Financing of PPP Infrastructure Projects in India: Constraints and Recommendations

Ranjan Agrawal*, Aayushi Gupta** and M C Gupta***

Infrastructure projects are complex, capital intensive and with long gestation period, posing multiple and unique risks to project financiers. Private investment in infrastructure in India over the past decade has not been up to the expectation, and there is a need for Public-Private Partnerships (PPPs) to play a much greater role than before. The paper analyzes the reasons for private financing not making its way into the different infrastructure segments, and examines the key constraints to private financing. It also suggests ways to mitigate these constraints for a sustained private investment in the Indian infrastructure.

Introduction
Infrastructure projects are complex, capital intensive, having long gestation period and involve multiple risks to the project participants. In many countries shortage of public funds have forced the government to enter into a long-term contractual agreement for financing construction and operation of infrastructure projects. A Public-Private Partnership (PPP) can be defined as private sector financiers of construction and operation of infrastructure projects, which would have been otherwise provided by the public sector. PPP structures are typically more complex than the traditional public procurement projects, and their complexity is due to the number of parties involved and the mechanism used to share the risk. PPP projects are characterized by non-recourse or limited-recourse financing, where lenders are repaid from only the revenues generated by the projects. The concessionaire is a special purpose vehicle in which the sponsoring entities are not responsible for the repayments of loans. These projects have a capital cost during constructions and a low operating cost afterwards, which implies that the initial financing costs are very large compared to the total cost. Further, a mix of financial and contractual arrangements amongst the multiple parties including the commercial banks, project sponsorers, domestic and international financial institutions and government agencies makes it further complex.
* ** Research Scholar, JIIT, A-10, Sector 62, Noida 201303, Uttar Pradesh, India. E-mail:gitmcollege@yahoo.co.in Associate Professor and HOD, JIIT, A-10, Sector 62, Noida 201303, Uttar Pradesh, India. Email: aayushi.gupta@jiit.ac.in *** Former Vice Chancellor, RGPV, Bhopal, and Director, AHL, Bhopal, HX 95 E7 Arera Colony, Bhopal, India. Email: mcgupta2000@yahoo.co.in 52 2011 IUP. All Rights Reserved. The IUP Journal of Infrastructure, Vol. IX, No. 1, 2011

In recent years, efforts have been made by the Government of India to increase the private investment in infrastructure. While Indias performance in increasing the investment is encouraging, about two-thirds of the investment has gone to the telecommunication sector since 2001. India realized sufficient investment in the transport sector but the investment in energy, water supply and sanitation has not yet picked up noticeably. Even at this rate India is well behind the other countries in attracting private investment. Financing gaps in infrastructure up to the year 2010-2011 have been estimated by the Planning Commission of India, and are provided in Table 1. To meet this funding gap, innovative financing models are needed to make economically essential projects commercially viable and allow active private sector participation to facilitate private sector efficiency in Indias infrastructure development. The paper examines key constraints to private financing of infrastructure, fiscal barriers and deficiencies in the government policies and regulatory framework. It further suggests practical ways to attract sustained private investment in infrastructure development. Table 1: Overall Financing Gap in Infrastructure Up To 2010-11( Billion)
Sectors Roads Power Telecommunications Railways Airports Ports Total Investment Needed 4,670 10,591 2,143 1,242 191 306 19,143
Source: Planning Commission

Financing Gap 1,106 3,500 478 151 72 236 5,542

Build Operate Transfer (BOT) Type Infrastructure Projects

Funds have to be raised to finance economically feasible capital investment projects. In a BOT type of project, a concessionaire which usually is from the private sector makes financial arrangements to construct and build the project, operate the project to generate revenue for debt repayment and investment recovery with profits, and then transfer the facility of the project in operational condition to the government/owner at the end of the concession period. Therefore, in a BOT type of project, the concessionaire is responsible for financing and operating the project. BOT is fashionable worldwide especially in developing countries to attract private capital to assist in developing public infrastructure (Shen et al., 2004).

