Infrastructure Finance in India

The fact that India has poor physical infrastructure is common knowledge. The government realizes this and is trying to make amends to the oversight of past decades. The effort required however is mammoth and it is not possible for the government to build the infrastructure for India on its own. It needs partners who can help fund the construction of power plants, roads, ports and other critical facilities the lack of which pulls down Indian GDP growth by about 2%. The government has realized over the past 15 years that the way to go about this is to seek partnership from the private sector in building infrastructure for India. When we talk about private sector participation it is through creation of business models in the infrastructure space that involve creation of infrastructure and then recovery of upfront cost through user fees, tolls and sale of power generated. The sector is a fascinating place for private developers with an immense opportunity to earn. But, this opportunity is open to only those with deep pockets and the ability to manage risk well. Infrastructure projects are highly capital intensive. A power project of 2x500 MW (you need at least 3 such plants to power a city like Delhi) costs nearly USD 1 billion to build. The funding model for such projects is generally debt and owners’ equity in the ratio 75:25. The funding however does not come easy. This article discusses the difficulties that private sector developers face while arranging for these funds. The article also discusses what banks look for in a project while lending.

When developers need finance of the magnitude as above they need to come up with a business model that guarantees pay back of the upfront investment with a reasonable degree of certainty. No bank would lend to a project unless there is certainty of repayment. The loans are unsecured and carry high interest rates. Asset liability maturity mismatches make it difficult for banks to lend long term to infrastructure projects. These projects are long gestation and have lives of over 25 years. Developers look for loans with payback period that matches the project life cycle. If this is not so the projects would have negative cash flows for a large portion of their life-cycle. For banks to lend long term, they should have long term funds on their books which is rare. So what banks look for is a consortium of lenders that finances the project with arrangements of take-out finance. This essentially means that the bank will have an arrangement with another financial institution through which the original lending bank exits the loan through a takeover of loan by the second institution. This solves the asset liability maturity mismatch problem.
Banks in India are risk averse and lending is subject to strict due diligence. The level of comfort with infrastructure projects is particularly low because of the genuine reason of lack of predictability of the economic environment in the long term. This makes long term lending even more infeasible. Then, there are other sources of risk for lenders and these factors form the risk in financial closure for developers. These risks are tabulated below and are self-explanatory.
 
Risks to Financial Closure
• Faulty project preparation: Often, risks are not shared by parties who are most suitable to take the risk. Correct demarcation and allocation of risks is critical to commercialization of infrastructure.
• Likelihood of project to face land acquisition problems, environmental clearance issues and rehabilitation of displaced population.
• Long concession periods bring prospects of uncertainty
• Inadequacy of equity contribution proposed by developers is again a source of excessive risk for the lender
• Aggressive or unclear traffic projections in road projects can make the lender wary of the project
• Inadequate protection of lenders’ interests
• Availability of competing facilities which could cause less than predicted cash flows
• Project costs too high as compared to other similar projects
Bank lending to infrastructure projects can be promoted through facilitating take-out finance, special concessions to the sector on ECB limits and credit enhancement for infrastructure projects. Providing the sector a priority sector status will also help in flow of funds to the sector. If the banks are allowed to raise long term infrastructure bonds, it will become easier for them to lend long term. Allowing the pension sector to invest in long gestation infrastructure debt will also make the availability of long term finance easier.
Apart from domestic debt, there are other sources of finance for Infrastructure projects.

Sources of funds
• External commercial borrowings
• Bond market
• Securitization
• Buyer credit
• Multilateral funding
• Initial Public Offerings
• Foreign Direct Investment
• Subordinated/Mezzanine Quasi equity, without collaterals
• Convertible instruments(CD’s/CCPs, convertible debentures with warrants)
• Issuing equity to users/stake holders e.g. land owners
• Viability gap funding by the government
• Alternate assets in project being developed such as opportunities for real estate development
• Levy of taxes/tolls, user fees

