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'Developers do not have market cap for buildout'

March 11, 2011 11:00 IST
The government of India has outlined very ambitious plans for building infrastructure in India over the coming decade.

In the upcoming 12th plan (2012-2017), the government has targeted total infrastructure spend of about a trillion dollars.

Of this, the private sector is supposed to fund 50 per cent. One has seen numerous articles debating the ability of the private sector to access enough debt to fund this build out.

The need to develop a corporate debt market, the asset-liability mismatch banks are running in funding infrastructure, the need to attract genuine long-term capital like insurance and pension monies in the space, are all well flagged issues.

The government has already moved on some of these pain points and seems seized of the problem.

In this Budget, we saw the FII limits on corporate bonds for infrastructure being raised by $20 billion, and numerous discussions to activate the corporate bond markets, encourage take-out financing, etc. are currently active.

Beyond debt, I think there is an issue on the availability of equity capital, simply put our infra developers do not have the market cap for the buildout.

The infrastructure sector (comprising both project developers and construction companies) has got massively de-rated by investors over the last few years.

After being a darling of the markets in the run-up to the peak of 2007, the sector has consistently underperformed.

The sector is so out of favour that it currently seems incapable of raising any new equity from the public markets.

Its only source of equity capital is from private equity players and that too in mostly structured/guaranteed return transactions.

If we look at a universe of more than 60 private sector infra companies (excluding Larsen and JSPL; they are doing more than just infra) their combined market cap is just $55 billion (out of total market cap of $1 trillion).

The typical promoter holding is below 50 per cent. Of this $55 billion, about $28 billion is the market cap of pure-play power developers.

If we want the private sector to invest $500 billion in infrastructure over the coming five years, even assuming a 70/30 debt equity structure, this implies a need for $150 billion of equity over five years.

How will a sector with a total market cap of $55 billion (50 per cent promoter holding ) generate $30 billion of equity contribution per annum?

This is difficult to contemplate as companies will not be able to raise multiples of their current market cap.

At best one can assume a 30 per cent dilution and that to, once every two years (yielding only $15-16 billion every two years and that too if every company can raise equity).

The constant need to dilute will also prevent the market cap of these companies from rising exponentially.

Thus, neither will markets support the quantum of equity fund raising needed, nor will promoters accept bringing their stakes down to zero.

Market cap is relevant, as most of these infra developers generate no-free cash flow as of today, and hence equity contribution will have to come from fresh fund raising.

The quantum of new equity any company can raise is intrinsically linked to its current market value. Without the equity, it does not matter how easily debt is available, as no project will get financial closure.

Debt approvals are normally contingent on equity being brought in first. The reality is that the Indian infrastructure sector does not have the size, financial muscle and market clout to fund the infrastructure this country needs.

While power projects may still go ahead, as we have 4-5 large power developers with a combined $28 billion of market cap, $27 billion of market cap has to support everything else from roads to ports, airports, sanitation, etc.

Again, the needs dwarf the capital, which can be raised.

There are various implications of this mismatch between current market cap, and incremental equity requirements.

First of all, we are going to be very dependent on foreign equity coming directly into project level investments.

This equity will need to come from specialised infrastructure funds or from global project developers who are willing to fund projects and can bring in the capital.

As a country, we may have to accept foreigners owning large chunks of our infrastructure, as is the case today with ports.

Secondly, the big boys of Indian industry will have to get more involved in infrastructure.

Their balance sheets and cash flows have to come into play.

The current lot of entrepreneurs in the space do not have the financial muscle, nor market credibility to fund the needed build out. We have already seen this happen in the power space, with all the top business houses contemplating investments.

Thirdly, markets have ignored the sector, given the poor economics demonstrated.

Most infra projects/developers generate no-free cash flow, have low ROE's and are very susceptible to project delays and policy risk. Investors are tired of projects stuck in red tape or subject to the whims and fancies of ministers.

Most of the large infra projects are also seen to be disguised bets on real estate, as their entire economics depend on the monetisation of some land parcels bundled along with the project.

Unless these project characteristics improve, money will not flow. Investors currently feel that only those developers who can manage the system, can make money in this space. This perception has to change.

We will also see significant concentration risk among a handful of companies.

In the power space, for example, only Reliance Power, Adani, Tata Power and JSPL have a market capitalisation in excess of $5 billion.

Any project above a certain size can only be put up by one of these four. In ports, the only company with a market cap in excess of $1 billion is Mundra.

In roads, only IRB has a market cap in excess of $1 billion. Larsen, with a market cap of $ 21 billion, is larger than all the other infra players combined (excluding the pure-play power developers).

Is the government and public policy environment prepared to have 2-3 private companies dominate every sector? How will banks handle group exposure issues?

India is attempting to implement one of the most ambitious public-private partnership programmes ever conceived.

Driven by a lack of resources with the government, we need the private sector to step up and fund/develop $500 billion of investments over the coming five years.

In a market with ROE's of 20 per cent, investors will not give capital to the infra developers, unless their projects can be seen to deliver similar returns (adjusted for leverage).

Will our public policy framework allow private developers to earn these type of project returns, on the scale needed and will the public be willing to pay the prices for infra services needed to deliver these high returns?

This is a fundamental contradiction and policy dilemma. We are not a capital surplus country, our high cost of capital and high corporate returns, much lauded by investors is actually a disadvantage when trying to build out infra projects.

Investor hurdle rates are too high.

We need a new set of investors, satisfied with steady 12-15 per cent annuity type returns, and willing to sit through multi-year project implementation cycles.

The author is Founder and CEO, Amansa CapitalĀ 

Akash Prakash
Tags: JSPL, ROE, Larsen, IRB, FII