Extended Annual Review Report

Project Number: 41932-01 Loan Number: 2369 June 2013

Loan People’s Leasing Company Limited (Sri Lanka)

In accordance with ADB’s public communication policy (PCP, 2011), this extended annual review report excludes information referred to in paragraph 97 (v) of the PCP.

CURRENCY EQUIVALENTS Currency unit – Sri Lanka rupee/s (SLRe/SLRs)

At Appraisal At Project Completion 31 August 2007 15 June 2013

SRe1.00 = $0.0088 Not applicable $1.00 = SLRs113.12 Not applicable

ABBREVIATIONS

ADB – Asian Development Bank bps

CBSL EROIC IPO LIBOR PLC ROIC SLC SME WACC XARR

– – – – – – – – – – –

basis points Central Bank of Sri Lanka economic return on invested capital initial public offering London interbank offered rate People’s Leasing Company Limited return on invested capital specialized leasing company small and medium-sized enterprise weighted average cost of capital extended annual review report

NOTES

(i) The fiscal year (FY) of People’s Leasing Company Limited ends on 31 March.

FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2000 ends on 31 March 2000.

(ii) In this report, "$" refers to US dollars.

Vice-President X. Zhao, Operations 1 Director General J. Miranda, South Asia Department (SARD) Director B. Carrasco, Public Management, Financial Sector, and Trade Division,

SARD Team leader A. Huang, Finance Specialist, SARD Team member R. Hernandez, Consultant, SARD

M. Hidalgo, Financial Sector Officer, SARD M. Panis, Senior Operations Assistant, SARD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page

BASIC DATA i

EXECUTIVE SUMMARY ii

I. THE PROJECT 1

A. Project Background 1 B. Key Project Features 2 C. Progress Highlights 2

II. EVALUATION 3

A. Project Rationale and Objectives 3 B. Development Impact 3 C. ADB Work Quality 7 D. ADB’s Additionality 7 E. Overall Evaluation 8

III. ISSUES, LESSONS AND RECOMMENDED FOLLOW-UP ACTIONS 8

A. Issues and Lessons 8 B. Recommended Follow-Up Actions 9

APPENDIXES 1. Private Sector Development Indicators and Ratings: Financial Intermediaries 10 2. Industry and Operations Review 12 3. Financial Statements 14

i

BASIC DATA People’s Leasing Company Limited (Loan 2369-SRI)

Key Project Data

As per ADB Loan Documents ($ million)

Actual

($ million)

Total Project Cost ADB Investment:

Loan: Committed Disbursed Outstanding

10.0

10.0 10.0 2.0

10.0

10.0 10.0 2.0

Key Dates Expected Actual

Concept Clearance Approval Board Approval Loan Agreement Loan Effectiveness First Disbursement Commercial Operations Date Loan Closing Months (effectiveness to commercial

operations date)

2007 2008 2008 2008 2008 Not applicable 15 Jun 2013 Not applicable

16 Aug 2007 23 Nov 2007 23 May 2008 23 May 2008 23 Jun 2008 Not applicable Not applicable

Financial and Economic Internal Rates of Return (%)

Appraisal XARR

Financial Internal Rate of Return (project financial rate of return on equity)

Economic Internal Rate of Return

None at appraisal None at appraisal

Not applicable Not applicable

Project Administration and Monitoring

No. of Missions

No. of Person-Days

Fact-Finding Appraisal Project Administration XARR Mission

1 1 1 1

16 3 8 3

ii

EXECUTIVE SUMMARY

On 23 November 2007, the Asian Development Bank (ADB) approved a $10,000,000 loan for People’s Leasing Company Limited (PLC) and a $7,500,000 loan for Commercial Leasing Company Limited in Sri Lanka from ADB’s ordinary capital resources. The loans were designed to improve small and medium-sized enterprise (SME) development. The ADB funds helped the two leasing companies obtain 5-year medium-term funds to balance their capital structure in order to expand their leasing services to SMEs.

This extended annual review report (XARR) covers only the PLC loan (the project).

ADB’s Private Sector Operations Department processed and administered the Commercial Leasing Company loan, which will be reviewed separately.

The PLC project was evaluated using criteria in ADB’s Guidelines for Preparing

Performance Evaluation Reports on Nonsovereign Operations (2007) and the related Project Administration Instructions, No. 6.07B (July 2008). The criteria are (i) development impact, (ii) ADB investment profitability, (iii) ADB work quality, and (iv) ADB’s additionality. Based on these criteria, the overall rating of the project is successful.

The project development impact is rated satisfactory using the four criteria of (i) private

sector development, rated satisfactory, due to the project’s contribution to the SME and capital market development; (ii) business success, rated partly satisfactory, because PLC’s real return on invested capital (ROIC) exceeded its weighted average cost of capital (WACC) only 3 of the 6 years from FY2007 to FY2012; (iii) economic sustainability, rated satisfactory, given the results of the economic real returns on invested capital (EROIC) in the 10%-20% range; and (iv) environment, social, health, and safety performance, rated partly satisfactory, as PLC’s compliance with the project environmental and social safeguards was weak.

ADB investment profitability is rated partly satisfactory. ADB loan pricing appeared to be

lower than the pricing of subsequently issued Sri Lanka sovereign debts, which should have the lowest possible risk and pricing. The anomaly was caused by the underdeveloped capital market in Sri Lanka and the unavailable market benchmarks, particularly the foreign currency sovereign and corporate debts during ADB’s project processing.

ADB work quality is rated satisfactory based on (i) screening, appraisal, and structuring

of the project, rated excellent; (ii) monitoring and supervision, rated satisfactory, because of minor oversights on social and environmental safeguard compliances; and (iii) ADB's role and contribution, rated satisfactory, given the positive development impact of the project.

ADB’s additionality is rated satisfactory. The ADB assistance directly helped PLC

balance its assets and liabilities in 2008, and boost its leasing advances to SMEs when the civil conflict was still ongoing and business and investor confidence was relatively low. Compared to PLC’s total borrowing of SLRs17,055 million ($150 million) in FY2008, the $10 million was limited in making a material impact on PLC’s business expansion. ADB’s additionality was subtle. The reputational effect of working with a multilateral lender strengthened PLC’s market standing, improved its subsequent borrowing capacity, and, to a certain degree, contributed to the successful launch of the second largest initial public offering (IPO) on the Colombo Stock Exchange in 2011.

