Financing Low Cost Schools - Akhil Kishore

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Financing Micro Projects in Education and Healthcare in Developing Countries Akhil Kishore Thunderbird, The American Graduate School of International Management (www.t-bird.edu) Email: [email protected]; Cell: (602) 741 9917 Abstract There is a growing need for private sector to get involved in the education sector in the developing countries. The demand for educational institutes is growing at a much faster pace than the government sector can provide. High start-up investments, misaligned policies of the government and lack of funds have been slowing the growth of the private sector. This paper explores a new way of financing small education projects involving investments in the range of $100,000 to $500,000 per project. The financial instrument uses the concept of pooling of debt and securitization of the local currency debt for financing GREENFIELD private sector projects in the education sector. The project would benefit educational institutes like primary schools, higher secondary schools & vocational training centers. Education Sector in the Developing Countries

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From 1996 till the year 2000, the percentage of private financing in the education sector has grown at about the rate of 1% per annum. The global education market is estimated (in year 2000) to be around $2.2 trillion and the private sector financing has grown to well over $350 billion of this amount. Out of this only around 15% is for the developing country which is low considering the fact that 83% of students in the world are located in the developing countries. With rising populations, the gradual evolution of economies to knowledge based economies and the slow growth of public sector funded education sector, the role of private sector in the developing countries is increasing. The growth of this sector effects the health of economies in developing countries thereby effecting overall business conditions. Moreover, financial institutions like commercial banks, investment banks, fixed income traders and real estate firms can all benefit from the growth of this sector by active participation in activities like providing loans, structuring & raising finance and also benefit from the offshoot services like providing student loans which as a stand alone business has huge potential in the developing countries. Proposed Model The model I propose works on future cash flows securitization therefore we will consider the example of Diego Portales University, which is the first Future Cash Flows Bonds Securitization project undertaken by the International Finance Corporation (IFC). There are several similarities and dissimilarities between the instrument I propose (called APCAFS for Advance Pooled CAsh Flow Bonds Securitization hereafter) and the Diego Portales University project (called UDP hereafter). The similarities make the instrument easier to understand when considered with reference to DPU and the dissimilarities bring out the issues, challenges and solutions related to APCAFS. NOTE: The proposed model can also be utilized for financing small projects in the healthcare sector as well. Universidad Diego Portales (UDP) Project UDP is a private non-profit Chilean university. The university was founded 20 years ago and has established itself as one of the most respected private universities in Chile. The total project cost was estimated at $30 million. The proposed IFC investment is a partial guarantee of a local bond issuance the university. The IFC partial guarantee covers up to 30% of the $23 million face value of the bond.

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Requiring $100,000 – 500,000 of Project Finance

(SOURCE: Merrill Lynch. 1999/2000. The Book of Knowledge: Investing in the Growing Education and Training Industry. Merrill Lynch and Co. InDepth Report; European Union (EU). 2001. “The Information Society and Development.”; International Finance Corporation (IFC). 2001. Investing in Private Education: IFC’s Strategic Directions) Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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Terms and conditions of the bond • Amount: UF (23 US$ Millions Approximately) • Currency: Chilean UF • Issue Date May 9, 2003 • Maturity: 8 years • Interest Payment: Quarterly • Principal Payment: • Annual • UF 100.000 for the first 5 years • UF 120.000 (Year 6) 180.000 (Year 7); 200.000 (Year 8) • Series: 1 Series • Nominal Value: UF 1.000 • Rating: AA- by the local affiliates of Moody’s, Standard & Poors, and Fitch. • Guarantee: IFC irrevocably guarantees the due & punctual payment in UF of the Guarantee Amount. • Guarantee Amount: Initially 30% of principal. Reduces gradually with principal repayment to an amount equal to 25% of outstanding principal. • To securitize the future cash flows from the School of law, School of Journalism, School of Public Relations and the School of Design. The diagrams below are taken from the presentation given by Mr. Lee Meddin, the Chief Structured Finance Officer at IFC at the IFC Banker’s Meeting in the first week of June in Washington. Figure 1 describes the structure of the bond whereas Figure 2 depicts the Cash Waterfall.

