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Case study analysis of HBR Case: Risk Management at Wellfleet Bank: "Megadeals"Topics include Introduction, What risks does the bank face, Evalutation of Proposals (Ashar Industries Steel, Gatwick Gold Corporation GGC) and Financial Evaluation
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MCB Report Group 1: Wellfleet Bank “Megadeals”
REPORT
Subject: Management of Commercial Banks (MCB)
Course: MBA Tech. (Finance)
College: Mukesh Patel School of Technology Management and Engineering,
NMIMS Mumbai
Group 1:
109 Ghanshyam Gupta
301 Balagopal Padmakumar
302 Harbir Singh Banga
402 Rishi Bajaj
503 Anirwan Bhattacharya
Case Study: Risk Management at Wellfleet Bank: Deciding about Megadeals
Contents:
§ Introduction
§ What kind of Risk does Wellfleet Bank face?
§ Overview of Proposal 1 and 2
§ Evaluation of Proposal 1 and 2
MCB Report Group 1: Wellfleet Bank “Megadeals”
Introduction
Wellfleet Bank was founded in London in the year 1847. In the days of British Empire
the bank provided its services to Asian and African colony. However, during the period
1960 to 1990 the bank developed a global presence providing its services in North
America and Europe. The bank’s profitability & capital were significantly reduced owing
to the European property/credit crisis in 1989-‐1992. The bank later focused on its core
markets in emerging economies while suspending its non-‐core activity in North
America and Europe. In 2007, the bank operated in 55 countries (2007) with total
assets of $329 billion and market cap of $51 billion. The bank had presence in about 78
nations by 2008 on account of several acquisitions it had undertaken. Wellfleet main
competitor was Global Bank.
Corporate Banking and Consumer Banking were the two main businesses the bank had
undertaken which accounted for 58% and 42% of its Pre-‐Tax profits respectively. The
bank focused more on the syndicated and leveraged loans segment to its large
corporate clients.
Syndicated loans were provided to a borrower through combined activities of several
banks. Members in this consortium could reduce their overall exposure, each bearing
only a part of any loss. Syndicated loans help small banks to participate in large
transactions which otherwise was not possible for them.
Leveraged loans were extended to companies that already had considerable amount of
debt. As these loans carry a higher risk of default, the lender usually charged a higher
interest rate and kept only a portion of loan on its Balance Sheet and transfers its
exposure to other banks by ‘selling down’.
Syndicated and Leveraged loans are carried through by Investment Banking division
but Wellfleet did have an IB division, so it carried this business through its corporate
banking division.
The corporate bank worked as an IB and recruited relationship managers from leading
investment banks and hired a senior risk officer, Catherine Richards. This gave Wellfleet
a risk perspective while analysing its proposals. Between 2004 and 2006, the bank took
around 40 deals in range of $500 -‐ $750.
MCB Report Group 1: Wellfleet Bank “Megadeals”
Wellfleet was based in London even though majority of its customers resided outside
UK. Wellfleet considered its ‘first world regulatory compliance’ helps it to gain
competitive edge over rivals in emerging market.
Wellfleet Bank gave importance to internal controls and risk management as it
considered them to be very crucial part of banking.
MCB Report Group 1: Wellfleet Bank “Megadeals”
What kind of risk does Wellfleet Bank face
§ Wellfleet Bank strategic intent was to pursue large transformational deals
through its corporate banking segment. The group had a decision making forum
consisting of three members namely the group chief credit officer, deputy group
chief risk officer & group head of client relationships. As per the mantra of the
bank: “If a billion dollar deal went wrong it could sink the ship”. As the deals
pursued by the bank were of large scale in nature, these large scale credit
applications itself counted as a mega risk facing Wellfleet Bank.
§ One important risk that the bank is facing is that there is no Risk Appetite
Statement which defines the tolerance level – the Group Credit Committee has
the powers to approve deals of any size (upper limit for Group Credit Committee
authority not defined). Further, the CEO/Board of Directors only reviews the
corporate loan portfolio and do not have any direct involvement with the
process. The Board has delegated responsibility for management of credit risk to
the Group Credit Committee and hence do not control their decision. The Group
Credit Committee does not report to the Board/Group Risk Committee. Group
Credit Committee is the highest forum of credit approval.