Overall, the project is rated successful. It contributed positively to PLC’s business

expansion from 2007 to 2012 and to a very limited extent Sri Lanka’s private sector credit

iii

growth, which was observed at 34% in early 2012. The ADB assistance was limited. If ADB had not lent the $10 million to PLC, it would probably have achieved the same business success and the SME development impact by using alternative financing sources. PLC’s business expansion benefited more from the post-conflict economic boom and its association with People’s Bank than from the project.

Issues and lessons that ADB could have incorporated in similar project designs are (i)

the development of innovative local currency financing modalities to accurately price the loan and reduce transaction’s foreign currency and interest rate risks, (ii) the identification of additional leasing product lines, such as hybrid vehicles or energy efficient capital equipments, to strengthen the project’s development impact, and (iii) the provision of a parallel program to improve the capital market’s offering of medium-term debts. The fact that specialized leasing companies (SLCs) in the country are converting themselves to finance companies in 2011 and 2012 in order to access deposits reinforced the urgent need to support the country’s development of medium- to long-term debt market.

ADB’s follow-up action is to continue pushing the agenda on the capital markets master

plan program initially proposed in 2010. The program should include components to strengthen the corporate bond market and the securitization market.

1

I. THE PROJECT

A. Project Background

1. Small and medium-sized enterprises (SMEs) are a major business sector in Sri Lanka, comprising 80%–90% of all enterprises and contributing to 75% of total employment.1 In terms of outputs, SMEs have traditionally accounted for 65% of tea production, 50% of apparel and garment manufacturing, 70% of public bus transport, 80% of domestic trade activities, 45% of tourism and recreation services, and 50% of the local construction. While SMEs have been the engine of Sri Lanka’s economic growth, they suffer from a chronic lack of access to finance. 2. Sri Lanka’s financial sector faces many challenges. At the time of project approval in 2007,2 the banking sector was highly concentrated and accounted for 58.1% of financial sector assets.3 The six largest commercial banks, classified as "systemically important" by the Central Bank of Sri Lanka (CBSL), accounted for 64% of financial sector assets. SLCs, which supported mostly SMEs, accounted for only 2.2% of financial sector assets (footnote 3). 3. Commercial banks’ asset-based lending culture was biased against SMEs which had little or no collateral. Thus, many SMEs had difficulty obtaining adequate financing from the financial system that was dominated by the commercial banks. Leasing was an alternative approach to circumvent this shortcoming: SMEs (lessees) did not have to purchase the equipment at the outset. This saved their limited capital. For leasing companies (lessors), the leased assets themselves were the collateral and this reduced leasing companies’ credit risk exposures. In addition, because the credit review was based more on business cash flows than collateral values, SMEs found leasing more attractive than commercial bank borrowing. Other benefits included accelerated depreciation allowances and tax credits. 4. In 2007, the leasing sector in Sri Lanka comprised of 72 licensed establishments: 15 commercial banks, 9 licensed specialized banks, 28 specialized finance companies, and 20 SLCs. SLCs provided mostly vehicle leasing to SMEs, in the form of finance lease, operating leases, asset finance, and term loans.4 PLC has been one of the largest and most profitable leasing companies in Sri Lanka. It has been a wholly owned subsidiary of the second largest state-owned People’s Bank and received its implicit support.5 In May 2008, ADB entered a $10 million term loan facility agreement with PLC to expand its leasing operations to SMEs. After being converted to a 5-year local currency loan (para. 11), the ADB fund supported the expansion of PLC’s lease advances to SMEs by providing medium-term funds to narrow its asset liability gap and improve its capital structure.

1 SMEs were identified as businesses with fewer than 150 employees.

2 ADB. 2007. Report and Recommendation of the President to the Board of Directors: Proposed Loans Democratic

Socialist Republic of Sri Lanka: People’s Leasing Company Limited and Commercial Leasing Company Limited.

Manila. 3 Central Bank of Sri Lanka. 2008. Annual Report. (Chapter 8: Financial Sector Performance and System Stability).

Colombo. Available: http://www.cbsl.gov.lk/pics_n_docs/10_pub/_docs/efr/annual_report/ar2008e/10.ar08_Chap_0 8_e.pdf

4 Finance leasing and hire purchase are the major businesses of specialized leasing companies, which account for

most leasing accommodations. Finance leases are for unregistered (new) vehicles, covered under the Finance Leasing Act No. 56, 2000 as amended by the Finance Leasing (Amendment) Act 2005. Hire purchases are for registered (used) vehicles, covered under the Sri Lanka Consumer Credit Act No. 29, 1982.

5 People’s Bank, which had a total asset of SLRs663 billion as of December 2011, was the second largest

commercial bank in Sri Lanka, after Bank of Ceylon, which had a total asset of SLRs835 billion as of June 2011.

2

B. Key Project Features

5. SLCs, unlike commercial banks, finance mostly capital goods and require substantial medium-term debt with maturities between 3 and 5 years in their capital structure. However, in Sri Lanka, the capital market was underdeveloped. Medium- to long-term capital for corporate borrowers was generally lacking. This was partly attributed to the relatively large government bond market, which tended to crowd out the private capital. Local corporate bond market was extremely small.6 SLCs often resorted to rolling over their short-term borrowing from commercial banks or issuing short- to medium-term (up to 3 years) promissory notes and/or commercial papers to serve their assets with 5 year’s maturity. SLCs with good credit ratings could borrow medium-term funds from the small securitization market by pledging their receivables as collateral. Nonetheless, the availability of funds from the securitization market has been limited. The project’s $10 million loan in 5-year’s tenor helped PLC obtain the local currency loan with the same maturity and reduce its funding risk. This in turn reduced PLC’s funding costs. C. Progress Highlights

