2._DCA_-_Pakistan_Market_Assessment_Final.pdf

Preliminary Mapping of DCA Opportunities in Pakistan

August 2013

To: USAID/Pakistan, Attn: Theodore Heisler, Senior Economic Growth Advisor

From: E3/DC, Dan Thomson, Amanda Femal

Purpose and Executive Summary The purpose of this assessment is to outline and identify possible Development Credit Authority (DCA) market-based solutions for USAID/Pakistan’s Office of Economic Growth (EG). The intent of this assessment is to catalyze discussions concerning DCA inclusion into EG programming moving forward and should not be viewed as an exhaustive resource on the subject.1 This DCA Opportunity Overview builds on the Concept Paper entitled, “Supporting the Development of a Debt Capital Market in Pakistan” dated April 14, 2013 and its 3 pillar framework – Sovereign, Sub-Sovereign, and Private Enterprise. The Assessment also attempts to identify possible DCA inclusion into financial sector development programming as described in USAID/Pakistan’s Pakistan Private Investment Initiative Annual Program Statement.

Financial Sector Overview Pakistan’s financial sector is robust and home to a healthy number of both public and private sector participants. The banking sector has witnessed drastic change since the country’s independence in 1947. Directly following independence in 1948 the State Bank of Pakistan was established, but the financial industry was weak and suffered from a lack of trained professionals. As a result, financial service delivery and product quality was poor.

During the 1950’s the private sector was encouraged by the central government to establish new private lending entities, but the resulting corruption that ensued led to the nationalization of all existing banks in 1974. The nationalization effort resulted in a weakened banking sector and privatization reforms re-commenced in the early 1990s. These efforts persisted and led to developing the robust financial sector that exists in Pakistan today.

The banking industry includes a mix of public and private banking institutions. Overall, the banking sector is comprised of 36 commercial banks,2 (including 25 private banks 4 public banks, and 7 foreign banks). The top five banks command around 50.0% of the marketplace; the top ten controls over 70.0% of the market, while the 5 smallest banks command a collective 1.0% of the lending market. The development of an Islamic banking sector and a Sukuk (Sharia compliant) money market is a relatively recent phenomenon. The market has grown at a quick pace, and there are now six Islamic banks operating in Pakistan. The microfinance sector is served by 8 microfinance banks (MFIs),3 and 7 Development Finance Institutions (DFIs) operate in Pakistan. At least 20 leasing companies also exist in Pakistan.

New technologies and private sector influence have transformed the banking landscape into a modern one in just the last few years. Yet taken as a whole, the industry has been performing poorly. Non-performing loans (NPLs) issued to the private sector are growing with SMEs possessing the largest share. This segment alone experienced a jump in NPLs to total loan portfolio from 15.8% in 2008 to 22.1% in 2009. However, according to the State Bank of Pakistan, this number retreated to 16.0% at the end of 2012.

The increasing NPL exposure has dampened bank profitability as well. Overall, earnings before tax for the industry, when measured by return on assets, have decreased by 24.0% over the last six years. Certainly, this reduction is much more pronounced in public sector commercial banks as it has come down from 4.0% in 2006 to 1.9% in 2012. Return on equity before tax has been reduced from 35.2% to 26.3% in the same time period. Accordingly, the perceived risk factor in lending to the private sector has been increasing. Banks have become more cautious in their lending practices and are

1 As a disclaimer, these illustrative models incorporate built‐in assumptions and will vary across regions dependent upon individual participants, regulatory demands, and investment climates. The models should be utilized to initiate exploratory discussions concerning DCA possibilities, and before refining, additional data must be collected and studied. Nevertheless, these models may serve as a starting point for discussion with USAID/Pakistan on which specific structures could best support the Mission’s Development Objectives while complementing existing programs at the same time.

2 For a complete listing of the commercial banks in Pakistan, please see Appendix A.

3 For a complete listing of the MFIs in Pakistan, please see Appendix B.

Key Pakistan Banking Facts

# of State-held Banks: 4

# of privately-held Banks: 25

# of Islamic Banks 6

# of MFIs: 8

# of DFIs: 7

# of Leasing Companies: 20

# of Investment Banks 16

Average Capital Adequacy (CAR): 10.1%

Required CAR Minimum: 8.0%

National Non-Performing Loan (NPL) Rate: 17.8%

Loan Loss Provisions to NPLs: 69.9%

Source: State Bank of Pakistan, 2011 focusing their loan activity towards the public sector. This focus is driven in part by increased government borrowing needs. According to the State Bank, the top five banks, which hold 51.0% of total banking assets and 50.9% of total investments, have parked 82.2% of their investments in government securities. Accordingly, foreign banks have parked 99.9% of their investments in government securities. This trend is common across the entire banking system.

