Unconventioal Loan_Presentation (1)

7/30/2019 Unconventioal Loan_Presentation (1)

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M M Nissim And Co.

Presentation

on

Unconventional loan and

Mezzanine Financing19th November 2011by

CA. SANJAY KHEMANI

M M Nissim And Co.


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UnconventionalLoans -

In order to understand UNCONVENTIONAL

LOANS, it would be best to know what a

conventional mortgage is .

M M Nissim And Co.

1


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Conventional mortgage loan -

A loan typically has two fundamental components:

an interest rate and

a time period.

When these two variables are known at the outset, and

will not change for the duration of the loan, they are

said to be fixed. Thus, a loan with a fixed interest rate

and a fixed period of time is a conventional loan.

M M Nissim And Co. 2


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Unconventional loan

Unconventional loan will have a varying rate of some sort i.e.

Either varying

Interest

Or period

Plus and Minus of Unconventional loans -

Pluses-

- Lower/ no down payment requirement

- Easier to qualify than conventional loans

- Loan program tailored for specific buyer



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Unconventional loan

Minuses

Interest rate subject to market rate (in cases of AdjustedRate mortgage) or higher than that in conventional loan.

Heavy cash outflow at the end of loan periodz



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Unconventional Mortgage - Who Might BeInterested

Small business owners in general- who have credit profiles that do not yield a high enough

credit score to secure a conventional loan.

- may have immense earning power, and even a long, well-developed credit history.

- but for some reason, their situation does not translate aswell to paper.



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Example of Unconventional Mortgage

Adjustable rate mortgage (ARM) - (Similar to Floating

interest rate loan in India) The rate may start off lowerthan fixed rate loan, but could go lower or higherdepending on many factors.

Interest only loans - only the accrued interest is paid,

allowing a reduction in the monthly payment (but leaving alarge amount principle to pay down when the loan periodexpires).

Jumbo loans (non-conforming loans)- given to those whocannot achieve the typical credit minimums. They may

also be necessary due to an typical use for the funds, orthe type of collateral offered to back the financing.

Loans with a balloon payment - large payment at the endof the loan period.



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Example of Unconventional Mortgage

Negative amortization loan (NegAm)- instalment wouldnot cover the total interest accrued each month. Theremaining interest amount would be added to theprinciple.



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Adjustable rate mortgage (ARM) -

interest rate that is charged on the loaned amount is notfixed and is subject to variations that result from changes inthe money market.

borrower is protected from drastic changes in the

interest rate by a maximum interest rate limitcalled Ceiling.

direct and legally defined link to the underlyingindex.

Main Features of ARM

Initial interest rate. This is the beginning interestrate on an ARM- generally lower than fixed rate

interest.M M Nissim And Co. 8


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The adjustment period- The rate is reset at the endof this period, and the monthly loan payment isrecalculated.

The index rate- Generally ARM interest rates arelinked to change in an index rate. Most commonbeing rates on one-, three-, or five-year Treasurysecurities, national or regional average cost of funds

to savings and loan associations. The margin - Percentage points that lenders add to

the index rate to determine the ARM's interest rate.



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Interest rate caps- limits on how much the interestrate or the monthly payment can be changed at theend of each adjustment period or over the life of

the loan.

Initial discounts- interest rate concessions, oftenused as promotional aids, offered the first year ormore of a loan. They reduce the interest rate belowthe prevailing rate (the index plus the margin).



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Adjustable rate mortgage (ARM)

Conversion. The agreement with the lender mayhave a clause that allows the buyer to convert theARM to a fixed-rate mortgage at designated times.

Prepayment. Some agreements may require thebuyer to pay special fees or penalties if the ARM ispaid off early. Prepayment terms are sometimesnegotiable.



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Negative amortization loan

Some type of ARMs (for example, option ARM loans) offer

payment caps rather than interest rate caps, which limit theamount the monthly payment can increase.

If a loan has payment cap but has no periodic interest rate cap,then the loan may become negatively amortized: if the interestrates rise to the point that the monthly mortgage payment doesnot cover the interest due, any unpaid interest will get added to

the loan balance, so the loan balance increases. Example:

Your loan has a payment cap of 7.5%. If your payment is Rs.1,000per month and interest rates rise, your new payment would beRs.1,200/month (assumed). But your capped payment is only

Rs.1,075. The other Rs. 125 get added to your loan balance, to bepaid off over time.