Figure 1. (Source : Meddin, Lee. Chief Structured Finance Officer, IFC “Local Currency Financing- A Structured Approach” (19th June 2003)

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(Source : Meddin, Lee. Chief Structured Finance Officer, IFC “Local Currency Financing- A Structured Approach” (19th June 2003) Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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Figure 2. (Source : Meddin, Lee. Chief Structured Finance Officer, IFC “Local Currency Financing- A Structured Approach” (19th June 2003)

Challenges with the current process and he proposed model: UDP is the first step that IFC has taken towards financing projects using securitizing future cash flows. The amount of financing required for UDP ($23Mn) makes it a large-scale project. This implies that smaller projects that require much less finance cannot benefit unless there is a modification in the UDP model. The model that I have been working on involves using the same concept as UDP but with a few refinements. I have termed it Advance Pool CAsh Flow Bong Securitization (APCAFS). The diagram below gives a visual representation of the model.

Figure 3

Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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As you can make out, the main differences between APCAFS and UDP are: 1. 2. 3. 4.

It is a bank or another financial intermediary that originates the loan and not the educational institute (shown as a “School” in the diagram) itself. The originator of the loan interacts with a ‘P’ool of educational institutes and the real estate owners who participate in the project. The educational institutes provide the service but they don’t get the money directly. The educational institutes and the real estate owners get their money THROUGH the originator who distributes the money based on pre-calculated basis.

Figure 4 on the next page shows the proposed cash flow waterfall. Key Challenges for APCAFS to be successful: Based on the 4 main differences between APCAFS and UDP, there are several critical issues that are raised. I have tried to highlight the issues and given a proposed solution to mitigate the risk that arises because of that issue. •

UDP is a running business but APCAFS is planning to finance Greenfield ventures. This implies a lack of information for the investors. This lack of history and information can firstly cause the cost of borrowing to go up and secondly, there might not be a big investor base. PROPOSED SOLUTION: This is the reason why it should be a bank or a financial intermediary that should be the

originator of the debt and not the educational institutes themselves. The banks being originators is a case of necessity as well as the educational institutes would not be able to raise debt on their own based on the small size of the debt ($100,000 - $500,000) and the lack of history. •

LACK OF INFORMATION ABOUT FUTURE CASH FLOWS: In the case of UDP the payment capacity of the organization is known as we know how many students the new infrastructure would be able to accommodate and what kind of fees and tuition would be charged. In the case of APCAFS the bank might not be clear on how the debt is going to be repaid as the future cash flows are not set yet. The future cash flows can be based only after knowing the number of students, costs and revenues. PROPOSED SOLUTION: I propose a situation where the originator knows in ‘A’dvance about the details of the

education projects it is going to finance through the bonds. The originator invests upfront for searching, evaluating and short-listing entrepreneurs & real estate owners. The entrepreneur submits a detailed business plan BEFORE the originator raises the money. This upfront knowledge forms a substitute for the surety for planning the capacity in case of projects like UDP. An issue this might raise is regarding how much debt should the originator raise from the market in one go so that it doesn’t have to go to the market frequently. For example, APCAFS might know in advance about 25 schools for sure but it might want to raise funds for 15 more schools so that it doesn’t have to go to the market again to raise funds. This would imply APCAFS to work hard to find more educational projects to fund. Moreover, like any company, there would be a learning curve for this way of financing which would gradually make the forecasts and estimates more accurate. •

Difficulty in finding a bank or financial intermediaries who would be willing invest to find and match a pool of investors and real estate owners. PROPOSED SOLUTION: If we consider the case of India, the Reserve Bank of India has mandated banks to invest 4

40% of their resources in priority sectors . Education is also a part of the priority-lending sector. Investing in APCAFS related projects would allow banks to meet their priority lending targets and might also allow them to earn better 5 spreads .

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Priority Sector Lending, Reserve Bank of India < http://www.rbi.org.in/index.dll/18637?OpenStory?fromdate=11/22/02&todate=11/22/02&s1secid=0&s2secid=0&secid=20/0/0> (19th June 2003) 5 The financial model of APCAFS is a work in progress. It would be completed once the entire concept is finalized. But for the time being we could say that IFC guaranteed debt would be lower in cost whether it is raised domestically or in international markets. Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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DEFAULT RISK: If an entrepreneur fails to grow the educational institute enough and does not manage efficiently, the probability of default rises. A secondary market for schools is non-existent.