MCB Report Group 1: Wellfleet Bank “Megadeals”
§ The bank had identified leveraged loans and syndicated loans as the future
growth segments. However as leveraged loans are provided to borrowers with
existing high debt the risk of default is high which could affect the bank
significantly.
§ It is mentioned in the case that if the deputy group chief risk officer & group head
of client relationships disagreed over a proposal then the Chief Credit Officer
would take the ultimate decision. There lies a degree of operational risk in view
of granting someone this kind of an ultimate authority.
§ Other risk that the bank is facing is there is a lack of a risk appetite statement to
set the level of tolerance for corporate banking loans.
§ Broadly, the bank is facing the regulatory risk which is compliance with the Basel
II standards, credit risk, increasing competition as well as the risk from
acquisitions.
§ Concentration Risk -‐ The bank has a very high concentration on its Corporate
Banking Group. As per the case, Wellfleet corporate banking group constituted
58% of profit before taxes and 72% of banks assets in 2007 while the remaining
portion is attributed to its consumer banking group. The consumer banking
group accounted for bad debt provisions of $611 million in 2006 as compared to
$214 million in 2004.
§ The structure of the bank (as shown in the figure above) was such that the credit
officers would process a loan application and sign off the application in case the
limits were under their powers. However in case the limits exceeded the credit
officer’s powers then the proposal had to be passed on to the next level (to the
regional credit officer) in the hierarchy. Likewise the Group Credit Committee
was at the apex of the hierarchy. Also, the loan application had to be signed off at
each level in the hierarchy (i.e. up to the level at which the loan is approved by
the decision making authority)
§ The Risk Management Function at the bank consisted of the Relationship
Managers who were responsible for generating leads and they viewed the
proposal from the point of view of margins/fees that the bank could earn from
MCB Report Group 1: Wellfleet Bank “Megadeals”
the deal whereas the Senior Credit Risk Officers viewed the proposal both from
its risk and reward perspective. There lies a challenge to manage these
relationship managers/sales people in cases where the proposal is not lucrative
for the bank.
§ Other important aspect is that the bank has compartmentalized risk greatly. The
various types of risk such as market risk, operational risk, reputational risk,
credit risk, country risk, compliance risk etc all are managed and controlled by
separate risk committees. However these different types of risk are all
interrelated to each other and thus cannot be separated.
§ The bank had its own internal credit risk assessment model summarized as
EL ($) = Probability of Default x Loss Given Default (%) x Exposure at Default ($)
EL ($) is the expected loss on the loan amount lent out by the bank. A risk here is
that bank officials over-‐relied on these models to make a decision. However the
bank also took into account the rating from external credit agencies such as
Moody’s. Risk Models must be used with other available data/experience to
arrive at a judgement. The current industry scenario along with the changes in
the industry must be factored in while arriving at a decision rather than simply
entering data/financials in the model and deciding based upon the output of the
model.
MCB Report Group 1: Wellfleet Bank “Megadeals”
Proposal 1
Client: Ashar Industries
Requirements and Details:
§ Underwrite upto $850 million of a EUR 8 billion facility for acquisition of
Zellmonte SA
§ Would be a partner to the Syndication of the facility that has been awarded to
Bentleys, Cramer & Dougherty, MetGen(Bookrunners) who have been joined by
ReinBank, Clouseau Brothers, Global Bank(Non-‐Bookrunners)
§ Knoxville has approached Wellfleet to join as a sub underwriter
Background:
§ World’s largest steel producer (6% market share by volume)
§ Specializes in low-‐end commodity steel.
§ Production across developed markets (North America – 40% sales (25% auto),
Western Europe – 33% sales) as well as developing markets (Algeria, Eastern
Europe, Kazakhsthan, Sounth Africa and Ukraine)
§ Controlled by Amit Asher and family having several unconsolidated JVs (eg.
