Lanka ORIX Leasing Company Limited - Adb

I. A. THE PROJECT Project Background 1. The Asian Development Bank (ADB) has actively promoted the leasing industry in Asia as an effective means of deepening and diversifying the finance sector and enhancing access to finance by small and medium-sized enterprises (SMEs) in several Asian countries.1 Leasing allows clients the use of equipment and machinery without the need to accumulate capital (or bank debt), thus providing a suitable alternative source of credit for small enterprises lacking equity or access to formal sources of finance. 2. In Sri Lanka, leasing companies fill a financing gap for SMEs that is created by the conservative and collateral-based bank lending prevalent in the country. However, nonbank leasing companies have to rely heavily on commercial paper and short-term borrowings from commercial banks to fund their long-dated lease portfolios. The resulting maturity mismatch increases operating risks, decreases efficient use of funds, and constrains leasing companies’ ability to serve their SME clients. 3. In 2006, ADB conducted a comprehensive review of the Sri Lankan finance sector and met with a number of private domestic banks and leasing companies. At that time, Lanka ORIX Leasing (LOLC), the first specialized leasing company in Sri Lanka, expressed interest in obtaining ADB financial assistance. In March 2007, ADB’s Board of Directors approved the South Asian SME Leasing Facility, which provided direct loans to LOLC and Maldives Finance Leasing Company.2 B. Key Project Features 4. On 15 August 2007, ADB signed a facility agreement with LOLC for a 10 million senior secured loan payable in 5 years, with no grace period. The loan had a floating interest rate of 6-month LIBOR plus a credit margin. The loan was fully disbursed on 24 August 2007. The loan was secured by a portfolio of specific lease receivables. C. Progress Highlights 5. LOLC was established in 1980 as a result of a government initiative to support the creation of a leasing industry and became Sri Lanka’s pioneer leasing company. Since then, ORIX Corporation (ORIX), a Tokyo-based financial services group, has been and still remains the single largest shareholder of LOLC with a stake of 30%. LOLC is listed on the Colombo Stock Exchange and was last rated BBB (lka) with a negative outlook in October 2012 by Fitch Ratings Lanka (Fitch).3 6. LOLC has strategically positioned itself to become a total financial solution provider by expanding its business scope through the acquisition of companies. To this end, LOLC made several strategic investments and acquisitions in financial and nonfinancial companies in 1 2 3 ADB. 1985. Technical Assistance for a Study of Leasing in Selected Developing Member Countries. Manila.; ADB. 2006. Technical Assistance for Capacity Building for Financial Institutions. Manila; ADB. 2001. Technical Assistance to the Democratic Socialist Republic of Sri Lanka for Enabling Small and Medium Enterprise Growth. Manila; ADB. 1998. Technical Assistance to the Republic of the Philippines for a Study of the Leasing Industry. Manila; ADB. 1990. Technical Assistance to the Republic of Indonesia for the Development of the Leasing Industry. Manila; ADB. 1991. Technical Assistance to the People’s Republic of China for a Study of the Leasing Industry. Manila. ADB. 2007. Report and Recommendation of the President to the Board of Directors: Proposed Secured Loans to the Republic of the Maldives and Democratic Socialist Republic of Sri Lanka for the South Asian SME Leasing Facility. Manila. LOLC then withdrew its Fitch rating in connection with its corporate reorganization into a holding company.

