Difference Between Trust and Retention Account and Escrow Account
Difference Between Trust and Retention Account and Escrow Account
Difference Between Trust and Retention Account and Escrow Account
Trust and Retention Account (TRA) mechanism TRA mechanism has been a common feature in financing of infrastructure projects. It seeks to protect the project lenders against the credit risk (the risk of debt service default) by insulating the cash flows of the project company. This is done through shifting the control over future cash flows from the hands of the borrowers (project company) to an independent agent, called TRA agent, duly mandated by the lenders. 2. The infrastructure projects are executed through a separate company created for the purpose (called 'Special Purpose Vehicle' - SPV) and the shares of the SPV would normally be held, among others, by the sponsors of the project. The cash flows of the SPV (project company) are subjected to a TRA arrangement. Under this arrangement, the lenders, the borrower and the TRA agent enter into a tri-partite agreement, which provides for all revenues of the project to be directed into a single account, maintained with the designated TRA agent. The lenders, in consultation with the borrower, draw up a detailed mandate for the TRA agent as to periodic transfer and utilisation of funds available in the TRA. The mandate basically spells out the manner and purpose of various payments including the debt service to the lenders. The payment to the lenders is to be made directly by the TRA agent, as per its mandate, without any intervention by the borrower. For operational convenience, the TRA could be sub-divided into several sub-TRAs dedicated to separate heads of expenses / purposes. In case of multi currency cash flows, there could also be separate TRAs with the same agent or different TRA agents for handling the cash flows in various currencies. Thus, the TRA agent acts as a trustee on behalf of the lenders and ensures that the cash flows are accessible to the borrower / project company, strictly as per the mandate. Thus, the TRA mechanism could be viewed as a sophisticated version of the traditional 'No Lien' accounts, on which the concerned bank could not exercise its right of general lien. 3. Illustratively, the mandate to the TRA agent by the lenders for appropriation of cash flows could prescribe the following sequence for end use of funds: All operation and maintenance expenses of the project; Monthly dues / accruals of net principal and interest payments to lenders; A debt service reserve equal to, say, six months' dues - which could also be backed by a letter of credit to be arranged by the sponsors of the project company; A cash reserve equal to, say, four months' operating expenses; After meeting all the foregoing obligations, either through L/C or out of project cash flows, the residual funds, if any, would be available to the project company for disposal as per their discretion or as pre-determined by the mandate given to the TRA agent. .
4. A Trust and Retention Account mechanism needs to be distinguished from an Escrow Account arrangement,though the two are somewhat similar. An Escrow Account is an arrangement for safeguarding the borrower against its customers from the payment risk for the goods or services sold by the former to the latter. This is achieved by removing the control over the cash flows from the hands of the customer to an independent agent, who in turn could ensure appropriation of cash flows as per the its mandate. The Escrow arrangement provides for directing a pre-determined payment stream from the customers of the borrower to a special account maintained with a designated agent. Payment / deposit by the user / buyer into such an account is assumed to be a valid discharge of his liability to the supplier of the goods / services. An Escrow arrangement involves parties different from the parties in a TRA mechanism. The Escrow arrangement would involve usually four parties: the lender, the borrower, the customers of the borrower and the Escrow Agent. The mandate to the Escrow Agent would normally be finalised by the lenders in consultation with the borrower and its customers. 5. Thus, for instance, in financing of a power plant which sells its power generated to a SEB, the Escrow arrangement would involve the power producer (borrower), the SEB concerned (customer), the bank / FI (lenders) and the Escrow Agent (a designated bank). The SEB would agree to direct its collection centres to deposit the electricity charges received from retail consumers, into a designated account with the designated bank (Escrow agent) and to direct its bulk consumers to deposit their payments directly with the Escrow Agent in the specified account. The Escrow Agent would then appropriate the funds in the Escrow account as per the priority laid down in the Escrow Agreement. * extract from co-ordination between banks and financial institutions, BP. BC. 82 /21.04.048/0001 dated February 26,2011, available at www.rbi.org.in
Escrow Account
For any Project company, the revenues from the project are the only source of revenue and all the obligations of the company (including taxes, O&M expenses and principal and interest repayment) are met through this revenue. So in order to have a proper monitoring mechanism it is critical that all the Project Proceeds are routed through a common bank account. An Escrow Account is one which addresses this issue. The Project Company opens a Single Bank Account called the Escrow account, which will receive and make all payments in/to the company.
control and authority in the routing of the money. To address this issue and to give a much better control mechanism to the lenders, a Trust and Retention Account is required. The lenders can control the flow of funds in a Trust and Retention Account through certain agreed terms and conditions. A specific Trust and Retention Agreement is executed for this purpose between the company and the Borrowers (sometimes also the Authority) which mentions the terms and operating procedure for the Trust and Retention Account.