Telmak Steel)
Credit analysis:
Challenges
§ Integration risk with the Target company
§ Need to further streamline the complex debt structure of present company
§ Possible real break off in hostile takeover
§ Possible political risk of Zellmonte SA
MCB Report Group 1: Wellfleet Bank “Megadeals”
Strenghts
§ Worlds largest steel maker
§ Diversified revenue stream
§ High level of raw material integration
§ Good financial performance, high EBITDA margins and FCF generation
Ratings
Agency Rating
Wellfleet Grade 5A
Moody Baa3/ review for downgrade
S&P BBB+/watch negative
Return to the Bank
Explicit
§ In 1st year – 52.5bp
§ Additional – 20bp-‐underwriting fee (10bp on agreement, 10bp on close of
general syndication)
§ Drop dead fee – 10bp (incase acquisition fails)
Future Scope
§ Total Possible earnings in medium term -‐ $1050000 comprising of
o Foreign Exchange Wallet $250,000
o Interest Rate Derivatives Wallet $300,000
o Commodities Wallet $250,000-‐500,000
MCB Report Group 1: Wellfleet Bank “Megadeals”
§ Other opportunities include Project finance, future M&As advisory, and
structured finance
Broader Picture
§ Integration track record is good
§ Management under control effectively by promoters and family
§ Complex structure, several unconsolidated joint ventures and associates.
However company claimed to have no unconsolidated debt.
§ Management track record of turning around underperforming assets to date
good
§ Clean audit reports
§ Strong record of leveraging to acquire and then de-‐leveraging
§ Deal expected to be 25% Debt-‐75% Equity
§ Wellfleet Reputational Risk Committee clears name
§ Several claims against environmental issues
§ Competitive practices abuse cases against company in EU
§ Industry Issues:
o Wellfleet’s exposure to the steel industry is currently $1.2bn, 5%of risk
weighted assets.
o Due to high fixed costs in their cost structure, steel companies display
sensitivity to product price movement.
o Supply and demand match over the last 10years
o Future growth: continued expansion in capacity in China and India
MCB Report Group 1: Wellfleet Bank “Megadeals”
Proposal 2
Client: Gatwick Gold Corporation
Requirements: Refinance $ 1 Billion Convertible-‐Bond Financing
Background:
§ GCC was world’s third largest gold producer, accounting for about 7% of global
gold production.
§ It operates in 21 mining operations in 10 countries across the globe and
conducted extensive exploration.
§ 41% of its production came from the deep-‐level hard rock operations in South
Africa.
Credit Analysis:
Challenges:
§ Need to refinance $ 1 billion convertible bond due to expire on 27th February
2009.
§ Total Debt to EBITDA was 800% in 2007.
§ Debt protection: EBITDA to interest expense was -‐3.1% in 2007, showing a
diminishing curve since 2003.
Strengths:
§ The world’s 3rd largest gold producer with 7% of global gold production.
§ Diversified production base.
§ Low-‐cost producer( in the lower 50% of global cost curves on average across all
their mines)
MCB Report Group 1: Wellfleet Bank “Megadeals”
Ratings:
Agency Rating
Wellfleet Grade 5B
Moody NA
S&P NA
GCC-‐ Broader Issues
Commodity prices/Hedging:
§ The single largest risk for GGC in the long term would be sustained fall in the
gold price. The risk trigger is gold price under $ 650/oz. During the recent
commodity price turmoil, the gold price has only been below $700 on one day.
§ Low prices would make some of its mines uneconomic and would impact
investment capex and exploration.
Mining-‐cost inflation: Mining costs are growing rapidly globally.
§ Electricity: Mines are heavy users of electricity. Electricity costs will increase in
line with the energy-‐price increases.
§ Labour: Labour costs in South Africa are increasing by around 12% PA
§ Equipment: Industry demand for new equipment was very strong from 2004-‐
2007, with sharp price increase, but the pressure is now starting to ease with
Capex cutbacks across the industry.
§ Cost inflation in GGC’s operations over the past 21 months has been appox. 21%
in $ terms. The rate is likely to slow down with the depreciation of the ZAR, fall in
disel prices, and fall in demand for mining equipment. Productivity investment
will begin to pay dividends.