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Negative amortization loan - Advantages

Controls cash flow (relatively stable payment),

Lower interest rates relative to the market at any given time

Pay back the money borrowed today at a depreciated value yearsfrom now (because of natural inflation).



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Mezzanine financing- Meaning

A hybrid of debt and equity financing -filling the gap betweenthe two.

debt capital with rights to convert to an ownership or equityinterest in the company if the loan is not paid back in time andin full.

A subordinate debt subordinate to priority of payment tosenior debt, but senior in rank to common stock or equity.

Interest payments on the securities usually involve both a cashpay portion and pay-in-kind (PIK) portion;

Examples

convertible debts, senior subordinated debt,redeemable preferred stock.



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Mezzanine financing- Characteristics

Medium risk and medium return capital

Appropriate for both public and private ltd.

capital markets transaction with a private financing company

Longer term and fixed rate capital

Flexible transaction structure Subordinate debt with equity kicker

less dilutive to ownership than equity



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Mezzanine financing- For whom

Best candidates are companies looking to grow through -

acquisition;

management buy-outs and ownership successions;

recapitalizations ;

growth financings;

Companies withAsset backed businesses such as real estate orfinancial markets.

Attributes of companies seeking mezzanine finance

experienced management team

business strategy or vision that addresses rapid growth

produces value-added products or services sufficient historical cash f lows to service debt and projected debt levels.

substantial increase in value as a result of the business strategy andfinancing



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Mezzanine financing- Pluses and Minuses

(+)ves -

Provides funding that may be difficult to obtain through seniorloans

Avoids diluting the voting rights of existing shareholders.

As treated as equity under balance sheet, allows to borrow moreand leverage its capital

Redemption schedules can be set to be relatively flexible (topostpone or accelerate redemption)

(-)ves

normally aggressively priced, lenders seeking returns of 20-30%.

Might include restrictive covenants. Ex- restriction not to borrowmore money or refinance senior debt from traditional loans.

Financiers might seek vote on the board of directors.

Financial experts believe that this type of financing hasaggravated the recent credit crunch.



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Mezzanine financing- Example

Acquisition financing

Condition when mezzanine financing would be apt Insufficient bank financing both acquirers and target company

s assets are insufficient to obtain bank financing OR insufficientworking capital to run both companies.

gap in the financing, often amounting to one or two EBITmultiples.

acquisition would result in significant upside in shareholdersvalue.

In the above scenario, the financing gap can be filled withmezzanine financing. While giving up some of the fruits of thedeal, owners have a well capitalized combined company andadequate bank lines of credit (liquidity).



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Differences between Debt, Mezzanine and EquityFinancing

Senior Mezzanine Equity

Typical Structure Revolving Debt Debt with warrants Preferred Stock

Investment Horizon Short/ Long Long Long

Security Secured Subordinate None

Ranking Senior Second Third

Risk Tolerance Low Medium High

Term Demand Term/ Patient Patient

Coupon Floating Fixed Dividend

Rate Prime Risk Adjusted Market Adjusted

Equity Kicker None Warrants Shares

Customization standard Rigid Flexible Flexible

Capital Providers Chatered Bank Private Capital Private Capital

Liquidity High Low Right of sale/ Shot gun



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Funding structure

Private Equity Structure

(% of total A sset)Expected Return on capital (%)

Senior Debt (30-60%)

Mezzanine

(20-30%)

Equity

(20-30%)

5%- 12%

13%-25%

More than 25%



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Types of Mezzanine loan

Mezzanine debt can take many forms and can mean different

things to different lenders.

Common type of mezzanine financing are-

Straight Debt

Participating loan

Hybrid Mezzanine loan

Preferred Equity



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Straight Debt Instrument

Key features

lender is in a subordinate position, no equity participation in the cash flow

no management participation.

usually up to 85% Loan To Value,

yields typically fall within the 9-13% range (depending onamount of leverage, type of project, and owner history).

also known as a second mortgage.

