Verifying DIAL financial model used in tariff-AERA use of consultants apt?

GMRs demand for 6x-8x tariff increase for Delhi Airport,  made for severe media and interest group scrutiny, as people were mentally reluctant to accept this tariff shock. Hence, the aviation regulator AERA thought it fit to have extensive consultations etc, and released a consultation paper in Jan12 inviting comments by Feb29,2012. While reading that consultation paper(CP-No.32/2011-12-Determination of Aeronautical Tariff –IGI Airport, New Delhi, read it http://aera.gov.in/writereaddata/consultation/116.pdf) I noticed a very interesting section from para 21 onwards which stated that in order to analyse, review and advise on the financial model used by DIAL as a part of their tariff application, the Authority appointed Consultants. The scope of the assignment included

1. Review and assessment of the models' arithmetic accuracy:-independent cell-by-cell  inspection and sheet-bysheet review of the arithmetic accuracy of formulae and calculations contained in the model including tracing items through the various interlinked sheets and calculations back to the input data and verifying the correct application of addition, subtraction, multiplication and division based on standard business and financial logic
2. Check for logical and calculation integrity of the models verifying that the links within the model are working accurately; assessing that any macros that govern calculations in the model are running as intended; assessing that the model is logically constructed, internally consistent with respect to calculations and formulae and is fit for the purpose of undertaking analyses of relevant  aspects for tariff determination by the Authority; assessing that assumptions in the Financial Model are at one place and that there are no hard coded numbers in calculations in the Financial Model that might influence calculation results in unexpected ways and checking whether the assumptions listed in the assumption sheet are getting correctly reflected in the various sheets of the financial model.  
3. Consistency check with key agreements/documents:- Further, the Consultants were also required to ensure that the Financial Model accurately reflects the concession offered by the Central Government with respect to the key agreement(s), and financial documents as also the provisions in the Act. The tasks here included consistency check for incorporation of provisions from key agreements related to various Building Blocks into the financial model.
4. Assistance in undertaking certain sensitivity analyses. The Consultants were further required to provide assistance to the Authority in identifying such elements that may need to be certified from auditors /Chartered Accountants of DIAL of key aspects/ assumptions taken from the key / concession agreement(s) and also assist the Authority in reviewing the implications/change in results through sensitivity analysis of various factors like growth rate in traffic, inflation etc., to be conducted with respect to specific changes to assumptions for a factor or even reviewing the drivers and projection bases for such factors. 

I agree that financial modelling is not easy, in fact there are entire specialized courses on the subject and that the very complex issues in this(as opposed to power/roads/ports) may have prompted the authority to seek external help. But while the first two aspects could have warranted taking a consultant's help for Excel alone, the consistency checks and sensitivity analyses surely comes within the expected circle of competence of the regulator. Maybe they did not want to risk mistakes in such an important case and so they engaged consultants. Also to be fair, even other regulators do engage consultants to advice on tariffs petition process(but they are not explicitly acknowledged in the orders), so maybe I'm just shooting the messenger(AERA) who was upfront in admitting this, even if for the purpose of protecting themselves against subsequent judicial review. But for anyone in the infrastructure finance field either as preparer, auditor or banker, the above process used by AERA is quite instructive

IFACs useful insights for aspiring financial services entrepreneurs

Recently, I read the IFAC SMP Practice Management guide aimed at small and medium size accounting practitioners. But due to the explosion of the field, it is relevant even for non audit services like valuation, management accounting, SAP consultancy, merchant banking etc. I would urge you to read the entire version here(http://www.ifac.org/sites/default/files/publications/files/SMP_Practice_Mgmt_Guide.pdf) but otherwise I give below a few salient points which I found insightful

