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 /21.04.048/00-01 dated February 26,2011, available at www.rbi.org.in

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Escrow and Trust and Retention Account

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.

Trust and Retention Account

A simple Escrow Account is only a pass-through account through which all funds (equity, debt, revenues and expenses) of the company is routed. However, the Lender may not have any

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.

Screenshot#1: Trust and Retention Methodology- How funds are routed

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 Sponsor’s deploy there funds into the Sponsor’s 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 Lenders4. Principal Payments to Lenders5. Major Maintenance Reserve Account(MMRA) and Debt Service Reserve Account (DSRA)6. Interest Payment of Promoter Loans7. Dividend Payments

8. Retention in the Surplus account (partial cash sweep if applicable)

Please refer to our discussions on MMRA and DSRA in the subsequent topics which has in-depth 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.

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Debt Service Reserve Account (DSRA)

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.

How much should be provisioned in the Debt Service Reserve account?

Generally principal repayments on term loans are made in quarterly intervals and interest is paid on a monthly basis. The lenders envisage that the company should maintain a minimum of one quarter principal and three month interest payments in the DSRA. However, as an additional measure of safety, many lenders opt for 2 quarters of principal and six months interest, primarily to tide over operations related uncertainties. For e.g. spike in gas prices may impact the cost of generation of a Gas based power plant. If the tariff is not a pass-through tariff then the company

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.

How is the DSRA funded?

After assessing how much funds needs to be provisioned for DSRA creation, we would need to evaluate whether the same can be funded by internal cash accruals (revenue proceeds net of expenses having higher priority) of the company. The DSRA is typically funded out of the cash flows of the company. However, there can be instances where the DSRA is not funded through cash but instead a Bank Guarantee for the provisioning amount has been secured. As a measure of cost optimization, many Asset owners choose to opt for DSRA funding (security) by way of Bank guarantee (BG) as the cost in this case would be the BG commission. If the equivalent amount of cash is freed up from DSRA provisioning, then these funds can be utilized in some other investment activities (i.e. Opportunity cost on blocking funds in DSRA) by the Owners.

DSRA monitoring periodIt is practically not feasible to monitor DSRA movements month-wise especially if it is funded through a BG. Because every month the DSRA requirement has to be assessed and a BG is made for the assessed amount, this increases the transaction cost of the company.  Hence, the DSRA funding could be on a quarterly, 6-monthly or annual basis.Timing of the DSRA creationOne other reason for opting for BG for DSRA funding is the timing of the DSRA creation. If under the loan agreement, the company agrees to create the DSRA before the commissioning of the project or the start of principal repayment. Since there wouldn’t be any cash generation (revenues) before the start of project (in most cases except for few), such kind of covenants are met through placing a BG to meet DSRA requirements.

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 illustration below explains how to calculate the DSRA requirement.

Screenshot #1 : A Simple DSRA requirement assessment table

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

Step2: DSRA calculation for the monitoring period

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.

The Screenshot#3 converts the Monthly DSRA requirements into Quarterly.

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.====================================================================================

Major Maintenance Reserve Account (MMRA)

Purpose of the MMRA

During the operational phase of a project, capital investment for maintaining the project asset is required to ensure that the project is able to continue operating as planned. Examples include, the resurfacing of a highway, a planned lane widening on a toll road or the major overhaul of key equipment in a thermal power station. These kinds of expenditure are significant in quantum and are required typically every 5-6 years depending on the type of the asset. Since the expenditure is significant, prior provisioning for the same is required to meet the expenditure during the year when this major maintenance work is taken up.

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.

How much should be provisioned in the MMRA?

The amount to be provisioned depends on the quantum of Major Maintenance Envisaged and frequency of Major Maintenance. For example if the Quantum of Major Maintenance envisaged is Rs. 100 million and the Major Maintenance is carried out every 5 years then every year Rs. 20 million (Rs.100 million / 5 years) should be kept as a provision in MMRA account.

Estimation of Major Maintenance Expenditure (MME)

The Major Maintenance Expenditure is a planned activity and the quantum of expenditure envisaged will vary from Sector to sector. MME depends on two factors namely Base MME and inflation factor.

1. Base MME is the estimated expenditure that will be incurred if the Major Maintenance is carried out today. This depends on the sector and the type of project assets (whether the machinery is old, refurbished or new ones, location of the site and temperature conditions among others).

2. Base MME assessed today may vary based on the inflation factor at the time actual expenditure.

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.

Scheduled Major Maintenance Expenditure Activity

The major maintenance activity is taken up after regular interval and these are planned activities and the frequency depends on the type of project and project assets. For e.g. in the case of a Highway project, the major maintenance activity is typically the resurfacing of the road, and the frequency of resurfacing could be in intervals of 5 years. Hence an assumption of 5 years is made for Interval of Major Maintenance Expenditure (MME) activity.

Modeling MMRA

For modeling MMRA we estimate the following parameters:

1. Interval of Major Maintenance Activity2. Base MME (If Major Maintenance is carried out today, what will be the expenditure incurred)3. Inflation factor

Step 1: Creating Schedule of Major Maintenance Expenditure (MME)

MME will be zero during construction period.

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

Step 2: Build provision for MMR Account

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.

Screenshot #2: MMR Provision

Step3: Modeling MMR  Account

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.

Screenshot #3: MMR Account

Check:

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.