The small remainder of loans that are serving the private sector are going to large privately-held corporations and not the SME market. This reluctance to lend to small entities is ailing the household level as well. It is estimated that only 1% of those households have access to a formal finance facility. In pursuit of serving the SME and single household markets, multiple MFIs have focused their attention upon SME financing. Recent developments and strategic focus on this important lending sector have been led by the State Bank of Pakistan, a private Pakistani bank, a multinational development organization, and a private multinational banking leader. These four entities and recent developments concerning their SME lending strategies will be discussed later in the paper. Prospects for SME lending moving forward appear to be improving, and these newly opened portals to SME borrowing will be examined in greater detail following an overall assessment of the Pakistani bond markets.

The Sovereign Bond Market As part of the drive to liberalize the domestic financial market, Pakistan authorities worked to develop a money and bond market in the late 1990’s. Prior to the development of the bond market, the majority of debt borrowing was accessed through bank borrowing. Development of the bond market was slow, especially when compared to other emerging market countries that pursued a similar path. In 1992, the very first bond was issued, but it was not until the year 2000 that the domestic bond market finally gained some critical momentum after the government issued a series of Pakistan Investment Bonds. Although stronger than before, the Pakistani bond market remains challenged by a lack of ancillary support mechanisms and transparency. The four most important factors impairing the sovereign bond market are listed below:

Weak Enforcement System (to process claims on defaults) – Weak enforcement raises the risk premium in the eyes of potential investors.

Lack of an Effective Benchmark Yield Curve – Lack of bond trading activity impairs the abilities of the investment community to establish market rates. Conversely, uncertainty surrounding bond market rates impairs secondary bond trading in Pakistan.

Lack of Transparency – Pakistani investors by nature are more risk adverse than their western neighbors;

ambiguity surrounding sovereign bond risk premiums and performance tend to detract potential investors.

Lack off Issuing and Regulatory Infrastructure – The weak regulatory environment discourages investors, while weak ancillary support resources increase transaction costs for the issuers.

One resulting impediment hampering sovereign bond issuance is the perceived high transaction cost. These costs include (but are not limited to) listing fees, trustee fees, advisory fees, and rating fees. These high transaction costs are further compounded by high risk perceptions. Local currency government bonds were recently downgraded by Moody’s to Caa1 from B3. Rationale behind the one notch slide include looming repayment obligations due to the IMF, a dwindling level of foreign-exchange reserves, and political instability. High transaction costs coupled with high risk perception have challenged potential bond investors to look elsewhere for more favorable returns and lower risk horizons.

However, recently the domestic bond market seems to be on a positive growth track. Pakistan’s bond market regulator, the Securities and Exchange Commission of Pakistan, approved the Debt Securities Trustee Regulation in 2012. This legislation should accelerate investment into both the bank and corporate bond markets by establishing a regulatory framework to govern bond transactions.

The Sub-Sovereign Bond Market Little progress has been accomplished in creating a sub-sovereign, municipality-level bond market. Although provincial governments are responsible for managing such public services as highways, health care, urban transport, farm to market roads, and irrigation,4 80.0% of funding revenue is still sourced from federal transfers. Although the responsibility to manage and collect revenue from public assets has been transferred from the federal government to local entities, the federal government retains ultimately responsible for repayment. Revenues are generated from public good usage fees, but are then channeled back to the federal government to service debt obligations. Financing from the federal government is also becoming harder to access at the sub-sovereign level as the country faces increasing resource constraints and higher

4 Please see Appendix C for a breakdown of Federal and Provincial public service delivery responsibilities.

debt burdens. Private financing could be a solution to this resource constraint, but many municipalities lack the financial and operational transparency required by the private investor audience. This is further exasperated by weak local autonomy and limited fiscal capabilities.

The Corporate Bond Market The foundation for the Pakistani corporate bond market was laid in 1995 with the first issue of Term Finance Certificates (TFCs). Since this time, the issuance of listed TFCs has totaled approximately PKR 80.0 billion or USD 783.0 million.

Most bond holders view the TFCs more as loans and less as marketable securities due to their high yield generation. This is one reason why a secondary trading market has yet to develop. All in all, the corporate bond market has been experiencing positive growth recently resulting from a combination of factors. Amongst these are de-regulation of the banking sector, lower interest rates, availability of benchmarks for both fixed and floating rate debt, and active inter-bank trading markets in government securities. Although the corporate bond market in Pakistan remains small (representing less than 1% of GDP) the market is improving.

There are two types of corporate financing issues in Pakistan: Term Finance Certificates (TFCs), which can be listed or privately placed and commercial paper. Privately placed TFCs can have short and long tenors. The issuance time is 30-45 days. These issues do not need approval from the Pakistan Securities and Exchange Commission of Pakistan (SECP), as prospectuses are not issued. Listed TFCs have a 5 to 8 year tenor (previously 3 to 5 year tenor).The investor base includes commercial banks, DFIs, employee benefit fund, insurance companies, and mutual funds. The issuance time is longer for listed placements than that for privately placed issues, in the range of 3-4 months. Listed TFCs require approval of the SECP and relevant stock exchanges and also require a rating.

