Project Number: 41909 Loan Number: 2321 October 2013

Loan Lanka ORIX Leasing Company Limited (Sri Lanka)

This is an abbreviated version of the XARR which excludes commercially sensitive and confidential business information that is subject to exceptions to disclosure set forth in ADB's Public Communications Policy 2011.

Extended Annual Review Report

CURRENCY EQUIVALENTS

Currency Unit – Sri Lanka rupee/s (SLRe/SLRs)

At Appraisal At Project Completion 26 February 2006 24 September 2013 SLRe1.00 = $0.00919 $0.00756

$1.00 = SLRs108.72 SLRs132.20

ABBREVIATIONS ADB – Asian Development Bank CLC – Commercial Leasing Company EMS – environmental management system IFI – international finance institution LIBOR London interbank offered rate LOLC – Lanka ORIX Leasing Company ORIX – ORIX Corporation SMEs – small and medium-sized enterprises

NOTES

(i) The fiscal year (FY) of Lanka ORIX Leasing Company ends on 31 March. (ii) In this report, “$” refers to US dollars.

Vice-President L. Venkatachalam, Private Sector and Cofinancing Operations Director General T. Freeland, Private Sector Operations Department (PSOD) Director C. Engstrom, Financial Institution Division, PSOD Team leader M. Hermans, Investment Specialist, PSOD Team members I. Chua, Senior Investment Officer, PSOD

S. Hruschka, Principal Investment Specialist, PSOD

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 1 C. Progress Highlights 1

II. EVALUATION 2

A. Project Rationale and Objectives 2 B. Development Impact and Outcome 3 C. ADB Investment Profitability 7 D. ADB Work Quality 7 E. ADB’s Additionality 9 F. Overall Evaluation 9

III. ISSUES, LESSONS, AND RECOMMENDED FOLLOW-UP ACTIONS 9

APPENDICES

1. Project-Related Data 10 2. Private Sector Development Indicators and Ratings: Financial Intermediaries 13 3. Industry and Operations Review 16 4. Comparative Financial Statements 18

BASIC DATA

Lanka ORIX Leasing Company Limited (2321 – Sri Lanka)

Key Project Data

As per ADB Loan Documents ($ million)

Actual ($ million)

Total project cost ADB investment

Loan: Committed Disbursed

10.0

10.0 10.0

10.0

10.0 10.0

ADB = Asian Development Bank.

Key Dates Expected Actual

Concept clearance approval Board approval Loan agreement Loan effectiveness Disbursement Prepayment

2006 2007 2007 2007 2007 2011

27 Jul 2006 27 Mar 2007 15 Aug 2007 15 Aug 2007 24 Aug 2007 1 Nov 2011

Financial and Economic Internal Rates of Return on Invested Capital (%)

Appraisal XARR

Return on invested capital Economic return on invested capital, real

Project Administration and Monitoring No. of Missions No. of Person-Days

Fact-finding 1 12 Appraisal 1 3 Project administration 2 4 XARR mission 1 2 XARR = extended annual review report.

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EXECUTIVE SUMMARY

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). 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. In turn, nonbank leasing companies, as providers of this service, often experience a shortage of long-term credit due to risk-averse and collateral-based banking practices. This holds true for most Sri Lankan nonbank leasing companies. In 2006, ADB conducted a comprehensive review of the Sri Lankan finance sector and met with several 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 financial assistance from the Asian Development Bank (ADB). On 27 March 2007, ADB’s Board of Directors approved a $10 million senior secured loan to LOLC. On 15 August 2007, ADB and LOLC signed the facility agreement. The loan, which was fully disbursed on 24 August 2007, was payable in 5 years with no grace period and had a floating interest rate of 6-month London interbank offered rate (LIBOR) plus a credit margin. ADB’s loan was collateralized by security over a portfolio of specified lease receivables. The transaction was prepaid 9 months early in 2011 to accommodate changes resulting from LOLC’s reorganization into a holding company. LOLC was established in 1980 with ORIX Corporation (ORIX) of Japan as its largest shareholder, holding a 30% stake in the company up to the present. Since that time, LOLC has become a market leader in the leasing industry and, in 2011, the holding company of a diversified multifinance provider. LOLC’s regional outreach, its core business of small ticket lease financing, coverage of the SME sector, and adherence to good governance and international standards have consistently attracted financing from ADB and other international finance institutions. Development impact and outcome are rated satisfactory when evaluated for (i) private sector development; (ii) business success; (iii) economic sustainability; and (iv) environmental, social, health, and safety performance. LOLC introduced the concept of leasing to SMEs in Sri Lanka and has contributed to significant growth of the leasing industry. It is servicing substantial number of leasing clients with predominantly small ticket leases through a network of 105 branches; 70% are located outside of Western Province. The company has excellent outreach into areas most affected by the civil war in the country’s north and east. During the tenor of the loan, it has achieved a position of market leader and transformed itself into a multifinance provider. ADB and its peers were attracted to LOLC because of its focus on building on the strategy of governance, safeguards, and international standards, and acting as a role model for its competitors. LOLC’s real return on investment capital is rated satisfactory as it is above the company’s weighted average cost of capital. LOLC’s economic return on invested capital after adjusting for inflation is rated excellent. 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. LOLC was required to have an environmental management system, including a screening system to select subprojects with no adverse environmental impact. LOLC is financing leasing projects or activities with no environmental impact, and confirmed that it had not provided ADB