1. A realistic self-assessment checklist:-Appendix 1.1A gives an interesting checklist which asks you to assess your technical skills,managerial or people skills, financial resources, marketing skills, support networks and personality. Also, how does this tie in with your financial and other goals? Appendix 1.6- Strategic planning diagram is also very interesting.
2. To specialize or to generalize? Your competitive strategy:-The three possible “market strategies” are Overall cost leadership(low price is easy, its low cost that is difficult!),Differentiation(but in services this can be copied with ease..) and Focus(while expertise may win you legitimacy and clients, make sure that market segment must be able to afford your services; otherwise you risk targeting the firm’s efforts into low-yielding work which your competitors would gladly see you do). Pricing Policy varies accordingly.
3. But eventually cover the full range of commercial issues:-As per current trends, be prepared to progressively expand your range of services to get higher share of wallet of clients, else risk losing them to a full service provider/other networks. This is where firm networks help.
4. Good promotion does not need to be expensive:-Subject to professional ethics rules, low cost are anonymous case studies to demonstrate the practical benefit from each service; newsletters or other media as an attachment to your engagement letters, engagement concluding discussions etc.
5. Partnership agreement checklist:- Appendix 2.2 Items to be included in a partnership agreement or shareholder agreement checklist, covers this. Interesting aspects are management, dispute resolution, exit provisions, valuation formula, and capital investment,decision-making process(including that on managing partner), partners’ access to profits/remuneration/loans etc.
6. The “devaluing” of information by the Internet:-Accountants charge a fee to provide advice to clients: the advice is based on information (which some clients might find free of charge via the Internet) and it is applied to the client’s specific situation. Accountants must consequently
   focus on value-adding for the client (delivering benefits, not just information) and continually resell the savings, security or the confidence that their services represent. This is true even for Certified Financial Planners who compete with magazines and stock tips!
7. Service delivery plan:-Mobile technology—especially telephones and Internet-based wireless communications—enables a “virtual office” to be operated
8. Sample staff office manual:-They actually enclose an entire sample manual including SOPs, office forms and guidelines on customizing it!
9. Beyond Revenues/profits:- Controlling debtors/work in progress(thereby better billing and liquidity) finally grows revenues, cash flows and profits. So it is the small things which matter. 
10. Minimizing potential problems in service delivery:-assess client expectations/intended use of reports; objective report, or does the client require subjective judgment; Is the service provided high risk?(like assurance services); Have any other professionals rejected the potential client?;Are there any concerns about a client’s viability, reputation, or management
11. Professional Indemnity Insurance:-Have you declared all services offered to the underwriter?How are you engaging subcontractors/agents/consultants, and how are you indemnified in respect to their work? Are you or is your advertising/promotional material deceptive or misleading as to your skill, qualifications, etc.?
12. Communicate outcomes:-Clients rarely see or know the full extent of the work you do. Therefore, the presentation of the final outcome assumes great importance in ensuring that clients are satisfied with your work or advice. Make sure that the client understands not only the cost of your service, but also the net benefit they have gained: in this way, you continually resell the importance of your work.
13. Rising levels of regulation and professional knowledge:-The combination of re-regulation plus higher professional standards will place enormous demands on accountants and their employees. Heavy investment will be required in ongoing training and on subscriptions to a wider array of information services, just to maintain current knowledge. In turn, this level of training and investment will also place substantial pressure, both financial and emotional, on the principal or partners of small firms
14. Information and resource management:-Where do you obtain your information and resources that you rely on? Are your information sources reliable? Do they support your obligation to take
    reasonable care? What about continuing professional development?
15. Client documentation:-have operational notes in client files (e.g. software, postal preferences),checklists,documented procedures such as manuals, standard letters, ISO needs.
16. Continuity of business: the second generation
17. Value drivers during exit:-A larger firm is unlikely to seek your infrastructure or systems. It is more likely they want your client base and recurring income stream. They will probably also be interested in your staff who have client relationships and institutional knowledge and history

What banks can learn from the retail industry

I Googled this title and related phrases and while I found quite a few good articles and research reports, not many covered all the points I wished to, and so this blog post. The stimulus of this blog post was an interview answer I gave recently, where I said that banks should learn from best practices in other sectors such as talent management in the ITES industry, supply chain management from FMCG and a lot from retail. The main learnings in my view are below