Risk in BOT Type Projects

This typically illustrates the relationship between principal participants in BOT type procurement. Much of the risk of a PPP project comes from the complexity of the arrangement itself in terms of documentation, financing, taxation, technical details, sub agreements, etc., involved in a major infrastructure venture, while the nature of the risks alter over the duration of the project (Figure 1).
Financing of PPP Infrastructure Projects in India: Constraints and Recommendations 53

Figure 1: Relationship Between Principal Participants in BOT Type Projects

Investors Sponsor (Usually Government) Concession Agreement (Franchise) Users (Where Applicable)

Shareholder Agreement

Off-Take Agreement (or Equivalent)

Lenders

Loan Agreement

Franchisee

Operation+Maintenance Operator Agreement Design-Construct Contract

Management and/or Checking Agreement(s)

Supply Contracts (Wherever Applicable)

Project Managers and/or Independent Checkers

Suppliers

Design-Construct Consortium

Major risks a project sponsor faces are: political, financial, constructional, operational, and market risks. The risks can be broadly classified into: (1) Elemental risks comprising physical, design, construction, operation and maintenance, technology, finance and revenue generation risks; and (2) global risks comprising political, legal, commercial and environmental risks (Merna and Smith, 1996). BOT type project assumes a much broader scope of risks than a mere contractor in a traditional design-bid-build contract. It is because of many responsibilities undertaken and the broad scope of risks assumed by the concessionaire, and the characteristics of nonrecourse or limited-recourse financing. A strong financial capability and ability of the concessionaire to manage the long-term financing of the project through innovative financing strategies is an important prerequisite for the successful development of a BOT type project.

Constraints to Infrastructure Financing

BOT projects are highly leveraged, and the repayment of loans and dividends on equity depends on projects earning only. The objectives that BOT project sponsors try to achieve in structuring the debt financing are maximization of long-term debt, maximization of fixed rate financing and minimization of refinancing risk (Tiong and Alum 1997). A common strategy of the sponsor is to use as much debt as possible while ensuring adequate sponsor equity as desired by the granting authority. However, adequate initial contribution of equity is important to avoid high cost debt during construction period.
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Equity can be provided by project promoters or financial investors. In an infrastructure project, financing equity mainly shoulders the greatest level of operational, financial and market risks. In the initial stages, mostly it comes from the sponsors but the ability of the sponsors to get it from the primary market remains limited. In the longer term, equity finance from financial investors such as venture capital funds and other institutional investors can prove to be critical as the sponsors equity is consumed at early stages and not recycled quickly enough due to lack of refinancing options. At present equity financing by institutional investors has the following major constraints. Limited Exit Options: While investing in infrastructure, financial investors are interested to know the exit options. The best route to exit from the equity is to sell the stake to the sponsors through a put option. However, in India such agreements are not easy and require the permission from the government for an unlisted company. This creates uncertainty. Exit option prevents investors in financing a privately managed infrastructure project. Shallow Capital Market and Corporate Governance Issues: Infrastructure project developers are mostly construction companies, equipment suppliers or operational services companies. Return for these companies on their investment comes from additional business generated from the project and not by the project. Transparency in disclosures and misuse of corporate assets are key problems for retail investors to keep them away from such projects. Minority shareholders, therefore, suffer and lose out in such situations.

Limited Mezzanine Financing: In the developing countries, many infrastructure

projects are funded through mezzanine finance which is a hybrid of debt and equity. For example, financing by convertible unsecured loansloan that pays fixed interest and the holder has the right to convert it into equity in futureis generally a subordinated debt which attracts the investor because of higher returns than that of senior debt, and on the balance sheet of a company, it is treated like quasi-equity. Lack of sufficiently large pool of infrastructure projects, interest rate caps on external commercial borrowing and regulatory norms, and premium pricing, are the factors that have restricted mezzanine financing in India in any sizeable amounts.