The screenshot#1 above illustrates the methodology of functioning of a Trust and Retention Account. The Blue box encompassing all the sub-boxes is the Escrow Account, with the smaller boxes as Sub-Accounts of the Escrow Account. Any project will have two distinct phases: Construction and Operations Period. Let us understand what the basic differences in the funds flow are during these two periods.
Construction Period
The Main Account during this period is the Construction Period Account, which will have various Sub-accounts around it. All the funds which are raised for implementation of the project are routed through the Construction Period Account. The Sponsors deploy there funds into the Sponsors Equity Account (the funds are deployed as per the terms of loan agreement). Similarly, the loans from the Lenders are disbursed into the Loan Account (disbursements as per the Debt Equity ratio and other terms of agreement). Any other type of Project funding is also routed through the Construction Account. All these are called the Inflow sub-account of the Construction Period Account (as illustrated in the Screenshot#1). The funds in the Construction Account can only be used for specific purpose, which are for project implementation work. The various outflow sub-accounts under the Construction Period Account can be seen in the Screenshot#1.
Operations Period
The main account during this period is the Operations Period account. The Revenue Proceeds are the major cash inflow items in the Operations Period. All the Revenue Proceeds are collected in the Revenue Proceeds Account. Any other Cash inflow items like money received on account of some insurance claims or liquidated damages or reimbursements etc. are received in various such sub-accounts (the number of sub-accounts may vary for different types of Project). One of the critical elements of the Operations Period Account is the Prioritisation of the Expenses & Reserves Sub-accounts. The funds in the Operations Period Account are apportioned as per the Priority of payments to be made out of the Operations Account. The Prioritisation (also called the waterfall mechanism) helps analyse the correct cash surplus/deficit position.
The prioritisation order with highest priority of payment ranked 1 and lowest ranked last is as under: 1. Statutory Payments (includes taxes , duties paid to Govt. and other Statutory Authorities) 2. Operations and Maintenance Expenses (includes operation expenses, regular and major maintenance expenses) 3. Interest Payments to Lenders 4. Principal Payments to Lenders 5. Major Maintenance Reserve Account(MMRA) and Debt Service Reserve Account (DSRA) 6. Interest Payment of Promoter Loans 7. Dividend Payments
Please refer to our discussions on MMRA and DSRA in the subsequent topics which has indepth analysis of the requirement of MMRA and DSRA in project finance and methodology of calculating the same. The methodology of prioritising cashflow will render a better picture of the cash position of the company. Further it will also help analyse the surplus/deficit in maintaining various reserve accounts. An Escrow waterfall based Cashflow calculation will be discussed in the subsequent topics. ====================================================================
A Debt Service Reserve Account (DSRA) is a provisional reserve account (cash buffer) created and maintained during good times, to meet the debt obligations of the company during periods of financial stress. During any period when the total cash available with a company after meeting all the statutory and operations expenses is not sufficient for interest and principal payment, then the debt obligations can be met using the amount maintained in the DSRA. Generally principal payments on term loans are made in quarterly intervals and delay (beyond 90 days from the due date) may tantamount to classification of the loan as Non-Performing Asset (NPA). When the debt becomes NPA the banks can invoke the security and collateral and curb the business activities of the company. Hence it is necessary for companies not to default on their debt obligations. At many times, when the economy is under stress, because of demand-supply issues, the revenues/margins of the company can go below expectations (base case business plan). In such eventualities, provisions like DSRA act as a buffer which allows some breathing room for the company to overcome extreme situations. These kinds of measures are essential to prevent the company from defaulting on loans and also beneficial for lenders to prevent restructuring of the loans.
Restructuring is a process that allows a private or public company, facing cash flow problems and financial distress, to reduce and renegotiate the terms of debt in order to improve or restore liquidity and rehabilitate so that it can continue its operations.
has to bear the price increase. Hence, to mitigate this kind of volatility in the price movements of input cost, it is advisable to create reserves like DSRA.
