Sector Review: Phases of highs and lows

Phases of highs and lows

In the 1990s, infrastructure projects were financed primarily through budgetary allocations and long-term debt provided by development financial institutions (DFIs). However, with the withering away of DFIs and the emerging role of commercial banks in the infrastructure finance ecosystem, an increasing number of infrastructure projects achieved financial closure.

The heyday of the Indian economy when commercial banks were liberal in lending to infrastructure projects is now ended. The economic slowdown has taken away the irrational exuberance and the underlying risks have become more visible. Infrastructure companies have gorged on debt and made themselves highly overleveraged. With banks scrambling to clean up their books, it has become imperative to create an enabling environment for alternative funding mechanisms. Further, there is an urgent need to attract patient capital to meet the long-term investment requirements of the infrastructure sector.

Indian Infrastructure rewinds the past 20 years to gauge how the infrastructure financing scenario has changed and highlight the major trends that have shaped the sector…

Fall of DFIs, surge in bank lending

In the pre-economic reform era, infrastructure project financing was spearheaded by three DFIs, namely, the Industrial Development Bank of India (IDBI), IFCI (the erstwhile Industrial Finance Corporation of India) and ICICI. However, in the early 2000s, the country witnessed a major shift away from traditional DFI-led lending to financing through commercial banks. The DFIs’ inability to raise statutory liquidity ratio bonds as a cheap and ready source of funds, pursuant to the recommendations of the Narasimham Committee report, and the relatively higher cost of raising funds triggered the process of transforming DFIs into commercial banks. The first such instance was the conversion of ICICI to ICICI Bank in 2002 with IDBI and IDFC (the erstwhile Infrastructure Development Finance Company) following suit.

In the late 1990s, all restrictions on commercial banks were removed in a bid to create a level playing field with financial institutions. The early 2000s were marked by a phase of low interest rates, high liquidity, high GDP growth rates and widespread enthusiasm and optimism amongst all stakeholders. Several positive policy developments helped create a sense of confidence in infrastructure development. Therefore, banks started lending more generously to infrastructure projects. This is evident from the fact that bank exposure to the infrastructure sector increased from 2 per cent in 1998-99 to 10 per cent in 2008-09 and further to 15 per cent in 2015-16. Thereafter, bank credit to the infrastructure sector decelerated and constituted about 12 per cent in 2017-18. Sector-wise, power, roads and telecom were the highest recipients of bank credit.

The downside of high bank lending to infrastructure companies/projects was a gross misassessment of the ground realities. Banks lacked expertise in project financing and were still on the learning curve trying to understand the nuances of cash flow-based long-term financing. A host of factors such as the economic slowdown, regulatory delays in clearances, issues with land acquisition, opaque tendering processes, and deficiencies in the credit appraisal of banks hampered the smooth implementation of infrastructure projects, thereby leading to poor cash flows for developers. This resulted in the twin balance sheet problem and pile-up of stressed assets. The gross non-performing assets (NPAs) of banks, which were consistently low till 2007-08 at 2-3 per cent, reached an unprecedented level of 11.6 per cent as of March 2018.

Role of NBFCs

The introduction of infrastructure finance companies (IFCs) as a new category of non-banking finance companies (NBFCs) was a noteworthy development. Some of the NBFC-IFCs include India Infrastructure Finance Company Limited (IIFCL), the Housing and Urban Development Corporation (HUDCO), the Power Finance Corporation (PFC), the Rural Electrification Corporation (REC), Infrastructure Leasing and Financial Services (IL&FS), Srei Infrastructure Finance, and L&T Infrastructure Finance. Together, their disbursements to the infrastructure sector have increased at a compound annual growth rate (CAGR) of 14 per cent during 2010-18 (till March). IIFCL’s wide gamut of schemes, such as takeout financing, credit enhancement and refinancing, have played a catalytic role in the infrastructure financing space.

Multilateral aid

The early 2000s witnessed a pickup in financial assistance from multilateral agencies, including the World Bank, the Asian Development Bank and the Japan International Cooperation Agency. These institutions not only extend development finance but also provide technical expertise and project structuring support. In the past, multilateral agencies had been actively providing financial assistance to the road, urban infrastructure, power and renewable energy sectors. Together, funding from these agencies stood at over $65 billion during 2005-18 (till March). More recently, the establishment of the Chinese-led Asian Infrastructure Investment Bank and the BRICS-led New Development Bank has widened the resource pool for the country to tap into.

