The Indian economy has registered a growth rate of about 5% in the year 2019-20, and is projecting a growth rate of about 6.5% in the year 2020-21, with a vision of becoming a US$ 5 trillion economy by 2024-25. India remains the world’s fifth-largest economy, despite the global economic slowdown, the on-going trade war, after effects of Brexit and distress in the domestic financial sector. The India economy is expanding significantly, and to sustain its economic progress, a substantial investment of about US$ 775 billion is required in the Infrastructure Sector. India has witnessed interest from multinational players in Infrastructure segments such as power, bridges, dams, railway, airport, roads and urban infrastructure development.
Business Models in the Infrastructure Sector
The infrastructure sector has always been the prime focus of the government in the country. Private sector engagement in infrastructure space along with the government has now become one of the most commonly adopted strategies:
- Public-Private Partnership Projects: Public-Private Partnerships Projects are projects which are owned, developed and implemented jointly by the Government and the private sector through a partnership arrangement.
- Traditional Public Investment Projects: Traditional Public Investment Projects are owned, developed and implemented solely by the Government. The projects are awarded to private players to develop on the basis of item rate, admeasurement, Design-Bid-Build (DBB), Design-Build and Engineer Procure Construct contracts, etc.
- Private Sector Projects: Private Sector Projects are implemented by the private sector. The Project mainly includes ‘Pre-construction Stage’, ‘Under Construction’ and ‘Operation and Maintenance’.
Government policies have been evolving very rapidly from traditional public investment projects to public-private partnership projects, which has opened many ways for the private sector to enter the Infrastructure domain. Some of the major projects announced by the government are:
a. Setting up an India-Japan Coordination Forum for Development of the North East
b. 100 smart cities across the country
c. Mumbai–Ahmedabad High-Speed Rail Corridor
d. 100 GW of solar capacity by 2022
e. 100 airports by 2024 under UDAAN Scheme
f. Chennai Bangalore Industrial Corridor and Delhi–Mumbai Industrial Corridor Project
g. Metro Railways
h. US government’s Overseas Private Investment Corporation (OPIC) is planning to invest in India’s infrastructure, in port and solar energy sectors
i. Construction of 43,000 houses every day until 2022 with a vision of ‘Housing for All’
j. Budgeted capital expenditure of US$ 22.04 billion in the railways for 2019-20
k. 2,000 kms of coastal connectivity roads have been identified for construction and development
l. 65,000 km of highways by 2022
The favourable government policies with the booming infrastructure sector has encouraged many multi-national players to enter the Indian Infrastructure marketplace. This boom has led to the need of financing in the private sector in the infrastructure domain.
Sources of Financing, Inter-creditor Agreement
Infrastructure financing has grown rapidly across the past few years. The Project Company raises financing from various sources in the form of a combination of equity and debt. There is no standard of source of finance, it usually depends on negotiations between the lenders, investors, and shareholders. Following are the key sources of financing:
- Equity Contributions: The project sponsors or joint venture partners are the investors providing expertise and some services to the project company. The investor holds the lowest funding contributions in a project and other contributors, such as lenders, will have the right to project assets and revenues before the equity contributors can obtain any return. The shareholders' agreement may involve several documents such as development agreement, joint venture agreement, articles of association and constitutional documents.
- Debt Contributions: Debt can be obtained from various sources (domestic or international) such as commercial lenders, institutional investors, export credit agencies, bilateral or multilateral organizations, bondholders and government agencies. Debt are the major source of finance in the project company. The repayment of debt can have fixed or floating rate of interest along with periodic payments by the project company. Foreign debt is usually available at lower rate of interest and flexible periodic payments in India.
- Bank Guarantees, Letters of Credit or Performance Guarantees: Bank Guarantees, Letter of Credit or Performance Guarantees are one of the most important conditions of awarding the new contracts to the project company. These instruments allow immediate access to payments in case of a default. Such guarantees may be on-demand or payable once the default is proven in court or arbitration.