Political Risk:
MCB Report Group 1: Wellfleet Bank “Megadeals”
§ Around 72% of current production is in Sub-‐Saharain Africa. Gold is a key export
and cash generator for all 6 African Countries.
§ Diversification of mines (21mines across 10 countries) mitigates risk.
Black Economic Empowerment:
§ BEE is a program launched by the South African Government to redress the
inequalities of the apartheid by giving, historically disadvantaged South Africans
economic opportunities previously not available to them. In terms of mining,
companies are required to convert their existing licences into a new generation
of mining licences. Companies that don’t comply with BEE legislation, which
most importantly includes the provision of transfer of ownership of equity or
assets to BEE.
Shareholder Distribution:
§ Company presently distributes 20% of earnings as dividends.
Management Team:
§ Good all-‐round mining experience supported by well-‐connected African-‐oriented
board.
§ Acquisitions are for shares and not for cash.
Industry Issues:
§ Financial profile of the gold industry is characterized by: heavy investment in FA;
2+ year development period, very high fixed costs.
§ Due to high fixed costs in their cost structure, gold mining companies display
extreme sensitivity to product price movements.
MCB Report Group 1: Wellfleet Bank “Megadeals”
Economic and Financial Analysis
Kindly refer to the Excel sheet for detailed calculations and comments.
Some Highlights
Particulars Proposal 1 Proposal 2
Expected Loss 10,63,282.00 20,37,750.00
Total Revenue 78,62,500.00 77,50,000.00
Risk Adjusted Revenue 67,99,218.00 57,12,250.00
Economic Revenue 45,99,218.00 19,12,250.00
Economic Profit 22,73,505.00 6,92,250.00
Proposal 1
§ CAGR over the last 3 financial years of Revenue has been at 74.84% while that of
EBIT has been at a phenomenal 180.52%
§ There has been a steady and healthy growth in Net Income of over 17.68% over
the last 3 years
§ The company has bounced back from the slump period in 2002-‐03 indicating the
ability of the management to turnaround underperforming assets
§ In the recent years, the company has increased its long term borrowings for
investment activities raising its D/E ratio to 0.82 in 2005 from the previous 0.34
§ Company has a history of overleveraging to acquire assets and then deleveraging
(seen during 2002-‐03 and again in 2004-‐05)
§ Debt servicability ratios are healthy at 13-‐17 times the EBIT and EBITDA.
Proposal 2
§ While Revenue has grown at a CAGR of 12.48% over the last 3 years, the
profitability has taken an enormous hit with EBIT having a negative growth
MCB Report Group 1: Wellfleet Bank “Megadeals”
§ There is a negative net income (loss) in the last 3 financial years § The company has shown decrease in EBITDA margin from 27.6% to 7.20% in the
past year having a negative ROI in the present year. § The EBIT to interest expense is negative indicating the inability of the firm to
service the present debts it has undertaken.
Closing Statements
From the Economic and Financial Analysis of the two proposals it can be seen clearly
that Proposal 1 (Ashar Industries) seems to be in strong financial position, growing at at
a rate higher than industry standards and is in the hands of experienced management
that has a history of turning around unproductive assets. It has experience in several
acquisitions and mergers, however the financial structure is complex and the current
debt taken is at very high levels. The company though has a history of heavy leveraging
for acquisition of assets and then deleveraging heavily as seen in the past.
Proposal 2 on the other end, of GGC is in the red. Having negative growth over the past 3
years, the statements show of loss and the company is unable to service its present debt.
Much harm has been caused to the company by the decision to hegde its gold prices for
the future two years in 2005. However the future outlook of must be considered with
respect to the industry it operates in.
A broader view must be taken with respect to the two companies, and one must
ascertain the exact use of funds in case the acquision by Ashar Industries does not turn
successful before approving the facility. However, we suggest the Bank stay away from
GGC until it turns profitable.
