Indian infrastructure: Bargain basement

"The good news and the bad news is that there isn't too much greenfield infrastructure investment happening right now in India" says M.K. Sinha, managing partner and CEO at IDFC Alternatives. Projects are stuck, developers struggling with leverage and banks unwilling to lend. In other words, there's an opportunity to capitalize on the deleveraging that needs to happen in the market.

"People are looking to sell a road, power asset, whatever gets them equity capital to pay down the debt on their balance sheet," Sinha continues. "At one level the current opportunity is better because it suits our needs as a financial investor much better - it's lower risk, more certain returns than what it was back in 2008."

Back in 2008, GPs were rushing to invest in the sector. According to Grant Thornton, private equity commitments rose from $153 million across five deals in 2005 to $3.9 billion in 2007 and $1.9 billion in 2008, with 44 transactions completed in each year. Taken together, activity in 2007 and 2008 exceeds that of the four subsequent years.

Infrastructure-specific funds were raised, such as IDFC's $927 million India Infrastructure Fund and 3i's $1.2 billion India Infrastructure vehicle. "The scale of the opportunity for infrastructure investment in India is tremendous," Anil Ahuja, then managing director and co-head of 3i's Asian operations, remarked in 2008 as the firm began work to make India a key plank of its infrastructure platform.

But in May this year, 3i Infrastructure decided to shift strategy away from India, blaming macroeconomic, market and regulatory conditions that were more challenging than they initially expected. "[The] investment has not, to date, delivered the premium risk adjusted returns that were expected and has brought unwelcome volatility to overall portfolio performance," the firm said.

3i's portfolio included a $245 million investment in Adani Power, which was to develop a portfolio of power plants across India. The month that the firm announced its decision to stop India investments, Adani reported its sixth consecutive consolidated quarterly loss, and its consolidated EBITDA fell by 22% to INR11.5 billion ($192 million) from the previous year.

3i is also an investor in highway developer Soma Enterprise, having put $102 million into the company in 2007. Soma has a debt burden of around INR 50 billion and is reportedly heading for corporate debt restructuring, after facing delays in payments for contract work.

The pile of restructured loans at banks has been growing. Creditors to ChrysCapital Partners-backed engineering and construction company Gammon India approved a INR 135 billion corporate debt restructuring earlier this month, after the company suffered project delays. In April of this year, about 215 infrastructure projects were stalled, involving a collective outlay of over INR7 trillion, according to Ministry of Finance estimates.

Road blocks

A combination of execution issues and aggressive bidding has affected investments, with the two biggest money draws, power and roads, seeing their share of troubles. It is important to note that the aggressive bidding isn't the fault of portfolio companies alone; their GP backers upped the ante in order to secure investments, which ultimately meant there was more capital to deploy in projects.

"The constrains in raising capital - both debt and equity - the lack of depth in debt markets in terms of type of offerings and liquidity, and the pace of consents and permissions and land acquisition are all encompassing challenges in infrastructure investing," says Archana Hingorani, CEO at IL&FS Investment Managers.

Road projects have also been hit because of traffic assumptions. As Harish H.V., a partner with Grant Thornton in India, explains, part of the problem in the earlier phase was extremely aggressive bidding. From an initial bid for certain money to be paid to them along with tolls, developers went into negative mode with upfront payment because the industry outlook was good.
The differences between the winning bids and the next best were in excess of 25% and in some cases as high as 35-40%.

The main issue, that nobody wanted to recognize, is that the whole procurement process was set up in a way as to select the bid with the most aggressive view on traffic. "As those projects have reached operation stage it has become obvious that those traffic projections are not going to be met, hence the impact on ability to service debt," says Manish B. Agarwal, executive director at PricewaterhouseCoopers (PwC).

Then there was the amount of debt that highway developers were willing to take on. In a build-operate-transfer (BOT) project, 70 -75% of funding for capital expenditure came from banks and the developer has to put in the rest. This additional equity would be borrowed from banks at the developer's holding company level, so essentially they were trying to create these projects for free, with no equity. When the cash flow or tolls didn't come through as expected it became difficult for them to service debt.

While some projects were executed but poorly conceived, others have struggled to get off the ground at all due to delays in land acquisition and environmental clearances. Developers' core engineering, procurement and construction (EPC) business has therefore slowed down, payments have been delayed and working capital cycles extended, forcing them to borrow more on the short term as well.