A regular concern of the private sector is that the cost of issuing TFCs is prohibitive. In addition to the coupon rate, the costs include listing charges, trustee fees, advising fees, rating fees and stamp duties. The stamp duty on a TFC issue is 0.15% of the face value at the time of registration which is considered to be on the high side. Although the TFC market is growing, some impediments to bond market development still exist. A major impediment is a lack of long term benchmark rates as a result of thin secondary market for corporate bonds. Second, since the sovereigns and TFCs are competing for the same investor pool, there is the potential for crowding out the riskier private sector option. A final major factor influencing the scarcity of corporate bond issuance is the role of commercial banks in the financial sector who also dominate the investor base for TFCs. This creates a conflict of interest between the commercial banks’ dual role of being the adviser as well as a principal investor in bond markets.

On the positive side, the corporate bond market does seem to be evolving into a more sophisticated debt instrument. More recent developments include the introduction of call and put options, the incorporation of a conversion option, as well as the emergence of a floating coupon rate. The strengthened corporate bond market is placing increased competitive pressure on the more established sovereign bond market which has historically won over investors seeking lower risk options. This pressure was further escalated during the financial crisis that occurred in 2008 when many corporate bonds defaulted and even more investors pivoted towards sovereign issuances.

Financing Options for Pakistan’s SMEs

There are roughly 3.0 million SMEs in Pakistan. SMEs employ nearly 70.0% of Pakistan’s non-agricultural workforce and comprise 90.0% of all businesses while contributing over 30.0% to GDP. The following offers a breakdown of SMEs by sector: 53.0% operate in the wholesale and retail trade including restaurants and hotels, 27.0% provide services, and 30.0% contribute to the manufacturing sector. Access to finance remains a significant hurdle. SMEs taken collectively, only account for 16.0% of total lending and 4.0% of total banking customers. It is estimated that 90.0% of working capital and 81.0% of new investment is self-financed. Historically, SME lending has been hampered by a lack of legal and regulatory provisions as well as an absence of SME-tailored products readily available on the market. Finally, the cost burden of borrowing is compounded by legal fees, collateral registration, and documentation requirements. A typical small business loan requires up to 27 steps and 9 face-to-face meetings with the bank. The majority of SME financing that does occur originates from the formalized private banking sector, and most loans support working capital needs. However, 64.0% of Pakistani SMEs do not have a formal bank account. In order to successfully serve the SME market, MFIs must customize lending products, procedures and requirements. Limited data exists to support whether or not MFIs are filling the working capital and capital expenditure needs of Pakistani SMEs. The number of total MFI borrowers in Pakistan is growing and measured 2.4 million at the end of 2012. Moving forward, multiple efforts from a diverse pool of lenders seem to be further targeting this sector.

In an effort to create jobs and reduce poverty through increased small banking loans, the government of Pakistan has extended affordable finance options to SMEs. The program is sponsored by the Pakistan Poverty Alleviation Fund (PPAF) and the State Bank of Pakistan (SBP). The program sponsored the creation of custom-tailored financial products for SMEs (including leasing, revolving lines of credit, working capital, asset acquisition, letter of credit, and overdraft options) and makes them available through a network of public banks located throughout the country. SBP has also paved the way for regulatory reform, easing SME collateral and credit registry requirements. On May 8, 2013 SBP announced that SMEs operating in the informal sector will no longer be required to provide audited financial reports to access a formal commercial bank loan. The removal of this documentation requirement, believed to be a first for the central bank, will allow businesses currently operating in the informal sector to begin accessing financing options previously available only to formal sector participants. On another positive note, SBP has also recently announced that collateral deposits will no longer be mandatory for SME loans up to USD 50,000.

SBP has also embarked upon an effort to prove by demonstration the ‘bankability’ and profitability involved in SME lending to market participants. In an effort to focus bank attention on this lending segment, SBP has created a specialized SME bank. The State majority-held SME bank was established in 2002, began operations in 2005, and currently has a total of 27 branches. However, the bank only serves 2,200 clients, roughly 1.2% of the total SME market opportunity.

72.0% of the bank’s SME bank loan portfolio is non-performing. On a comparative note, it takes SME Bank an average of 40 days to disburse a loan. SME-focused BRAC bank in Bangladesh accomplishes this same process in 15 days. It is thought that until the bank is privatized and loan officers are trained in SME lending, lackluster performance will continue.

Another SME-focused lending institution is First Micro Finance Bank Pakistan (FMFB), operating in Pakistan and majority held by the Aga Khan Development Network, a multi-national development organization with a special focus on Asia and Africa. FMFB maintains 130 branches and serves all Pakistan provinces. In 2011 FMFB possessed 118,700 loans valued at USD 26.0 million. Most borrowers (70.0%) are engaged in rural livelihoods and 40.0% of loans are going to women.

The international commercial banking sector also appears to be targeting the SME segment. Standard Chartered, a British multinational banking and financial services provider headquartered in London, has targeted the Pakistani SME sector with small business-friendly loan options. Collateral free loan facilities valued from USD 5,000 to 20,000 are available to SME borrowers for working capital purposes. Loan tenor is one to three years and interest rates are competitively priced.