6. The project successfully achieved the stated output and outcome targets. For the project output of “loan requests received by the leasing companies increased by 10% per annum from current levels,” relevant proxies from FY2007 to FY2012 of average annual revenue growth, 29.3%; average profit growth, 35.3%; and average asset growth, 33.5% indicated that the growth of lease advances was at least 10%. This output target has been achieved.7 In terms of the first project outcome of “PLC’s number of SME lessees increases (10% in the next 24 months),” because over 90% of PLC’s leases were to SMEs, the same proxies in FY2009 and FY2010 also indicated that this outcome target has been achieved. In terms of the second project outcome of “PLC’s credit quality further improves; NPL (nonperforming loan) level of less than 2% for PLC,” PLC’s nonperforming loans to total loans ratio declined from 4.1% in FY2007 to 0.65% in FY2012. The calculation of PLC’s nonperforming loans was based on CBSL’s classification of 180 days past due,8 as implicitly implied under the project. 7. PLC’s lease advances grew exponentially from FY2009 to FY2012, while maintaining relatively sound asset quality (paras. 13–18). However, PLC’s business growth should be viewed against the backdrop of rising general market demand. From 1997 to 2011, Sri Lanka was undergoing a long period of sustainable economic expansion with an average annual gross domestic product growth rate of 5.0%.9 Following the end of the 26-year civil conflict in March 2009, the economy grew more rapidly. From 2007 to 2011, Sri Lanka’s total credit to the private sector increased from 8.9% to 34.5% per annum to accommodate the rising demand for goods and services.10 In this connection, although PLC substantially achieved the project outcome of improved SME finance, its extraordinary corporate revenue and asset growths were not unique.

6 In 2007, the corporate bond market in terms of the eight issuances of corporate debenture on the Colombo Stock

Exchange totaled SLRs8.2 billion, comparing with the SLRs896 billion government bond market at the end of 2006 and the SLRs821 billion equity market capitalization at the end of 2007.

7 Although PLC did not track the number of lease applicants, if the growth rate of lease advances has exceeded

10%, it is certain that the growth rate of lease applications has exceeded 10%. 8 CBSL’s loan classification standard was lax: (i) lease receivables are categorized as nonperforming if they are 180

days past due, and (ii) lease receivables previously classified as nonperforming are recategorized as performing upon full settlement of arrears.

9 ADB. 2001–2011. Asian Development Outlook. Manila.

10 Central Bank of Sri Lanka. 2008–2011. Central Bank of Sri Lanka Annual Report. Colombo.

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II. EVALUATION

A. Project Rationale and Objectives

8. The project rationale to strengthen SMEs and general financial sector development by supporting a leading leasing company in Sri Lanka was sound. Leasing has been widely used as a valuable instrument to strengthen the underserved financial sector to promote SME development. ADB’s 2008 Independent Evaluation Department study, Support for Financial Intermediation in Developing Member Countries, showed that financial leasing lines were among the most successful ADB projects, with a success rate of 100% from 1968 to 2007.11 The same study also found that when channeled through private (or independent) leasing companies, the development funds were also more efficiently mobilized to SMEs than when channeled through development financial institutions (footnote 11). 9. PLC was uniquely positioned to serve SMEs because of its most extensive branch network among all leasing companies in Sri Lanka. PLC benefited from its ability to access People’s Bank’s rural banking network, such as by operating PLC’s window offices in People’s Bank’s rural branches. As a result, 70%–80% of PLC’s revenue came from rural areas, and 90% of revenue from SMEs.12 The expansion of PLC’s reach to the post-conflict northeastern region also enhanced the project’s development impact in underserved regions of Sri Lanka, supporting inclusive and sustainable economic growth. 10. The project’s objective to provide medium-term fund to strengthen PLC’s asset liability management in order to expand its leases to SMEs was also sound. A significant portion of PLC’s lease assets had a maturity of 5 years, but the market could not supply sufficient funds of equivalent maturity. The available debt instruments were mostly short-term, with up to 12 months’ tenor. Issuance of corporate debt was expensive, and was mostly used by the largest and most creditworthy companies to achieve cost-effectiveness. PLC relied on its parent company’s debt and equity injection, including the use of redeemable preference shares, and the limited securitization market in Sri Lanka for its longest-term (5-year) funds. The extent of funds availability was constrained by the People’s Bank’s single borrowers limit and the volatile market conditions. The hybrid debt of redeemable preference share was unusually expensive, with an interest rate of about 20%. Therefore, PLC needed all the medium-term funds available to expand its operations. 11. Despite PLC’s revenue in Sri Lankan rupees, ADB was unable to provide a local currency loan. This was due to local financial market constraints, particularly the absence of a long-term cross-currency swap market and a restrictive capital account. As a result, PLC invested the $10 million as a deposit at the People’s Bank. Against such collateral, local currency fund with a 5-year tenor was borrowed. However, such a transaction structure was inefficient. It increased the project currency and interest rate risk. B. Development Impact

1. Private Sector Development 12. The project’s $10 million loan to PLC accounted for about 1 month (0.9%) of the company’s total annual disbursement of $110 million (SLRs12.3 billion) and 6.7% of total assets

11

ADB. 2008. Support for Financial Intermediation in Developing Member Countries. Manila. 12

47% of PLC’s lease facilities are less that SLRs500,000 ($4,500). From 2007 to 2012, an average of about 25% of the lease advances was for trucks, 20% for buses, 20% for passenger cars, and 20% for vans. The remaining leases were for three-wheelers, heavy vehicles, machinery, tractors, office equipment, aircraft, and others.

4

of $150 million (SLRs17,054) in FY2008.13 Despite the relatively small amount, the project benefited approximately 1,477 SMEs, assuming an average lease size of $6,770. This contributed positively to the country’s SME development. The rapid growth of the leasing sector also provided a viable financing option to private sector development. In 2011, PLC’s IPO, the second largest ever on the Colombo Stock Exchange, further contributed to Sri Lanka’s expanded stock market capitalization. Based on the above observations and Appendix 2, the project’s impact on private sector development is rated satisfactory.