- Bond & Capital Markets Financing: Bond and Capital Markets are generally used by the parent company to raise large rounds of funding in order to invest in several project companies. Through bond and capital market, debt can be raised directly from an individual, corporates, institutions, etc. Bond financing generally involves lower borrowing costs in comparison to equity contribution.
- Mezzanine or Subordinated Contributions: Mezzanine or Subordinated Contributions are characterized as quasi equity and preference shares. Mezzanine or Subordinated Contributions allow the company to maintain a greater level of debt-equity ratio in the project company. In the past, Mezzanine or Subordinated Contributions have been financed at higher interest rates in comparison to debt contributions.
- Inter-creditor Agreement: An inter-creditor agreement is generally entered into by the lenders to address key issues between the different sources of financing into one project company, also known as a Consortium of Banks. Inter-creditor issues include drawdown, maturity, allocation of debt, security rights, insurance of funds, voting decisions, management of repayment, etc.
Key Challenges: Financing in the Infrastructure Sector
Infrastructure projects are capital intensive in nature, with huge initial construction costs and some operating costs. Infrastructure projects normally require long-term financing due to long gestation periods. Multinational companies with their local partners are using various financing strategies to achieve cost competitiveness. The market, project site, commercial risk, uncertainty in projections are of concern to the proposed lenders or an investor in the project. Some of the key issues that may arise in financing new projects are:
- Uncertainty in Revenues: The projects usually generate revenue after the pre-construction stage. It is important for an investor / lender to forecast the revenue stream post-construction stage. The lender / investor would usually evaluate the project basis the following:
- Demand profile of the project, growth prospect, demographic movement
- Necessary approvals from the host government and local authorities
- Impact of foreign exchange risk, political risk, technical changes or other government regulation which might affect the revenue stream in the future
Usually financial institutions prefer a medium period off-take contract i.e. an average period ranging between seven to nine years. The offtake contract with longer or shorter periods may have commercial risks attached.
- Infrastructure Projects under Special Purpose Vehicle: Infrastructure Projects are usually executed through an independent company i.e. a special purpose vehicle (SPV) company. Promoters prefer to execute the projects under an SPV to protect the parent company from any financial / compliance risks. The special purpose vehicle would not have any relationship with the parent company nor any credit history except an initial investment although financial institutes prefer to lend or invest in the special purpose vehicle only when the projects are secured by the group company. It is, therefore, important that the company has an appropriate structure that enables the lender or an investor to obtain securities.
- Financial Ratios and Financial Covenants: Financial ratios can determine different aspects of the project, like the financial position and business operation. The Lender / investor can exercise their additional rights and powers in case breach of financial ratios. The company must always maintain the ratios which have been agreed upon by the lender / investor.
- Lender Protection: The Infrastructure projects are characterized as limited recourse financing i.e. lender / investor can be paid only when the project generates revenue. Therefore, the lender / investor must always ensure that revenue stream of the project is protected.
- The Lender or an investor would usually obtain practical control mechanisms, such as activities which company cannot do without their approval and step into management during non-performing situations and take security over project assets.
The project company would be required to provide an undertaking to the lender / investor that it will not change the project plan, project contracts, capital expenditure program etc. without their consent. The project company may also be required to provide warranties & representations concerning the financial, commercial, legal and operational status of the project to the lender / investor. They may also seek undertakings concerning government approval, compliance, and other obligations.
- Termination compensation: The lender / investor clearly define the termination compensation on the event of a default by the project company. The lender / investor ensures to step into the management of the company and control the project assets in case of a default. The lender / investor also ensures that the guarantor pays an amount of money that compensates the pending construction of project assets, penalties and excessive interest. All the parties must ensure that the termination clause must fit within the applicable legal regime.
Conclusion
In the current scenario, the domestic banks dominate financing of the infrastructure sector in India. The multinational companies along with their local partners are demanding more financial solutions to execute their projects timely. The domestic banks usually provide finance for a period of up to seven years. But companies now require financing solutions for a period of up to twelve years, which is common in the international market.
Multinational players have now started partnering with local players and bringing in foreign debt. The international market allows raising large amounts of funding at favourable rates and terms of repayment.
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