2 areas such as agriculture and plantations, renewable energy, leisure, construction, automobile services, and trading. In 2011, LOLC successfully transformed its business from being primarily focused on financial services to a diversified conglomerate. By the end of 2012, the LOLC Group had entered into more than 13 joint venture companies.4 7. In 2008, LOLC acquired a 97% stake in Commercial Leasing Company (CLC). The acquisition created cost synergies in core operations and treasury, and some back-office functions of the two companies have been integrated since the acquisition. However, both companies operate as separate entities and are managed independently. With the acquisition of CLC, LOLC is now a market leader in the leasing and factoring industry. 8. To effectively manage its varied interests, LOLC reorganized into a holding company to focus its strength and resources in managing its subsidiaries. The Central Bank of Sri Lanka approved this step in April 2011. As a result, the LOLC Group’s leasing business is now exclusively located in LOLC’s subsidiary CLC, and LOLC acts as a holding company with controlling interest in 13 firms offering diversified financial services. 9. While lenders in general agreed with the reorganization as an impressive and successful business move, the new corporate structure was not compatible with ADB’s facility agreement. As a result of cooperative negotiations between LOLC and ADB, the parties agreed to a prepayment of the loan 9 months before its scheduled maturity. The loan was fully paid on 1 November 2011.5 II. A. EVALUATION Project Rationale and Objectives 10. Prior to approval of the loan to LOLC in 2007, SMEs were estimated to make up 80%– 90% of all enterprises in Sri Lanka and accounted for 75% of employment. Even as SMEs play a significant role in economic growth and development, most had limited access to finance as banks are risk averse and prefer collateral-based lending. Additionally, most SMEs in rural areas had limited access to banks and credit lending. Leasing provides a valuable alternative source of credit for SMEs. However, the underdeveloped nature of the corporate debt market in Sri Lanka at that time made nonbank leasing companies heavily reliant on commercial banks for funding through short-term loans. 11. The ADB loan to LOLC was structured to provide access to long-term funds and thus enabled LOLC to support its lease finance portfolio and promote alternative financing instruments to SMEs. The project aimed to promote the growth of SME operations and enhance SME profitability and competitiveness. As a secondary goal, by strengthening the leasing system, ADB hoped to improve the development of broader capital markets in Sri Lanka once leasing companies had established an operating history and could access the equity and debt markets. 4 For the purpose of this report, the term LOLC Group is used to denote LOLC and its consolidated subsidiaries before the conversion into a holding company structure. After April 2011 the term denotes the holding company including the subsidiaries contained in it. 5 Considering that significant developmental results had already been achieved, other alternatives considered at the time were too expensive or time consuming for ADB, given the relatively short remaining tenor of the loan and the fact that other ADB business with LOLC (through its subsidiary CLC) remains ongoing.

3 B. Development Impact and Outcome 12. The development impact and outcome are rated satisfactory when evaluated using the following criteria: (i) private sector development; (ii) business success; (iii) economic sustainability; and (iv) environmental, social, health, and safety performance. 1. Private Sector Development a. Beyond Company Impact 13. Leasing industry. The leasing industry of Sri Lanka comprises commercial banks, licensed finance companies, and specialized leasing companies licensed to provide leasing facilities.6 During 2007–2012, the leasing industry grew stronger as an alternative source of financing, with lease volumes increasing at a compounded annual growth rate of 18.7% (Table 1). 14. As the largest leasing and factoring provider, LOLC was one of the drivers of industry growth. LOLC continues to develop new products and services, and create new markets. The post-war economic development has opened new geographic areas for the LOLC Group and thereby for the leasing industry in war-affected areas of Sri Lanka (paras. 18–21). Table 1: Lease Volume, 2007–2012 (SLRs million) Registered Finance Leasing Establishments Commercial banks a Leasing companies Total 2007 61,058 79,886 140,944 2008 54,530 79,257 133,787 2009 42,866 64,477 107,343 2010 51,292 87,503 138,795 2011 95,389 166,051 261,440 2012 117,505 214,866 332,371 a Data pertains to licensed finance companies and specialized leasing companies. Source: Central Bank of Sri Lanka Economic and Social Statistics, 2012. 15. LOLC started its operations in 1981 as the country’s pioneer leasing provider for SMEs. ORIX, the single largest leasing company in the world and the second largest financial solutions provider in Japan, has provided continuous guidance and expertise to LOLC in the field of leasing and factoring business. It provided knowledge and skills in leasing and factoring to LOLC and its subsidiaries and other leasing companies in Sri Lanka benefitted. 16. Capital markets. The ADB loan aimed to support LOLC operations and financial performance, thereby enabling it to access debt markets and support debt market development as a secondary goal. During fiscal year 2011/12, LOLC issued SLRs1.25 billion of debentures comprising (i) SLRs610 million with a 4-year tenor at 11.7%, (ii) SLRs500 million with a 4-year tenor at 12%, and (iii) SLRs140 million with a 5-year tenor at 11.9%. These debentures are listed on the Colombo Stock Exchange and rated A–(lka) by Fitch, indicating their high credit quality and strong payment capacity. 17. The investments of LOLC and its subsidiaries in new and existing companies as a result of the company’s diversification served as an important contribution to the Sri Lankan economy and capital markets by turning around troubled companies to become profitable and sustainable, thus preparing for expansion and employment generation. One example was LOLC Group’s acquisition of the troubled Seylan Bank, a systemically important bank in Sri Lanka. LOLC Group acquired 23.42% of the voting shares of Seylan Bank in 2009. In 6 Lease facilities extended are mainly finance and operating leases. In operating leases, ownership of the leased asset remains with the lessor during the life of the transaction. Finance leases resemble an installment purchase agreement and the lessee becomes the owner of the lease object at the end of the transaction.