2. Business Success 13. PLC has been a market leader in the leasing sector in Sri Lanka. PLC enjoyed an approximately 15-20% of the market share from FY2007 to FY2012. It offers a comprehensive line of leasing products of finance leasing, operating hire purchase, hire purchase, asset financing, and term loans. PLC has achieved unprecedented business growth since the inception of the project: total company revenue increased from SLRs6,334 million ($55 million) in FY2007 to SLRs13,991 million ($110 million) in FY2012. During the same period, total assets increased from SLRs17,045 million ($150 million) to SLRs76,628 million ($600 million). Return on equity improved from 29.4% to 32.6%. Finance lease and hire purchase of vehicles accounted for 94.4% of the company’s total revenue as of FY2012. In terms of geographic coverage, in FY2012, about 48.8% of PLC’s lease portfolio was in the western region where the capital Colombo is located; the post-conflict northern and eastern regions accounted for about 10% of the total advances, and such a ratio is expected to rise. 14. However, the rapid business and asset growths have also led to the deterioration of the company’s capital adequacy. From 2007 to 2011, prior to PLC’s IPO, total borrowing expanded from SLRs14,015 million ($120 million) to SLRs47,432 million ($360 million), while the share capital from its parent company, People’s Bank, increased only from SLRs3,030 million ($26 million) to SLRs8,442 million ($65 million). The gearing (debt to equity) ratio deteriorated from 4.7 to 5.6. CBSL in its examination letter to PLC in November 2010 urged PLC to capitalize its reserves and expand its core capital through an IPO. 15. PLC’s asset quality was improving. Nonetheless, CBSL’s classification of nonperforming assets was based on 180 days past due, which was lax when compared with the more stringent international best practice of 90 days past due. Although PLC’s asset quality target implicitly adopted CBSL’s classification and was below the threshold of 2% in FY2011 and FY2012, the reality was less positive. By adopting international practice, PLC’s nonperforming assets improved from 11.3% in March 2008 to 3.2% in September 2011. 14 In terms of other performance indicators, PLC’s management turnover was minimal. Its liquidity position, reflected in the current ratio (assets over liabilities), deteriorated from 0.97 in FY2007 to 0.73 in FY2012. 16. PLC’s operation was also affected by the recent regulatory changes. The Finance Business Act No. 42 of 2011 required SLCs to maintain at least 5% tier 1 capital adequacy ratio and 10% tier 2 capital adequacy ratio. In addition, SLCs are required to maintain liquid assets at 5% of total assets from January 2012 and 10% from January 2013. As a result, PLC had to implement its capital adequacy control and improve its liquidity position. 17. On 3 November 2011, PLC successfully launched an IPO by offering 390,000,040 shares of its common stock at an issue price of SLRs18, raising total capital of SLRs7 billion

13

People’s Leasing Company Limited. 2008. Annual Report 2008/2009. Colombo. 14

Fitch Ratings. 2012. People’s Leasing Company, Update. Colombo.

5

($54 million) from domestic and foreign investors and PLC employees. 15 The shares were oversubscribed by 1.3 times.16 Following the IPO, the shareholding pattern changed; the share of People’s Bank decreased from 100% to 75%, and public ownership now stands at 25%. The expanded capital base raised PLC’s capital adequacy ratio to 25.5% in FY2012. However, PLC’s operational deficiency remained to be its asset and liability mismatch, which continued to affect its capital structure and liquidity position in FY2012. 18. In terms of PLC’s overall business performance, PLC achieved persistent credit-rating upgrades from 2006 to 2012. Its national long-term rating from Fitch Rating Lanka improved from BBB+(lka) (stable outlook) to A–(lka) (stable outlook) in 2006, to A(lka) (stable outlook) in 2011, to A+(lka) (stable outlook) in January 2012. In July 2012, Fitch upgraded PLC’s national long-term rating again to AA–(lka) (stable outlook).17 These persistent credit-rating upgrades reflected PLC’s improved financial performance.18 19. For corporate loans, ROIC is used as a proxy for financial internal rate of return,19 which is then compared to the company’s WACC to determine the level of profitability. In the calculation, the general and other reserves are removed from PLC’s equity capital because they are non-earning assets. Because both short- and medium-term debts were the essential earning capital, PLC’s total borrowing was used as the denominator. The ROIC improved from 12.3% in FY2007 to 17.0% in FY2012 (Table 1). The 2007 report and recommendation of the President did not provide any estimate of PLC’s ROIC or WACC as a benchmark (footnote 2). The WACC, now estimated at about 18.2%, is based on the stated return on equity of 25%–30% from FY2007 to FY2012; the average cost of debt, reflected by CBSL’s average weighted lending rate from about 17% in 2007 to about 15% in 2012; and an average gearing ratio of 5. 20. Based on the ADB’ Guidelines For Preparing Performance Evaluation Reports On Nonsovereign Operations using ROIC as a parameter and the threshold that return on invested capital is the equal or greater than the sum of WACC but less than the sum of WACC plus 700 basis points (bps) during the 3 of the 6 years from FY2007 to FY2012 (Table 1), the stand alone project is rated partly satisfactory.20

Table 1: Return on Invested Capital of People’s Leasing Company

(SLRs million, unless otherwise stated)

Item FY2007 FY2008 FY2009 FY2010 FY2011 FY2012

Net operating profit after tax 748 803 1,047 1,200 2,579 4,207 Total operating capital 6,065 8,321 10,601 9,793 21,599 41,490 Return on invested capital 12.3% 15.4% 18.3% 28.6% 18.4% 17.0%

Source: Asian Development Bank estimates.

15

10% of the shares were allotted to PLC employees; 10% to unit trust investors; 22.5% to individual investors; 27.5% to non-retail investors; and 30% to identified investors.

16 The price should have been set around SLRs22, as commented by some local financial analysts following the IPO.

17 Fitch Ratings Lanka Limited. 2012. Various Reports. Colombo. Available: http://www.fitchratings.lk/doc_view.php?

doc=23_0&org=76 18

PLC’s rating upgrade was also attributed to the same rating upgrade for People’s Bank, its parent company, and a 100% government-owned and a systemically important commercial bank that is expected to provide essential support during a time of crisis.

19 The ROIC is calculated by dividing net operating profit after tax by total shareholder equity and long-term debt.

20 ADB. 2007. Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Manila.

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3. Economic Sustainability 21. The types of SMEs that benefited from the ADB assistance, measured by PLC lease portfolios from September to December 2008 (after the ADB disbursement in June 2008), included agriculture, construction, services, trading, industry, transportation, and fishery sectors. The analysis of the vehicle and non-vehicle leases led to the assumption of general economic benefits in terms of service and product value addition, some capital formation,21 possible foreign exchange earnings, employment and income generation, and poverty reduction. The sustainability of the project also rests upon a developed and well-functioning leasing sector in Sri Lanka to support SME development over the long-term. 22. To quantitatively assess the project’s contribution to economic development, the EROIC is used as a proxy when the ADB fund does not target any specific investment project.22 Income before depreciation, amortization, and tax is usually used for the numerator and total operating capital as the denominator. The EROIC improved from 18.9% in FY2007 to 25.8% in FY2010, and then declined to 15.7% in FY2012 (Table 2). According to the ADB guideline (footnote 20), the EROIC is mostly between the ADB-prescribed hurdle rate of 10%–20% range for a satisfactory rating and is therefore rated satisfactory.

