A Sound Option

Opportunities offered by InvITs outweigh the challenges

Infrastructure investment trusts (InvITs) were conceptualised three years ago and are the one of the fastest financial products to be brought to fruition. The product has had a great start. There have been three InvIT listings, which together have raised capital of Rs 100 billion. InvITs are better than debt instruments due to lower volatility, higher returns and lower leverage. Though the regulatory framework is still at an evolutionary stage, the product has the potential to attract investors, both domestic and foreign, once there is adequate education and awareness about it. The investment vehicle has already been a success in countries such as Japan, Singapore, Hong Kong, the US and the UK.

Potential of InvITs

The instrument is capable of breaking the “vicious circle” of infrastructure development. The vicious circle starts with infrastructure developers with under-capitalised balance sheets, taking the debt for equity structure to fund their equity investments. In addition to this, they borrow from various sources to finance their projects. The interest cost component in the debt for equity structure, which starts accruing even while the project is under construction and has no revenue stream, starts hitting the profit and loss account and takes a toll on earnings, thereby worsening the balance sheet. This depresses the stock prices and inhibits equity infusion, which in turn leads to further under-capitalisation. In infrastructure project development, the first five years, also known as the period of pain, were extended to 10 years owing to the global financial crisis. This limited the availability of capital for infrastructure projects. The problems were further compounded by currency risks, policy paralysis, downscaling of the capex cycle, etc., all of which led to stress in sectors such as power and roads.

InvITs can play an important role in creating a “virtuous cycle” of infrastructure development. The cash flow from InvITs deleverages the balance sheet and also releases growth capital. This growth capital helps improve project ratings, which in turn facilitates securing cheaper funds. All this leads to higher profitability and helps the developer in undertaking new projects. These projects could further potentially get transferred into the InvIT.

Since the launch of the three InvITs, the bulk of the investments have come from foreign investors. There has been limited participation by domestic insurance and pension funds due to inadequate information about the product. Despite being an excellent product, the unfavourable demand-supply scenario for InvITs explains the lethargy in the system. The current bull run in the equity market is testimony to this. The Indian equity market is at an all-time high amidst a scenario of the depreciating rupee and volatile interest rate. Despite this, India is among the preferred destinations for investments. This is because the market forces (demand-supply) are working in favour of the economy.

Although the power sector has seen some activity in the InvIT space, the renewable energy sector is yet to witness any such issuance. The backloading of tariffs and front-loading of costs leads to lower initial returns from renewable energy projects. The first three to five years do not offer a regular stream of cash flows due to aggressive bidding and the resultant lower tariffs. Developers that are able to execute and deliver projects in a timely manner can offer an 8-10 per cent yield initially and a 12-13 per cent equity internal rate of return later. The sector is likely to take the InvIT route given the huge capital requirement. However, one of the challenges faced by the renewables sector is the relatively fewer number of credible players with a proven track record. Since public market deals are not going through at the desired rate, private placement of InvITs can be a viable option for renewable energy players.

There is no common risk-and-return matrix for each individual asset. Based on the assets in which investors invest, the return expectations will vary. For instance, a port asset with a traffic and execution risk vis-à-vis a road asset with a toll risk will not offer the same returns. For better returns, investors are seeking an optimal leverage and ratings threshold. A uniform leverage of 49 per cent for all asset classes is rendering suboptimal returns. InvITs offer lucrative withholding tax rates to foreign investors vis-à-vis tax rates imposed on domestic investors. The product is also better than tax-free bonds in terms of post-tax yield and returns.

The beauty of InvITs lies in the fact that profitability depends on the price at which the assets are bought. Even non-profitable projects become profitable under an InvIT structure if they are sold at a haircut. Factors such as capex, traffic, costs, etc., associated with projects put on the block do not hold much relevance. Another element that comes into play is the credibility of the developers. Companies with a long-term vision will not create assets of substandard quality which could raise questions about their credibility.

Case in point: Sterlite Power’s InvIT

Amidst a scenario of falling yields on government securities (G-sec), IndiGrid (Sterlite Power Grid Ventures’ InvIT), offers much higher returns than G-sec and slightly lower returns than the Sensex post-listing. The InvIT has mostly attracted long-term investors. A year after its listing, IndiGrid has seen wider participation of high net worth individuals. The investor base has increased from 2,000 at the time of the initial public offering to 3,500 at present. Considering a minimum trading size of Rs 0.5 million, the InvIT has fared well. Domestic institutions have consistently raised their shareholdings, insurance companies have increased from three to seven, and pension funds and mutual funds are being added. Although the InvIT is susceptible to volatilities in the international market, these have not yet impacted the product’s performance.

Outlook and recommendations

The product has a great future in the country with certain tweaks being made along the way. As one of the policy recommendations, the leverage should be linked to the ratings. If a company has achieved more than AA rating, it should be allowed to leverage up to 70 per cent as is the case with any other asset class. Second, the threshold of the Rs 0.5 million ticket size should be reduced. Third, the product should be brought at par with other equity and debt instruments in the market for regulators including the Employees’ Provident Fund Organisation, the Insurance Regulatory and Development Authority of India, and the Pension Fund Regulatory and Development Authority (PFRDA). Fourth, the regulation of eligibility of investment must be aligned with either equity or debt. Along with more awareness about InvITs, some of the nuances of the regulations must be changed. For instance, the PFRDA provides that a pension fund can invest in an InvIT as an entity as long as the sponsor is AA rated. This has restricted pension funds from investing in the product, though it ideally suits their investment strategy in terms of time horizon. Therefore, it is recommended that the rating of the trust should be taken into account rather than that of the sponsor as the latter has sold its assets to the trust.

Currently, InvITs are highly illiquid. Therefore, they need to be marketed well so that there is sufficient domestic demand for the product. A vibrant market of at least $5 billion-$ 6 billion worth of listed InvITs must be created for attracting large global funds. A market-making mechanism is required to be put in place without which the product will struggle to take off. InvITs are high-yielding instruments offering good quality assets. If understood and marketed properly, the product has the potential to provide a funding impetus to the country’s infrastructure sector.

Based on a panel discussion between Bharat Parekh, Executive Director, Infrastructure Research, CLSA India; and Harsh Shah, CEO and Whole-Time Director, IndiGrid, at a recent India Infrastructure conference

 

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