4 December 2010, the bank's profits doubled from SLRs555 million in December 2009 to SLRs1.2 billion in December 2010. 7 The bank is now well on the way to providing solid support for the finance sector. b. Direct Company Impact 18. SME growth. LOLC’s core area of business is in lending to the SME sector. The substantial expansion in its loan portfolio reflects the impact it has had on SMEs. Table 2 shows LOLC’s new disbursement in SLRe volume. To appreciate the degree to which business is focused on the lower end of the SMEs with traditionally limited access to equity and commercial funding, note that the company’s loan and lease size averages SLRs630,000 (currently below 5,000). From 2008 to 2012, LOLC was able to reach close to 50,000 clients annually on this basis. Table 2: Lease Disbursements to Small and Medium-Sized Enterprises, 2008–2012 (SLRs million) Item LOLC (Company) LOLC Group 8 Number of transactions 2008 12,127 14,320 22,730 2009 12,170 14,906 23,660 2010 4,569 21,963 34,862 2011 5,036 47,392 75,225 2012 3,926 58,233 92,433 LOLC Lanka ORIX Leasing stand-alone, LOLC Group including group companies, such as CLC and others. Source: LOLC annual reports, company information, Private Sector Operations Department calculations. 19. One of LOLC’s key success factors for promoting SME growth has been its nationwide presence and accessibility. LOLC has 105 branches comprising main branches, minibranches, and Lanka Indian Oil Company fuel stations (Appendix 1, Table A1.2). Continued geographic expansion has created opportunities for LOLC to serve SME borrowers, in particular those residing in the previously war-torn Northern and Eastern provinces, which do not have much access to finance. Through its branch networks and through 32 Sri Lanka Post branch offices and 87 service centers, LOLC has been able to reach SMEs and small entrepreneurs on a nationwide scale. As of year-end 2012, 70% of LOLC Group branches were outside Western Province. Countrywide improved management information systems link the entire branch network enabling services to reach even rural customers. Moreover, branch operations are backed by a round-the-clock customer service hotline. 20. Long-term finance. LOLC has been successful in sourcing funding from IFIs at attractive rates and terms. The IFI contributions provided funding to the LOLC Group and helped LOLC attain operating excellence, enhance its existing processes and procedures, and improve compliance and governance (Appendix 1, Table A1.3 lists LOLC’s global funding partners). The ADB loan was not the only support for LOLC’s funding activities, but long-term loans from other IFIs have strengthened the LOLC funding base as well. In turn, LOLC has made conscious and sustained efforts to appeal—in its products, corporate governance, reporting, and safeguards—to the requirements of IFIs, which are still among the prime sources of long-term finance in the Sri Lankan market. This mutually beneficial cooperation between LOLC and its IFI partners has enabled the company to access the bond markets on a regular basis, strengthening its financial base and aiding the development of local bond markets. 7 8 Fitch Ratings Lanka. 2013. Seylan Bank PLC. http://www.fitchratings.lk/doc view.php?doc 23 0&org 19 An average transaction size of SLRs630,000 (less than 5,000 equivalent) was used to estimate this number. Since in the later years covered in this report most lease origination was done by the LOLC Group’s company CLC, CLC’s average lease transaction size was used as a proxy.

5 21. New products. LOLC has been instrumental in introducing major changes for SMEs by providing leasing companies with financial solutions. Aside from conventional leasing and loan products, which required equal monthly installments, LOLC has provided customers with flexible repayment schedules according to their ability and capacity to pay. It has also provided SME clients with working capital solutions using invoice discounting, check discounting, packing credit, and factoring. Apart from creating synergies among LOLC Group companies, the strategic move to become a holding company has created new business opportunities for LOLC’s microfinance company through the sharing of branch networks in order to reach low income borrowers with microfinance products. c. Overall Assessment of Private Sector Development 22. The expansion of LOLC’s lease portfolio reflects its contribution to strengthening the leasing industry, and promoting and supporting SME growth and development. In this regard, the contribution of ADB assistance to private sector development is rated satisfactory. 2. Business Success 23. LOLC’s net profits remained positive despite macroeconomic uncertainties during FY2008–FY2012. After 30 years, LOLC reached business maturity, prompting it to diversify into other areas of finance and acquiring more than 13 subsidiaries and affiliates in areas such as finance, trading, plantations, renewable energy, and leisure. Selected LOLC financial indicators based on audited consolidated figures are shown in Table 3. 24. Following its transformation to a diversified multifinance conglomerate in 2011, LOLC Group’s net income grew by an exceptional 194.5% in FY2011, thus yielding a compounded annual growth rate of 40.3% from FY2007 to FY2012. Growth was primarily driven by the strong performance of the financial services group, which contributed 60% of the net profit, reinforcing the stability and sustainability of LOLC’s core business. 25. Asset quality. LOLC has maintained a strong focus on asset quality supported by stringent loan monitoring and effective collection efforts. While NPL ratios increased in 2008/09 due to the civil war and effects of portfolio seasoning, the 2012 ratio at 1.6% is a laudable result in comparison with the industry average NPL ratio of 7%. 26. Liquidity. LOLC’s track record of financial strength and affiliation with ORIX has allowed it to gain access to local and foreign institutional funding. The appeal of LOLC’s business model, its quality of corporate governance, and adherence to IFI safeguard standards has attracted long-term funding from ADB; the Organization of the Petroleum Exporting Countries (OPEC); FMO, the Netherlands development finance company; DEG, the German investment and development corporation; the World Bank, and others (Appendix 1, Table A.1.3). 27. Return on invested capital. The time-adjusted real financial return on invested capital, used as a proxy to derive the financial internal rate of return, when adjusted for inflation, is rated satisfactory.