Modeling DSRA
Step1: Creating monthly DSRA requirement
The DSRA requirement at the start of every month is calculated. To calculate the monthly DSRA requirement we should know what is the DSRA provisioning needed as per the terms of the debt. The monthly DSRA requirement is the sum of the interest payable and the principal repayments made for the provisioning period. For illustration let us assume that the lenders have envisaged a DSRA provisioning of one quarter. Then monthly DSRA requirement= Sum of Interest for next three Months + Sum of Principal Due in the next Quarter
The Row 2 of the screenshot above is the principal installments of loan amount with an opening balance of Rs. 500. As can be seen the principal installments are due at the end of every quarter (i.e. 3rd, 6th, 9th and 12th), however the interest payments are due every month (refer Row5). Please refer to our Topic on Loan Repayment Schedule to make simple and effective repayment tables like one above. The Row7 of the screenshot is the DSRA provisioning. Refer to Cell C7, which is a month prior to the first interest payment month. The DSRA in Cell C7 is the sum of the interest payments due in the quarter ahead and the principal payment due in the quarter ahead. DSRA for month0 (M0) = Sum of Interest for next three Months (M1, M2 & M3) + Sum of Principal Due in the next Quarter (Q1) The DSRA for the next month is calculated for the progressive interest and principal payments due. The illustration for the next month DSRA is given in the Screenshot#2 below.
Screenshot #2 : Simple DSRA Assessment table- how to calculate for various months
From monthly DSRA the DSRA requirement for each monitoring period is calculated. For illustrations let us take that the DSRA monitoring period as one quarter. If the monitoring period is one quarter then we take the monthly DSRA requirement in that quarter and take the maximum monthly requirement as the DSRA requirement for that monitoring period.
If the monitoring period is one year then the DSRA requirement for each year is simply the maximum monthly DSRA for the subsequent 12 months (from month t+1 to month t+12). Hence, Yearly DSRA required in T0 is Max (DSRA from T1 to T12).
In the following topic we will discuss the methodology for funding a DSRA/c Expert DSRA Calculation. The topic also gives a wholesome understanding of the interlinkages of DSRA calculation with other Schedules in an advanced financial modeling exercise. ====================================================================================
MMRA:
MMRA: Major Maintenance Reserve Account is an account in which the company keeps aside a portion of their earnings to fund the future Major Maintenance activity.
Every year the project company makes a provision to keep aside a portion of their earnings for Major Maintenance Activity. The account in which the provision is parked is called the Major Maintenance Reserve Account (MMRA). The company will credit MMRA every year and whenever there is Major Maintenance the company will use this money.
The first factor is estimated after detailed due diligence and taking expert advice from technical consultants, insurance advisors and industry norms. The second factor can be estimated by analyzing the past inflation figures.
Modeling MMRA
For modeling MMRA we estimate the following parameters:
1. Interval of Major Maintenance Activity 2. Base MME (If Major Maintenance is carried out today, what will be the expenditure incurred) 3. Inflation factor
Once the project becomes operational Major Maintenance Activity is expected to be carried out after every estimated interval. During the year in which Major Maintenance activity is carried out MME will be equal to the estimated base quantum expenditure multiplied by the inflation factor. For illustration let us assume that base quantum expenditure for Major Maintenance activity is Rs. 100 million, frequency of Major Maintenance is 5 years, estimated inflation is 5% and the construction period is 3 years. Then after every 5 years from the operation start date Major Maintenance is carried out. MME on that year will be Rs. 100 million * inflation index. Inflation index for the first year (ie. The year in which construction starts) is 1. Then for subsequent years it is the inflation index of previous year multiplied by the factor (1 + estimated inflation).
Screenshot#1: Major Maintenance Reserve Schedule The formula in Cell L10 (refer Screenshot#1) is for scheduling MME at the end of every five years starting from the operations start date of the project. The formula has 3 parts
1. If L6= 0 then MME=0,which means the asset is not operational or the asset life span is over then there will not be any MME. 2. If L6< MME_Interval then MME=0, which means the no of operational years is less than first MME interval and so MME will be zero. 3. If (MOD(L6, MME_Interval)=0 then MME=Base_MME* Inflation index. MOD calculates the intervals of 5 (i.e.5th, 10th, 11th years and so on). On such years, the Base MME Assumption is multiplied with the inflation index for that year
Provision for MMRA is equal to MME requirement divided by the frequency of Major Maintenance. Let us look at cell H12 in screenshot #2. The formula If H6>0 checks whether the project is operational. If it is operational then MMRA requirement is the sum of Scheduled MME for five years starting from the current year divided by the frequency of Major Maintenance.
Yearly opening balance of MMR Account is the closing balance of MMR account in the previous year. For the first year the opening balance will be zero. Credit to MMR Account is the provisioning done for the MMR Account in that year. Debit to MMR Account will be equal to the Major Maintenance Expenditure in that year. It will be zero when there is no Major Maintenance. Closing balance of MMR Account is the sum of opening balance plus the credit to MMR Account minus the debit from MMR Account.
The MMR Account will be zero during construction period The MMR Account will go to zero during Major Maintenance Period as all the money will be utilized for Major Maintenance (though in reality it need not be the case, as Major Maintenance expenditure could be less than the estimated). Debit to MMR Account will happen only during the Major Maintenance period.