Standard Chartered operates 174 branches across the country and provides on-line account access to customers. Currently, the SME loan facility is available in Karachi, Lahore, Islamabad, and Rawalpindi.

Finally, a Pakistani private bank, Bank Alfalah, is targeting the SME sector with some help from the IFC. Bank Alfalah was incorporated in 1992 as a commercial bank and is headquartered in Karachi. The bank is the number two Islamic bank in Pakistan, possessing 471 branches (65 of them recently opened in 2012) across 163 cities, and also maintaining an international presence in Afghanistan, Bangladesh, and Bahrain. In mid-2012, Bank Alfalah entered into a partnership with the IFC to foster a strategy and business model for targeting the SME sector. The IFC, through its advisory services division, will assist Bank Alfalah in creating an SME strategy and business model, reengineering the bank’s credit underwriting processes, and restructuring the organization for optimal service delivery to SMEs. The program cost is USD 800,000 and the program goal is to increase access to banking services for SMEs in Pakistan. Asked why the bank embarked on this program, CEO Atif Bajwa replied “There is tremendous growth for small-scale entrepreneurs; however, they have been long troubled getting financing access and the right financial advisory services for their banking needs, which limits their growth prospects.” Bank Alfalah’s current strategy is to bridge the gap between the SME community and access to affordable finance by becoming a true partner to the SME segment. The IFC believes that once successfully completed, the project can provide proof of SME segment viability and profitability to the entire Pakistani commercial banking sector.

USAID’s Development Credit Authority Financial institutions in developing countries have available capital but prefer ultra-safe investments. USAID’s Development Credit Authority (DCA) works with investors, local financial institutions, and development organizations to design risk-sharing agreements known as credit guarantees that unlock financing options in the developing world. Credit guarantees prove the viability of lending to underserved markets and help signal commercial viability to lenders.

Congress has enabled USAID the authority to grant development credit in pursuit of national development goals. USAID's Office of Development Credit (DCA) provides USAID with the capability to partially guarantee loans extended in the commercial finance sector. This guarantee facility seeks to improve financial market access and inclusion for underserved borrowers.

In deciding whether or not to pursue a guarantee facility, DCA (in concert with the local mission) weighs the expected development results (outputs, outcomes, and impact) resulting from a financial market intervention against the opportunity cost of using USAID resources for more traditional grant programs. Also, we have to justify that we are not crowding out the private sector and that the guarantee is structured to address the identified market imperfection.

As the US Government's development agency, we have a mandate that calls on us to maintain a significant risk appetite.

The DCA guarantee is backed by the full faith and credit of the U.S. Government and paid out by Treasury. We help mitigate the risk by providing technical assistance to the targeted sector; and this is why mission-level support is key and an integral part of the loan guarantee model.

Transaction Considerations The Development Credit Authority aims to provide subsidized loan guarantees to support the development goals of USAID and local missions by providing cost-effective solutions that can unlock financial constraints. However, when implementing and applying this powerful tool, considerations must be placed upon the nature of the transaction, deal structuring, and the individual lending entities involved.

Guided by the considerations outlined above, this assessment will now attempt to identify specific DCA-led solutions that can be organized around the 3 pillar framework identified in the Supporting the Debt Capital Market in Pakistan Concept Paper. The following section attempts to apply specific DCA opportunities and models for possible inclusion into the following 3 pillar focus areas: Sovereign, Sub-Sovereign, and Private Enterprise Sector. It also attempts to design solutions in alignment with the PPII program by linking SME debt-based facilities to equity investment funds.

Sovereign

Challenge: Fiscal and regulatory policy reform in the financial sector must take place in order to pave the way for the creation and implementation of financial instruments and resources that will extend capital and financing solutions to those entities seeking debt financing in Pakistan. Specifically, regulatory and legal reform surrounding Pakistan’s debt markets must take place if sovereign bond issuances are to prosper. At the same time, a culture of saving should be woven into the regulatory reform blanket that encourages the citizenry to save and drives the creation of additional savings options.

Proposed Solution: At this time, we do not recommend direct DCA sovereign entity support. Per DCA’s authorizing language, sovereign governments and entities are not eligible recipients of a DCA loan guarantee. This opportunity assessment assumes that USAID/Pakistan will pursue foundation level policy reform in order to set the stage for subsequent and successful financial mechanisms that will assist in freeing up the ‘downstream’ lending environment, be it sub-sovereign or private in nature. Possible interventions could include supporting technical direction and advisory services aimed at encouraging banks to free up capital currently held in perceived low risk sovereign holdings so that it may be utilized for private and sub sovereign lending purposes.