6 Table 3: LOLC Selected Financial Indicators, 2007–2012 (SLRs million, unless otherwise indicated) Item Loans and advances Total assets Long-term loans Total borrowings Total liabilities Total equity Gross income Net income Debt to equity (times) NPL ratio (%) ROA (%) ROE (%) 31 Mar 2007 5,751 24,484 10,308 16,740 20,659 3,825 8,317 1,050 5.4x 0.6% 4.3% 27.5% 31 Mar 2008 8,563 32,994 12,970 21,797 27,816 5,178 12,676 1,271 5.4x 1.8% 3.9% 24.5% 31 Mar 2009 12,550 46,287 18,608 29,013 40,196 6,091 13,622 1,055 6.6x 4.3% 2.3% 17.3% 31 Mar 2010 15,085 75,371 18,016 35,248 55,632 19,740 14,902 2,385 2.8x 3.0% 3.2% 12.1% 31 Mar 2011 29,402 113,071 28,368 45,219 78,256 34,815 32,077 7,023 2.2x 1.7% 6.2% 20.2% 31 Mar 2012 40,129 145,204 36,525 61,414 101,991 43,213 35,533 5,704 2.4x 1.6% 3.9% 13.2% LOLC Lanka ORIX Leasing Company, NPL non-performing loans, ROA return on assets, ROE return on equity. Source: LOLC audited consolidated financial statements, 2008–2012. 3. Economic Sustainability 28. The economic return on invested capital is rated excellent as it meets the uppermost hurdle rate. 9 29. LOLC has contributed to economic development by expanding lending to SMEs, which eventually contributed to job creation and higher employment. LOLC itself has 948 staff while the LOLC Group has 3,699. LOLC contributed to the economy and government revenue by paying SLRs738 million of corporate income taxes during FY2008–FY2012. 4. Environment, Social, Health, and Safety Performance 30. LOLC’s environment safeguards are classified as FI with respect to ADB’s Environment Policy and category C for ADB’s Involuntary Resettlement Policy and Policy on Indigenous Peoples (footnote 2). As the facility agreement prohibits financing of any subprojects that could have adverse environmental impacts, LOLC was required to have an environmental management system (EMS) including a screening system to select subprojects that have no adverse environmental impact. Given that LOLC (i) had an EMS, (ii) is financing leasing projects or activities that have no environmental impact, and (iii) confirmed that it had not provided ADB funding to any borrowers to support activities that could have adverse environmental impacts, 10 LOLC’s compliance with environmental standards, practices, and procedures is rated satisfactory. 31. LOLC required, as part of its due diligence, that all its prospective borrowers submit a clearance from local environment authorities prior to loan approval. LOLC reviewed the environmental implications of all subprojects assigned under the ADB loan and confirmed to ADB that they did not provide any borrowers with funding to support activities that could have adverse environmental impacts. Moreover, LOLC maintains strong relationships with several international funding partners that have strict EMS regulations, such as the International Finance Corporation; United States Agency for International Development; FMO, the Netherlands development finance company; Proparco (Société de Promotion et de Participation pour la Coopération Economique); and Triodos Investment Management. The LOLC Group was driven by its green initiatives to minimize carbon footprints by constructing 9 10 ADB. 2007. Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Manila. Letter from LOLC, dated 13 September 2013. The LOLC Group has stopped financing two-stroke three-wheelers as these vehicles are identified as contributing to air pollution.

7 the first commercial building with the largest number of solar panels in the country (around 2,000) and provides approximately 15% of the building’s monthly energy needs. 32. Social safeguards. The project is categorized as C for involuntary resettlement and indigenous people as per the involuntary resettlement Policy (1995) and Policy on Indigenous Peoples (1998)

ORIX Leasing (LOLC), the first specialized leasing company in Sri Lanka, expressed interest in obtaining ADB financial assistance. In March 2007, ADB's Board of Directors approved the South Asian SME Leasing Facility, which provided direct loans to LOLC and Maldives Finance Leasing Company.2 B. Key Project Features 4.