1. Retail banking-the low hanging fruit:- Retail banking has retail in its name-what more similarity can you want! Essentially, learnings like location, merchandising, targeted advertising
2. Focus from branches to Points of Sale:-FMCG industry always harps on its points of sale(POS) instead of stores, and banks are slowly moving to non branch models like business correspondents, full fledged ATMs, multiple touch points etc too.
3. From 'commodity focus' to 'experience focus':-The greatest of retailers be they Sam Walton or Kishore Biyani know that even though low price/wide selection is necessary, what is more important is to design the store with an inviting ambience for its target customer, and to have customer friendly policies in return/payment(something Nordstrom is famous for). 
4. Loyalty programs:-This is something missing in the retail segment(except for maybe high end customers) but which corporate bankers implicitly do in their relationship banking. Agreed that bank pricing cannot be made so transparent to allow loyalty programs, but the bank should strongly communicate that it values customers who maintain long banking relationships with them. Also, tieups with other industry is prevalent in the credit card segment, maybe banks can do this for tieups with preferred service providers like auditors, valuers, chartered engineers, insurers etc, provided the respective regulators/professional bodies do not see red
5. Talent Management/Non monetary motivators:-In retail, the salaries are not the best especially at the store level, resulting in attrition yet the management does their best to keep staff motivated. As the banking regulators clamp down on high pay, banks must increasingly learn how to keep their personnel motivated even without that promise of a $MM payday. 
6. Pricing to explictly recognize loss leaders/market penetration/activity based costing:-Retailers have done this kind of pricing for decades, but bank pricing models are nowhere near this level yet, with some arbitary model adjustments done for 'relationship' reasons. 
7. Selling outside brands as well as private labels:- Banks focus on their proprietary products aka 'private labels' but they are slowly realizing that they need to offer third party products as well to ensure better infrastructure utilization and better customer service. While the tussle for 'shelf space'/'sales force attention' will always be there, there is no reason both cannot coexist.

These are just a few points, am sure readers can think of more. 

If REC ignores audit recomendations, then why have the audit?

REC is a well known equity and debt issuer, with an IPO/FPO and many successful bond issues under its belt. It even has Navratna status, and is an important partner in the Indian Government's efforts for rural electrification. But when it comes to listening to its auditors and solving their audit queries, it has a long way to go. From the Feb12 bond prospectus(http://www.sebi.gov.in/cms/sebi_data/attachdocs/1330060059753.pdf), I noticed that many points were repeating in the audit objections in Appendix I F-1 to F-4 after Pg 302, which are tabulated below in brief.

You would notice that the major violations relate to utilization of government grants, monitoring of loans given to SEBs/discoms, and an elementary thing like obtaining search reports. And despite power projects getting 'restructured' routinely, it had not occured to the management to ensure that they ascertain the viability of the revised project before according their routine sanction to the restructured loans.

And mind you, this was not the C&AG audit which is anyway expected to be critical. It was the statutory financial audit, for which the points were raised but not acted upon(hence they repeat for each year). It is not my intent to criticize the auditors-after all change takes time in government organizations, and they did play their part by qualifying the report.  Note that the financial auditor has only the audit report to apply 'moral suasion' on the company to make the change. But for some points to be unresolved for the past 4-6yrs as seen in this table, is a bit incredible. To their credit, REC did solve a few audit objections by FY11(hence they drop off) but the pace is just too slow. It is hoped that listing and the frequent bond issues will make REC more respectful of the auditor's recommendations.