The mission could possibly play an important role directing TA towards a public service campaign which encourages the citizenry to save for the future. This could also be accomplished by creating national public service announcements and initiating a compulsory savings programs. This opportunity assessment assumes that USAID/Pakistan will pursue policy

Policy Constraints

• USAID DCA funding/support is dictated by

Bureau level or Mission level policy initiatives;

as a result, guarantee will require buy-in from either individual missions or a pillar bureau of

USAID

• Other DFIs and state-owned banks cannot be granted a guarantee

• The counterparty under guarantee must be a bona fide commercially motivated lender

• DCA cannot guarantee equity, but it is possible to guarantee subordinated or mezzanine debt

Financial Structuring Constraints

• DCA cannot provide a first-loss guarantee

• DCA cannot give credit to equity/grants as first-loss

Minimum Eligibility Qualifications for a Lender

• Must have audited financial statements

• Must not be owned or controlled by a government entity

• Strong portfolio quality (i.e., NPLs<10%)

• Should be in existence for at least three reform at the foundational level in order to ‘set the stage’ for a subsequent and successful sub-sovereign and corporate bond issuance. Capacity building must also be instilled across multiple stakeholders groups, (including underwriters, rating firms, market makers, etc.) and a strong legal framework must be in place if successful bond issuance is to be effective.

Sub-sovereign

Challenge: Demand for infrastructure and publically-provided asset-generated services at the regional level are growing.

However, due to the current challenges presented by the local lending environment, and the challenge in securing federal funding, local sub-sovereign governments are unable to secure the construction financing required to acquire these assets.

Proposed Solution: If a sub-sovereign entity is to successfully source funds from an external investor audience through a bond issuance, they must fundamentally possess the internal capabilities to effectively manage and report financial performance. Potential investment returns must be credible and correctly forecasted. Project (or revenue) bonds could be a viable instrument in attracting funding if a sound fiscal foundation is first demonstrated by the governing entity.

Subsequently, projected asset revenue streams derived from asset usage fees must be predicted, collected, enforced, and earmarked for debt servicing. Public infrastructure projects, capable of producing steady revenues through usage fees would be a good target for funding made available through a revenue bond issuance.

USAID could look for immediate and short term solutions at the sub-sovereign level. By supporting the issuance of a revenue (or ‘project’) bond offering through an underlying DCA guarantee, USAID can expedite the issuance and subsequent marketing of a long term funding platform. By attracting long term investment, the bond issuance then becomes a source of debt-based funding for sub-sovereign borrowers. Once secured, this debt-sourced capital can help fund local infrastructure projects at the regional or municipal level. The bond could be marketed to institutional investors (such as pension and insurance companies) seeking long term steady returns directly correlated to public service usage fees (tolls, taxes, etc.). A DCA loan guarantee can accelerate the development of a liquid bond market by decreasing the perceived risk and increasing the perceived stability in Pakistan’s bond market to domestic and international investment communities.

Given the need for A) a responsible and transparent local government that possesses the capacity to manage a bond issuance and attract funding, and B) a risk reducing instrument to mitigate the risk premium perceived in lending into the sub-sovereign marketplace, a potential solution may exist. Two potentially credit-worthy and relatively transparent local governments, the cities of Karachi and Lahore, could potentially possess the ability to generate independent project-based revenue through a bond issuance. USAID could then partner with one of these local entities in decreasing the perceived risk associated with funding a municipal revenue-based project. One potential mechanism for reducing the perceived risk attached to a municipality-level bond issuance could involve a guarantee on the downward side risk. USAID could provide a DCA bond guarantee to decrease exposure levels in the eyes of potential investors and attract investment.

Illustrative DCA Concept - Facilitate the Issuance of a Sub‐Sovereign Project‐based Bond Sustainable service delivery is crucial at the municipal level; however, sourcing funding for the infrastructure projects required to deliver these services is sometimes difficult. Supporting a sub-sovereign public service-related project through a DCA bond guarantee can help municipalities leverage future income (tariffs and taxes) towards securing third party investment for the construction of an income generating project. By spreading the required upfront construction costs over the useful life of the asset, a municipality is able to manage project cost burdens much more effectively. However, in order for this funding model to work, the municipality must be capable of both effectively providing the public service consistently and reliably, while at the same time ensuring that usage fees are collected transparently on a fair and regular basis. Managed effectively, public works projects developed and funded at the municipal level can lead to increased fiscal and resource autonomy for local government entities.

To promote public service delivery and fiscal autonomy at the sub-sovereign or municipality level, a DCA guarantee can be applied to secure investment from a local, regional, national, and/or international investor participant audience. The guarantee can assist in driving down the perceived risk involved in committing investment towards an unknown entity. Key to this

USAID 50%

Bond

Guarantee financing model is ‘ring-fencing’ both the required project costs and project-generated income around the bond issuance.

