SUBJECT: INVESTMENT BANKING

CASE STUDY ON: ESSAR STEEL-DEFAULTING ON DEBT REPAYMENT

SUBMITTED BY v HARDIK SUTARIYA (108050592004) v BHAVESH JAIN (108050592024)

SUBMITTED TO: Ms. ESHA PANDYA

SUBMITTED ON: MARCH 6, 2012

S. R. LUTHRA INSTITUTE OF MANAGEMENT AFFILIATED TO GUJARAT TECHNOLOGICAL UNIVERSITY, Batch 2010-12

Preamble
All the major business newspaper headlines in India on 21 July 1999 were screaming, "Essar creates history, defaults on FRN $250 million". Essar group had defaulted on its loan repayment of $250million of floating rate notes in international markets. It became the first Indian Company to default in International market raising fears in Indian corporate sector regarding future fund raising capabilities in the international market.

The case examines the financial crisis faced by Essar Steel (Essar), the leading Indian sponge iron manufacturer and the flagship company of the Essar Group, during the late1990s and the early 21st century.

It discusses how the company issued floating rate notes (FRNs) in the mid-1990s to finance its Hazira HRC plant and examines in detail the reasons why it defaulted in repaying the FRN-holders on the maturity date.

The case critically analyzes the measures taken by the company to come out of its financial problems, the role of the FIs and the promoters.

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Q1. Why did Essar decide in favor of utilizing FRNs as a debt instrument? What benefits do FRNs offer to companies, in comparison to the other popular debt interment? What are the benefits for the investors?

FRNs means: A note with a variable interest rate. The adjustments to the interest rate are usually made every six months and are tied to a certain money-market index. Also known as a "floater"

Characteristics of floating interest notes: 1. Floating rate notes have little interest rate risk. 2. A company or government entity can issue floating rate notes. 3. Notes tend to have maturities of approximately five years.

The floating rate notes list of benefits to investors includes: (1) They protect against interest rate hikes and (2) They have higher yields than many short term loan and fixed bonds. (3) FRNs are listed on stock exchange which provides the notes holder with a liquidity option. (4) Minimum interest rate are stipulated to ensure minimum returns to the investors.

Benefits do FRNs offer to companies, in comparison to the other debt interment The various types of bond instruments include (A)straight fixed rate debt (B) equity related bonds (C) dual currency bonds (D) floating rate notes (E) zero coupon bonds (F) composite currency bonds. (1) FRNs is defined as a medium to long term bearer notes, which can be liberally traded. (2) Interest on FRNs is paid periodically. However, the interest rate moves in tandem with the level of floating indices (standard interest rate /reference index). (3) In a market where interest risk fluctuation and capital market volatility are common, the risk associated with loans taken by a corporate also increased considerably.

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(4) Moreover the lenders are not interested in lending the money at fixed interest Rates on long term basis. Because of lending at fixed rates for long term is costly for lenders. (5) So that Instrument like FRNs came to the save of both borrower and lenders. the instrument essentially act as a guarantee of rate of return linked to LIBOR or other reference. (6) Apart from these FRNs also offer equal benefits to both investors and lenders as they assure high yields compared to many short term notes and also offer a liquidity option.

Why did Essar decide in favor of utilizing FRNs as a debt instrument?

The liberalization of the Indian economy in the early-1990s opened up many opportunities for the Essar group. The company diversified its operations by entering into the power, steel offshore construction, pipeline laying, contract drilling and marine transport and oil businesses.

Essar was incorporated in 1976 as Essar Steel Ltd Essar was the first private sector company, which was permitted by the government to set up a 2-million tone steel plant. During that period (1989), the group found out that it was difficult to acquire long-term funds for financing capital-intensive projects such as steel in India.

The plant was to be commissioned in October,1992, but in October,1992 company announced that it had changed the scope of the project. As a result the cost of project increased from initial Rs 13.94 billion to Rs 33.5 billion. Now company announced that it will commission the plant in June 1994. However the project was further delayed, which resulted in cost overruns of 33%, taking the cost to Rs 44 billion. As the need for funds was not fulfilled by the domestic loans the company decided to raise funds from other countries by issuing FRNs.