ECB trends

Issues relating to hedging currency risks make external commercial borrowings (ECBs) a less attractive option. In order to promote the route, the ECB policy has been modified from time to time to address specific needs (by allowing NBFC-IFCs to raise funds through ECBs for further on-lending to the infrastructure sector, permitting refinancing of rupee loans via ECBs, relaxing the ECB limit for infrastructure companies, etc.). During the 10-year period between 2007-08 and 2017-18, ECB issuances were the highest in value terms in 2013-14 at around $24 billion owing to rising domestic interest rates, difficulties in tying up domestic loans, the relatively stable rupee against the US dollar, and relaxed ECB norms. The oil and gas, telecom and power sectors have resorted to the ECB route the most.

Underpenetrated bond market

The Indian bond market is dominated by government securities with the penetration of corporate bonds at a low of about 14 per cent of GDP. However, as bank credit, the largest source of debt, is facing capital constraints under Basel III norms and is nearing sectoral limits, bond issuances by infrastructure companies is gradually picking up, supported by a series of enabling measures introduced by the Reserve Bank of India (RBI). The introduction of tax-free infrastructure bonds was perceived as a very positive step. In 2010, IDFC launched India’s first issue of tax-free infrastructure bonds. Since then, there have been several tax-free bond issuances from financial institutions such as PFC, REC, the National Highways Authority of India (NHAI), HUDCO, etc. Other regulatory measures such as allowing banks to offer partial credit enhancement to corporate bonds, increase in the ceiling for investments by foreign institutional investors in corporate bonds of infrastructure companies, the introduction of new listing norms for municipal bonds, etc., were steps in the right direction.

Masala bonds (rupee-denominated bonds) were introduced to encourage offshore borrowing by domestic companies. So far, the Housing Development Finance Corporation (HDFC), NHAI, NTPC Limited, Adani Transmission Limited and the Indian Renewable Energy Development Agency have raised funds in this format.

Despite having entered the market fairly recently, India has become one of the largest green bond markets in the world. Issuances have been floated by YES Bank, Hero Future Energies, Axis Bank, ReNew Power, Greenko Energy and Azure Power, among others.

After a hiatus of 14 years, the municipal bond market received a shot in the arm when the Pune and Greater Hyderabad municipal corporations tapped the route for water supply and road projects respectively. Further, Indore recently became the first city to list municipal bonds on the National Stock Exchange.

Private equity investment

The equity market as a source of finance remained largely untapped in the 1990s due to infrastructure firms’ lack of access to the capital market and the conservative stance of private equity (PE) players in the infrastructure space. However, things began to change with the country’s improving economic fundamentals and plans for higher capex by infrastructure companies. The PE market picked up pace 2004 onwards and reached an all-time high of around Rs 322 billion with 75 deals being struck in 2007-08. While sectors such as telecom, power and ports attracted the maximum investor interest, PE players refrained from taking exposure to the road and urban infrastructure (water supply and sanitation) sectors. Although PE activity lost steam during 2012-14 on account of a weak investment climate and poor returns on listed and unlisted investments, it was reinvigorated from 2015-16.

Historically, an exit through an initial public offering (IPO) was the route preferred by PE players, who usually held their investments for four to five years. Typically, returns from PE investments upon exit were in the range of 25-30 per cent. The project equity market was not very well developed. Very few players such as IDFC, IL&FS and IFC, with substantial experience in the infrastructure domain, experimented with the project equity route. Such investments were witnessed in the road, port and power sectors.

The scenario has changed significantly today. PE investors have shifted their investment strategy from investing in growth capital to investing in operational projects. Since 2015, the infrastructure sector has witnessed a surge in asset sales. There is a growing preference for operational assets that are being offloaded by cash-strapped developers who are invoking debt restructuring schemes. Project equity investments have been prominent in the road and conventional power sectors. Other booming sectors such as renewable energy and logistics are perceived to be attractive bets by investors due to their high return and good growth potential. With regard to the exit route, strategic buyouts (sale to other PE investors) and trade sales (sale to other companies) have emerged as the most preferred routes.

IPO market

The primary market too witnessed heightened activity till 2007-08 owing to rising investor confidence in the India growth story. Bullish stock markets resulted in extremely high valuations and supernormal returns. While sectors such as oil and gas, telecom and ports gave good returns, the power sector and diversified companies gave mixed returns. However, the global financial meltdown took a toll on the IPO market, which went through a period of lull as companies shelved their IPO plans. After a year of crisis, the capital market bounced back. IPO activity peaked in 2010-11 with funds of over Rs 235 billion raised from 15 issuances in the infrastructure space, with the listing of Coal India Limited being noteworthy for garnering over Rs 150 billion. Though activity fizzled out during 2011-14 on account of dismal performance of listed infrastructure stocks on the bourses, it has regained momentum since 2015-16. A buoyant stock market, improved business environment following the formation of the new government, and brighter earnings outlook have contributed to the evolution of the country’s IPO ecosystem at a rapid pace. With the IPO market in full throttle, a number of players such as ReNew Power, Sembcorp Energy India, GR Infraprojects and Montecarlo, are expected to float fresh issues soon.