Availability of finance is an added constraint. Financial conditions have tightened as road construction firms are already leveraged and are unable to raise more debt in the absence of fresh equity. Gross bank credit to the roads sector was INR1.26 trillion at the end of December 2012, according to the Reserve Bank of India. As of end-May this year, Indian banks had loans outstanding of INR7.7 trillion to the infrastructure sector and many are nearing their lending limits.

As a result, the balance sheets of some road construction companies have become levered enough to force debt restructuring. Infrastructure accounted for around 23% of corporate debt restructurings for Indian banks at the end of March, up from 20.5% a year ago. The infrastructure sector is likely to be the biggest risk for Indian lenders in the year ending March 2014, Fitch Ratings said in a note.

Power outages

On power projects, problems can be traced back to fuel supply and coal linkages. In March 2012, the office of India's Comptroller and Auditor General disclosed that 155 coal acreages were allocated without auction resulting in windfall gains to the firms that secured them. Known as the Coalgate scam, it caused further setbacks in a sector already facing coal shortages due to a lack of government clearance to develop mines in environmentally sensitive areas.

The viability of loss-making state electricity boards to pay for electricity supplied to them and the inability to pass on a rise in fuel costs to customers have also caused problems. "When we started investing the fund in 2008 it was a lot clearer. Concession agreements in the roads sector, coal linkages for power plants, and environmental clearances were assumed to be all sorted out. It is a lot less certain as we speak right now," says IDFC's Sinha.

A lot of companies are in a situation where their capital investments have not started generating EBITDA and their debt on operating assets is now due. These debt-stressed operators come under pressure from banks to offload operational assets to strengthen balance sheets.

That is one of the reasons why IDFC has changed strategy, shifting from investing in greenfield construction assets in the early part to interest assets that are either operational or likely to be so in 6-12 months. Sinha observes that few fresh investments are being made while deals struck on overleveraged terms in the last five years are now deleveraging. He sees it as a huge opportunity and he's not the only one.

The SBI Macquarie Infrastructure Fund is another private equity investor poised to pick up assets. In February it bought a controlling stake in a road project from debt-laden GMR Infrastructure.

Over the last 12-18 months, at least half a dozen portfolios that have been in the market as well as individual projects. GVK Power and Infrastructure is talking to funds to sell about 25% of its airport business by the end of 2013. It may also rope in an investor for its road building business.

Unlike new builds, existing projects already have funding in place. If things go according to plan, a long-term investment in such infrastructure assets will ring returns from a combination of annuity dividends from operational assets, recapitalizations once assets move from construction to operational phase and ultimate capital gains when the assets are sold. KKR and The Blackstone Group are among those said to be looking at buying into completed projects.

However, there are challenges in the form of gap in valuation perceptions between buyers and sellers, according to Vikram Hosangady, head of transaction services and private equity at KPMG India. "Also, for projects that are stuck because of land acquisition or clearances, a potential investor will ask, ‘Why should I step into something that already has problems?'" he reasons.

The Indian government, for its part, has been rolling out policy measures to help meet its $1 trillion infrastructure investment goal between now and 2017. It has proposed a move away from the public-private partnership (PPP) model to fund projects, where developers finance construction out of their own pocket, often in exchange for the right to charge toll fares.

It has been suggested the government might revert to a form of conract where it funds part of the road building, taking on more of the risk of the project itself. But many question whether the government can afford to meet the large funding requirement that comes with the shift.

Other policy tweaks mean road developers no longer have to wait for clearance from forest authorities to start construction. They can also offload all their equity to interested buyers, up from the current 74% divestment limit. However, critics say this will encourage irresponsible bidding in the future by helping developers who aggressively pursue highway projects and have no cash in hand to execute them now.

The renewables sector is also seeing deals to unlock capital. India became the world's third-biggest wind turbine market in 2010, after China and the US, partly as government-backed tax depreciation benefits spurred companies to invest in thousands of farms. Corporates such as truck maker Ashok Leyland and indebted property developer DLF are among those selling non-core business renewable energy assets. So far this year DLF has sold 228 megawatts of wind power projects for INR5 billion ($99.5 million).

As the excesses of the boom years unwind to bring new opportunities, prudent, long-term investors are well-positioned to capitalize on the rewards. With this in mind, although slowing growth and sector specific challenges have impacted investment, IL&FS' Hingorani believes the phase is transitory.
"Given the inherent demand for infrastructure, we believe and over the medium to long term, infra assets will deliver quality return to investors," she says.

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• Topics
• South Asia
• Infrastructure
• Infrastructure
• Infrastructure
• India
• Infrastructure India
• Infrastructure
• ChrysCapital Management
• IL&FS Investment Managers
• IDFC Private Equity