borrowings, if any, from non-governmental sources and the degree of compliance with the covenants.

Debt Management

  • Composition of current debt burden.
  • Interest and debt service coverage ratios.
  • Past debt service performance.
  • Interaction with lenders.
  • Evaluation of credit enhancement mechanisms, if any.
  • Commitments/encumbrances on cash flows.
  • Degree of reliance on short term borrowings.
  • Cash flow adequacy vis-à-vis debt maturity profile;
  • Recourse available to lenders, in case of default, as per the Act.

State Finances

  • Status of state government finance;
  • Trends of revenue surplus/deficit, revenue deficit/Gross Fiscal Deficit;
  • Interest payment/Revenue expenditure; Debt servicing/Gross transfers;
  • Interest Payments / Revenue Receipts
  • Non-development expenses/Aggregate disbursement; Tax revenues/Revenue exp.
  • Internal Debt / Revenue Receipts
  • Gross transfers/Aggregate disbursements;
  • Trends in overall deficits and Gross Fiscal Deficits.
  • Debt / NSDP.
  • Timeliness of devolution of grants and taxes from the State Government to ULB.

Economy & Demography

  • Nature of local economy.
  • Local employment & income.
  • Development indicators and current availability of urban services.
  • Proportion of working age population to the overall population of the ULB.
  • Crude Birth Rate.
  • Crude Death rate.
  • Population proportion by age group.
  • Average literacy levels as a whole and by gender.
  • Gender ratio.
  • Decadal population growth rate.

Project Viability

  • Constitution of the project as a departmental project or an SPV (Special Purpose Vehicle).
  • Sources and uses of funds pertaining to the project being financed.
  • Analysis of projected revenue and expenditure for the tenure of the loan and the underlying assumptions.
  • Revenue flow pattern from the project and extent of cost recovery.
  • Committed budgetary support and other credit enhancement measures.
  • Sensitivity analysis to user charge hikes, cost of borrowing, etc.

Legal Issues

  • Borrowing powers and limits.
  • Pending litigations or disputes.
  • Powers of taxation.
  • Powers to levy user charges.
  • Actual control over revenue sources considering the political implications of tax and user charge hikes.
  • Collection enforcement mechanisms under the Act and restrictions on operations.

Methodology - Recovery Ratings for Asset Reconstuction Companies

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act was enacted for facilitating banks to recover their non-performing assets without Court’s intervention. The Act provides three alternative methods for recovery of non-performing assets, namely securitisation, asset reconstruction and enforcement of security without the Court’s intervention. This act enables resolution of long-drawn legal matters in recovery cases and involves professional expertise of securitisation companies (SCs) / asset reconstruction companies (ARCs) in the recovery process. The instruments issued under the ‘The SARFAESI Act’ by SCs/ARCs after acquisition of assets to Qualified Institutional Buyers (QIBs) are named as Security Receipts (SRs). Relevant guidelines have been issued by RBI for computation of Net Asset Value(NAV) on these SRs issued by SCs/ARCs.  This ensures that QIBs value their investment in SRs in accordance with the applicable guidelines. Thus, rating serves as an objective tool for the computation of NAV. Recovery rating is based on the ‘recovery risk (probability of recovery)’ and not the ‘default risk (probability of default)’. Value of underlying security and its recoverability are of prime importance in recovery rating; whereas, cash flow adequacy and future volatility in cash flows (including various other financial parameters hold significance in credit rating.

The assumptions made by the SC/ARC in arriving at valuation of SRs are evaluated and modified by Infomerics, wherever required. SRs are valued on a present value basis from their cash flows, till maturity. An indicative yield is imparted for discounting the cash flows of the SRs. Once Infomerics arrives at an expected valuation, it assigns appropriate recovery rating (the rating gives the range of recovery possible), which indicates the recovery expected from the underlying loan (and SRs), with respect to the face value of the SR, within a predefined band.

The absence of a defined repayment schedule imparts certain equity like features to SRs. The SR investor gets to keep the upside of his investment if the recovery from the NPA exceeds the face value of the SR. The NAV is assessed on the basis of recoveries being considered till the maturity of the concerned SRs. Thus, recoveries are defined as the net present value of all payments that the SR investor might expect over the life of the instrument.

Recovery rating is a function of two variables:

  • Collections from NPAs.
  • Recovery on SRs.