FDI trends

Foreign direct investment (FDI) inflows in infrastructure have grown at a CAGR of 10 per cent during 2008-18. India continues to be an attractive investment destination, given the resilience it has shown amidst the global economic slowdown. During the latter part of the aforesaid period, factors such as a change in government (in 2014), continued reforms for ease of doing business, and mega-programmes such as Make in India augured well for the country’s attractiveness for FDI inflows. In addition, the government eased FDI norms for a number of sectors such as telecom, banking, construction, civil aviation and railways, which increased foreign investor interest in the economy.

New funding avenues

The acceptance of the fact that infrastructure financing cannot be left to commercial banks alone has necessitated the development of new and alternative financing mechanisms. Against this backdrop, in 2011, the government introduced guidelines for the setting up of infrastructure debt funds (IDFs), allowing them to be set up either as mutual funds (MFs) or as companies. Since inception, the growth of IDFs has been slower than anticipated, the biggest hindrance being banks’ unwillingness to relinquish operational projects that have lower credit risk. IDF-NBFCs have scaled up better than IDF-MFs. In March 2015, RBI revised guidelines to allow IDF-NBFCs to invest in public-private partnership (PPP)/non-PPP projects. Despite this, there are only four IDF-NBFCs with outstanding loans of over Rs 150 billion in operational infrastructure projects. It may be hoped that facilitative regulations can revive interest in this space.

Proposed in 2014-15, the fledgling market for infrastructure investment trusts (InvITs) has seen many regulatory changes in the recent past. Despite the regulators’ continuous efforts to make the instrument attractive to investors, the product has had a dismal beginning. The failure of two InvITs – the IRB InvIT Fund and India Grid Trust – to create any excitement on the bourses is evidence to this. This has also forced other infrastructure developers to defer their plans of launching an InvIT. Pressing issues such as taxation-related anomalies and inadequate education about the product continue to keep investors at bay. The product has a lot of potential which can be realised only if there is better investor education and a proactive role is played by regulatory authorities in making the instrument a success.

Besides these instruments, the government set up its first sovereign wealth fund – the National Investment and Infrastructure Fund (NIIF) – in 2016 for funding commercially viable greenfield, brownfield and stalled projects. After a year’s wait, the NIIF achieved a significant milestone by closing its first major deal with the Abu Dhabi Investment Authority in 2017.

Role of long-term investors

Historically, the participation of long-term investors in the infrastructure space has been very limited due to their diffidence towards the sector. Though insurance and pension funds are ideally suited to financing infrastructure projects, their scope is limited by their fiduciary responsibilities. At present, the insurance industry’s exposure to the infrastructure sector stands at 16.3 per cent of the entire portfolio, which is only marginally higher than the mandate of 15 per cent. However, there is no such mandate for pension and provident funds. Meanwhile, foreign pension funds including the Canada Pension Plan Investment Board and Caisse de dépôt et placement du Québec (CDPQ) have been scouting for assets in emerging economies. India, being at the helm of the emerging markets investment strategy for Canada pension funds, offers a wide range of opportunities in the operational as well as stressed assets space.

Insolvency and Bankruptcy Code, 2016

Hailed as a game changer, the Insolvency and Bankruptcy Code (IBC), 2016 was perceived as one of the biggest reforms in the past decade aimed at time-bound default resolution. The enactment of the IBC has shifted the debtor-creditor dynamics from “debtor under possession” to “creditor in control”. At present, over 400 cases (including infrastructure companies) have been admitted by the National Company Law Tribunal. RBI, as a crackdown measure for the stressed asset menace in the country, recently floated a circular on Resolution of Stressed Assets – Revised Framework, under which it withdrew all its existing guidelines and schemes and put in place a time-bound resolution mechanism in case of a default. The new framework, aimed at stricter credit discipline, appears to be intended to supplement the IBC.

In sum

The investment gap in infrastructure is not a result of a shortage of capital. In fact, the key challenge is the limited number of bankable projects on the table. Proper project structuring, a prompt dispute resolution mechanism, speedy clearances, enhanced project appraisal capacity, and ironing out of sector-specific issues hold the key to securing the required funds from the wide repertoire of financing sources. India requires trillions in investment over the next 20 years for infrastructure development. It is, therefore, hoped that in the long run, new structures such as InvITs, IDFs and NIIF will be able to unlock the value of existing assets to release capital for fresh investments.