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funding to any borrowers to support activities that could have adverse environmental impacts. No involuntary resettlement or impacts on indigenous peoples were observed as a result of LOLC’s leasing activities. LOLC’s compliance with environmental standards, practices, and procedures is rated satisfactory. Investment profitability was assessed by drawing comparisons from similar transactions made at the time of project approval. ADB investment profitability is rated satisfactory. The evaluation of ADB work quality considers screening, appraisal, and structuring of the project; monitoring; and supervision. The loan was conceived after several ADB missions to Sri Lanka to assess the country’s finance sector, and the conduct of extensive due diligence and consultations with several potential clients. LOLC was selected as one of the top leasing companies: it had a long operating history, an internationally experienced shareholder—ORIX Corporation, a track record of good financial performance, and sizable regional outreach. The screening, appraisal, and transaction structures, particularly security arrangements, are rated satisfactory. ADB’s Project Administration Unit achieved the required credit monitoring and consistently met the internal requirements of annual reviews. The monitoring unit provided input in renegotiating covenants and in finding a mutually agreeable solution to LOLC’s early repayment. The late follow-up on the submission of LOLC’s environmental management system is reflected in the partially satisfactory rating for monitoring and supervision. Overall, ADB work quality is rated satisfactory. Beyond the financing provided to LOLC and the Sri Lankan SME sector, this reports credits ADB with an incremental but valuable role in working with LOLC to enforce international standards of safeguards, governance, and financial documentation (particularly in working on covenant issues with the borrower), thereby providing additionality that goes beyond the value of the loan itself. ADB's additionality is rated satisfactory. Overall, this review rates the project successful.

I. THE PROJECT A. 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 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.

2 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.

3 LOLC then withdrew its Fitch rating in connection with its corporate reorganization into a holding company.

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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. EVALUATION

A. 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.

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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

2007

2008

2009

2010

2011

2012

Commercial banks 61,058 54,530 42,866 51,292 95,389 117,505

Leasing companiesa

79,886 79,257 64,477 87,503 166,051 214,866

Total 140,944 133,787 107,343 138,795 261,440 332,371 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.

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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 2008 2009 2010 2011 2012

LOLC (Company) 12,127 12,170 4,569 5,036 3,926

LOLC Group 14,320 14,906 21,963 47,392 58,233

Number of transactions8 22,730 23,660 34,862 75,225 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 Fitch Ratings Lanka. 2013. Seylan Bank PLC. http://www.fitchratings.lk/doc_view.php?doc=23_0&org=19

8 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.

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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.

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Table 3: LOLC Selected Financial Indicators, 2007–2012 (SLRs million, unless otherwise indicated)

Item 31 Mar 2007

31 Mar 2008

31 Mar 2009

31 Mar 2010

31 Mar 2011

31 Mar 2012

Loans and advances 5,751 8,563 12,550 15,085 29,402 40,129 Total assets 24,484 32,994 46,287 75,371 113,071 145,204 Long-term loans Total borrowings

10,308 16,740

12,970 21,797

18,608 29,013

18,016 35,248

28,368 45,219

36,525 61,414

Total liabilities 20,659 27,816 40,196 55,632 78,256 101,991 Total equity 3,825 5,178 6,091 19,740 34,815 43,213 Gross income 8,317 12,676 13,622 14,902 32,077 35,533 Net income 1,050 1,271 1,055 2,385 7,023 5,704 Debt to equity (times) 5.4x 5.4x 6.6x 2.8x 2.2x 2.4x NPL ratio (%) 0.6% 1.8% 4.3% 3.0% 1.7% 1.6% ROA (%) 4.3% 3.9% 2.3% 3.2% 6.2% 3.9% ROE (%) 27.5% 24.5% 17.3% 12.1% 20.2% 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 ADB. 2007. Guidelines for Preparing Performance Evaluation Reports on Nonsovereign Operations. Manila.

10 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.

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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) and the relevant Operations Manual F2 and F3 (2006). No involuntary resettlement or impacts on indigenous peoples were observed as a result of LOLC’s leasing activities. 33. As a member of the United Nations Global Compact,11 the LOLC Group accepted the charter on sustainability in practice. LOLC reports to the United Nations Global Compact through its annual communication on progress reports on specific commitments in terms of human rights, labor rights, environmental protection, and action against corruption. The reports and the LOLC annual reports, disclosed in the LOLC website, document the LOLC Group’s compliance with core labor standards and the national labor laws of Sri Lanka.

34. The LOLC Group, through LOLC Care, carries out corporate social responsibility initiatives in rural areas targeting the poor and vulnerable. Initiatives include (i) partnering with the National Council for Child and Youth Welfare to sponsor the renovation and maintenance works of schools and hostels; (ii) supporting social and community relations projects in rural areas, including infrastructure development and support for farmer associations; (iii) providing educational assistance to children of economically impoverished rural communities; and (iv) enhancing the financial literacy of migrant workers and their family members.

35. LOLC’s compliance with regard to environment, social, health, and safety performance is rated satisfactory. C. ADB Investment Profitability

36. The ADB senior secured 5-year loan to LOLC was priced at 6-month LIBOR plus a credit margin. ADB’s investment profitability is assessed by drawing comparisons from similar transactions made during the time of project approval, and from government-issued bonds during the same period. The repayment of LOLC’s loan 9 months early was conducted on mutually agreeable terms to both parties. Based on this, the profitability of the ADB loan to LOLC is considered satisfactory.12 D. ADB Work Quality 37. ADB work quality is rated satisfactory based on screening, appraisal, and structuring of the project; monitoring and supervision; and its role and contribution.

1. Screening, Appraisal, and Structuring of the Project 38. The ADB loan to LOLC was part of the South Asian SME Leasing Facility, which included another approved loan to Maldives Finance Leasing Facility in 2007 (footnote 2). Joint processing of the two loans made the process much more expedient.

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The United Nations Global Compact is a group of responsible bodies and businesses that have embraced a charter on sustainability in practice. The charter, known as the United Nations Global Compact Principles, holds members to specific commitments in terms of human rights, labor rights, environmental protection, and action against corruption.