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PROPOSED SOLUTION: Assuming APCAFS is successful, there would be a pool of applicant entrepreneurs that

would be generated on a constant basis. The due diligence of these potential entrepreneurs would be an operation the originator would have to invest in. Once one entrepreneur defaults, another one from this pool could be selected. Moreover, over time the knowledge gained through multiple projects (failures & successes) would be leveraged to assist current and potential entrepreneurs. Risk Management The core of this model relies on promoting entrepreneurship in the field of education. In developing countries there are multiple factors that make it difficult for an entrepreneur to get project financing unless he/she is from a well-connected and/or wealthy background. This resources asymmetry can be reduced by APCAFS by providing a package of services to 6 deserving entrepreneurs. The package would include: • Knowledge and expertise • Low cost long term loans • Access to other resources like real estate at favorable terms The reason why I focus on entrepreneurs is for the following reasons: • Entrepreneurs’ primary goal is to succeed in their ventures. They are driven and highly motivated towards this cause. Enabling a deserving entrepreneur would go a long way in creating a successful education related venture. 7 • IFC is well aware of the fact that the returns per unit of resources invested in the private sector is much higher as compared to the public sector. • With suitably structured covenants in place, the entrepreneur can be made to focus on issues like lower cost for students while maintaining growth and high quality.

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Deserving – I would equate the funding process for education related entrepreneurs with the entrepreneurs from other fields. Investors invest money not in projects but in the management team and their ability to execute plans and strategy. This implies the management team must be highly competent, highly experienced and have the right strategy to succeed in the education industry. 7 Money, time & intellectual capital Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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I compare the APCAFS model to a fast food franchise model where a successful format can be replicated effectively as running an educational institute like a primary or higher secondary school has very similar characteristics in terms of standardized processes and input parameters. Certain things like purchasing power can vary from region to region but more or less the processes can be standardized. In other words, the knowledge gained from one venture can be transferred to other ventures across the world.

Since the model relies on entrepreneurs, it is imperative to provide as much support to the entrepreneurs as possible. One way this can be done is to transfer part of the risk from the entrepreneur to the originator of the loan, which in APCAFS’ case is a bank or a financial intermediary. As the diagram on the left shows, the originator gets a new portfolio of assets based on the projects it plans to fund. On the liabilities side, the first loss is the entrepreneurs’ and the originators. The mezzanine risk is shared between the originator and IFC the same as senior risk. I expect the securitization structure to be the same as the one followed in the UDP project. Figure 6. shows the structure. As it is clear from the diagram, based on the bond structure, the pass through is structured in various tranches which can vary from one client to another but in all likelihood, it will be similar to the CMO structure followed in UDP.

Figure 5. Risk Sharing

The role of IFC There are 2 ways that I think IFC can use the APCAFS to finance small size projects in the education sector in the developing countries. • Syndicated loans: through their B-Loan Program • Partial credit guarantees method, which is something IFC has already done through the UDP project. It could either be either one of them separately or a combination that could be used. The financing mechanism and the structure of the deal would vary from case to case.

Figure 6. Traditional Structure of Domestic Securitization

Other issues related to the structuring of the deal: Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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Local debt or International Debt: The originator can raise funds from the domestic as well as the international markets. UDP raised funds in the domestic market and didn’t have currency volatility risk but the depending on the case the originator might want to raise funds in the international markets and would want to hedge both the currency and the interest rate risk. This would provide not only a risk management tool to the originator, but also provide a source of revenue to IFC. This would also depend on the policies of the government, the structure of the market and the interest shown by investors.

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Other parameters to be fixed include: • Underwriting standards & Bond structure: The LTV (Loan to Value), the DSC (Debt service ratio) are closely linked in the case of APCAFS. Since the project would have no historical basis for the investors to take a decision on the LTV could be high but given that the demand for educational institutes is high, the DSC could be low. The bond structure also depends on the education initiatives. For example the originator would have to know the details about the cash flows of the educational institutes in order to determine the bond term and the coupon rates. The coupon rates would also depend on the risk investors attach to the project and the originator. The coupon rate and the principal payment would have a hardening effect on the tuition fees that the educational institutes would be able to charge. Therefore based on the cash flows, risk associated with the projects, investor profile the bond maturity period and the coupon rate would be fixed. • Credit scoring system: This involves rating of both the originator and the entrepreneur. The rating of the entrepreneur would have an effect on the rating of the debt for the originator, as that would influence the quality of loans made. The originators would be rated by credit rating agencies and the originators themselves would in all likelihood rate the entrepreneurs. • Prepayment (this would vary for each project) • Insurance (this would vary for each project) • Documentation required (this would vary for each project)

Akhil Kishore, The American Graduate School of International Management Cell: (602) 741 9917; [email protected]

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