Party Ashar Industries
Wellfleet Rating-‐ 5A Probability of Default (PD)0.22%
Loss Given Default (LGD) 56.86%Draw amount 85,00,00,000.00 (Eight hundred fifty million US $)
Expected Loss (EL) 10,63,282.00 Draw Amount *PD*LGD
Interest Income (bp) 52.5 44,62,500.00 Total Interest IncomeFee IncomeUnderwriting fee (bp) 20 17,00,000.00Participation fee (bp) 20 17,00,000.00
34,00,000.00 Total Fee Income
Total Revenue 78,62,500.00 Total Interest Income + Fee Income
Risk Adjusted Revenue (RAR) 67,99,218.00 Total Revenue (TR) -‐ Total Expected Loss (EL)
Net Capital Charge 22,00,000.00
Economic Revenue 45,99,218.00 RAR -‐ Net Capital Charge
Transaction Cost 8,25,713.00Tax 15,00,000.00
Economic Profit 22,73,505.00 Economic Revenue -‐ Tax -‐ Transaction Cost
Party Gatwik Gold Corporation
Wellfleet Rating-‐ 5B Probability of Default (PD)0.39%
Loss Given Default (LGD) 52.25%Draw amount 1,00,00,00,000.00 (One billion US $)
Expected Loss (EL) 20,37,750.00 Draw Amount *PD*LGD
Interest Income (bp) 47.5 47,50,000.00 Total Interest IncomeFee IncomeUnderwriting fee (bp) 30 30,00,000.00Participation fee (bp) 0 0.00
30,00,000.00 Total Fee Income
Total Revenue 77,50,000.00 Total Interest Income + Fee Income
Risk Adjusted Revenue (RAR) 57,12,250.00 Total Revenue (TR) -‐ Total Expected Loss (EL)
Net Capital Charge 38,00,000.00
Economic Revenue 19,12,250.00 RAR -‐ Net Capital Charge
Transaction Cost 3,00,000.00Tax 9,20,000.00
Economic Profit 6,92,250.00 Economic Revenue -‐ Tax -‐ Transaction Cost
Ashar Financials2002 2003 2004 2005 2002-‐03 2003-‐04 2004-‐05 CAGR 3 years CAGR 2 years
Income StatementRevenue 4889 9567 22197 26132 95.68% 132.02% 17.73% 74.84% 65.27%D&A 177 331 553 829 87.01% 67.07% 49.91% 67.31% 58.26%EBITDA 395 1700 5827 5575 330.38% 242.76% -‐4.32% 141.67% 81.09%EBIT 215 1369 6274 4746 536.74% 358.29% -‐24.35% 180.52% 86.19%PBT -‐24 1400 6133 4703 -‐5733.33% 338.07% -‐23.32% 480.84% 83.28%Interest Expense -‐208 -‐200 -‐265 -‐339 -‐3.85% 32.50% 27.92% 17.68% 30.19%Net Income 49 1182 4701 3365 2312.24% 297.72% -‐28.42% 309.51% 68.73%Minorities 0 35 615 520
Cash Flow Funds from Operations(FFO) 150 1413 5784 4511Change in WC 18 -‐93 -‐1171 -‐537cash From operations(CFO) 168 1320 461 3974Gross CAPEX -‐108 -‐421 -‐898 -‐1181Other Investments/acquisitions 28 -‐275 95 -‐6431Cash from investing activities -‐80 -‐696 -‐803 -‐7612Cash Dividend 0 -‐164 -‐736 -‐2092
Balance SheetCash & Eq. 77 760 2495 2035Marketable Securities 0 0 1 14Fixed Assets 3035 4654 7562 15539Total Assets 5512 10137 19153 31190Short term debt 262 760 341 252Long term debt 2022 2287 1639 8056Gross debt 2284 3067 1980 8308Net debt/(Cash) 2207 2307 -‐516 6259Common Equity 128 2561 5846 10150Minority Interest 0 261 1743 1834Shareholder's equity 128 2822 7589 11984
ProfitabilityEBITDA margin 8.10% 17.80% 30.80% 19.80%EBIT margin 4.50% 14.30% 28.30% 16.90%Net margin 1% 12.40% 21.20% 12.00%ROE 21% 87.90% 111.80% 42.10%Return on Capital Employed -‐0.80% 3.40% 7.20% 2.80%