Collections from NPAs

Recovery ratings hinges on the assessment of recovery from the underlying debt exposure. An important point in the analysis is the resolution strategy: asset sale, restructuring/relief, change of management and so on. The likely outcome of the resolution strategy is analysed in detail. Needless to make a mention that NPAs are essentially distressed debt obligations which are in default for varied durations. The process of recovery has a high element of variability with respect to the financial health of the borrowers. This is apart from the willingness of the borrowers to repay its debt obligations. Thus, the quality of collaterals and the liquidity associated with the collaterals, apart from the business prospects of the issuer, are of prime importance in such cases.

Further, the type of resolution in these cases are also analysed in detail. There are mainly two types of resolution – liquidation approach and going concern approach. The two approaches for resolution are used in different circumstances. There can also be a combination of the two approaches, wherein a part of the business or assets of the company are sold to reduce the debt. Similarly, support from group/promoters may be made available to retire some debt and revive the business with a lower debt burden. The recovery assumption on a going concern basis is assumed to be higher than that in the liquidation approach. Under going concern approach, Infomerics may draw various scenarios and the recovery assessment would be the probability-weighted average of recovery under these scenarios.Infomerics’ assessment also incorporates the resolution strategy as well as the capabilities and track record of the ARC concerned in devising and implementing these resolution strategies.

Recovery on SRs

The assessment of recovery on specific SRs are further assessed based on the following factors

  • Borrower’s capital structure and recovery for the Trust

There are various types of liabilities for any entity like statutory liabilities, secured creditors, trade creditors and other forms of unsecured creditors, subordinated debt, convertible bonds, and preference shares. The claim of each class on enterprise assets has been clearly laid down by law. The assessment includes a review of the entire capital structure of the borrowing entity, the key covenants of the loan facilities parked in the Trust issuing the SRs, and the terms of any arrangement arrived at between the borrower and the lenders, as may be applicable. This determines the likely recovery for the various loans parked in a particular Trust. Recovery could be constrained by the seniority/amount of the lender’s claim even if the recoverability from collateral or otherwise is higher.

  • Structure of the SR and cash flow waterfall

The payments to SR holders are effected only if monies are actually credited into the trust accounts and are available for distribution. SR holders receive the payments only if monies are actually received by the Trustee and are available for distribution. Interestingly, there exist no pre-set schedule of payment to the SR investors. The cash flow waterfall as defined in the transaction documents are taken into account while assigning the recovery rating. Resolution expenses and Trustee fees are generally considered senior to pay-outs to SR holders. Multiple SRs can be issued by a single trust, which may or may not be paripassu to each other. Accordingly, the recovery estimates for both series of SRs may be different. Infomerics’ Recovery Rating incorporates all payments expected to be made to the SR holders over a period commencing from the assignment of rating and ending with the expiry of the resolution time frame or the maturity date of the SRs, whichever is earlier.

Conclusion

Recovery ratings indicate the present value of the expected recovery divided by the face value of the SRs. It is an estimate of how much the investor can realise over his investment in the SRs during a specified time frame. The final rating depends upon the different range of recovery.


SURVEILLANCE AND DISSEMINATION OF RESULTS

Review of ratings

Recovery rating, once assigned, remains under regular surveillance throughout the tenor of the SRs. Rating reviews are generally undertaken twice a year. In case of special situation, rating reviews can be more frequent.

The factors that may impact recovery ratings at the time of surveillance are including:

  • Significant developments not forecasted during the last rating / surveillance exercise.
  • Comparison between the assumptions made for the recovery process during the time of the last rating / surveillance exercise and the actual happenings.
  • Any differences in the realisation of recovery proceeds and the one envisaged earlier.
  • Part-redemption of the SRs.
  • Impact on the borrower’s business fundamentals and valuation of collateral security on account of changes in macro-economic factors.

Dissemination of rating actions

Infomerics Ratings shall be disseminating their accepted ratings and the related press release. Such dissemination is normally done through channels including website of Infomerics Ratings (www.infomerics.com).

INFOMERICS RECOVERY RATINGS SCALE


Rating Symbol Rating Definition
IVR RR 1+ It indicates that the present value of expected recoveries is more than 150% of the face value of outstanding SRs
IVR RR 1 It indicates that the present value of expected recoveries is in the range of 100%- 150% of the face value of outstanding SRs
IVR RR 2 It indicates that the present value of expected recoveries is in the range of 75%- 100% of the face value of outstanding SRs
IVR RR 3 It indicates that the present value of expected recoveries is in the range of 50%- 75% of the face value of outstanding SRs
IVR RR 4 It indicates that the present value of expected recoveries is in the range of 25%- 50% of the face value of outstanding SRs
IVR RR 5 It indicates that the present value of expected recoveries is in the range of 0%- 25% of the face value of outstanding SRs