Some of the above sources merit further explanation and comments and the same are discussed below:
External Commercial Borrowings (ECB):
Sources of ECB include: (i) international banks, (ii) international capital markets, (iii) multilateral financial institutions (such as IFC, ADB, CDC, etc.,), (iv) export credit agencies, (v) suppliers of equipment, (vi) foreign collaborators and (vii) foreign equity holders (other than erstwhile OCBs).
ECB for infrastructure is subject to government norms like a cap of USD 500 million per firm per year. The government recently modified ECB guidelines, allowing Infrastructure Finance Companies (IFCs) to avail of ECBs up to 50 percent of their owned funds under the automatic route. Borrowing of greater amounts will need to go through the approval route. This change will enable greater availability of funds to the infrastructure sector.
Bond Market:
At the developers’ end the lack of a mature bond-market in India makes it difficult for developers to have access to sufficient long term lending. The creation and facilitation of bond markets in India has long been a focus of the government but the progress is slow since there is high demand for equity instruments as compared to debt instruments in India. Unlike the US where the bond markets are even larger than the equity markets, in India the bond markets largely comprise of government T-bills and corporate issues of bonds are few and far between.
Securitization:
Securitization generically refers to the pooling of cash flow producing assets (e.g. loans, mortgages, bonds) and subsequent issuance of securities in the capital markets backed by these collateral pools. Securitization can serve as an effective method for banks to hive off risk of long term receivables from infrastructure projects into the securities market. However, disowning risks through securitization instead of managing risks underlined the recent financial crisis. This has dissociated securitization from its positive attributes and given it a negative connotation. This does not bode well for the nascent securities market in India and the infrastructure sector which could have seen strength in bank lending based on risk distribution through securitization.

Foreign Direct Investments (FDI):
Even though provisions for FDI in infrastructure are liberal, the flow of FDI into the sector is tardy because of various reasons:
• Multiplicity of laws, rules and regulations
• Unstable tax structure in India
• Widespread corruption and political risks
• Complicated land acquisition and potential law suits
• Clearances from multiple agencies
• Complexities in labor laws
The above problems are well known but solutions to these are hard to come by because of the political nature of these issues. Till the time these issues exist health inflows of FDI into the sector cannot be a reality.
Issuing equity to stakeholders:
Another source of funds can be the issue of equity to stakeholders such as equipment suppliers (such as power equipment suppliers) or land owners whose land is acquired. Such measures bring down the need for upfront spending and debt and expand the equity base. Sharing of mining revenues is another example in which upfront debt requirements can be substantially reduced.
Viability gap funding (VGF):
The government recognizes the welfare role of infrastructure and the fact that not all infrastructure projects may make business sense. For projects that do not promise private developers positive returns on their investments there is a provision called Viability Gap Funding (VGF) through which the government funds part of the investment required in the infrastructure project to make it viable and thus attractive to private bidders for the project. When bids are sought from private developers they can quote a figure for the VGF required and it is then up to the government to evaluate the bidders w.r.t. the VGF demanded.
Alternate assets in Infrastructure projects:
Another way to make infrastructure projects attractive to developers is to allow them to develop real estate on the project premises in such a way that this development benefits from the project and provides the bidder another stream of revenue. The onus is on the bidder to assess the potential of such development and factor that into his bid to make it competitive. For instance, an airport developer is given the opportunity to develop hotels and shopping areas inside or in the vicinity of the developed airport. Such arrangements form indirect source of funding to infrastructure projects and are typical of them.

Conclusion:
Infrastructure projects are complex with a multitude of stakeholders. For a project to be successful, it is critical that interests of all stakeholders are safeguarded. The developers need to offer the lender a rational and stable revenue source of revenues. India is currently the largest Public-private partnership funded infrastructure market in the world. To sustain this market and to help it power infrastructure growth in India diversity in sources of liquidity is a must. No single institution will take up the risk of lending to long gestation risky projects. At the same time strong risk mitigation measures are required on part of the developers. They need to develop a very good understanding of the risks involved and price the risk at the start of the project. Unprofessional bidding on the part of developers leads to low bid prices which ultimately lead to the downfall of the developer as also the great harm to societal good. Promoters tend to downplay risks at project inception to get access to funds. Greater transparency in infrastructure projects can help the banking sector to lend more easily to infrastructure projects. Policy reform especially in land acquisition, tax structures and simplification of regulation can go a long way in encouraging participation of more players in infrastructure finance.
References:
www.finmin.nic.in
www.rbi.org.in
The author has worked in the Infrastructure Sector project execution for six years and is currently pursuing the Post Graduate Program in Management at the Indian School of Business, Hyderabad.