Capital StructureTotal debt to common equity 17.84 1.20 0.34 0.82Net debt to common equity 17.24 0.90 -‐0.09 0.62Total debt to EBITDA 5.78 1.80 0.29 1.49Net debt to EBITDA 5.59 1.36 -‐0.08 1.12Hostoric market cap 267.00 5679.00 23708.00 16879.00
Debt ProtectionEBIT to interest expense 1.00 6.80 23.70 14.00EBITDA to interest expense 1.90 8.50 25.80 16.40EBITDA -‐ CAPEX to interest expense 1.40 6.40 22.40 13.00
-‐1000
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EBITDA
EBIT
PBT
Interest Expense
Net Income
GGC Financials2003 2004 2005 2006 2007 2003-‐04 2004-‐05 2005-‐06 2006-‐07 CAGR 4 yearsCAGR 3 yearsCAGR 2 years
Income StatementRevenue 2109 2297 2632 2975 3269 8.91% 14.58% 13.03% 9.88% 11.58% 12.48% 11.45%D&A 280 409 505 602 590 46.07% 23.47% 19.21% -‐1.99% 20.48% 12.99% 8.09%EBITDA 878 642 682 820 235 -‐26.88% 6.23% 20.23% -‐71.34% -‐28.07% -‐28.47% -‐41.30%EBIT 618 233 177 219 -‐354 -‐62.30% -‐24.03% 23.73% -‐261.64% #NUM! -‐214.96% #NUM!PBT 676 116 -‐175 127 -‐428 -‐82.84% -‐250.86% -‐172.57% -‐437.01% #NUM! -‐254.52% -‐256.39%Interest Expense 48 80 99 117 113 66.67% 23.75% 18.18% -‐3.42% 23.87% 12.20% 6.84%Net Income 515 113 -‐198 -‐87 -‐605 -‐78.06% -‐275.22% -‐56.06% 595.40% #NUM! -‐274.94% -‐274.80%Minorities 18 19 23 30 31 5.56% 21.05% 30.43% 3.33% 14.56% 17.73% 16.10%
Cash Flow Funds from Operations(FFO) 525 579 667 1224 1027Change in WC -‐64 -‐121 -‐112 -‐129 -‐176cash From operations(CFO) 461 458 555 1095 851Gross CAPEX -‐363 -‐585 -‐723 -‐818 -‐1021Other Investments/acquisitions 55 -‐231 -‐63 57 -‐38Cash from investing activities -‐308 -‐816 -‐785 -‐761 -‐1059Cash Dividend -‐328 -‐205 -‐165 -‐135 -‐149
Balance SheetCash & Eq. 503 288 210 496 493Marketable Securities 0 26 8 0 0Fixed Assets 2753 5870 5911 6065 6672Total Assets 4838 8176 8303 8961 9747Short term debt 350 318 188 59 337Long term debt 804 1282 1708 1426 1522Gross debt 1154 1600 1896 1485 1858Net debt/(Cash) 651 1286 1678 989 1365Common Equity 1621 3142 2617 2990 2362Minority Interest 53 58 59 62 63Shareholder's equity 1674 3199 2676 3053 2424
ProfitabilityEBITDA margin 41.60% 27.90% 25.90% 27.60% 7.20%EBIT margin 29.30% 10.10% 6.70% 7.30% -‐10.80%Net margin 24.40% 4.90% -‐7.50% -‐2.90% -‐18.50%ROE 33.50% 5.10% -‐7.30% -‐3.10% -‐23.00%
Capital StructureTotal debt to common equity 0.71 0.51 0.72 0.50 0.79Net debt to common equity 0.40 0.41 0.64 0.33 0.58Total debt to EBITDA 1.31 2.49 2.78 1.81 7.89Net debt to EBITDA 0.74 2.00 2.46 1.21 5.80Hostoric market cap 10467 9311 13103 13045 11848
Debt ProtectionEBIT to interest expense 12.90 2.90 1.80 1.90 -‐3.10EBITDA to interest expense 18.30 8.10 6.90 7.00 2.10EBITDA -‐ CAPEX to interest expense 10.70 0.70 -‐0.40 0.00 -‐7.00
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EBITDA
EBIT
PBT
Interest Expense
Net Income