P.S. An inter-creditor agreement, which spells out the rights and

remedies of a mezzanine lender and the interaction between amezzanine lender and senior lender, is usually required in suchtransactions.



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Participating Notes

Key features

lender is in a subordinate position, higher leverage , with cash flow or equity participation by lender,

no management control

a slightly lower coupon rate on the note (ranging 8-11% ).

a higher overall yield from the combination of the coupon rateand the equity obtained in the transaction.

Expected Internal rate of return ranging 15-18%

usually up to 90% Loan To Value,



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Hybrid Mezzanine Loan

Key features

lender is in a subordinate position, secured by the stock held by the company that owns the property

involved.

on failure of timely payments, the lender can foreclose by seizingthe stock

if the lender has control of the stock, the lender has control ofthe company and the property.



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Preferred Equity

Key features

provides lender some control over the project, along with agreater equity position.

borrower and lender usually enter into a partnership or joint-venture agreement, which defines the role each party will play,the equity ownership of each and any other terms.

higher overall yield and the ability to step in and take over theproperty in the event of default.

lender assuming greater risk with the high CLTV and limitedborrower capital.



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Mezzanine financing- Pricing

Mezzanine pricing is as complicated as any equity financinginvolving present and future business valuation issues;

priced appropriately between bank debt(Prime/MIBOR plus a%) and equity financing (usually 35%+).

A typical transaction might be a five year term loan with interestonly in the first year, followed by 48 monthly payments

Coupon rate would range between 12% and 14% fixed.

Origination fee generally of 2%.

Warrants to purchase stock, a royalty, or a revenue participation

fee based on the growth of the business. Warrant is typically lessthan 10% of the outstanding common equity (but not always)depending upon the future value of the company .

Expected internal rate of return (IRR) of 20% to35%.

While interest rates are straight forward, the warrant position is

not. M M Nissim And Co. 6


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Mezzanine financing- Action Checklist

What other avenues of financing are available that would notload the company with so much debt?

In return for the loan, does the company have to cede someindependence to the lender?

Does the loan restrict the company to spending money in certain

areas?

Does your company have a strong market position based on itsproducts/technology and a market share that will allow it torepay the loan?

Does your company have a focused business strategy and positivelong-term development prospects?

Do you have positive, stable cash flows that can be forecastedreliably?



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Legalities

RBI Guidelines for subordinate debt by Banks

Subordinated debt instruments shall not be issued with a putoption. Call option may be exercised after the instrument hasrun for at least five years

Step-up option may be exercised but only once and the step-upshall not be more than 50 bps

The instruments should be fully paid-up, unsecured,subordinated to the claims of other creditors and free ofrestrictive clauses

Subordinated debt instruments will be limited to 50 per cent ofTier-I Capital of the bank. These instruments, together with

other components of Tier II capital, should not exceed 100% ofTier I capital.



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Legalities

Mezzanine loan from NBFCs perspectives - poses certain

advantages that balances the cost of raising capital classified under Tier II capital. NBFC could leverage this capital

with banks to raise additional funds. This effectively reduces thetotal cost of funds. For example, Tier II capital can be used toleverage bank finance up to 5 times. If the interest rate for the

mezzanine debt is 30% and the interest rate for the senior debt is12%, the total interest paid would be 90 p on total debt of Rs 6.This is 15% of the loan amount and only 3% more than the cost ofdebt from banks.

Assist in adhering to capital adequacy norms. For instance if the

total risk weighted assets of a non-bank originator is Rs 100 andits networth is Rs 10. The CRAR (Capital to Risk-weighted assetsRatio) is 10% which is below the prescribed norm of 15%(effective from April 2011). If the non-bank originator were to gofor an alternate capital structure with Rs 10 equity and Rs 5 worth

sub-debt then the CRAR would become 15%, which is theprescribed, minimum CRAR.M M Nissim And Co. 6

I f i i f i d bt / tibl


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Issues for issuing foreign debt / convertibleinstruments in India

Foreign debt issuances have end use restrictions Issuing convertible equity on a preferential basis is limited to a

maximum conversion period of 18 months and with inflexibleconversion pricing guidelines.



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THANK YOU

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Unconventioal Loan_Presentation (1)