However after the liberalization the market experienced considered changes and the interest rates were revised at regular intervals. Instruments such as FRNs now emerged as attractive financing option for many companies as because of In a market where interest risk fluctuation and capital market volatility are common, the risk associated with Page 4 of 9

loans taken by a corporate also increased considerably. The actual rate of interest through the year ranged between 7.63% and 8.53% based on the volatility in The LIBOR rate. FRNs also offer equal benefits to both investors and lenders as they assure high yields compared to many short term notes and also offer a liquidity option.

Q2. Analyze and explain the reasons behind Essar defaulting on FRNs repayment critically comment on the role of FIs in The issue. Could Essar avoid the problems by better planning /management? If so, how?
By the late-1990s, the profits of the entire Essar group had started declining. Analysts attributed this to the various unrelated diversification moves undertaken by the group during the early and mid 1990s. In 1998, the group incurred a loss of Rs 4.13 billion (it had earned a profit of Rs 1 billion in 1997). Some of the major reasons for this were: ineffective project planning, delay in the completion of projects, dumping, wrong choice of financial instruments, and reduced returns on investments. (1) The immediate launch of various projects during the mid-1990s pushed the group towards a liquidity crisis. Essar started with a three year delay in the functioning of the Hazira plant (1997 in stand of 1994) which incurred huge over run cost. (2) A major part of Essars exports were directed to south east Asia which was facing economics slump in mid 1990s, due to the Asian currency crisis and in this year also an account of global downturn in the steel industry and a host of other internal problems Essars financial position weakened. (3) Essars high costs also affect the company badly. According to industry observers, the companys input costs were very high. The production cost of Steel is $432 per tone which is very high in compare of foreign company like US steel ($313PT) and Nippon steel ($300PT). (4) The another reasons for the defaulting is mismanagement of funds raised trough various sources, poor asset liability management practices followed at Essar responsible for all the problems.

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(5) In 1998 Essar raised funds from FIs in the for of guarantees from at ICICI bank, short term funds from deutche bank and standard chartered bank and non convertible debenture from insurance company. (6) In 1999 IDBI reportedly had an exposure of Rs.22.06 billion in the company of which an estimated Rs.20.62 billion was over due for payment. Essar sold its stake in Essar oil for a sum Rs. 160 Million still the payment was outstanding in 1999. The company debt could be categorized as secured rupee debt (Rs. 19 billion), partly secured foreign debt ($262 million), unsecured debt ($250 million it is FRNs). (7) The insufficiency of fund for repayment was due to delay in project approved, and when the operation started the company substituted the debt by issuing high equity share at premium. However in 1998 the price of steel fell across the globe ($180PT in 1998 from $400PT in 1995). Following this company tried to raise finance from other source like $400 million from foreign investors by way of GDRs and ECBs. But it was cancelled by Government of India in nuclear test. The financial institutions, which had major exposure in Essar, backed off and left Essar in the lurch when it came to disburse sanctioned loans for the ongoing projects of Essar It was not only a financially disastrous year for the group but its public image also suffered a major setback. (1) In July 1998 IDBI rejected the offer of Essar for fresh loan of Rs.7.5 Billion. Following this company attempted to export deal worth Rs. 12 billion with THYSSEN leading steel company in Germany but deal required to be guaranteed by some bank or FI, which is refused by FI and banks.

(2) In June 1999 Essar began to securitize its future receivables through the sales of steel. FIs asked company for performance guarantee and also carefully studied the terms and condition of MoU singed between Essar and marathon power. They doubt about to get ready cash to honor its FRN issue on its due date. However the FIs agreed to refinance Essar, provided certain condition were fulfilled. Which include the opening of escrow account, sale of the Hazira plant, sale of Essar oil and mineral subsidiaries. But company failed to open escrow account and IDBI refuse to bail it out Because

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IDBI felt that the supporting to Essar could decrease the bank image and also lead to fall in price of its share in the market.