12 ADB. July 2007. Guidelines for Preparing Extended Annual Review Report for Nonsovereign Operations. Project Administration Instructions. PAI 6.07B. Manila.

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39. The Country Strategy and Program Update 2006-08 stated that ADB support should complement the Sri Lankan government strategy to stimulate the private sector in general and SMEs in particular. The loan to LOLC was designed to address the insufficient access to long-term funds of leasing companies, which was an important source of financing for SMEs. The project team conducted several missions to Sri Lanka to assess the country’s finance sector. The missions met with several banks and leasing companies, and carried out due diligence. LOLC was selected as it was one of the top leasing companies, had a long operating history, and a track record of good financial performance and regional outreach. The strength and experience in the leasing business of ORIX, as anchor investor, were important. All of these elements raised the probability of project achievement. 40. ADB's screening, appraisal, and structuring of its assistance are rated satisfactory.

2. Monitoring and Supervision 41. The dealing officer and project administration unit of ADB’s Private Sector Operations Department (PSOD) regularly monitored overall business and financial performance of LOLC and submitted the required monitoring reports on time. Economic conditions in Sri Lanka and LOLC’s growth process caused covenant breaches on certain occasions. LOLC and PSOD worked these out patiently and professionally, including one covenant in particular that required renegotiation.13 PSOD invested more than average amounts of effort in solving these issues jointly with LOLC and performed very satisfactorily in a complicated situation. 42. One of the conditions precedent to disbursement was LOLC’s submission of an EMS. Subsequent monitoring found that the EMS had not been submitted prior to disbursement and was only provided to ADB in 2008. Based on this oversight, ADB monitoring and supervision is rated partly satisfactory, despite the commendable results in working with LOLC on the financial covenants.

3. Role and Contribution 43. LOLC did not secure ADB consent for conversion into a holding company prior to securing approval from the Central Bank of Sri Lanka. As part of the process, LOLC relinquished its leasing license, which constituted a breach of the facility agreement. PSOD called this to the attention of LOLC management and raised concerns of adherence to contractual covenants. PSOD subsequently worked with LOLC to find a solution that was economically feasible for both parties and satisfied assurances ADB had received under the facility agreement. While LOLC agreed to transfer the balance of the ADB loan to CLC (after the reorganization CLC was the sole center of leasing business in LOLC Group), ultimately LOLC and ADB agreed to an early repayment of the facility, 9 months before maturity as the most efficient solution for both parties. ADB’s working relationship with CLC continues. 44. ADB’s role and contribution are rated satisfactory. This is illustrated by monitoring and supervision interactions (paras. 41 and 42) and ADB work in connection with LOLC’s corporate reorganization. While LOLC has been professional and highly responsive throughout the transaction, ADB’s cooperative response to covenant breaches is hoped to have provided reporting and fiduciary insights to LOLC operations, which will help with its ongoing borrowing relationships with IFIs and the internationalization of its funding operations in general.

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Whether the covenant was calculated too conservatively during due diligence or was broken due to market factors is not clear in retrospect, but redefining covenant definitions in the documents and negotiating new covenant levels (in cooperation with the Office of Risk Management) was required.

9

E. ADB’s Additionality 45. ADB, through its intervention in 2007, was able to become part of the transformation of LOLC. In its continuing transition to a diversified finance conglomerate, LOLC’s strategy focused on actively embracing the standards of IFIs such as ADB. This has been instrumental in building a sustainable organization and attracting the support of other IFIs and commercial lenders. ADB had an incremental but valuable role in working with LOLC in adhering to international standards of safeguards, governance, and international documentation standards, providing additionality that goes beyond the value of funds provided to LOLC and Sri Lankan SMEs. ADB's additionality is rated satisfactory. F. Overall Evaluation Overall, ADB’s loan to LOLC is rated successful. Table 4 provides a summary of the individual category ratings.

Table 4: Evaluation of ADB's Loan to LOLC

ADB = Asian Development Bank, LOLC = . Source: ADB.

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

46. In 2007, PSOD proposed a dollar-denominated guarantee to LOLC to securitize its lease assets. The proposed transaction required LOLC to sell a portfolio of eligible lease assets to a local special purpose company, which would issue senior and subordinated bonds partially guaranteed by ADB. This type of structure would have been the first true sale securitization in Sri Lanka and could have been used as a benchmark transaction for other market participants. However the deal was canceled due to the international economic turmoil following the global financial crisis. This type of project could provide alternative sources of funding to leasing companies in Sri Lanka, provide a paradigm for similar transactions in other markets, and be worthy of reconsideration.

Indicator/Rating Unsatisfactory Partly

Satisfactory Satisfactory Excellent

A. Development Impact and Outcome √ 1. Private sector development √ 2. Business success √ 3. Economic sustainability √ 4. Environment, social, health, safety √ B. ADB Investment Profitability √ C. ADB Work Quality 1. Screening, appraisal, structuring √ 2. Monitoring and supervision √ 3. ADB's role and contribution √ D. ADB's Additionality √ Overall Rating Successful

10 Appendix 1

PROJECT-RELATED DATA

1. Lanka ORIX Leasing Company is the leader in Sri Lanka’s leasing and factoring market. LOLC commenced operations in 1981 as the country’s pioneer leasing provider to small and medium-sized enterprises and commercial institutions. Today it is a diversified company with widespread interests in trading, plantations, leisure, insurance, stock broking, power, and energy.1

2. LOLC, a registered leasing entity under purview of the Central Bank of Sri Lanka, currently acts as the parent company of the LOLC Group’s diverse business interests. The core financial services of the LOLC Group are carried out by three subsidiaries: Lanka ORIX Finance (LOFC), LOLC Micro Credit, and Commercial Leasing & Finance (CLC).