Goldman Sach disclosures on mutual fund conflicts of interest

While reading the offer document for Goldman Sachs India Equity Fund (http://www.sebi.gov.in/cms/sebi_data/attachdocs/1329211311237.pdf) filed last month, I noticed a very interesting section titled 'Material Interests of the Sponsor, AMC and Trustee Company', in which they went all out to explain the direct and indirect interests that their various arms may have. I think this was to stave off conflict of interest accusations which popped up post the infamous Abacus controversy, in which though Goldman Sachs lost money themselves, they were accused of playing both sides by advising Paulson and then helping sell the securities he helped select. So thought he CEO did apologize and clarify things later, they seem to be playing extra cautious. Just sample some of the illustrations in that offer document

1. Due to information barriers, conflicting fund objectives etc, the investment decisions taken by GS for its proprietary and client accounts may be superior to or conflicting with its decisions as an AMC. For example, a scheme holding debt securities of an issuer may seek liquidation while a scheme holding equity securities may push to delay it. 
2. The AMC may not have access to, and may make recommendations different from the research/models/information of the GS group. 
3. While allocating investment opportunities/purchase sale decisions to different schemes, that depends entirely on the AMCs good faith assessment, and may result in no allocation to the scheme
4. Due to regulatory requirements resulting from other activities of GS group like market making/capital market advisory etc, the scheme may not be permitted to deal in certain securities. 
5. GS may act as broker/dealer/lender/agent/trading network owner/settlement system or trading system owner etc, and would benefit from the incomes to that extent when the scheme uses those services.

SEBI does try to investigate and stop some of these conflicts by imposing code of conduct, transfer pricing approval by 'Mutual Fund advisory board' etc, but can do things only till a point. Investors are helpless to find out and act on the above points even if they exist. Atleast GS is explicitly disclosing these risks, which is commendable. 

Want to do well in corporate finance? Know these Indian legal/tax nuances

Corporate finance is less about number crunching, and more about navigating multiple minefields of people, institutions, procedures and laws. More so in highly regulated environments like India. Though I've not worked in corporate finance before and defer to to the judgement of my seniors in this regard, the below is my perceptions from the varied theory I've studied before this.

1. Although operating cash flow/FCF are modeled for purpose of financial calculations, know that Section 205 of the Indian Companies Act 1956 allows declaring of dividends only out of profits post depreciation charge. So do not assume that 100% FCF can be paid out as dividend.
2. For listed securities, capital gains tax is nil for holding period over 1year(but only IF sold on exchange, and not if through buyback/open offers) but dividend distributions are taxed @18% or so. Hence, irrespective of shareholder preferences/liquidity desires, it may make sense to reward shareholders through long term capital appreciation rather than dividends/buy backs. 
3. While listing carries associated obligations, note that it has tax advantages like being considered widely held company for tax purposes(hence freedom to make certain related party loans, get certain tax benefits etc) besides the tax free exit option for investors post listing. Hence, factor that in during the cost benefit analysis for listing.
4. Some companies prefer to infuse equity as shareholder loans to benefit from the tax shield. To avoid this quasi equity structuring, some tax authorities have thin capitalization rules wherein in certain circumstances, excessive leverage will be treated as equity for tax purposes. Even India is considering such a proposal in the Direct Tax Code bill. So take that into consideration.
5. Transfer pricing may be seen as an internal management tool to ensure the overall coordination and efficiency of different sub units, but tax authorities(be it excise, customs or direct tax) are taking an increasing interest in ensuring that the transfer prices between units are at arms length. Hence, be it intragroup treasury transactions for cash management; transactions between vertically integrated units etc, transfer pricing does attract the long arm of the law, and may pose problems if the policy is not easily defensible or negotiations cannot be proven.
6. Depreciation for statutory financial reporting is NOT just a business decision, but is subject to certain minimum statutory limit under Schedule IV of the Companies Act. Adopting higher depreciation rates may result in lower profits, but also a lower tax base for the Minimum Alternative Tax(MAT/AMT) which is based on adjusted reported profits.
7. Many economic laws/fiscal laws/competition laws have a default provision of vicarious liability which hold the company/its officers/other responsible person liable in case of violations. However, permitted defenses include good faith/ignorance(in case of non executive directors) or entrusting a competent/reliable person with the compliance duty-IF he was actually in a position to discharge it. Hence to save their skin under Section 205(5) of the Companies Act 1956 and other similar laws, directors are well advised to ensure that their top accountants/legal personnel are top notch and given appropriate organizational respect
8. For investing surplus funds in shares of other companies, Section 372(5) of the Companies Act 1956 mandates a specific Board resolution for every transaction, with the unanimous consent of every director present and entitled to vote on the matter. And this power cannot be delegated.  There is no legal distinction between treasury investments and strategic investments for this purpose. There are other restrictions on investments/lending under both Section 292 and Section 372 as well. 
9. In case long term leverage limits(measured as a multiple of paid up capital+free reserves, numerator excluding short term loans in course of business) exceeds 1x, there is shareholder consent needed, and for certain other borrowings/investments as well.
10. In a public offering, a company is not permitted to raise more than 5x of its existing equity funds in domestic markets, as per SEBI ICDR Guidelines. To circumvent this, companies have gone for ADR/GDR offerings in the past, but now SEBI is clamping down on this by mandating disclosures of fund utilization, and also an earlier norm of simultaneous domestic IPO along with GDR/ADR. 
11. Before capitalizing profits into reserves or into bonus shares, remember the impact on dividends or additional restrictions like appointing audit committee/secretarial compliance etc. For example, once profits are transferred to reserves, using them to declare dividends becomes cumbersome with limits of 20% etc, and once paid up capital(as opposed to shareholder funds) crosses Rs 5 crore, Section 292A mandates appointing an audit committee with independent directors and all. Also, Section 294 mandates Government approval for appointing a sole selling agent in every case that paid up capital>Rs 50 lakh.  So take note of these unintended consequences that may hamper confidentiality and financial flexibility, especially for unlisted companies.

