Diamonds in the rough

Sentiment around the infrastructure sector, darling of Indian public market investors during the go-go years of 2007-08 has, of late, swung to the other extreme. There has been an increasing overhang of pessimism around Indian infrastructure among the developer and investor communities. Delays in obtaining approvals, land acquisition, fuel shortages in the power sector, and protracted dispute resolutions, have led to the dampening of developer sentiment. On the other hand, compromised economics, due to execution challenges and delayed exits, have led to reduced investor appetite.

As investors, we can sometimes be guilty of exaggerating the effects of the short term and underestimating the effects of long-term trends. The much ignored silver lining in the dark cloud is that India achieved 95 percent of its investment target of $500 billion in the 11th Five Year Plan (FYP). To put the achievement in perspective, India added 55,000 megawatts (MW) of capacity in the power sector in the last five years and 17,600 kilometres (km) of roads, as against capacity expansion of 21,080MW and 9,008 km in the power and roads sectors respectively, in the five years before that.

The creation of such a massive private footprint in the infrastructure sector within such a short time frame is no small feat. Going forward, the 12th FYP targets total investment of $1 trillion, of which around 48 percent is expected from the private sector.

The rapid pace of build-out in Indian infrastructure on the back of easy liquidity far outstripped the requisite governmental planning, administrative coordination, regulatory capacity and private sector appreciation of risks, thereby leading to a mismatch in expectations. India is presently in a period of assimilating the implications of this mismatch, and taking calculated steps forward. With GDP growth rates in recent periods being much below planned targets, the government realises that systematic infrastructure development is one of the essential pillars required to reach its goal of sustained economic growth, and therefore, has taken several proactive measures to reduce regulatory bottlenecks in infrastructure development.

Notable examples include introduction of the much-awaited land acquisition act, financial restructuring of state utilities, fiscal incentives for renewable energy, and favourable exit norms in the road sector to enable churn of capital. We are also hoping to shortly see the Contracts (Settlement of Disputes) Bill 2013 come to the legislature, which has the potential of being a landmark policy framework to speed up commercial dispute resolution and create a friendlier and more importantly, a predictable, environment for private sector participation. While these policy initiatives may not lead to immediate salvation for some of the on-going projects, their impact will be demonstrated across sectors over the coming couple of years.

Our experience with the infrastructure sector

At IDFC, we have been investing across the infrastructure sector from our circa $930 million India Infrastructure Fund (IIF-1) since 2008. Our experience has reaffirmed that an investment strategy independent of public market sentiment and evaluations based on cash flow investing – wherein underlying concessions, assets or contracts drive inflation-adjusted cash flows to shareholders – can reap rich dividends.

The importance of a thorough evaluation of execution risks, sector-specific challenges, stage of project completion, and the overall positioning of the target company vis-à-vis these risks, cannot be underscored enough. For instance, we stayed away from bidding for road projects over the last three years given the aggressive bids being put in by the contracting community purely to shore up their EPC (Engineering, Procurement, Construction) order books through captive projects.

We also shied away from engaging with sponsors who were more focused on building up a story for capital markets in the short term rather than getting into a dialogue on the underlying project issues or economics. Our primary focus has been to adhere to our mandate of generating income over a period of time and to partner with well governed companies which we believe will have predictable and sustained revenues, good management and long-term competitive advantages.

Present sector stress: an opportunity in disguise?

While regulatory reforms and proactive government action are indeed expected to bring respite for the sector in the medium to long term, it is admittedly a difficult environment for infrastructure developers at present. Apart from rising interest costs and decreasing margins, which have taken a toll on growth projections, developers also have to trudge through a difficult financing environment characterised by (i) limited free cash flow available on their books; (ii) restricted funding from banks; and (iii) volatile and limited appetite in public markets for new capital issuances, leading to a number of developers turning towards monetising their operational assets in order to pare down leverage.

However, from an investor perspective, this translates into an attractive investment opportunity as it presents the twin benefits of being able to purchase assets at reasonable valuations, and being able to earn higher yields in the future as the replacement value of these assets, tariffs, economic growth rate etc., increase. Since January 2013, it is estimated that at least 10 developers have sold or announced the sale of assets, in a bid to pare down circa INR3.58 trillion of debt.

Given this backdrop of massive deleveraging in the Indian infrastructure market, we believe it is an opportune time to build a low-risk diversified portfolio of operating assets in India which can create long-term value for our investors. Through our second infrastructure fund, the Indian Infrastructure Fund II, we aim to selectively pick projects with an attractive potential of stable revenue generation alongside suitable sponsors.

While the balance sheets and the income statements of infrastructure companies are still to reflect all the pain that the project owners are going through, the silver lining is that these are long-life concessions with mismatched debt maturities. We believe that the same – once corrected and coupled with the fundamental premise of significant supply deficits in the country – will lead to more sustainable and stable infrastructure businesses over the medium to long term. The challenge is to figure which of the companies and sponsors will be able to ride out the current storm.

India represents a large and robust investment opportunity and has seen continued interest from global investors seeking to buy into long-term annuity assets. Global limited partners continue to be cautiously optimistic with regards to potential and the promise of the Indian infrastructure opportunity. While significant asset creation has happened over the last five years, unless the same ultimately translates into value creation/cash flow generation for investors, it will be challenging for these sectors and sponsors to attract institutional capital for incremental capacity creation.

As we move to the next phase of build-out, the infrastructure sector stands interestingly positioned in a propitious environment of conducive regulatory reforms, a wiser set of infrastructure players with realistic expectations on valuations and a nuanced appreciation for execution risk, and an attractive bouquet of operating assets available for investment.

*Aditya Aggarwal is a partner – infrastructure at IDFC Alternatives in Mumbai. He was part of the core investment team which set up IDFC Project Equity Company, the investment manager to the $930 million India Infrastructure Fund (“IIF”). He has over 17 years’ experience across banking and financial services with a focus on equity investing, project finance, project development and advisory services.
Aggarwal primarily focuses on originating and evaluating equity investments along with managing the portfolio and exits for the infrastructure equities business of IDFC Alternatives. He represents IIF on the boards of its portfolio companies and is a part of the investment committee of the recently raised second infrastructure fund, the India Infrastructure Fund II. He has a strong domain expertise in the energy and roads sector, and brings with him established relationships across major infrastructure groups in India.