Table 2: Economic Return on Invested Capital of People’s Leasing Company (SLRs million, unless otherwise stated)

Item FY2007 FY2008 FY2009 FY2010 FY2011 FY2012

Operating profit before tax, depreciation, and amortization 1,144 1,511 2,299 2,522 4,198 6,494

Total operating capital 6,065 8,321 10,601 9,793 21,599 41,490 Economic return on invested capital 18.9% 18.2% 21.7% 25.8% 19.4% 15.7%

Source: Asian Development Bank estimates.

4. Environmental, Social, Health, and Safety Performance

23. The project’s environment safeguard was classified as category FI. PLC nominated a senior manager for risk management and control to adopt an appropriate environmental management system. However, this was not implemented. There was no associated project environmental screening and classification process. PLC did not diligently identify and assess the environmental impact associated with the SME leases. There are no relevant safeguard guidelines or operations manuals.23 Nevertheless, PLC complied with national environmental, labor, and other pertinent laws and regulations, and did not finance environmentally polluting vehicles banned by the government. It submitted required annual environment reports and semiannual compliance reports, but not on time. The project was classified under category C for involuntary resettlement and indigenous people. No involuntary resettlement or any impact on indigenous peoples was observed as a result of PLC’s leasing of vehicles and other capital goods. In addition, PLC has a sound corporate governance structure. Its designated corporate social responsibility department carried out several projects aimed at working with the communities in which it operates. PLC also published a sustainability report for 2011/12 outlining the company’s role in the environment and social responsibilities during its business dealings. In summary, PLC’s environment and social performances are rated partly satisfactory.

21

Capital formation here refers to an increase in the amount of capital or investment. 22

The EROIC is calculated by dividing net operating profit adjusted for tax and others (e.g., consumer surplus, effects on competitors, and benefits to suppliers, including labor) over total shareholder equity and long-term debt.

23 For example, no internal control mechanisms are in place to reduce the number of energy-inefficient vehicles, and PLC has not actively promoted energy-efficient electric and hybrid vehicles.

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C. ADB Work Quality

24. ADB work quality is measured against three subindicators: (i) screening, appraisal, and structuring of the project, rated excellent; (ii) monitoring and supervision, rated partly satisfactory; and (iii) its role and contribution, rated satisfactory. The overall satisfactory rating is based on the ratings for these three subindicators. According to the ADB guidelines (footnote 20), ADB’s performance was materially up to a high professional standard for multilateral development banks engaged in private sector investment operations. Performance was satisfactory or better against all three subindicators. 25. Prior to project processing, ADB lent to a leading private leasing company, Lanka Orix Leasing Company in 2006/2007.24 This and other ADB-wide experience in the leasing sector helped the deal team better screen the existing leasing companies to promote SME development. From 2003 to 2007, PLC was already undergoing a business expansion. It had solid financials, a competent management team, and a good overall performance track record. Most importantly, PLC received an implicit support from the “systemically important” People’s Bank, its parent company and the second largest state-owned commercial bank in Sri Lanka. The transaction’s credit risk was low. The deal team conducted extensive due diligence and negotiations to finalize the appraisal and structuring of the project. ADB's screening, appraisal, and structuring performance met the high standards of multilateral development banks and could serve as an example of best practice. It is rated excellent. 26. ADB monitored the project through annual reviews and missions. The annual review monitored required implementation compliance, including analysis of the project’s financial performance and other key data and information. The review was then submitted to ADB’s Office of Risk Management for evaluation. In terms of the loan covenants, all financial ratios were maintained at a satisfactory level, except for the asset and liability gap… Since ADB has not kept itself informed to react in a timely manner to material change in project performance or taken timely action when needed, portfolio monitoring and reporting of progress, covenant compliance, and risk management practices are rated partly satisfactory. 27. The project’s contribution to PLC’s maturity mismatch was temporary. Nevertheless, the project achieved its desired objectives satisfactorily. The $10 million contributed positively to PLC’s improved market standing as an industry leader. This strengthened PLC’s position to attract subsequent medium-term funds to expand its lease advances and contribute to SME development. To a certain degree, it also contributed to PLC’s successful IPO. ADB’s role and contribution were in line with ADB operating strategies, policies, and standards. Overall, ADB work quality is rated satisfactory. D. ADB’s Additionality

28. Measuring against the guidelines (footnote 20), the project was not believed to be a necessary condition for realizing the designed development impact of increased PLC lease advances to SMEs. The $10 million accounted for 22% of PLC’s total annual borrowing in FY2008 of SLRs5,217 million ($45 million) and had a limited direct contribution to PLC’s business growth in subsequent years. Rather, ADB’s additionality was subtle. In addition to the benefits listed in para. 278, ADB’s additionalities also included the improvement of PLC’s capacity to implement aid-funded projects and the awareness-raising on the compliance with environmental and social safeguard measures. The direct loan was found to be an appropriate

24

ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Secured Loans to the Republic of the Maldives and the Democratic Socialist Republic of Sri Lanka for the South Asian SME Leasing Facility (Loan 7251-SRL: Lanka Orix Leasing Company Limited for $10 million).

8

modality as compared with other funding alternatives, such as local bond issuance or a structured finance transaction. While local bond issuance may have supported the corporate debt market development, prior to the end of the civil conflict when market sentiment was subdued, potential assistance on PLC’s bond issuance could have been a costly exercise, particularly in light of PLC’s then A– local long-term rating, which was low investment grade. Similarly, ADB’s partial credit guarantee would have also been hindered by the lack of a long-term cross-currency swap market in Sri Lanka. Overall, the project’s additionality is rated satisfactory. E. Overall Evaluation

29. The project is rated successful. It contributed positively to PLC’s business expansion from 2007 to 2012 and rapid private sector credit growth in Sri Lanka. However, the ADB assistance was limited. The project’s $10 million to PLC only accounted for about 1 month (0.9%) of the company’s total annual disbursement in 2008 (para. 12). The limited ADB assistance could not improve PLC’s capital structure in a sustainable manner. PLC’s business success benefited more from the post-conflict economic expansion and its association with People’s Bank than from the project support. However, the project provided the critically needed medium-term fund to repair PLC’s capital structure in 2008 and improved its subsequent market standing. The project’s positive economic externality and sustainability were high in terms of ADB involvement in the transaction and associated demonstration effect on the developments of Sri Lanka’s leasing sector, private sector, SME sector.