Tata Power's perpetual bonds-tax deductible 'interest' with equity treatment?

While reading the 3Q'12 financials of Tata Power(http://www.tatapower.com/investor-relations/pdf/q3-results-31-dec-11.pdf), I was intrigued at a note which mentioned that

This issue was of Non Convertible Debuntures in Jun-11, and the features(subordinate, perpetual, deferred interest possibility, not redeemable at option of holders) do make it like the quasi equity instruments that banking regulators are demanding for banks to issue as part of their Tier I capital. As long as the company is a going concern, it will pay interest(remember this is a TATA group company which has never defaulted), and hence the substance of the obligation is debt-indeed that is why the holders are willing to trust it with such a risky instrument. However, optimism and past history does not guide accounting more than the legal form, and therefore the instrument is classed as equity, with corresponding effect as interest.

What really interests me is the below questions. I could not download the prospectus, so had to make do with its summary and CRISIL's rating FAQs here(http://www.crisil.com/Ratings/Commentary/CommentaryDocs/CRISIL-ratings_tata-power-faqs_may11.pdf).

1. Banks & rating agencies treat this as equity or debt. I think they would make proforma adjustments at the bare minimum, likening this to preferred stock which is routinely classed as debt in models. For instance, CRISIL said that it would 50 per cent equity content to this instrument. It implies that  its analysis of Tata Power's capital structure and financial ratios, will treat 50 per cent of the principal amount as equity and the remaining as debt.  The reason for the partial debt treatment is CRISIL's belief that the the high fixed coupon of up to 11.6 per cent and a step-up of up to 200 basis points (bps) would prompt Tata Power to exercise  the first call option date after 10 years
2. Does the company deduct withholding tax as interest or dividend:-Since form rules over substance, I guess the company would treat this as interest for tax purposes, which would give the best of two worlds-tax deductible interest but not expensed. So far, India does not have GAAR rules to re-characterize financial instruments in this manner-although the Direct Tax Code 2011 would certainly arm the taxman powers to so. Since the bond issue is new, this matter has not been litigated yet, and the result would be interesting.

Thought the total debt is a pittance compared to Tata Power's existing debt and equity base, investors should watch out in case other issuers adopt this for a larger proportion of their capital structure.So before taking the debt numbers from that free online service, just take a note of these things also