Power play: India’s power sector

Inida set an unfortunate world record this summer: It suffered the largest power outage in history as 620 million people - half the national population and 10% of the global population - were left in darkness.

Power shortages are nothing new in this part of the world, with urban areas suffering occasional blackouts and a large portion of rural dwellers completely cut off from the electricity grid. In September, demand for electricity outstripped supply by 8.6% at peak hours, with deficit rates in Uttar Pradesh and Andhra Pradesh - two of the largest states - reaching 16% and 22%, respectively.

PE investors have certainly played a role in narrowing down this supply-demand gap since the government opened up the power sector to competition in 2003 and improved the policy environment for private investment. 3i Group, for example, paid $229 million for an 8% stake in Adani Power in 2007. Two years later, its holding jumped in value at the company sold another 13% via IPO for $630 million. At the time, it was the second-largest IPO ever seen in India.

The combination of demand and realizable value led to an influx of private equity investment in the sector. According to AVCJ Research, $1.2 billion was deployed each year in 2010 and 2011, double the 2008 level. This year, however, investment has fallen off a cliff. Eight deals had been completed by November with a total size of $300 million and none of them relate to conventional power generation. Seven were in the renewable energy space while the other was a power solutions company.

Manish Aggarwal, a partner at KPMG India, argues that private equity investors might have underestimated the execution challenges while overestimating the potential returns for past conventional power investments.

"The fundamental assumption of supernormal returns at 22-25% was made when the sector was busy, but there is a very large gap between what investors expected and what the sector offers in reality," Aggarwal tells AVCJ. "I'd say valuations today are much more reasonable and investors are more realistic in tapping the opportunities offered by the high electricity deficit."

There are also two chronic issues plaguing the power sector and attracting considerable negative publicity: insufficient coal supplies and bankrupt state-run electricity distributors.

Although Coal India enjoys a monopoly position, the company has not increased output due to sluggish developments of new mines and technologies, resulting in a large chunk of power generation capacity being shelved or put on hold. Last year, domestic coal production grew by just 1%, compared to an 11% increase in power plant capacity.

Imports, a natural alternative, have become strained by Indonesia - India's biggest coal supplier - doubling its prices.

"Even if a project has a signed contract for imported coal, the risk of commodity price fluctuation is not mitigated, there is a strong possibility of not making profits," says Archana Hingorani, CEO and executive director of IL&FS Investment Managers. "Given uncertainties on pricing and the availability of this fuel type, either from international or domestic sources, it is difficult for investors to forecast revenues as well as the investment timeframe."

Worse still, some power generators also face delayed payments from state-owned electricity distributors, which are more or less bankrupt with liabilities of $35 billion, primarily due to electricity thefts and a failure to increase power tariffs for political reasons.

Although it is unknown how many private equity-backed power companies will suffer as a result of these problems, it is reported that Visa Power has failed to meet certain performance milestones tied to The Blackstone Group's 2011 investment in the company, prompting the PE giant to defer payouts of its $111 million in committed capital. When Blackstone invested, Visa claimed to have 6,600 megawatts in capacity under development, including a 1,320 MW coal-based super critical power plant in Orissa.

The government is certainly not blind to power generators' plight. In April, it issued a presidential directive to Coal India to sign fuel supply agreements (FSAs) guaranteeing power producers of at least 80% of their coal needs or face financial penalties. At the same time, various state electricity boards are in the process of raising tariffs in order to strengthen their own balance sheets and lower consumption demand.

"The government has been trying to tackle these problems but its efforts aren't fully recognized because of the negative perception of the sector," says KPMG's Aggarwal. "As far as the power sector is concerned, most of the issues are known and we are expecting a revolution in the coming 2-3 months."

In light of the negative publicity, shares in Indian power companies have dropped an average of 50% in the last two years, according to Bain & Company. However, Robert Thorpe, managing director of Macquarie Infrastructure and Real Assets (MIRA), argues the correction in valuations has provided attractive entry opportunities for private equity investors.

"We have not seen a better time for investing," says Thorpe. "Several attractive investment opportunities are available right now, all on reasonable terms and at valuations that we did not see two or three years ago, simply because alternate sources of long term capital are not available."

An ambitious plan

Apart from lower valuations, Amit Sinha, leader of Bain & Company India's industrial goods and services practice covering power and energy, adds that the sector is still attractive in the long term because the country's power needs will continue to increase in tandem with economic growth. The government's planning commission wants to add more than 88,000 MW of power generation capacity during the 12th Five-Year Plan period, which runs to 2017, up from 78,000 MW in the previous plan.

This huge expansion cannot be met by public investment alone. The private sector will provide 52% of the additional capacity, compared to 19% over the previous five years. As such, it is generally accepted that the government will continue to ensure an investment-friendly environment, with private participants likely to see IRRs of 15-20%.

"The power sector has typically offered modest returns and the 16% forecast rate for base-case scenarios is actually not bad," says Sinha from Bain & Co. "If your portfolio allows returns of such kind, this is a sector in which you can participate. Given the country's growing power needs, there is significant upside."

In order to avoid potential construction risks on land acquisitions, coal allocations and changing regulatory frameworks, investors are advised to target more mature power assets. Simply as a function of time, there are more of these assets available, with a number of developers having guided project into operation and now generating positive earnings.

"It is refreshing for us to see the sector transform, albeit slowly, from a green field-dominant investment environment to a mix of established, operating power projects as well as the classic green field opportunities," says Thorpe of Macquarie. "Although these completed power plants do not have a long operating history, key development and construction risks no longer remain, and this makes them attractive."

On the contrary, green field investments - which were popular among private equity investors during 2010-2011 - must still go through approvals processes with more than a dozen authorities from the local to the national level.

While going into more mature assets may limit some of the downside risks, a growing number of private equity investors have also diversified their portfolio by investing into renewable energy. Among the 35 transactions in the power sector during 2011-2012, 25 targeted renewables. Morgan Stanley Infrastructure Partners, for example, completed the largest power deal this year through the purchase of a majority stake in Continuum Wind Energy.

"There are uncertainties and risks in the power sector but this doesn't imply that good opportunities do not exist," says Hingorani of IL&FS Investment Managers. "For example, there is a clear appetite for renewable energy and we are more comfortable with developers having a diversified mix of conventional and renewable power in their portfolios."

 

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• Topics
• Infrastructure
• South Asia
• India
• Infrastructure India
• 3i Asia Pacific
• energy
• Commodities
• IL&FS Investment Managers
• Macquarie Group