India’s silver linings

If there is one economic element that has largely achieved consensus among successive central and state governments across India over the last 15 years, it is the importance of infrastructure development in their constituencies and the vital role of private sector participation.

This is amply demonstrated by infrastructure spend growing from less than 4.0 percent of gross domestic product (GDP) in 2001 to 7.3 percent of a much larger GDP in 2011 to 2012. More interestingly, the private sector’s share in infrastructure investment grew from 17 percent in 2001 to 38 percent by 2012.

During the 11th Five-Year Plan (2007 to 2012), the target investment in infrastructure of $500 billion was substantially met and now there is a $1 trillion target that is projected in the 12th Five-Year Plan (2012 to 2017).

AT THE CROSSROADS

But despite the rise of capital allocation to infrastructure, the sector today finds itself at a crossroads and facing some strong headwinds. Capital providers, both debt and equity, have developed increased risk aversion for Indian infrastructure projects in the last couple of years on account of challenges around land acquisition, stalled environmental clearances, nonavailability of feedstock and prolonged dispute resolution processes with concession-awarding authorities etc.

The additional elements of political uncertainty, a slowdown in GDP growth rate, fiscal/current deficits, persistent high inflation and currency volatility have not been helping investor sentiment.

Although there is government inaction, financiers – both private equity and debt players – and project sponsors have to share part of the blame too. Many infrastructure developers have stressed balance sheets because of a host of internal legacy factors such as excessive leverage, aggressive bidding, execution delays and lack of commensurate equity.

Between 2007 and 2012, the consolidated debt for the 10 largest domestic infrastructure players grew at 40 percent compound annual growth rate (CAGR) and this debt accounted for 13 percent of all loans in the Indian banking system. Given the high leverage levels, current cash flows from the underlying assets are
barely enough to service interest let alone repayment obligations.

Increasing interest rates have further exacerbated the woes of the infrastructure companies. Given this backdrop, it is not surprising that there is a marked diminution in private sector appetite to take up new capacity creation.

RISING INCOMES

The dark clouds of 2014 are not without silver linings. While the underlying fundamentals of the Indian economy which feed into GDP growth continue to be strong i.e. favourable demographics, rising incomes and a high savings rate, policy makers have also undertaken various measures recently to address macro issues, including a reduction in fuel subsidies, disinvestments of state-owned enterprises, relaxation of foreign direct investment (FDI) limits, an increase in gold and silver import duties, and increased rates for non-resident foreign currency deposits to stabilise the currency.

Within the infrastructure arena, there have been many initiatives undertaken which are expected to yield results over the next 12 to 24 months. These include the formation of a cabinet committee headed by the Prime Minister to spur investment in large projects and clear regulatory hurdles, a renewed focus on reforming state power utilities and correcting their tariff structures, initiating a process to set up an independent road regulator, the signing of coal supply agreements, the constitution of a dispute settlement committee for roads, and the revision of tariff determination in the ports sector.

An important development to take note of is the fact that policy makers have been demonstrating a very pragmatic and practical approach while trying to address private developers’ woes, whether it’s the matter of unviable power purchase agreements (PPAs) given coal- and gas-related issues, or the last round of road bid restructuring discussions around the back-ending of premium.

This is a very positive sign, coupled with the fact that entrepreneurs and financiers are also now better equipped with the help of hindsight to avoid the kind of uncalculated risks they were prepared to take earlier. Most sectors are seeing recalibration of the allocation of risk and reward among all stakeholders in a more balanced and sustainable way which is paving the way for serious long-term investments instead of short-term opportunism.

While many global investors are concerned with the current infrastructure investment climate in India and hence are not overly enthused about committing capital at this stage, there is another set of investors which is cautiously optimistic given that fundamentally nothing has changed.

India continues to have robust domestic demand, a demographic dividend, user ability and willingness to pay for better services, and vibrant entrepreneurial spirit. There also seem to be a number of investors which are waiting on the sidelines in ‘wait and watch’ mode for the outcome of national elections scheduled in May 2014.

STRONG MANDATE COULD UNLOCK DEAL FLOW

Currently, there continues to be some uncertainty and scepticism about reforms – which admittedly are taking place in fits and starts – but if the summer elections result in a decisive leadership with a strong enough mandate, sentiment can change quickly and a lot more capital can start flowing back to India, benefitting the contrarian investors which are committing capital to India now.

For any investor which has a long-term view, India is one of the largest infrastructure opportunities in the world and cannot be ignored. No one can argue against the premise that India simply cannot grow without creating incremental infrastructure, whether it is power, roads, ports or logistics centres.

Unlike China, India has always been building infrastructure to cater to the growth which has already happened and hence will continue to be an infrastructure-deficient economy for some time. For developed economies with a huge, aging population and corresponding large pension liabilities, Indian infrastructure offers a unique opportunity to earn attractive returns which are inflation-linked and will continue over the next 20 to 25 years.

At IDFC Alternatives, we have continuously strived to recalibrate our approach to adapt to the rapidly evolving landscape. We strongly believe the current scenario presents an attractive opportunity for investors wanting low-risk operational assets primarily in the road and power sectors that the developers will be looking to monetise and sell in order to to de-leverage their balance sheets and correct their capital structures.

As the Indian market evolves, we expect the Indian private equity infrastructure
landscape to move towards the Western model of more involved participation where fund managers frequently acquire controlling stakes and play a more active role alongside the operational partner.

We believe that the creation of independent aggregation platforms offers better and more efficient portfolio management, enables majority stakes, obviates the necessity of paying a ‘promote’ to the developers/project sponsors and offers easier liquidity through public markets and/or strategic sales.

IDFC Alternatives has already created aggregation platforms in the road sector and renewables with independent management teams and is looking to create similar such vehicles in other sectors. In parallel, we will also continue to seek minority interests in well governed companies and with sponsors that have a good track record of wealth creation while adopting sustainable environment and social standards.

POLICY ISSUES

More than the policy issues, which we believe are not structural in nature and can be quickly fixed if there is the intent to do so, it is who you partner and invest with that is more of a concern for us. We would like to invest a significant portion of our new fund with industrial houses that we have had a positive outcome with on the equity side in the past, groups that IDFC has had a strong relationship with, and sponsors that value their brand presence and franchise as long-term developers and partners.

Our long-term optimism and belief in this strategy is shared by many global institutional investors which have supported us by committing to our second infrastructure fund, despite the prevailing environment of uncertainty and despondency.

Aditya Aggarwal is a partner at IDFC Alternatives, the India-based fund manager