3. LOFC, the flagship financial service provider of LOLC Group, engages in both conventional and Islamic financing activities. The transfer of the LOLC Group’s lending portfolio and branches to LOFC during FY2011 aided the company in reporting year-on-year deposit growth of 44% to SLRs25 billion in FY2012. LOLC Micro Credit is one of the largest microcredit providers in the country and market leader in financing agricultural activities. The company is a licensed financing institution and is partnered with Netherlands Development Finance Company (FMO). CLC, a total financial solution provider with a wide range of services spanning from fixed deposits and savings to leasing, factoring, and hire purchases, is also a listed licensed finance entity.

4. LOLC Group’s diverse business interests provided the foundation for a structural change in FY2011 with a number of new acquisitions. LOLC currently has 13 subsidiaries with controlling stakes and a number of affiliates with a strong brand and a loyal customer base. LOLC’s acquisition of Diriya Investment, the holding company of another mini-conglomerate, Browns & Company, resulted in creation of synergies across entities dealing with agricultural equipment and accessories.

5. LOLC has gained a controlling interest in Confifi Hotels, which includes Palm Garden Hotels, Riverina Hotels, and Eden Hotel. This was considered another strategic acquisition with the objective of serving Sri Lanka’s booming tourism industry. The LOLC Group has more than 600 rooms in five resort hotels. Its interests in plantations are represented through its investment in Maturata and Pussellawa, regarded as the two largest regional plantation companies in the country.

6. Overall, the dynamic growth and diversification of LOLC has enabled the company to play an integral role in the development of Sri Lanka’s economy as it evolves to become a sustainable business conglomerate. LOLC Group’s business structure and industry sectors are provided in Figure A1.1. LOLC Group’s regional network is highlighted in Table A1.2. and its global funding partners are listed in Table A1.3.

1 Sri Lanka Equity Research: LOLC. September 2012. TKS Securities. Colombo.

Figure A1.1: LOLC Group Business Structure

Source: LOLC Group.

Ap

pe

ndix

1

10

12 Appendix 1

Table A1.2: LOLC Group, Regional Breakdown of Branches, 2007–2012

Number of Branches by Region 2007/08 2008/09 2009/10 2010/11 2011/12

Central 4 4 5 9 10

Eastern 1 1 3 10 10 North 0 0 3 4 7 North central 4 6 7 9 10 North West 3 5 6 6 7 Sabaragamuwa 2 2 2 3 7 Southern 5 5 5 11 14 Uva 3 3 3 7 9 Western 14 17 20 25 31

Total Number of branches 36 43 54 84 105 LOLC = Lanka ORIX Leasing Company. . Source : LOLC Group.

Table A1.3: LOLC’s Global Funding Partners Global Funding Partner

Type of Facility/ Assistance

Purpose of Funding

Loan Period

OPEC Long-term dollar loan SME financing and development

13 Oct 2005– 13 Oct 2012

PROPARCO, France Long-term dollar loan, long-term euro loan

Tsunami-affected SME financing

16 Jun 2006– 31 Oct 2012

ADB Long-term dollar loan SME financing and development

15 Aug 2007– 1 Nov 2011

BIO, Belgium Long-term euro loan SME financing and development

14 May 2009– 30 May 2014

FMO, Netherlands Long-term Sri Lanka rupee loan, equity tier I & II and debt capital for the microfinance company

SME and microfinance financing and development 05 June 2007–

15 Oct 2014

DEG, Germany Long-term euro loan SME financing and development

15 Feb 2007– 15 Feb 2012

OPIC, United States Long-term Sri Lanka rupee facility

SME financing and development

17 Apr 2006– 17 Oct 2012

EIB, Europe Long-term Sri Lanka rupee, euro refinancing scheme

Tsunami-affected SME development and support for tourism

FINNFUND, Finland Long-term dollar loan SME financing and development

19 Jun 2008– 19 Jun 2015

ADB = Asian Development Bank, BIO = Belgische Investeringsmaatschappij voor Ontwikkelingslanden, DEG = Deutsche Investitions- und Entwicklungsgesellschaft, EIB = European Investment Bank, FINNFUND = Finnish Fund for Industrial Cooperation, FMO = Nederlandse Financierings-Maatschappij voor Ontwikkelingslanden (the Netherlands Development Finance Company), LOLC = Lanka ORIX Leasing Company, OPEC = Organization of the Petroleum Exporting Countries, OPIC = Overseas Private Investment Corporation, PROPARCO = Société de Promotion et de Participation pour la Coopération Economique, SMEs = small and medium-sized enterprises. Source: LOLC Group.

Appendix 2 13

PRIVATE SECTOR DEVELOPMENT INDICATORS AND RATINGS: FINANCIAL INTERMEDIARIES

Indicator Rating

a Justifications

1. Beyond Intermediary and Subborrower Impacts

1.1 Private sector expansion and institutional impact

1.1.1. Contribution to an increased private sector share and role in the economy and to sustainable jobs or self-employment

Excellent ADB’s loan provided LOLC with medium- to long-term funding to support lease advances to SMEs, which constitute about 80% of private business establishments in Sri Lanka. Lease and hire–purchase have proven to be leading sources of financing in the SME sector and LOLC was the pioneer in that field. As a company with several subsidiaries and affiliates, LOLC was able to create more opportunities for its existing employees. The growth of LOLC and its subsidiaries have brought greater employee mobility within the LOLC Group through promotions, transfers, and lateral career moves, which have improved employee morale.

LOLC has 3,699 employees within LOLC Group and a retention rate of 82%. Gender equality is maintained, with female staff appointed in some key positions. A woman holds the highest position in LOLC.

b

Reflecting the continuing expansion of economic activity, Sri Lanka’s unemployment rate declined to 4.0% in 2012 from 4.2% in 2011. This was the lowest annual unemployment rate in Sri Lanka.