Table 3: Evaluation of People’s Leasing Company

Indicator/Rating

Unsatisfactory

Partly Satisfactory

Satisfactory

Excellent

Development Impact √

Private sector development √

Business success √

Economic sustainability √

Environment, social, health, and safety performance

√

ADB Investment Profitability √

ADB Work Quality √

ADB Additionality √

Unsuccessful

Partly successful

Successful

Highly successful

Overall Rating √ ADB = Asian Development Bank. Source: Asian Development Bank estimates.

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS

A. Issues and Lessons

30. First, ADB should continuously explore innovative ways to provide local currency financing to its borrowers, including the use of a partial credit guarantee (on local currency bond issuance), a cross-currency swap transaction, or a nondeliverable forward contract to raise local currency funds in similar future transactions. The current transaction structure of pledging the $10 million loan as collateral to borrow local currency loan of similar maturity was inefficient, exposing ADB and PLC to foreign exchange and interest rate risks.

9

31. Second, the project’s development impact on SME development could have been strengthened by adding other development objectives. In any possible follow-up transaction, ADB could request PLC to adopt energy-efficient equipment leases or possible innovative electric or hybrid car leases. Attention could also be given to Islamic finance, leases to female entrepreneurs, and microfinance. 32. Third, ADB’s direct loan to a financial intermediary could be accompanied with a technical assistance to carry out appropriate reforms in the legal and regulatory environment, develop an enhanced monitoring and compliance mechanism, and promote innovative product lines as mentioned in para. 331. Establishment of a comprehensive enterprise risk management system could also strengthen institutional compliance with regulatory and project related requirements on environmental and social safeguards. 33. Fourth, ADB provided a $65 million program loan in 2004 to develop Sri Lanka’s financial markets.25 The policy-base lending included a $60 million component to restructure People’s Bank, the parent company of the PLC. The resulting turnaround of the People’s Bank laid the groundwork for successful implementation of the project given internal sequencing considerations. 34. Finally, PLC’s inability to access medium-term debt particularly during tight market liquidity was not a standalone issue but a reflection of a more systemic deficiency in Sri Lanka’s capital market development. The lesson is that ADB should provide a parallel component to address the underlying deficiency in developing a local corporate bond market or securitization market. B. Recommended Follow-Up Actions

35. From 2007, the government has made some progress in capital market development, including the issuance of five sovereign bonds, the passing of relevant prudential legislation on nonbank financial institutions, and the listing of a number of nonbank financial institutions on the Colombo Stock Exchange to improve transparency and increase trading volume. From 2010, ADB has also been actively engaging the government on a proposed capital market master plan program to support Sri Lanka’s capital market development. It is recommended that ADB continue the dialogue with the government on the proposed program loan. It should support the continuous expansion of the government foreign and local currency bond issuance to construct a benchmark yield curve to better forecast long-term interest rate movements. In addition, it could also help the government reduce its restriction on foreign capital flows to enhance the market demand for longer-term debt instruments and help improve differential tax treatment between government debt securities and corporate bonds to set a leveled playing field.

25

ADB. 2004. Report and Recommendation of the President to the Board of Directors: Proposed Loans to the Democratic Republic of Sri Lanka for the Financial Markets Program for Private Sector Development. Manila.

10 Appendix 1

PRIVATE SECTOR DEVELOPMENT INDICATORS AND RATINGS: FINANCIAL INTERMEDIARIES

Indicators Ratingsa Justifications

1. Beyond Intermediary and Subborrower Impacts

1.1 Private sector expansion and institutional impact

1.1.1. Contributes to an increased private sector share and role in the economy, and to sustainable jobs or self-employment 1.1.2. Contributes to expanded SME lending with good portfolio and subborrower performance

1.1.3. Contributes to institutional change by (i) improving supply and access generally to formal credit and banking service to SMEs; (ii) influencing a more enabling environment for SMEs via lobby activity, policy dialogue, or otherwise in which the bank(s) become more engaged

Satisfactory

Satisfactory

Partly satisfactory

The project contributed medium-term funds to support PLC’s lease advances to SMEs, which constitute 90% of the private sector share. The enhanced business activities led to employment creation and income generation. PLC’s selected SME leasing portfolio, immediately following the ADB disbursement of $10 million to PLC, has shown clear private sector development impacts. The project did not materially alter PLC’s corporate strategy or business behavior to enhance the project or general development impact. PLC’s leasing portfolio would have remained the same without ADB assistance.

1.2. Competition. Contributes to new competition

for SME business among local banks (including new product and service offerings, local currency products) and/or contribution to increased competition in key subborrower markets

Partly satisfactory

The project did not materially alter PLC’s corporate strategy or business behavior to enhance the project or general development impact. PLC’s leasing portfolio would have remained the same without ADB assistance.

1.3. Innovation. Contributes to new ways of

offering effective banking services to SMEs (including new products, services, and technologies) in ways that are replicated by other banks and in the financial system (item 2.2)

Partly satisfactory

The project did not materially alter PLC’s corporate strategy or business behavior to enhance the project or general development impact. PLC’s leasing portfolio would have remained the same without ADB assistance.

1.4. Linkages. Contributes to local savings and

deposits mobilization via networks of participating bank(s), and/or relative to size of subportfolios; contribution to notable upstream or downstream link effects to subborrowers’ businesses in their industries or the economy.

Satisfactory

The project did not help mobilize local savings or deposits. However, PLC’s planned bond issuance in 2012 and successful launch of its IPO in 2011 contributed to the country’s capital market development.