Could Essar avoid the problems by better planning /management? If so, how? Yes, of course company can avoid these problems by proper planning and assets management. (1) The fault did not in the instruments itself but in financial planning that went behind it. So very first step is to be proper financial planning which include the requirements of funds , time when fund is require, allocation of funds and finally best strategy for repayment of debt and other obligation in proper time. (2) Firm should create a debt reserve account for the timely repayment of debt abilities with out failing. Essar should control on the raising of the debt. And also take in to consideration of the proper investment in fixed asset as well as try to maintain the debt equity ratio for avoiding bad image in mind of FIs and banks. (3) Company should control its diversification activity and it should be undertake at right time and in reasonable interval. It should evaluate its investment in regular time interval to avoiding huge loss. (4) Company should also do proper project management (network diagrams, critical path analysis) to avoid the delay in completion of project. And also recruit the highly qualified team for feasibility test. (5) Essar also should undertake appropriate environment analysis to avoid the price fall in Asian market. It should developed competitive strategy by effective and efficient utilization of resource to avoiding the price war over the foreign competitors.

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Q3 Describe the restructuring initiatives undertaken by Essar to improve is financial position and comment whether it would be able to meet the new repayment schedule for the FRNs or not. What other option could the company explore to come out of its financial problems?
In late 1999 the global steel industry began recovering and price reached a high of $450 per tone by 2000. Which would improve the cash flow of Essar and it would be able to pay back its debts in due course. This view was also strengthened by the massive restructuring exercise undertaken by company in 2000. The objective of financial restructuring was to avoid constant liquidity crunches enhance debt service and interest coverage ratios and frame repayment terms to ensure a smooth flow of operation. FRN holders as well as partly secured creditors are agreed to extension by 8 years and 5-6 years respectively. After the implementing this plan Essar is able to reduce its interest cost (Rs. 600 million P.A) and able to improve its cash flow. Apart from restructuring Essar restored its product profile, marketing, cost management practice and enhanced production capacity (2.1 Million) and increase export (8.3%) in 2000 as well. As part of restructuring, Essar proposed to buy back a portion of the $250 Million FRNs and pay of high cost syndicated foreign debts. Essar announced plans to raise Rs.6.3billion from divestments related companies. While the buyback and foreign debt amounted Rs.10 Billion. However Essar failed to provide comprehensive plan to repay FRNs and interest outstanding on them. In august 2000 FRNs holders announced their decision to opt for five year rollover of the loan. In extraordinary general meeting held to this effect, 97% of the FRNs agreed for a five year extension of the maturity period. The repayment to be done in three phase (10% in 3 rd, 10% in 4 th, 80% in end of 5th year) But again Essar in defaulted in repayment in late 2002.

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Following these two FRNs holders filed the petition for the wending of the company in Ahmadabad high court. In January 2003 Essar came up with a new proposal pay off the FRN holders. As per this proposal Essar gave to option to its FRNs 1) Redemption of FRNs at deep discount of about 75-80% 2) Repayment over a period of 14-15yaers. The proposal was due for finalization by the corporate debt restructuring committee which constituted FIs and banks. Finally the as per the industry source the company was aware about the facet that the repayment of the FRNs would not be possible given its low profitability. IDBI had made that it clear to the company that it might not be able to repay the FRNs and had suggested that arrangement be made for refinancing the FRNs. There is not any option available for repayment of loan but company must do proper fund raising planning for future financial performance. IDBI advice that it was a general practice in the steel industry to have a repayment period of 12-15 Years for Debt raised for large capital intensive project such like steel in short the loan trough medium term instrument is disastrous when it is required for long term. The fault did not in the instruments itself but in financial planning that went behind it. So very first step is to be proper financial planning which include the requirements of funds , time when fund is require, allocation of funds and finally best strategy for repayment of debt and other obligation in proper time.

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