1.1.2. Contribution to expanded SME lending with good portfolio and subborrower performance

Excellent LOLC and the LOLC Group’s financial services companies are focused on SME and microfinancing. As of March 2011, credit facilities in the form of loans, hire–purchase, and finance leases totaled SLRs39.8 billion. This was equivalent to an increase of 120% over loans and leases in March 2010. Of total loans and leases in 2011, 75% was disbursed to the SME sector with approximately 80% from semi-urban and rural areas.

c Asset quality was robust with the NPL ratio

reported at 1.6% as of the end of March 2012.

LOLC ventured into microfinance to fill the void for microcredit through its subsidiary, Lanka ORIX Micro Credit. The company focuses on grassroots entrepreneurs in agriculture, trading, services, and transport. Its key success factor was its overall presence in rural areas. It now has 39 branches and 53 service centers, and carries out lending activities in 12 districts.

1.1.3. Contribution to institutional change by

(i) improving supply and access to formal credit and banking service for SMEs; and

(ii) influencing an enabling environment for SMEs via lobby activity, policy dialogue, or otherwise

Satisfactory LOLC aggressively pursued branch expansion, improving access to loans and leases across wider areas of the country. LOLC set up ties with Sri Lanka Post to enable the company to reach the most remote areas of the country. As of March 2012, LOLC had 80 branches, 25 mini branches, 32 post office branches, and 87 service centers.

LOLC Group expanded into less-urbanized provinces outside Western Province, providing access to finance to the greater population of Sri Lanka. By 2012, LOLC Group’s branch network and service centers cover about 70% of the total area outside of Western Province.

Advanced information and communication technology systems link the entire branch network, enabling services to reach rural customers. Moreover, branch operations are backed by a round-the-clock customer service hotline.

1.2. Competition. Contribution to

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

Satisfactory LOLC was considered a specialized leasing company (SLC) prior to becoming a holding company. It was a pioneer in the SLC subsector; currently the country has about 13 SLCs and 45 leased finance companies (LFCs). Competition is quite tight among leasing companies regardless of the market segment they service. LOLC and its LOLC Group companies continue to develop products and services to fuel growth of

14 Appendix 2

Indicator Ratinga Justifications

subborrower markets the SME sector. The latest innovation introduced was the “speed draft,” a loan scheme targeting small businesses with short-term bridge financing requirements. The customer can withdraw any amount up to an approved limit and repay in full or partially as and when they want or can repay. This product entails no fixed or regular repayment installments. While this product has previously been employed in the banking industry as an overdraft facility, it is considered new in the nonbanking financial sector.

1.3. Innovation. Contribution to

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

Excellent LOLC was the first company to introduce the concept of leasing to the SME sector and is a trendsetter in the leasing business in the country. Moreover, LOLC was the first to introduce loans and leases with customized terms of payment. These products and services are now widely used by the other leasing companies and by commercial banks in Sri Lanka.

The LOLC Group companies have a diverse product mix ranging from asset financing to group loans. LOLC Microcredit is now offering microinsurance, the first kind in the industry.

LOLC and its subsidiary, Commercial Leasing Company (CLC), were pioneers in the field of factoring. Earlier factoring operations were restricted to urban and semi-urban areas of Colombo and the Western Province. Currently, CLC has penetrated remote parts of the country, thus creating an opportunity for small businesses and microenterprises to access working capital needs.

1.4. Links. Contribution to local

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

Satisfactory LOLC is not a deposit-taking institution. However, its subsidiaries, such as CLC and Lanka ORIX Finance (LOFC) are. LOFC holds a unique position, it is the only LFC with approval to engage in foreign currency business. LOFC has about 10,000 clients who are considered as out-of-country workers. Through its project, Economic Prosperity for Rural Poor Through Remittances, LOFC has provided these workers and their families with assistance in the form of goal setting prior to departure and training in investments and finance.

1.5. Catalytic element.

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

Partly satisfactory

Since the ADB loan, LOLC obtained additional long-term funding from BIO (Belgium) and FINNFUND (Finland). But there is no data to show that LOLC catalyzed mobilization of funds from other local and international financiers to SMEs in Sri Lanka.

1.6. Affected laws, frameworks, and/or regulation. Contribution

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

Partly satisfactory

There is limited LOLC contribution to improvement of the nonbank financial institution sector’s laws and prudential regulations.

1.7. Wider demonstration of new standards. Contribution to

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

Satisfactory Transparency and corporate governance have underpinned the business success of the LOLC Group.

LOLC standards of excellence and operating performance have been recognized in Sri Lanka and across ORIX subsidiaries. LOLC received the Special ORIX Award for Excellent Performance in 2011 and 2012 out of a field of 100 international ORIX subsidiaries.

LOLC is now a member of the United Nations Global Compact (UNGC), a group of responsible bodies and businesses that have embraced a charter on sustainability. Members adhere to international best practice and specific

Appendix 2 15

Indicator Ratinga Justifications

commitments in the areas of human rights, labor rights, environmental protection, and action against corruption.

2. Participant Banks and Subborrower Impacts

2.1. Skills with wider impact potential.

Contribution (i) to improve the 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 operating their businesses, e.g., via good appraisal, and monitoring by the bank(s)

Satisfactory Through leasing, LOLC was able to change the lives of farmers by providing them with access to farm machinery and equipment. LOLC and its subsidiary CLC ventured into factoring to help SMEs gain access to working capital funding. These products have resulted in a positive impact on the lives of clients and contributed to the country’s economy. LOLC and CLC were the first in the industry to introduce leasing and factoring, and these products and services are now widely used.

LOLC is prudent in approving credit facilities to new clients. LOLC’s credit department, which reports directly to its Credit Committee, is responsible for management of the companies’ credit risk including the formulation of credit policies, establishment of authorization limits for the approval and renewal of credit facilities, review and assessment of credit risk, and review of compliance of business units with agreed exposure limits.

