Infrastructure sector needs to think beyond traditional finance options

Infrastructure project financing is the key to taking projects successfully from planning to completion stage. The lion’s share of infrastructure finance is shouldered by banks but with stricter regulations on banks and their lending to the infrastructure sector due to NPAs, projects will require new sources of finance.

Choosing the right means of funding infrastructure projects is as important as choosing the right kind of technology for implementing projects. Many projects have failed and have had to face liquidation because of the wrong choice of capital and lenders. The objective of financing should be to maintain the right level of liquidity both in the pre-construction and post-construction stage of the project at the right cost from the right source through the right kind of capital and deal structuring.

Typically, infrastructure projects are either funded by equity or debt with D/E ratio 3:1. Earlier, Equity contribution was always pure equity, however currently it is not mandatory that promoter’s infusion should be in pure equity form. It could even be in the form of hybrid instruments (Compulsory Convertible Debentures/Optionally Convertible Debentures/Optionally Fully Convertible Debentures), Non-Convertible Debentures (NCD) and even Inter-Corporate Deposit (ICD).

The color of promoter’s equity contribution and the cost of borrowing decides flexibility in cash flow of the project, tax shield and overall viability of the project. Investors and lenders alike are willing to accept a minimum of pure equity and the rest in other forms to provide flexibility and reduce tax cost. The issue with promoter’s contribution as pure equity is it offers less flexibility on cash flow and comes with a high tax cost as interest is tax deductible whereas Dividend is nontax deductible.

Interest bearing hybrid instruments and NCD/ICD offer flexibility to pay interest and redeem the instruments without getting into the tedious and time-consuming process of capital reduction. These instruments also provide tax shield, which provides kicker to the Return on Equity and boosts project viability. Normally such instruments are sub-ordinated to senior lenders and the interest repayments are subject to compliance to the financial terms of lenders. Financial markets are comfortable with a 10- 25% range (of promoter’s contribution) as pure equity and the remaining 75% as other instruments, subject to compliance to other regulations such as the Companies Act and FEMA- FOCC.

Debt financing is another important source of finance for infrastructure projects. Many infrastructure projects are funded using debt-based financial instruments. The scale of debt financing makes it an important decision for any company as typically in any infrastructure project P &L, interest cost is 40-60% of gross revenues assuming a typical 70:30 to 80:20 Debt to Equity ratio. Typically, companies have two options: they can either borrow from the domestic market or from the international market. Both has its own advantages and disadvantages.

The timing, source and method of borrowing has a huge impact on the overall viability of the project. There are two things to consider here: one is ensuring timely financial closure as per project documents and disbursement of funds on a need basis to reduce IDC (interest during construction).

International borrowings such as bonds and External Commercial Borrowings, come with flexible financial covenants and offer a higher amount of financing in comparison to domestic borrowings. The downside is that the overall cost of international borrowings (interest/hedging/transaction cost) is higher than domestic borrowings, although they tend to provide higher liquidity support and flexible financial covenants.

Large conglomerates prefer international borrowings to not fully exhaust the single borrower group limits of Indian lenders. This is perhaps the best option for companies, who can leverage and borrow from the international market at the holding company level. While Indian banks do not lend for equity infusion, foreign lenders allow foreign debt to be infused as equity in India. International borrowings may not be a suitable option for small and medium size companies though because of the high cost of borrowing.

Domestic borrowings are a lot more complicated. The existing RBI and government policies has forced large scale borrowers to move away from conventional bank led lending. Historically no infrastructure lending institution has been successful in India, because of regulatory and other political issues. Infrastructure lending institutions such as ICICI, IDBI, IDFC, IFCL, IL & FSL, L& T infra etc., have either converted into banks or shut down operations.

The lenders market for infrastructure financing has shrunk considerably because of the high Non-Performing Assets of the industry.

It cannot be denied that infrastructure is a key determinant of economic growth. The Government of India has a huge infrastructure plan to transform India from a developing country to a developed country. It has floated infrastructure specific lending and investment institutions such as National Investment and Infrastructure Fund (NIIF) & National Bank for Infrastructure and development Bank (NBFID) to provide much needed equity and borrowing support to the infrastructure sector.

Bonds are another source of debt funding for infrastructure projects. It is however rare in the construction phase of the project. Most domestic bond investors don’t take project construction risks and prefer investing after completion. The construction phase of a project is a high-risk one. A project does not generate cash-flows during this phase. Unexpected events are likely due to the complex nature of infrastructure projects.

Under-construction projects usually rely on traditional project lenders or sector specific lenders such as the Power Finance Corporation, Rural Electrification Corporation, Indian Renewable Energy Dev Agency Ltd, etc for construction financing. Power sector is blessed with such central government lending institutions, however other infrastructure projects (Road/port/airport/telecom/warehouse &logistic) do not have such a variety of sector specific/specialized lenders. Interest rates on loans given during the project construction phase are higher by 100-200 bps, depending on the promoter’s credibility and the company’s track record of project completion.

Medium term loans of 3-7 years period can help in reducing interest rate during the project construction phase, as the interest for medium term loans is lower than long-term loans. Infrastructure developers can opt for refinancing once the project is completed and has an operational history of 1-2 years. In the operational phase, the project generates positive cash flows, and the risk of default diminishes considerably.

Refinancing of bank loans is quite common. The rating of the project, the loan tenure and deal structuring all play a critical role in deciding the interest cost. A better rating and shorter tenure can attract a lower interest rate. Ratings are decided by deal structuring and financial covenants. Credit enhancements (pooling of cashflow of different projects, hold company guarantee, third party credit guarantee, etc.) result in better ratings. Borrowers who offer a higher security to lenders have a higher chance of getting lower interest rates.

The bond market also opens up for refinancing of operational projects, but they are not very common. The bond market is rating sensitive. There is too much bond money chasing too few AAA rated instruments. The bond market needs to expand its risk appetite and adopt risk- based pricing with adequate margin, so that even BBB rated instruments also finds investors. Right now, it is more skewed towards AAA or AA rated instruments.

The devil lies in the details and these details can be found in the financial covenants of an infrastructure project.  The choice of a wrong financial covenant can ruin any project. Financial covenants should be flexible and achievable. Enough flexibility should be built in to the financial agreements to avoid event of default (a threshold that allows the lender to demand immediate and full repayment of a debt). The objective of financial agreements are to ensure financial discipline and to avoid fund diversion. Highly restrictive agreements, without sufficient cushions for absorbing various risks can potentially drag a project to liquidation by triggering EOD (Event of Default).

Infrastructure finance is currently dominated by equity and debt. There is a need to broaden potential group of investors, and this would require long-term investors to recognize infrastructure as an attractive asset class. A broader mix of financial instruments for infrastructure finance would make the sector more attractive to investors.