1.5. Catalytic element. Contributes to

mobilization of other local or international financing to SMEs, and to positive demonstration to market providers of debt and risk capital to SMEs

Excellent PLC leveraged the project to improve its creditworthiness to obtain additional medium-term funds from the local capital market and successfully launch its second largest IPO on the Colombo Stock Exchange. The positive market demonstration is the key element of the project design.

1.6. Affected laws, frameworks, regulation.

Contributes to improved laws, regulation, and inspection affecting formal SME banks and banking services to SMEs in the local financial system

Partly satisfactory

The project did not contribute directly to the improvement of nonbank financial institution prudential regulations, which were nonetheless improved as a result of the deteriorating operating environment.

Appendix 1 11

Indicators Ratingsa Justifications

1.7. Wider demonstration of new standards.

Contributes to raised standards in the financial sector or in subborrower industries and sectors in corporate governance, transparency, and stakeholder relations

Partly satisfactory

The project did not significantly improve the leasing system operating standards, but has improved its contribution to the SME sector.

2. Participant Banks And Subborrower Impacts

2.1. Skills with wider impact potential.

Contributes (i) to improved SME credit approach at all stages in the participant bank(s) in ways that will be replicated by other providers of SME finance and banking service; and (ii) via the participating bank(s) to improved subborrower skills in operation of their businesses, e.g., via good appraisal, and monitoring by the bank(s)

Satisfactory

The project expanded the financial products available to SMEs, including to rural areas and nonvehicle (e.g., capital equipment) leases. The project improved the financial position of the most successful leasing company in Sri Lanka, and contributed to SME development.

2.2. Demonstration and new standards-setting potential. Demonstrates potential through

improved and achieved standards in corporate governance and transparency, stakeholder relations, and ESHS spheres

Satisfactory

The project has led to an improved corporate social responsibility in PLC with a designated department and a relevant publication. The company’s transparency of operations has been improved with the strengthened prudential regulations. The exposure to the ADB project also improved PLC’s awareness of the environmental and social safeguard measures imposed by multilateral lenders. However, internal safeguard guidelines and relevant operations manuals are still lacking.

Overall Rating

Satisfactory

ADB = Asian Development Bank, IPO = initial public offering, NPL = nonperforming loan, PLC = People’s Leasing Company Limited, SMEs = small and medium-sized enterprises. a

Ratings scale: excellent, satisfactory, partly satisfactory, unsatisfactory. The rating is not an arithmetic mean of the individual indicator ratings, which have no fixed weights. Consider already manifest actual impact (positive or negative) and the potential impact and risk to its realization.

12 Appendix 2

INDUSTRY AND OPERATIONS REVIEW

Industry Performance of Specialized Leasing Companies (%, unless otherwise indicated)

Item 2006 2007 2008 2009 2010 2011

Capital Adequacy

1. Capital funds to total assets 16.8 16.7 16.6 17.4 19.1 18.1

2. Total borrowing to capital funds (gearing) 4.1 4.2 4.2 4.0 3.5 3.8

Asset Quality

1.

Nonperforming accommodation (NPA) to total accommodation 3.5 4.3 4.8 5.2 6.0 3.8

2. Provisions to NPA 52.5 58.9 60.2 61.5 63.9 87.9

3. Total advances to total assets 85.3 81.5 80.5 80.7 74.3 74.4

4. Total advances to total borrowing 125.3 116.3 114.1 116.1 111.4 109.6

5. Provision made against total advances 2.1 2.5 2.5 3.2 3.8 3.3

Earnings and Profitability 1.

Net profits before tax to total assets (ROA) 3.7 35 2.7 2.4 3.8 5.3

2.

Operating profit before provision to total assets 4.6 4.4 3.1 3.1 5.0 5.7

3. Profit after tax to capital funds (ROE) 17.7 15.2 10.5 7.6 11.8 20.5

4. Interest income to interest expenses 183.2 156.7 140.3 137.5 158.8 205.6

5. Net interest income to gross income 38.3 30.4 24.5 23.1 29.4 39.9

6. Net interest income to total assets 6.2 5.5 5.0 4.9 5.8 6.7

7. Net interest income to net profit before tax 168.1 156.1 190.6 203.8 154.9 127.1

8. Operating cost to net interest income 66.8 73.2 94.0 102.6 83.1 71.3

Liquidity

1. Net loans to total borrowing 122.6 113.4 111.2 111.5 105.8 104.7

2. Liquid assets to total assets 4.3 6.0 7.5 5.3 10.2 4.2

3. Liquid assets to total borrowing 6.3 8.6 10.6 7.6 15.3 6.1

Assets and Funding Structure

1. Bank borrowing 68.0 70.1 70.1 69.5 66.7 67.9

2. Loans and/or accommodation 85.3 81.5 80.8 … … …

3. Investments 2.2 3.4 4.9 4.1 6.7 11.5

Lending

Total accommodation growth 24.0 17.0 14.2 9.6 (3.6) 41.8 ( ) = negative value. Please spell out all abbreviations here using alphabetical order. Source: Central Bank of Sri Lanka Financial System Stability Review 2009 and 2011.

Appendix 2 13

1. Sri Lanka began to offer limited leasing products from the late 1970s. Significant growth occurred after the establishment of two specialized leasing companies (SLCs): Lanka Orix Leasing Company in 1980 and Mercantile Leasing in 1983, which were both partly sponsored by the International Finance Corporation of the World Bank Group. By the end of 1985, the two companies accounted for 77% of all lease transactions. Subsequently, other companies entered the leasing sector due to lax regulatory supervision compared with that for commercial banks and finance companies.

2. Leasing companies were largely unregulated before the Finance Leasing Act, No. 56 of 2000. Under the Act, SLCs were not permitted to accept deposits, and had to rely heavily on funds raised from commercial banks to meet asset demands. In 2011, the Finance Business Act, No. 42 of 2011 was enacted in November 2011, repealing the Finance Companies Act. The new Act required SLCs to comply with the statutory liquid asset requirement of 5% of total liabilities by 1 January 2012 and 10% by 1 January 2013; to maintain capital adequacy ratios from 1 July 2011; and to seek prior approval for structural changes in a company.