LOLC Group has set appropriate risk limits and controls, and monitors portfolio risk and adherence to limits. Individual credit assessments are in consultation with the business units and cover the following: collateral requirements, credit assessment, credit risk grading, legal requirements, and compliance with regulatory and statutory requirements. Authorization limits are allocated to a business units’ credit officer for the renewal of a client’s credit facilities. Regular reports on the credit quality of local portfolios are provided to LOLC Group’s Credit Division, which determines the corrective action to be taken if necessary.

2.2. Demonstration and new standards-setting potential.

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

Satisfactory LOLC commenced compliance with good corporate governance rules by listing on the Colombo Stock Exchange (CSE) and by adhering to the listing rules of the CSE.

The board of LOLC comprises 9 directors, 6 are nonexecutives including the chairperson. Two of the six nonexecutive members are independent board members. This meets the recommended corporate best practice.

The United States Open Compliance and Ethics Group recognized LOLC Group’s sound governance, risk management, and compliance practices in 2012.

d LOLC was

the first Asian business entity to receive this award.

As a newly formed holding company, LOLC ensures that good governance practices are embedded in the company and flow down to its subsidiaries.

Overall Rating Satisfactory

BIO= Belgian Investment Company for Developing Countries, LOLC = Lanka ORIX Leasing Company, NPL = non-performing loans, SME = small and medium enterprises. a

Ratings scale: excellent, satisfactory, partly satisfactory, and 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.

b Rohini Nanayakkara is the chairperson of LOLC.

c LOLC annual report for 2010/2011. p. 16.

d The Open Compliance and Ethics Group is a global nonprofit organizations that provides a framework for integrating governance, assurance, and management of performance, risk, compliance, and ethics.

16 Appendix 3

INDUSTRY AND OPERATIONS REVIEW

Table A3: Specialized Leasing Companies Industry Performance (%)

Item

2007

2008

2009

2010

a

2011

a

2012

a

2012 September

1. Capital Adequacy

1.1 Capital Funds to Total Assets 16.7 16.6 17.4 19.1 18.1 23.4 23.6

1.2 Total Borrowings to Capital Funds (Gearing) 4.2 4.2 4.0 3.5 3.8 2.9 3.5

2. Asset Quality

2.1 Nonperforming Accommodation (NPA) to Total Accommodation 4.3 4.8 5.2 6.0 3.8 2.5 2.4

2.2 Provisions to NPA 58.9 60.2 61.5 63.9 87.9 66.5 82.5

2.3 Total Advances to Total Assets 81.5 80.5 80.7 74.3 74.4 87.5 88.5

2.4 Total Advances to Total Borrowings 116.3 114.1 116.1 111.4 109.6 130.8 35.9

2.5 Provision Made Against Total Advances 2.5 2.5 3.2 3.8 3.3 1.7 1.9

3. Earnings and Profitability

3.1 Net Profits Before Tax to Total Assets 35 2.7 2.4 3.8 5.3 6.9 5.3 3.2 Operating Profit Before Provision to Total

Assets 4.4 3.1 3.1 5.0 5.7 6.1 3.0

3.3 Profit After Tax to Capital Funds 15.2 10.5 7.6 11.8 20.5 21.4 16.1

3.4 Interest Income to Interest Expenses 156.7 140.3 137.5 158.8 205.6 212.2 183.1

3.5 Net Interest Income to Gross Income 30.4 24.5 23.1 29.4 39.9 45.6 39.5

3.6 Net Interest Income to Total Assets 5.5 5.0 4.9 5.8 6.7 7.8 7.5

3.7 Net Interest Income to Net Profit Before Tax 156.1 190.6 203.8 154.9 127.1 112.5 142.2

3.8 Operating Cost to Net Interest Income 73.2 94.0 102.6 83.1 71.3 51.8 53.8

4. Liquidity

4.1 Net Loans to Total Borrowings 113.4 111.2 111.5 105.8 104.7 127.9 132.7

4.2 Liquid Assets to Total Assets 6.0 7.5 5.3 10.2 4.2 2.6 2.9

4.3 Liquid Assets to Total Borrowings 8.6 10.6 7.6 15.3 6.1 3.9 4.5

5. Assets / Funding Structure

5.1 Bank Borrowings 70.1 70.1 69.5 66.7 67.9 66.9 65.1

5.2 Investments 3.4 4.9 4.1 6.7 11.5 3.3 3.4 a At the end of the financial year (March)

Source: Central Bank of Sri Lanka. Financial System Stability Review. 2012

1. Finance and leasing companies in the nonbanking system are vital components of the Sri Lankan finance sector, complementing the mainstream banking system. Although accounting for only 6.4% of the finance sector, leasing has a deeply rooted business model in Sri Lanka concentrating mainly on collateralized lending. In addition, it also offers traditional products such as finance leasing, hire–purchase, and pawning. Nonbank financial institutions comprise 45 lease finance companies (LFCs) and 13 specialized leasing companies (SLCs).

Appendix 3 17

2. The leasing industry caters to a specific segment of the population that includes those who do not have or are reluctant to access the banking system due to documentary and collateral requirements to secure credit. This is among the reasons why the leasing industry has proven to be a leading source of financing of fixed assets for SMEs in Sri Lanka. Leasing serves the underserved and encourages financial inclusion. 3. With the envisaged economic growth and business expansion, competition is expected to intensify significantly particularly within the banking system, which extends its services to SMEs. Given that banks are in a better position to offer attractive rates to new customers due to their lower borrowing costs, leasing companies need to consolidate and merge to retain and expand their market share to remain competitive. This is in essence why the government is ruling out the provision of new leasing licenses in the short term.