A local, regional, or internationally-based private bank can then underwrite the bond and market it to the investment community, be it through a public or private conduit. In a public offering, the bond terms and platform are established by the issuer and multiple parties competitively bid on the open market. The winner is the party that offers the lowest interest rate. In a private placement, funding is sourced through direct negotiation with a single investor or multiple private investors. In general, private placements do not need to be registered with the local regulatory bodies and do not require many of the disclosure requirements found in public offerings. In both cases, be it public offering or private placement, the marketing of the bond will be handled by the issuer and usually involves pricing and channeling it to a targeted project bond investment community. The DCA guarantee can promote the attractiveness of the bond to potential investors by decreasing the perceived risk associated with default. The local mission can play a key role in providing both the technical support related to the bond issuance as well as providing a DCA bond guarantee to reduce the perceived risk.

In this model, USAID/Pakistan would support the bond issuance by providing technical assistance to the sub-sovereign debt originators through training and facilitation. Technical training and field development is critical prior to the bond issuance. A funding model must be designated and implemented in support of a bond issuance. Mechanisms must also exist that can ‘ring-fence’ the investment funds and subsequent project revenues prior to going to market.

Illustrative DCA Concept – Facilitate a Pooled Financing Investment Fund Many projects can be funded by multiple parties if a common investment conduit is utilized to pool the resources from multiple investors into a single financing mechanism. This fund, which is usually established as a trust or special purpose vehicle (SPV) also acts as a risk mediating tool because exposure levels for individual investors are reduced as multiple parties share the overall risk.

In the illustrative model below, multiple lenders provide debt-based financing to a common fund that channels financial resources to multiple public works projects. In this example, a development bank such as the IFC provides financing to the fund at discounted rates.

At the same time a USAID bond guarantee (as described in the previous example) is utilized to secure a project-based bond issuance from a private lender. Given the involvement of the development bank and the USAID bond guarantee, the pooled fund should be able to attract a third party private lender to provide additional commercial-grade debt capital to the fund.

Once the capital is sourced and pooled in a collective investment fund (also referred to as a special purpose vehicle or SPV), it is then ready to be channeled across multiple public works projects. In this example, pooled debt financing is made available across multiple public works projects while technical assistance is provided by USAID/Pakistan at the project level and increases the lender’s propensity to extend financing. Projects generate revenue (via usage tariffs) and repay the loans over time. Successful repayment leads to proven market viability for the private lender involved in the feeder fund and for external investor communities as well.

Additionally, the model above can be altered to depict multiple municipalities aggregating their resources across multiple projects through a shared funding pool. In this model, municipalities could pool their resources collectively to support the issuance of a revenue-based bond that provides finance across multiple projects. This model is effective in attracting project capital to smaller municipalities that would not necessarily be able to attract debt financing on their own. By pooling their resources, multiple municipalities can many times attract a greater level of capital financing then going it alone while at the same time lowering the transaction costs related to the deal structure.

Private Enterprise

Challenge 1: As Pakistan continues to stabilize, many Pakistani firms will be seeking capital to expand their business and service operations. However, gaining access to this much needed capital will be challenging given the current limited selection of financing options. Simply put, Pakistan’s capital markets are underdeveloped; especially when compared to other emerging economies. The financial sector must embark upon reform and development so that new debt instruments and financing resources are made available to private sector participants. Specifically, the corporate bond market must continue to evolve into a viable resource for capital acquisition. This means that long term debt horizons must become palatable to investors and that secondary market trading activity ensues.

Challenge 2: Only an estimated 200,000 SMEs out of the 3.1 million Pakistani SMEs (6.5%) have access to bank-issued debt financing. Banks continually pass over SME lending opportunities due to perceived high risk levels, and instead, loan in favor to the more stable corporate and government segments. This ‘crowding out’ of the SME segment is slowing growth and stifling economic development. Banks must be made comfortable with the SME marketplace and initiate the extension of debt resources. In addition, lending sources must exist to play a ‘wholesale’ role in extending capital to secondary loan ‘retailers’. These retailers are the micro finance institutions (MFIs) who provide working capital loans to fulfill business operation needs. However, in many cases MFIs are under-capitalized themselves and require external funding sources prior to on-lending to these borrowing segments.

Proposed Solutions:

A DCA Bond issuance can also assist private sector entities in acquiring project-based investment capital. In a special illustration at the end of this section, we demonstrate how an existing Pakistani electric utility may source needed investment capital to implement improved service delivery and revenue recovery systems.

A ‘Downstream’ DCA Portfolio Guarantee can secure a multitude of SME loans, issued by one lender, across a targeted sector. By securing up to 50.0% of the default risk to one sector, the loans can mobilize funding to SMEs in need of working capital to finance production demands.

Convertible Debt is an effective tool that early stage SMEs can engage to attract quasi-equity investment funding while avoiding the burden of immediate debt obligations.

DCA lease guarantees can be applied to increase product accessibility in various consumer market segments.

Specifically, by supporting a local equipment supplier, the DCA lease guarantee can allow an industrial good to be rapidly deployed across the country.

DCA loan guarantees can also be utilized in tandem with a supplier-issued forward purchase contacts to assist SME suppliers in securing working capital to meet production and delivery targets.

