The Viewpoint: The Funding Crunch in Infrastructure – Some Causes and Remedies

There is no doubt that one of the key challenges for the new government would be kick starting investment in infrastructure, which is currently estimated at INR 40.9 trillion. Most new infrastructure projects are proposed to be based on Public Private Partnership (PPP) model and funded by the private sector..However, India has consistently fallen short of meeting such targets in the last few years. Implementation issues are faced by developers at all stages, from development stage (such as securing consents and approvals, land etc.), to securing financing for the project and finally, executing it within cost and time. To attract investment in infrastructure various implementation challenges and policy issues needs to be addressed..Under the PPP models adopted in India for providing infrastructure-based services, the public sector/government signs a contract with a special purpose vehicle (SPV) for a clearly defined project to be financed and developed by a private developer, who shares risks and rewards with the government. In this model, the ability of the private developer to access funds and achieve financial closure becomes critical. In layman’s term, financial closure is achieved when all tie ups with banks/financial institutions for funds are made and all the condition precedents for initial draw down of debt are satisfied by the borrower. These conditions for disbursement typically include timely completion of all project development activities, award of project contracts (for equipment supply, EPC and O&M, etc.), tie-up of offtake arrangements, procuring land (an increasingly difficult task in India), obtaining of all required consents for the project, and bringing equity. Unfortunately, in the last few years the private developers have been struggling to achieve financial closures for infrastructure projects, leading to various projects getting delayed or scrapped altogether..The debt gap – reluctant lenders and competing debtors.There is a significant gap in fund availability when we consider the requirement of funds for infrastructure vis-à-vis estimated debt funds available. This gap is a result of, among other factors, the global financial crisis, worsening investment sentiment in the infrastructure sector, increased risk perception resulting from muddled project implementation, and banks hitting their lending limits for the infrastructure sector. There is also a perceptible fear among lenders/investors that infrastructure financings (usually carrying a long pay-back period) could easily become a non-performing asset on their books as a result of policy changes, cost overruns and delays. All these factors have resulted in banks/financial institutions becoming much more selective about the projects they lend to, and it can be expected that this trend will continue. Overseas funding is not always feasible for many large infrastructure projects due to the cap on the amount that can be raised, hedging cost, and end use restrictions. Various lenders and market participants feel that the widening debt gap will lead to lenders seeking more stringent conditions for disbursing of funds, robust security packages (including asking the borrower to provide credit enhancements) and examine project risks and their credit risk carefully – affecting the rate at which large infrastructure projects are financed..Project risks – Optimal risk allocation is required.Lenders are the most at risk during the development and construction stage of a project, which leads to greater financing risk during this stage. Therefore, the conditions for draw-down are designed to eliminate the risks faced by lenders during this period. One of the main reasons why private developers have failed to fulfill these conditions for financial close is that the risk allocations in most PPP projects are not always optimal. Procuring project approvals and land acquisition, which ideally should be responsibility of the government at pre-tender stage, are passed on to the private developer leading to delays or failure in meeting conditions for financial close..In order to increase the financial viability of the projects, they should be awarded only after 100% of the land has been acquired (as is the global practice) and all necessary consents are in place. While some of the standard concession agreements are adopting this approach, there is a need for all PPP documents to follow this approach consistently..Need for robust lenders’ rights and flexibility to raise equity.In the recent past, loans to infrastructure projects have become NPAs or had to be restructured due to projects being planned beyond their scope, dated cost estimate/project data leading to cost escalation and delays, unrealistic bidding by private developers, or unexpected regulatory changes making the projects unviable. This has made banks/financial institutions circumspect in their lending practices. In contrast to commercial loans which tend to be fully collateralized, the assets which form the security for project loans typically do not cover the full amount of the loan. The ability of lenders to recover the loan depends largely on the performance of the project. The limited rights that lenders typically have for taking-over the project assets or restructuring the ownership of the SPV under the concession agreements have only increased their uneasiness..There is, therefore, a need to relook at the standard provisions of the concession agreements dealing with lenders rights, security creation, termination and exit mechanisms. Lender feedback on the contracts should be sought. Also, concession agreements usually restrict the private developers from transferring the project or selling equity in the project till commissioning. Since the requirement of funds and the risk is greater during the development and construction phase, a more liberal approach is required regarding transferability of projects as long as the minimum financial and technical requirements set by are met. Such move may trigger investment from private equity and institutional investors and make it easier for private developers to raise equity funding for their projects..Negative perceptions – effect on credit risk evaluation.The lack of funds available with banks and financial institutions for lending to the infrastructure sector and the rising NPAs has made banks/financial institutions skeptical to fund large infrastructure projects which they now perceive to be high risk due to the implementation issues affecting infrastructure projects in the recent past. Lenders have started asking for credit enhancements (such as sponsor support etc.) and government support (such as viability gap funding/grants etc.). While government support in the form of Viability Gap Funding (VGF) is available for the infrastructure sector, there are concerns regarding its design (such as disbursement of grant is done only after commissioning). To add to it, most lenders discount VGF for the purpose of financial close. Most private players active in the infrastructure sector are already highly leveraged (due to various factors such as cost escalations and delays in their existing projects) and providing the required sponsor support (in some cases even the equity component) has proved difficult for them therefore, delaying financial closure..Cure for the malice?.Given the gap in demand and availability of debt funding for the infrastructure sector, the government must take steps to revise the underlying structures and contracts for implementing PPP-based infrastructure projects. The contracts should provide greater flexibility to the private developers to raise equity from private equity players/institutional investors and make security creation over project assets easier. The risk allocation to the private developer needs to be optimised, and the tender process should be designed such that it ensures only ‘fully baked’ projects are put out to tender and ‘over ambitious’ bids are weeded out..While the structural changes to the PPP model will address some of the financing risks, the government should also take steps to increase the debt pool available. A robust bond market as an alternative source of funds to bank loans should be developed. While in developed markets many infrastructure projects are funded using bonds, in India the usage of bond market for financing projects is near negligible. Revising the sectoral cap and prudential norms for lending to infrastructure and making the ECB regime more flexible to allow innovative funding structures should also be considered..Avirup Nag is an Associate Partner at HSA Advocates. Views expressed in the article are personal.