4. To effectively meet competition from the banking system, leasing companies have had to reshape their business model by diversifying into products and services not offered by banks. This will help leasing companies attract new customers and expand the industry’s market share.

5. The leasing industry remained resilient notwithstanding the challenging global and domestic market conditions. Despite high interest rates in the market that raised concerns of the possible deterioration of asset quality of the banking and nonbanking systems, the gross nonperforming assets (NPA) ratio remained at 5% as of the end of September 2012. When considering the loan loss provision, the net NPA was reported at 1.6% at the end of September 2012 compared with the net NPA of 1.9% in September 2011.

6. The robust credit growth of the leasing industry in 2012 had a favorable impact on earnings. The net interest margin improved to 7.1% for the 12 months ending September 2012 compared with 6.6% year-on-year in 2011. However, net income after tax declined to SLRs12 billion during the 9 months ending September 2012 due to fiscal policy measures that increased fuel prices and the import duty on vehicles. The return on assets remained modest at 4% and the return on equity at 19%.

7. The total asset base of the leasing industry increased by 15% to SLRs564 billion during the first 9 months of 2012. The growth in lease portfolios was the main driver for the expansion of total assets, while investment portfolios remained constant. Deposits continued to be the major source of funding for LFCs, while short-term borrowings were the major source of funding for the SLCs, with LFCs representing 41% and SLCs 30% of the total sector liabilities. Total deposits grew by 25% to SLRs232 billion, while borrowings remained static during the first 9 months of 2012. Higher interest rates and the change in status of several SLCs to LFCs to enable them to mobilize public deposits instead of borrowing was the primary reason for the lack of borrowing growth.

8. The leasing industry’s capitalization increased by a healthy 19% by the end of September 2012. Sustained profitability and the recovery of distressed assets were instrumental in strengthening capital funds. The tier 1 capital adequacy ratio increased to 17%, significantly above the 5% minimum prudential requirement. The total capital adequacy ratio, where the required minimum is 10%, increased to 17%, ensuring a robust cushion to absorb losses.

Appendix 4 18

COMPARATIVE FINANCIAL STATEMENTS

Table A4.1: LOLC Comparative Balance Sheets, 2008–2013 (standalone basis) (SLRs million)

Balance Sheet 2008 2009 2010 2011 2012 2013

Assets Cash and cash equivalents 606 553 420 392 250 730 Short-term investments 179 13 22 Investment in term deposits 4,240 2,281 1,174 Trading assets, fair value through

profit or loss 1,723 2,459 805 Other investment securities 365 295 4,718 2,188 1,645 494 Rental receivables on lease

assets, hire–purchase, and operating leases 9,984 6,498 3,383 1,791 57 50

Advances and other loans 6,742 8,670 6,897 9416 5870 2,727 Installment sales 2,955 2,168 Factoring receivables 1,109 Inventories 9 2 Current tax assets 75 36 154 Trade and other current assets 1,771 3,637 3,362 1,550 11,276 8,398 Investment properties 71 242 248 413 413 Real estate stocks 39 3 Investment in joint venture companies 100 10 136 14 14 Investment in equity accounted

investees 278 278 555 4,405 4,739 6,747 Investment in subsidiary

companies 911 2,997 3,478 28,832 28,176 29,796 Deferred tax assets 562 539 431 110 99 65

Other intangible assets 41 65 61 48 95 Property, plant, and equipment 2,108 2,493 2,813 3,283 2,947 2,750 Total Assets 28,996 31,335 29,738 54,213 58,028 53,239

Liabilities Bank overdraft 787 1,910 1,351 2,094 1,604 1,375 Trading liabilities, fair value through profit or loss 114 125 Short-term borrowings 7,556 Interest-bearing borrowings 22,940 21,736 20,141 22,203 18,006 Finance lease liabilities 961 Provision for taxation 9 48 57 72 30 Long-term borrowings, current 3,868 Current tax payable 183 179 74 Trade and other payables 1,909 1,284 1,099 990 705 842 Long-term borrowings, noncurrent 9,102 Retirement benefit obligations 43 52 66 80 86 97 Total Liabilities 24,234 26,233 24,309 23,603 24,777 20,519

Appendix 4 19

Balance Sheet 2008 2009 2010 2011 2012 2013

Equity Stated capital 475 475 475 475 475 475 Reserves 494 529 552 1,721 1,368 768 Retained earnings 3,793 4,097 4,401 28,413 31,408 31,477 Equity attributable to equity holders of the company 4,762 5,102 5,429 30,610 33,252 32,721 Minority interest

Total Equity 4,762 5,102 5,429 30,610 33,252 32,721 Total Liabilities and Equity 28,996 31,335 29,738 54,213 58,028 53,239 LOLC = Lanka ORIX Leasing Company. Source: LOLC audited financial statements

.

Table A4.2: LOLC Comparative Income Statements, 2008–2013 (standalone basis)

(SLRs million)

Income Statement 2008 2009 2010 2011 2012 2013

Gross income 5,222 9,691 6,774 6,344 7,561 4,684 Revenue 3,496 1,200 Less: Cost of sales (2,993) (1,030) Gross Profit 503 170 Income 4,961 6,124 4,552 3,512 3,017 3,542 Other income/ (expenses) 261 71 1,022 2,833 4,544 1,142 Net finance cost (2,972) (4,205) (3,091) (2,384) (2,572) (3,464) Profit before operating expenses 2,250 2,492 2,654 3,960 4,990 1,219 Operating expenses Direct expenses excluding finance cost (174) (315) (226) (267) (198) (34) Provision for bad and doubtful debts (115) (200) (447) (100) Personnel costs (361) (359) (245) (341) (275) (142) Net impairment loss on financial

assets (270) (54) Depreciation and amortization (298) (410) (589) (685) (603) (560) Other operating expenses (461) (626) (655) (674) (572) (362) Change in fair value of investment

properties 5 Results from operating activities 841 582 491 1,898 3,071 68 Gains on bargain purchase

(negative goodwill) Loss on disposal of subsidiaries

and associates Profit before income tax expense 841 582 491 1,898 3,071 68 Taxation 218 (77) (164) (375) (94) (34)

Profit for the year 1,059 506 327 1,523 2,977 34 ( ) = negative value, LOLC = Lanka ORIX Leasing Company. Source: LOLC audited financial statements.