An ‘Upstream’ DCA Loan Guarantee can assist an MFI in acquiring capital from a wholesale lender. By securing up to 50% of the MFI default risk, the MFI borrower becomes less risky in the eyes of the wholesale lender. Once the capital is received, ‘downstream’ loans can be mobilized by the MFI towards SMEs desperate for their own working capital. In additional to mobilizing these much needed financial resources, reduced borrowing rates are many times extended to the ultimate borrowers because of the discounted up front borrowing rates achieved by the MFI.

Illustrative DCA Concept – Support Local Enterprises to Source Capital with a DCA Bond Guarantee Similar to supporting a sub-sovereign revenue bond issuance (example provided earlier in this paper), a USAID bond guarantee can be utilized by a private entity in sourcing capital for asset acquisition.

Specifically, this model could be a potential concept to discuss further with KESC, the Karachi-based electric transmission equipment supplier. The utility requires additional capital in pursuing transmission efficiencies and revenue collection though the implementation of a ‘Smart Grid’ system.5 Once installed, public benefits delivered would include increased transmission reliability and electricity availability. Improved service delivery and collection rates would lead to greater revenue recapture.

These revenue streams could be utilized by the utility to service debt payments due to bondholders.

5 Please see Appendix D which contains the ‘Smart Grid’ concept note proposal.

Utility Profile

Transmission and Distribution Loss

30.0%

System Availability 89.0%

Revenue Recovery Ratio 94.0%

Company-owned Generation Capacity

67.0%

Imported Generation Capacity 33.0%

In order to fully implement the ‘Smart Grid’ system, the utility will need to finance improvements to transmission networks and metering systems. Monitoring systems will also need to be acquired and installed to improve system distribution management and revenue collection rates. By spreading the capital required to implement the ‘Smart Grid’ system over the useful life of the acquired assets, the utility will be capable of managing project cost burdens much more effectively. However, in order for this funding model to work, the utility must be capable of both effectively providing the public service consistently and reliably, while at the same time ensuring that usage fees are collected transparently on a fair and regular basis.

In the model above, USAID/Pakistan will support the bond issuance by providing technical assistance to the bond originators through training and facilitation. Technical training and field development is critical prior to the bond issuance. A funding model must also be designated and implemented in support of a bond issuance. Mechanisms must also exist that can ‘ring-fence’ the capital acquisition funds and subsequent project revenues prior to going to market.

Illustrative DCA Concept – Support a Loan Portfolio Guarantee that Extends Credit to SMEs

In parallel with the USAID ‘Pakistan Private Investment Initiative (PPII)’, debt-based funding can be leveraged by the equity investments made into SMEs from the newly formed equity investment fund(s). Commercial debt can be sourced locally and secured by a DCA Loan Portfolio Guarantee supporting individual loans issued across the same portfolio of SMEs receiving funding from the PPII fund(s).

Guarantees can be very effective in mobilizing resources to beneficiary recipients ‘downstream’ of the loan provider. In this model, DCA guarantees can support SMEs in attracting commercial debt funding for business expansion and new investment. The DCA guarantee working in parallel with early stage investment funding made possible through the PPII can springboard SMEs to these new debt windows.

Guarantees are most effective when paired with technical assistance that supports potential borrowers and the selected partner financial institutions.

In creating a technical assistance program, the mission may want to consider implementing the E3/EG agricultural and clean energy toolkits for financial institutions. The toolkits provide a collection of resources, tools, and templates for banks to use in developing new loan products and methodologies in targeting these key sectors. This could provide an important resource if the portfolio of SMEs supported by the guarantee includes businesses from the agricultural and clean energy sectors.

Illustrative DCA Concept – Support a Loan Portfolio Guarantee that Extends Convertible Debt Convertible debt is debt that can be converted into a predetermined amount of a company's equity at certain times during its life, usually at the discretion of the investor. Since it is structured a lot like equity, it is an attractive instrument to many start-ups seeking seed capital. It allows the upside of equity to a company's balance sheet without the burden of immediate debt obligation. Essentially, why startups may prefer convertible debt to equity can be boiled down to these four reasons:

1. Valuation: Determining the valuation of a startup is hard, especially if the startup is pre-revenue and only in the idea phase. How do you put a value on the potential of the team/idea? It is easier for a startup to put off that question until they have some traction and social proof. Convertible debt is attractive for a startup because it delays this issue.

2. Cost: Sometimes it doesn’t make sense to pay the additional legal costs for closing the equity round if the funding increase is less than $250,000.

3. Speed: The equity valuation conversation can take weeks of negotiating before terms are agreed upon.

With debt, the terms are simple, easier to negotiate, and you can close on them pretty quickly.

4. Control: When a startup raises debt, the founders retain the majority of the voting stock in the company. That means when it comes time to make a decision that requires a vote, the company will be in a better position to execute its plan.

While DCA has yet to transact with convertible debt, it is a conceivable concept that is possible to execute. The DCA component would be structured similar to any other Loan Portfolio Guarantee (LPG), as depicted in the diagram. The Guarantee Party would likely be an investment fund making convertible debt investments.