Limited Use of Take-out Financing: Commercial bank funding of infrastructure

projects has the risk of asset liability mismatch which can be taken care of by take-out finance. In take-out financing, a bank which is funding an infrastructure project gets into an arrangement with a financial institution for buying bank loans after a certain period. Excess liquidity in the system and limited number of bankable projects with no liquidity crunch are the main factors limiting the use of take-out financing. High stamp duties and limited number of bankable projects reduces the attractiveness of take-out financing. Undeveloped Corporate Bond Market and Lack of Longer Term Financing: India still does not have a wide or deep enough corporate bond market. According to
Financing of PPP Infrastructure Projects in India: Constraints and Recommendations 55

the estimates of the Bank for International Settlements (BIS), the size of Indias corporate bond market was 0.3% of nominal GDP in Dec 2003, much lower than that of Malaysia 43.3% or South Korea 27.7% (World Bank, June 2006, p. 31).

Other Constraints
The financial sector related factors which have been identified as above mainly prevent private investment in infrastructure. However, the sector policy and regulatory framework are also closely linked to these funding issues. The main constraints other than financial sector related are as under:

Fiscal barriers to private financing of infrastructure. Approvals, red tape and inadequate administrative capacity. Multiple clearances. Lack of coordination between departments. Delays in award of contract. Limited capacity within government to execute PPPs in infrastructure. Poor infrastructure regulations. Recommendations for Private Financing to Infrastructure
PPPs can play much important role in bridging the financial gap for building the requisite infrastructure. Suggestions for mitigating the key constraints to private financing of infrastructure are given as under:

Facilitating equity financing by improving exit policy and better corporate

governance to protect minority shareholder rights.

Removing interest rate caps on External Commercial Borrowings (ECBs) to

encourage foreign investors to use innovative financing instruments like mezzanine and take-out financing.

Developing a well developed government bond market. Investment policy and regulatory guidelines to insurance companies, pension
funds, mutual funds and other financial institutions for participation in infrastructure financing.

Fiscal concessions by reducing custom duties on capital goods and machineries

which are critical to construction of infrastructure projects and provision of other tax concessions and tax holidays.

Government should provide clear policy frameworks to reduce uncertainties and

set up high level committees to resolve inter-ministerial issues involving multiple clearances for various sectors.
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 The government should develop domestic capabilities of financial institutions and

government officials to manage and participate in PPP projects. Recent step by the central government to fund through the Viability Gap Funding (VGP) up to 40% is a welcome step. However, it will require proper institutional capacities to manage, participate in/and monitor PPP.

Make transactions transparent, clear, predictable and competitive. Government should create a stable, transparent and fast acting regulatory
environment.

Conclusion
India faces large financing gap which can be bridged only by active private participation in building the necessary infrastructure. Reforms that facilitate the use of various financing instruments by investors are needed. However, the funding issues are closely linked to sector policies and regulatory frameworks and therefore, private investment will also require that the fiscal barriers, red tape and professional inefficiencies should also be addressed properly. Increased private financing for infrastructure on a sustained basis will require governments proactive role and policies to provide wide spread reforms in infrastructure that will go beyond the financial sector.

Bibliography
1. Merna A and Smith N J (1996), Guide to the Preparation and Evaluation of Build-Own-Operate-Transfer (BOOT) Project Tenders, Asia Law and Practice, Hong Kong. 2. Shen L Y, Li Q M, Drew D and Shen Q P (2004), Awarding Construction Contracts on Multicriteria Basis in China, Journal of Construction Engineering and Management, ASCE, Vol.130, No. 3, pp. 385-393. 3. Tiong R L K and Alum J (1997), Evaluation of Proposals for BOT Projects, International Journal of Project Management, Vol. 15, No. 2, pp. 67-72. 4. World Bank (2006), Financing Infrastructure: Addressing Constraints and Challenges, World Bank, p. 6.
Reference # 27J-2011-03-03-01

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