Well-developed infrastructure is critical for a developing economy. It facilitates steady flow of private and foreign investments, thereby augmenting the capital base of the economy. India needs to spend an estimated Rs 50 trillion over the next five years (2018-22) to develop its infrastructure. These funds are expected to be spent across key sectors such as roads, highways, railways, urban infrastructure, ports, airports and power.
At one time, infrastructure investment needs were met almost entirely by the government’s budgetary allocations and internal resources of public sector companies. However, in the past couple of years, infrastructure spending as a percentage of GDP has come down. This is not only attributed to the increasing liabilities on the banks’ balance sheets but also the unwillingness of lenders to invest in projects with long gestation periods. Given the stress in the banking sector, the role of the capital market has become even more important.
However, there are two myths surrounding the country’s infrastructure sector. The first is that a large part of infrastructure financing is through budgetary approvals, multilateral aid and bank lending. Capital markets have a small role to play. This perception needs to change in order to attract long-term investors in the infrastructure sector. The second myth is that investment in infrastructure assets allows diversification of a portfolio. This again does not hold true in the Indian context where around 30 per cent of the assets are in the power sector, 20 per cent in roads, and 15 per cent in urban infrastructure. Therefore, mutual funds and insurance companies refrain from buying infrastructure assets as that increases their risk exposure.
In particular, insurance and pension funds are known for being risk-averse. They are not willing to take construction risks and as a result they do not invest in under-construction projects. This only leaves them with the option of investing in operational assets. These assets too have certain shortcomings of their own such as cash leakages, etc. These issues notwithstanding, long-term investors prefer to park funds in the latter.
Issues at hand
One of the issues that have kept insurance and pension funds at bay is the sponsor risk. Although the credit history of promoters is available, keeping track of the promoters’ credibility for, say, a period of two decades or so, is difficult. Regulatory risk is another challenge. As the business environment changes, project economics are not able to keep up with the regulatory amendments. Besides these, liquidity risk too becomes a key concern for investors if a proper exit mechanism is not available.
With respect to the insurance sector, the Insurance Regulatory and Development Authority of India mandates an investment of up to 15 per cent in infrastructure. However, most of the investment has been in non-banking financial companies such as the Power Finance Corporation and the Rural Electrification Corporation which further lend to infrastructure companies. The insurance regulator also mandates that more than 75 per cent be invested in AAA-rated assets and 5 per cent in less than A-rated securities. This is primarily due to the lack of capital in such companies to absorb losses. The fiduciary role played by insurance and pension players constrains their risk-taking appetite.
In order to address issues related to liquidity, infrastructure investment trusts (InvITs) and real estate investment trusts (REITs) were introduced with the idea of attracting capital market investors. However, these instruments too are beset with problems. InvITs, being quasi-equity in nature, offer equity-like risk but do not offer equity-like returns. Valuation of assets too has perplexed investors. They cannot determine whether the valuation given by sponsors is accurate or not. Pension funds such as the Canada Pension Plan Investment Board (CPPIB) has not invested in public InvITs because they neither meet the risk profile of the targeted investors nor provide the governance commensurate with such structures. Further, the CPPIB’s investment thesis was proven correct when public InvITs started trading significantly below their issue prices, and still continue to do so. Fundamentally, though the assets have not underperformed, the InvITs have.
With regard to infrastructure debt funds (IDFs), the regulatory amendment of allowing investment in public-private partnership (PPP) projects (with or without the project authority) and non-PPP projects has exposed the instrument to various risks. The amendment has removed the credit enhancement mechanism available to IDFs making the instrument less attractive to investors.
With a view to overcoming some of the aforementioned challenges, the CPPIB came up with a policy under which the board will evaluate the sponsor, its underlying assets and special purpose vehicles to gauge the level of risk. It now has the ability to evaluate risks for itself. Once the board identifies a platform for investment, it will try and de-risk the platform through a transition plan. The idea behind this exercise is to ensure that the risk profile of the platform is commensurate with what the board can underwrite as risk. Nevertheless, there still exist a multitude of challenges (regulatory changes such as demonetisation) which are not in the sponsor’s control.
In addition to regulatory issues, the design of concessions poses another challenge for investors. Projects with a concession period of 25 years or so fail to attract investments as the longest loan available is for a maximum of 18 years. The structure of concession agreements, which the debt markets are not deep enough to support, poses another problem in attracting capital market investments. Rebalancing of risks is another issue. Unfortunately, in India, the lack of proper governance exposes investors to huge risks.
The way forward
Going forward, trillions of rupees will be required for infrastructure development in the coming years. It is therefore critical to recycle capital as well as introduce long-term funding sources. Also, it is imperative that additional sources of financing are tapped owing to the paucity of public funds. There is a need to attract capital from long-term investors, including insurance funds, pension funds and provident funds.
To be able to invest in infrastructure, investors have prepared a wish list. First, they are more interested in homogeneous assets as it is easier for them to understand how these assets operate. Second, the possibility of having a track record of repayment of the principal amount and payout of interest for one or two years gives them a lot of comfort. Third, investors also ask for insolvency resolution structures which will take care of the risks involved in debt-like structures such as IDFs. Some of the other items on the wish list are minimum sponsor ratings and third-party valuations.
At present, investors have adopted a wait-and-watch approach for REITs and InvITs, to better understand the risk-return profile, given the quasi-equity nature of these instruments. It should be understood that both these instruments are attractive on a risk-adjusted basis and are better suited to patient capital. With respect to private InvITs, the Securities and Exchange Board of India has done an excellent job in designing the regulations for such InvITs. The regulations provide the necessary governance while allowing the board to take some equity risk, besides creating a structure to give consistent yields. L&T Infrastructure Development Projects Limited has come out with the country’s first private InvIT. Five assets worth $1 billion have been transferred to the InvIT and several investors, including the CPPIB, have invested in the platform.
All-inclusive, the lack of financing options does not pose as big a problem as the marginal role of the public sector, disproportionate reliance on the private sector, unjustified expectations from the capital market investors, and the absence of a robust concession framework. The key requirements of long-term investors are a need to respect the available capital, slice the concession agreements and focus on governance.
Based on remarks by Sashi Krishnan, Chief Executive Officer and Chief Investment Officer, Aditya Birla Sun Life Pension Management; Pushkar Kulkarni, Principal, Infrastructure Private Investments, CPPIB; and Bharat Parekh, Executive Director, Infrastructure Research, CLSA India, at a recent India Infrastructure conference