The underlying investments would likely be structured with a bullet repayment at the end of the term. The investment fund would agree to conversion terms (strike price, valuation methods, etc.) with the investment recipient. The fund will have the right to convert the debt to equity ownership in the investment throughout the term of the loan. Upon conversion to equity, the company is no longer obligated to pay the bullet payment. Therefore, it will no longer be covered under the DCA guarantee, and the fund will realize returns through the sale of equity.

At the end of the investment term, the fund’s total assets will be valued using agreed upon valuation methods. If it has lost investment principal after valuation, DCA will carry out standard loan default process to fund 50% of losses covered under the loan guarantee. If the fund has returns exceeding investment principal, the USAID guarantee is not called upon.

Illustrative DCA Concept – Support a Leasing Guarantee In this lending model, a DCA Loan Guarantee allows an equipment supplier or leasing agent (financial partner) to capture a new customer segment by offering a lease option as a means to acquire their product(s). The DCA loan guarantee offers partial realized loss absorption (net recoveries) thus allowing an equipment supplier to serve new consumer segments where lack of market knowledge equates to higher risk perception.

In the model, a customer acquires a durable good utilizing the product provider’s leasing option or a third party financial leasing institution. The customer enters into a lease repayment plan directly with the goods provider or third party leasing agent. Technical assistance could be designed to support the targeted borrower group. The 50% lease default guarantee (net recoveries), issued by USAID allows the lessor to target new customers and markets.

As discussed earlier, an electric transmission utility, KESC, has submitted a concept proposal to USAID concerning the installation of anti-theft devices (aerial bundled cables) onto transmission cables in Pakistan. The proposal outlines the utility’s need to distribute this updated transmission equipment in order to improve service delivery. Our guarantee could be applied to a leasing arrangement that allows KESC to deploy the equipment rapidly throughout the country or into security sensitive areas. Municipalities and provinces could lease the equipment, making acquisition and installation more affordable and the equipment would be deployed in a timelier manner.

Illustrative DCA Concept – Support SME Suppliers with Forward Contract Support To promote equitable growth and employment generation, particularly in rural areas, a DCA guarantee can be structured to support suppliers to off-taking domestic and/or multinational corporations (MNCs). In this lending scenario, a commodity purchaser (off-taker) is identified who is actively sourcing agricultural outputs from local farmers (or inputs from local suppliers in the case of manufacturing), preferably in aggregate from a collective or cooperative. Possible target off-takers in Pakistan could be Nestle or PepsiCo.

In order to meet the strict delivery quality and timing requirements demanded by corporate buyers, suppliers will many times require pre-production working capital. However, in many cases, lenders are hesitant in extending working capital loans to these SMEs due to perceived high levels of default risk. In the cases where credit is made available, the lending rates and/or collateral requirements demanded are many times prohibitive to borrowers.

USAID can induce local lenders to provide accessible credit by offering a loan guarantee. The guarantee can be structured specifically to support the local suppliers of a specific off-taker where business interests intersect with USAID development objectives. In such cases, the guarantee can target local SME suppliers that have a purchase contract with a partnering off-taker. These contracts would provide local banks an additional layer of risk mitigation as they reach out to new borrowers.

The illustration outlines this supply chain facilitation guarantee model. Forwards contracts specifying pricing and production quantity are issued to smallholders and SMEs prior to production or harvest. Smallholders secure working capital loans from a lender utilizing the forwards contract as collateral. USAID’s 50% default guarantee coupled with forward purchase agreements issued by the off-taker entices the lender to mobilize working capital loans to the producers and SMEs. Smallholders and SMEs then sell their products to the off-taker for previously agreed upon prices and order quantities. Individual loans are repaid. USAID technical assistance can support smallholders and SMEs in: a) acquiring new production-related technology and skills, and b) achieving international supplier certifications and standards. In this example the off-taker has absorbed or ‘gifted’ the guarantee subsidy cost required to mobilized the DCA guarantee.

Illustrative DCA Concept – Support an ‘Upstream’ Capital Acquisition Guarantee

In this model, a bank, corporate entity, or MFI is able to source affordable lending capital with the assistance of a USAID loan or bond guarantee. Once acquired, this capital can then be channeled to borrowers in the form of informal SME or micro loans. Given the hesitant nature of Pakistan’s MFI sector to on-lending due to poor capital funding, a DCA guarantee can induce wholesale lending which mobilizes capital onward to the retail lenders. This capital can then be loaned ‘downstream’ to individual SME and smallholders in the form of working capital loans.

The model also applies to a lending entity that is seeking the acquisition of capital through a bond issuance. In this case, the international lending community can be further assured of repayment and against default with the attached guarantee.

Upstream Loan or Bond

Guarantee

Commercial Bank MFI

Farmer

Trader

Processor

USAID

Technical

Assistance

Next Steps Once a DCA…