Government support to the road sector has been crucial at the present time. One of the worst hit by the Covid-19 pandemic, green shoots of recovery are finally being seen in the road sector. Traffic has reached almost 90 per cent of the pre-Covid levels, construction is in full swing and project award activity has picked up pace. Though most of the projects are being awarded on an engineering, procurement and construction (EPC) mode, hybrid annuity model (HAM) contracts are also finding takers despite cracks in the model. However, falling interest rates to underpin the growth of the economy has dimmed the prospects for HAM.
Current scenario
As per projects tracked by India Infrastructure Research, HAM constituted about 24 per cent of the project awards (in terms of length) by the National Highways Authority of India (NHAI) in 2019-20. The share increased tremendously from 8 per cent in 2015-16 to 53 per cent in 2016-17 due to the euphoric sentiment regarding the new model. However, the share reduced to 45 per cent in 2017-18 with issues related to financial closures and land acquisition surfacing, thus bringing prudence in bidding on the part of developers. Increased risk aversion among a pool of investors, lenders’ chariness, issues related to last-mile land acquisition, and cash flow problems of operational projects brought awards through HAM to nought during the period April-December 2019-20.
According to NHAI, 40 projects – spanning 1,330 km and worth Rs 473 billion – were awarded in the April-September period of 2020-21, despite the pandemic-triggered challenges. Of the 40 projects, 24 highway contracts were EPC projects while the remaining 16 were HAM contracts.
As per the RajyaSabha, as many as 210 national highway projects have been delayed due to various reasons such as poor performance by developers, problems in land acquisition and regulatory hurdles. There are also some HAM projects that are yet to attain financial closure. Most of these projects are in Uttar Pradesh, Andhra Pradesh, Maharashtra and Tamil Nadu. A number of banks are now putting stringent conditions such as upfront equity investment and loan disbursement only after 30 per cent of physical progress. Hence, most of the developers are facing financial difficulties in arranging funding for HAM projects.
Falling bank rate – A major concern
During the operational phase, cash flow is assured for HAM projects in the form of semi-annual annuity payments from NHAI covering 60 per cent of the inflation-indexed completion cost along with the Reserve Bank of India (RBI) bank rate plus 3 per cent. As far as private investors are concerned, cash flow issues have emerged for operational HAM projects owing to the recent reductions in the bank rate. This has reduced their appetite for new projects. Multiple policy rate cuts by the RBI in the past few months have not been transmitted by banks to the developers. HAM projects, that are currently under construction or are operational were awarded at a time when the RBI repo rate was in the range of 6 per cent-6.5 per cent. As the bank rate has steadily declined from 6.25 per cent in February 2019 to 4 per cent in August 2020 without a corresponding reduction in the cost of borrowing, the cash flows of operational HAM projects are expected to moderate. Developers are facing a severe cash crunch as the cost of borrowing for them has not declined commensurately with the policy rate cuts.
Further, most of the banks are charging an interest of 9.5 per cent-11 per cent during construction and 9 per cent-10.5 per cent during the operation period. However, now NHAI will pay them an interest of 7 per cent (4 per cent + 3 per cent) only. Hence, there will be a deficit of 2 per cent-3.5 per cent which has to be met by the developers. The additional funding requirement will put further pressure on the developers’ balance sheets. In the recent past, there have been various HAM acquisition deals announced, in one of which Cube Highways agreed to buy HAM assets from KNR Constructions and DilipBuildcon. These deals will also require renegotiation in view of the falling RBI repo rate. This low interest rate regime is likely to continue while the government is trying to revive growth. Thus, NHAI must address the interest gap urgently and offer an exit clause to developers that are struggling to meet their bank payment obligations.
The pressure on developers’ balance sheets and falling profitability can be evidenced from the recent bidding patterns. The lowest bids for HAM projects announced in 2020 are 25-35 per cent higher than NHAI’s expectations vis-à-vis an average 15 per cent premium that was seen two years ago.
According to ICRA, for every 25 basis points (bps) decline in the bank rate, the cumulative debt service coverage ratio (DSCR) for a HAM developer falls by 2 bps. As a result, developers are seeing the return on their equity shrink by 125-350 bps. In such a scenario, both divesting and refinancing of HAM projects will be difficult for developers. Developers may have to incur losses if they were to sell the projects now. While lenders are willing to refinance operational road projects, they will shy away from lending to HAM projects at this point. Unlike toll projects, there is no upside in HAM projects as a fixed annuity is paid and lenders will have to review the DSCR levels at which they are willing to refinance. Falling DSCR levels certainly do not work in favour of HAM.
Fast-tracking payment cycle – A positive
NHAI has been taking various initiatives from time to time to support concessionaires, contractors and consultants, and this has instilled confidence in the bidders in the road sector. Steps such as monthly payments to contractors were taken to ensure cash flow to them. Since NHAI and the Ministry of Road Transport and Highways moved to the monthly billing system, the cash conversion cycle has shrunk for developers. For HAM projects, NHAI released funds for working capital needs even before the milestones were completed. The funds were offered at 200 bps above bank lending rates, and provided low-cost working capital to developers. The payments will later be set off against settlements that the government owes the contractors under HAM projects. Developers, especially those who faced a cash crunch when toll collections fell sharply during the early lockdown period, welcomed the move.
Outlook
Although NHAI has plans to rely on private sector investment for upcoming road projects, the outlook for HAM seems bleak in the near future due to the unhealthy balance sheets of project developers during the ongoing Covid-19 crisis. It has become harder for developers to achieve financial closures since banks are unwilling to lend in this uncertain market environment. Banks continue to be selective in funding infrastructure projects due to the pile-up of sour loans and fear of delinquencies. These factors, combined with prudent bidding, will reduce the share of HAM projects in the overall pie of project awards in the next few quarters. With the first round of HAM projects completed/likely to be completed in the near term, these are best suited for acquisition by investors. Though an opportunity area for global investors, the delay in transmission of rate cuts can disrupt cash flow streams, in turn, lowering equity returns to investors. Moreover, the delay in execution of some projects due to slow equity infusion from weak sponsors in light of Covid-19 and land acquisition issues will further wane investor interest in the segment.
As per the task force on the National Infrastructure Pipeline (NIP), there is a need to reduce the share of HAM as it has adversely impacted build-operate-transfer (BOT) (toll) concessioning and the financial health of NHAI. However, industry veterans have a different view. The development of alternative modes such as dedicated freight corridors and inland waterways as well as competing roads under Bharatmala are bringing about a paradigm shift in the transport sector. These factors will make traffic forecasting extremely challenging and will thus render BOT (toll) in its current form unfavourable. Therefore, NHAI will need to continue relying on EPC and HAM with some improvements and tweaks in the latter.