With the second largest road network in the world at over 4.7 million km, India offers significant opportunity for private players to participate in and benefit from growth in the sector. More than 60 per cent of freight and 85 per cent of passenger traffic in the country is serviced by road. Already concessions worth $25 billion have been awarded to the private sector. At the same time, the growth potential is large – the share of national highways in the overall road length is just 2 per cent and the country has one of the lowest per capita travel by road rates (445 km per annum compared to more than 8,000 km per annum in the US). Recent policy measures announced by the government to upgrade and strengthen highways and expressways also bode well for the sector.
Financial investors in the highway sector
The highway sector has all the ingredients to attract financial investors. With the first privatisations taking place as early as the 1990s, the regulatory framework has evolved affording a high degree of regulatory stability for national highway projects. Revenue linkage to the wholesale price index and more recently to a combination of the wholesale and consumer price indices provides a hedge against cost and interest rate variations and ensures stability of returns. Last but certainly not least, there are many assets with good operational history and established cash flows, making the assessment of their value relatively easier. These factors have led to the sustained interest from financial investors in the highway sector, starting from the early 2000s to the present. However, as investors have gained experience, their investment models have undergone a change.
Where has the classic PE model led us?
The advent of the National Highways Development Programme and the first wave of privatisations in the late 1990s and early 2000s induced a large number of investments by private equity (PE) players in the “classic” style which entailed the infusion of growth capital and taking a minority stake in Indian construction companies. The investment thesis was to take the development risk along with the Indian partner, grow the platform and exit through a capital market/sale event to the public or yield-seeking investors, thereby making healthy risk-adjusted returns.
While this appeared fine in theory, investors were making a call on three inherent factors – the ability of the local developer to infuse most of the funds, the ability of the portfolio to keep growing at healthy risk-adjusted return rates and project development occurring within the budgeted cost and time frame. Deviations in any one of these aspects would have a large impact on investor returns. Unfortunately, all the above assumptions went wrong. Between 2008 and 2012, projects were bid at abysmally low returns, the development of projects hit major land and regulatory hurdles leading to high cost and time overruns, and the financial health of Indian developers deteriorated due to large debt burdens and sluggish economic growth.
As a result, the exit thesis of investors took a beating with most of the classic PE investors unable to achieve their desired form of exit. Ac-cording to VCCEdge, since 2005, though 86 PE firms have invested $2.9 billion in the highway sector, there have been only been 8-10 exits.
Paradigm shift in the PE model
While a lot of what occurred could not have been anticipated, investors now understand there is a need for adopting a different strategy. The new strategy involves the complete buyout of projects, thereby eliminating funding risks and a dependence on local construction companies. Furthermore, financial investors now want to focus on operational projects, thereby eliminating development risks. Focusing on such projects will also provide immediate cash yield to shareholders, while the addition of new projects will add the “growth alpha”, creating a unique yield-plus growth model that is attractive to investors. This strategy is aided by the fact that there are close to 200 operational highway projects that can be evaluated for acquisition by investors.
The strategy has met with success thus far as investors such as I Squared Capital, the International Finance Corporation, IDFC, Macquarie and Brookfield have acquired highway projects either directly or through their professionally managed investment platforms. So far, around 15 deals have been undertaken by these investors in the past four years.
The acquisition model is however not devoid of risk. The success of this model hinges on factors like an innate understanding of traffic flows, maintenance characteristics and local issues governing the project, the ability to resolve such issues, and the ability to identify and reduce financial risks of the project so that investors get suitable risk-adjusted returns.
The only sustainable way of successfully mitigating these risks is for the investor to create a highly motivated, in-house team of professionals across traffic, maintenance, merger and acquisition, and project finance functions. The management, with access to capital, the right technologies and negotiation skills, can identify and suggest workable solutions.
Issues faced by financial investors
With a plethora of operational highways available for potential divestment, one cannot be blamed for thinking that financial investors are spoilt for choice. Given this, it is therefore difficult to reconcile the facts – of the over 200 potential assets, only 15-18 have changed ownership. Several projects do not meet the investment criteria because they are beyond redemption quality-wise; either the debt levels are abnormally high or the bids are structured poorly (due to aggressive bidding to get a project at any cost).
Of the deals that meet the investment criteria, an issue one invariably encounters is the time taken to close the deal, which involves lengthy negotiations with sellers and long approval processes with banks and regulators. Exceptions aside, a typical deal in the highway sector can take nine months to a year to close, in contrast to three to five months in the developed world.
Another aspect unique to highway assets in India is the typical transaction size. The policy of the government has been to award highway projects in packages – a highway of around 200 km would typically consist of three to five packages awarded to different developers. This makes the size of a project, and therefore the transaction size, quite small. Couple this with the inordinate amount of time taken for deal closure and we are talking about concluding a $30 million-$40 million transaction in about a year. This does not enthuse many investors who have alternative avenues of perhaps deploying that capital elsewhere.
There is no such thing as a “perfect” project in India. Almost all projects come with their own set of issues, many of which are related to their financing structure, upcoming major maintenance, and structural condition of the pavement. Therefore, an extremely careful and detailed assessment by investors is required on what solution, if any, they can come up with to resolve and mitigate such issues. This entails a thorough due diligence exercise, unlike a typical classical PE transaction. In some ways, this can also create unique opportunities. If one takes the time and has the diligence to find appropriate solutions to resolve major issues, an investment could actually yield a better risk-adjusted return. This is where the role of a competent, cross-functional management team becomes extremely critical.
Another issue commonly encountered by financial investors is the level of compliances adhered to by the developers related to labour, the Companies Act, or even environmental, social, health and safety concerns. These issues are extremely critical to financial investors and must be understood and addressed appropriately.
Enabling momentum
Issues aside, there are still many fundamentally sound operational projects that are available for acquisition and have the potential to realise good returns. More projects are becoming operational which adds to the pool of available assets. The government’s own auction programme under the toll-operate-transfer model will unlock around 75 operational projects that could be acquired by private players . For some financial investors who are willing to take a calculated development risk, the hybrid annuity model opens up a new area of investment. Finally, a number of projects that were earlier financially unviable are being revisited as lenders open up to “right sizing” the debt so that some value remains for the acquirer.
All these factors, coupled with benign, investor-friendly government policies, ensure that the highway sector will continue to see sustained interest from financial investors.
Likely future PE model
With this inevitable growth potential, going forward, the involvement of financial investors in the highway sector are largely expected to be in two modes. The first class of investors would continue with the acquisition model, either directly or through their investment platforms. The former is likely to adopt a “buy and sell” philosophy where they could exit by divesting these assets to, say, a foreign developer. The latter is likely to follow a “buy and hold” strategy where the investment platform keeps growing and the possible exits of the current financial investors could be through capital market or a strategic sale.
The second class of financial investors would follow the classic minority-based private equity model where they partner with some investment platforms (as mentioned above) and participate in the growth of the portfolio. As with a classic private equity investment, it would be important for such investors to choose the right platform and assess the key risks carefully before investing.
To conclude, the interest of investors in the highway sector is likely to remain robust, given the growth prospects. All in all, current and future conditions augur well for the sector and all its stakeholders.
Sandeep Lakhanpal, Head, M&A and Business Development, Cube Highways and Transportation Assets Advisors Private Limited
