Back to the Basics

Construction players return to the EPC model

India’s construction sector is one of the major contributors to financial stress on bank books. While banks are responding to the situation by invoking various debt conversion schemes, construction players are shifting their business models to get out of the credit default cycle once and for all. This has resulted in a surge in sales of operational assets by construction players, as they are exiting new business areas on which they had pinned their hopes a few years ago. The trend of selling off operational assets is gaining traction, as a number of investors are looking to take exposures in such assets that give them regular income streams without any construction risks.

Current scenario

As per the Financial Stability Report released by the Reserve Bank of India (RBI) in January 2017, the construction sector ranks high among industries that have a significant debt burden (defined as interest expense as a percentage of earnings before interest, taxes, depreciation and amortisation). This, along with no signs of a re-duction in demand (by construction companies) for fresh debt from banks, exerts pressure on the financial standing of these firms.

Besides, RBI’s macro-stress test of sectoral credit risk reveals that among seven select sectors (agriculture, construction, cement, infrastructure, iron and steel, engineering, and automobiles), the construction and engineering sectors are expected to register about 15-20 per cent of gross non-performing assets (NPAs) by March 2018, under the baseline scenario.

Shift in business model

Among engineering, procurement and construction (EPC) players, many tested waters with regard to the build-operate-transfer (BOT) format of construction. In the BOT model, a company executes the project with its own funds, operates it for a specified duration to recover the initial investment and transfers the project to the government after earning profits. However, a number of factors such as a financial crunch, slow pace of project execution, the lack of liquidity and a huge backlog of stalled projects have impacted cash flows of these players, and pushed them into a debt trap.

Key players that have offloaded operational assets in the past 12-15 months include Soma Enterprises, Madhucon Projects, Ramky Infrastructure, Nagarjuna Construction Company Limited, Gayatri Projects Limited, the GMR Group, IL&FS Transportation Networks Limited, and Gammon India Limited. Others that are moving ahead with similar plans include Sadbhav Infrastructure Projects and GR Infraprojects Limited.

The trend of offloading BOT projects has been the most prominent in the road sector, where a large number of players are looking to deleverage. Several companies exited the space by monetising operational BOT projects, in a bid to shift the focus back to the EPC space, where construction works are executed by an EPC firm using funds extended by the government.

Who is buying?

The response from the buyers’ side has also been encouraging, as investors are looking to purchase these revenue generating assets to diversify their asset portfolio. Interest is being evinced across various investor classes, including private equity (PE) firms, foreign pension and insurance funds, as well as sovereign wealth funds.

In the PE space, entities such as IDFC Alternatives, the Macquarie Group and I Squared Capital are actively pursuing such transactions. The Canada Pension Plan Investment Board, Caisse de depot et placement du Quebec and the Public Sector Pension Investment Board have also stepped up investments in the space during recent months. Asset reconstruction companies (ARCs), global investors and developers that are more robust financially are purchasing such assets through strategic debt restructuring (SDR) and the Scheme for Sustainable Structuring of Stressed Assets (S4A).

Moreover, RBI too has played its part in facilitating the offtake of distressed assets. In September 2016, it allowed non-banking financial companies, financial institutions and other lenders to buy stressed assets from banks. Earlier, only ARCs and securitisation companies were permitted to do so. Schemes such as S4A and SDR are expected to fare better following the apex bank’s announcement. Meanwhile, the scenario with regard to valuations is also improving, as pricing is seeming more realistic than that which prevailed two-three years ago. Global investors too are bullish on the Indian market, prompted by limited investment opportunities globally.

In sum

Going forward, the sale of projects by construction players is likely to continue, buoyed by a wide range of investors scouting for such assets and providing a ready market to companies looking to deleverage and modify their business strategies. Valuations, however, will be a key factor in the finalisation of these transactions. Going back to the EPC space will not only benefit the companies that are reeling under debt at present, but will also free up a significant amount of blocked capital on their books.

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