Appendix 4 20

Table A4.3: LOLC Comparative Balance Sheets, 2008–2013 (Consolidated) (SLRs million)

Balance Sheet 2008 2009 2010 2011 2012 2013

Assets Cash and cash equivalents 1,073 1,833 2,083 5,089 4,029 6,591 Short-term investments 863 920 87 Investment in term deposits 4,363 3,864 2,786 Trading assets–fair value through

profit or loss 4,477 6,259 1,709 Other investment securities 366 218 11,611 11,919 10,391 13,174 Rentals receivables on lease assets, hire–purchase, and operating leases 11,602 17,193 17,832 29,168 40,129 38,090 Advances and other loans 8,563 12,550 15,085 29,402 38,985 49,724 Insurance premium receivables 240 303 Installment sales 2,955 2,168 Factoring receivables 1,109 Inventories 21 20 1,252 1,555 3,198 2,798 Current tax assets 532 774 982 Trade and other current assets 1,587 2,120 4,087 5,822 7,817 6,664 Prepaid lease rentals 314 306 297 289 Investment properties 163 452 1,123 5,156 6,340 Real estate stocks 161 32 23 16 16 3 Timber stocks 3,615 Immature/mature plantations 1,308 Consumer biological assets 2,985 2,773 2,871 Bearer biological assets 2,931 3,375 3,618 Advances for margin trading 80 Investment in equity accounted

investees–associates 493 676 3,035 2,769 3,541 10,105 Deferred tax assets 563 549 775 388 356 509 Goodwill 151 151 Other intangible assets 203 228 563 645 769 Property, plant, and equipment 2,151 2,840 8,481 14,026 17,223 18,440

Total Assets 32,994 46,287 75,371 113,071 145,204 162,981 Liabilities Bank overdraft 1,090 2,751 2,987 4,037 4,011 6,875 Deposits from customers 3,340 5,229 10,095 17,899 26,233 34,278 Trading liabilities, fair value through

profit or loss 259 5 628 Short-term borrowings 7,865 Interest-bearing borrowings 29,013 35,248 45,219 61,414 65,342 Insurance provision, life 48 116 Insurance provision, general 326 928 Finance lease liabilities 962 Provision for taxation 21 166 198 Long-term borrowings, current 3,868 Current tax payable 688 775 925 Trade and other payables 1,501 2,612 5,628 7,739 6,325 7,072 Long-term borrowings, noncurrent 9,102

Appendix 4 21

Balance Sheet 2008 2009 2010 2011 2012 2013

Deferred taxation 16 351 442 1,285 1,633 2,156 Deferred income 274 245 269 293 Retirement benefit obligations 52 74 760 885 952 997

Total Liabilities 27,816 40,196 55,632 78,256 101,991 119,609 Equity Stated capital 475 475 475 475 475 475 Reserves 506 554 766 2,369 2,391 2,269 Retained earnings 4,143 4,982 6,663 10,213 16,703 18,144 Equity attributable to equity holders

of the company 5,124 6,011 7,904 13,057 19,569 20,888

Minority interest 54 80 11,836 21,758 23,664 22,485

Total Equity 5,178 6,091 19,740 34,815 43,213 43,373

Total Liabilities and Equity 32,994 46,287 75,371 113,071 145,204 162,982 LOLC = Lanka ORIX Leasing Company. Source: LOLC audited financial statements.

Appendix 4 22

Table A4.4: LOLC Comparative Income Statements, 2008–2013 (Consolidated) (SLRs million)

Income Statement 2008 2009 2010 2011 2012 2013

Gross income 6,248 13,622 14,902 32,077 35,533 41,481 Revenue 3,496 3,571 14,288 16,849 16,988 Less: Cost of sales (2,993) (2,869) (9,911) (10,958) (10,722) Gross profit 503 702 4,377 5,891 6,266 Income 5,935 9,843 9,942 11,943 18,021 22,891 Other income/ (expenses) 283 1,389 5,846 663 1,602 Net finance cost (6,441) (6,178) (6,421) (9,346) (14,528) Profit before operating expenses 4,187 5,854 15,746 15,229 16,232 Operating expenses Direct expenses excluding finance

cost (218) (498) (542) (1,018) (930) (1,530) Provision for bad and doubtful

debts (172) (370) (636) (546) Personnel costs (522) (728) (921) (1,985) (4,164) (4,899)

Net impairment loss on financial assets (890) (2,090)

Depreciation and amortization (320) (498) (676) (1,075) (1,615) (1,980) Other operating expenses (649) (987) (1,625) (3,276) (4,018) (4,684) Change in fair value of investment properties 13 (14) 272 910 Results from operating activities 963 1,107 1,468 7,832 3,884 1,960 Share of profits of equity accounted

investees 88 140 116 179 270 246 Gains on bargain purchase

(negative goodwill) 132 1,424 272 2,915 1,501 Loss on disposal of subsidiaries

and associates (167) Profit before income tax expense 1,183 1,247 2,841 8,283 7,068 3,706 Taxation 160 (192) (455) (1,259) (1,364) (1,154)

Profit for the year 1,343 1,055 2,385 7,023 5,704 2,552 ( ) = negative number, LOLC = Lanka ORIX Leasing Company. Source: LOLC audited financial statements.