3. In 2007, 72 financial institutions were providing leasing products, including 20 SLCs, 28 finance companies, 15 commercial banks, and 9 licensed banks. The annual total disbursements of finance leases of all registered leasing firms increased to SLRs78.8 billion ($0.70 billion). The leasing sector was still concentrated. Seven companies accounted for 83% of total assets. In 2011, two SLCs migrated to licensed finance companies and the licenses of three SLCs were canceled. The number of SLCs decreased from 20 in 2007 to 13 in 2012,1 but SLC assets rose from SLRs95.5 billion in 2007 to SLRs137.7 billion in 2011. PLC and Lanka Orix Leasing were the two largest SLCs in the country. PLC has continuously occupied the market leader position for 10 consecutive years. PLC mainly benefits from its backing from the state-owned People’s Bank, the second largest commercial bank in Sri Lanka. Lanka Orix Leasing converted to a finance company in 2011, and PLC plans to follow in 2012. This conversion allows them to access public deposits and improve their capital structure.

4. The SLC sector grew dramatically from 2006 to 2011. Due to the rapid asset growth, capital adequacy deteriorated as reflected in the debt to capital (gearing) ratio, which declined from 4.1 to 3.8 during the period. Asset quality declined slightly in terms of nonperforming assets to total accommodations. Provisions increased correspondingly. However, the introduction of the new capital adequacy and liquidity requirements under the Finance Business Act might push some SLCs to convert to finance companies in order to strengthen their capital structures. Overall earnings improved from 2006 to 2011. However, with the requirement of Central Bank of Sri Lanka (CBSL) for public listing of SLCs, the increased equity might lead to a lower return on equity in 2011 and 2012. Finally, the rapid asset expansion also caused a weakening liquidity position. From 2011, the government’s tightening monetary stance to curb inflation pressure and other macroeconomic imbalance exacerbated an already worsening liquidity position for all SLCs.

1 CBSL Registered Finance Leasing Establishments. http://www.cbsl.gov.lk/htm/english/05_fss/popup/registered_le.

htm. Central Bank of Sri Lanka. 2007. Financial System Stability Review. Colombo.

14 Appendix 3

FINANCIAL STATEMENTS

INCOME STATEMENT (SLRs million) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

For the Year Ended 31 March Gross Income 899 1,484 1,984 2,904 3,861 4,590 6,527 7,247 9,256 13,243 Profit Before Interest & Provisioning 751 1,239 1,651 2,397 3,188 3,653 5,285 5,858 7,324 12,153 Specific Provision 44 11 20 47 194 139 138 128 (136) 6,170 Profit Before Tax 154 225 314 767 1,016 1,353 1,890 2,100 3,721 5,983 Taxation … … (4) (151) 268 550 843 900 1,142 1,776 Profit After Tax 154 225 310 918 748 803 1,047 1,200 2,580 4,207

BALANCE SHEET (SLRs million) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

For the Year Ended 31 March Assets Cash, Reverse Repo and Deposits with Financial Institutions 190 291 179 231 212 484 1,652 2,085 1,529 1,730 Rentals Receivable 4,978 8,106 10,614 14,039 15,481 18,686 21,470 25,006 46,442 67,387 Loans & Other Advances 34 144 194 415 432 536 1,063 1,711 2,943 4,170 Property, Plant and Equipment 122 175 206 238 345 299 398 503 375 713 Total Assets 5,637 9,033 11,990 15,242 17,045 20,672 25,558 30,848 55,874 79,628 Promissory Notes 1,576 2,945 4,221 4,471 3,043 4,106 6,565 9,416 15,591 14,499 Borrowings 3,137 4,292 5,387 7,042 8,731 10,794 10,585 10,680 24,364 40,790 Other Payables 526 614 980 1,158 2,241 2,155 2,961 4,523 7,477 6,069 Total Liabilities 5,239 7,851 10,588 12,671 14,015 17,055 20,111 24,619 47,432 61,358 Share Capital 100 200 200 500 500 500 500 500 500 11,608 Redeemable Preference Shares … 500 500 500 450 350 1,350 1,350 1,350 1,350 Reserves 298 482 702 1,571 2,080 2,767 3,597 4,379 6,592 5,312 Shareholders' Equity 398 1,182 1,402 2,571 3,030 3,617 5,447 6,229 8,442 18,270 Total Liabilities and Shareholders' Equity 5,637 9,033 11,990 15,242 17,045 20,672 25,558 30,848 55,874 79,628

STATEMENT OF CASH FLOW (SLRs million) 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

For the Year Ended 31 March Net Cash Inflow/ (Outflow) from Operating Activities (1,846) (1,307) (1,105) (1,632) 85 (2,501) (1,458) (1,257) (19,535) (18,994) Net Cash (Outflow) from Investing Activities (70) (157) (66) (73) (245) (57) (1,405) (998) (88) (1,513) Net Cash Inflow/ (Outflow) from Financing Activities 1,965 1,480 1,221 1,707 (246) 2,208 3,555 2,481 18,977 20,075 Increase/(Decrease) in Cash & Cash 49 16 50 2 (406) (350) 692 226 (646) (432)

15 Appendix 3

Equivalents

KEY FINANCIAL INDICATORS 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Earnings Per Share (SLRs) 0.13 0.18 0.21 0.73 0.58 0.65 0.82 0.82 2.05 3.11 Net Assets Per Share (SLRs) 0.34 0.58 0.77 1.77 2.21 2.79 3.59 4.34 6.32 11.13 Interest Cover (times) 1.34 1.33 1.36 1.65 1.66 1.63 1.57 1.65 2.04 1.97 Effective Ordinary Dividend Rate (per share - SLRs) 2.50 1.36 1.50 1.50 1.50 1.50 1.50 1.50 1.50 1.00 Dividend Cover (times) 6.16 7.71 8.17 11.37 9.13 10.16 12.84 12.86 31.96 2.59 Return on Capital (%) 36.49 34.84 31.52 57.36 29.43 25.29 22.94 19.00 38.44 32.62 Debt Equity Ratio/Gearing (times) 11.84 11.34 11.21 5.79 4.74 4.67 4.38 4.18 5.55 3.23 Equity: Assets Ratio (times) 14.16 7.64 8.55 5.93 5.63 5.72 4.69 4.95 6.62 4.36 Current Ratio (times) 0.88 0.96 1.12 0.86 0.97 0.86 0.92 0.82 0.71 0.73

( ) = negative value. Source: People’s Leasing Company Limited. 2012. Annual Report FY2012: Ten Year Summary. Colombo.