But current projections indicate a massive shortfall in funding – particularly in debt financing – that will require the country to find innovative ways to bring new sources of both domestic and international investment into the marketplace in order to close the growing funding gap.
Setting the stage for investment
To that end, India’s Ministry of Finance recently announced guidelines for two types of Infrastructure Debt Fund (IDF) structures that show significant promise towards creating an environment for attracting new investment into the sector. Both face significant challenges but – if successful – may well provide a framework for future funds, not just for India, but also as a model for the rest of the developing world.
However, India faces a number of fundamental challenges that will need to be overcome for the IDFs to make a positive impact. One is the need for new, long-term investors to participate in infrastructure funding. To date, debt financing has largely been led by the banking sector which – with significant assets already on the books – is fast approaching their debt limits. As a result, the market is looking to new types of investors such as pension funds and life insurance companies who are generally well capitalized and seeking long-term returns.
The country must also seek new ways to reduce the risk of infrastructure investment. In part, this will require new approaches to enhancing the credit ratings of infrastructure projects to make them more attractive to risk-averse investors who are largely unwilling to extend credit to projects outside of the ‘safe’ category of AA or AA+ ratings. For foreign investors, the challenge is compounded by the low credit ratings at the country and state levels, which are generally only slightly above investment grade.
Creating an IDF Mutual Fund structure
Both of the proposed IDF structures may well overcome these challenges. The first is a Mutual Fund style IDF that effectively allows investors to pool their resources across a range of infrastructure assets in order to reduce their risk. Investments can be made in any kind of infrastructure project – from early stage through to late stage – and may be income tax exempt for participating sponsors.
However, the structure also contains certain drawbacks. For example, the entire credit risk would effectively be shouldered by the end-investor with no opportunity for credit enhancement guarantees. The funds will also be limited to Rupee denominated units, resulting in currency risks for foreign investors who will need to include hedging costs into their calculations. This structure may be useful for investors who are willing to bear some additional risk in exchange for a higher return.
An IDF Company
The second planned structure would see the creation of a non-bank finance company (NBFC) that is effectively restricted to investing in PPP projects that have passed the one-year commercial operations date and can therefore offer a very focused investment outlook. It can also put in place credit enhancement mechanisms to attract different categories of investors. As a result, the structure is likely to be able to achieve a credit rating that would be acceptable to risk-averse investors. The NBFC may also issue bonds in both Rupee and foreign currencies, thus further reducing the risk for international investors.
The NBFC will also face a number of challenges. For example, the sponsor will be limited to less than 50 percent of the shareholding, meaning that other institutional investors will be required to take a stake in the fund. The forced focus on late-stage assets also means that investors are effectively limited to government sponsored assets and the market opportunity will therefore be reduced accordingly. The structure is likely to operate on thin spreads, with income tax exemption and lower capital adequacy norms expected to stimulate returns.
Making positive progress
Currently, the market is largely focused on the potential for the creation of a USD10 billion fund through the NBFC model that, at the time of printing, was rumored to involve the government-owned India Infrastructure Finance Company Limited, the Life Insurance Corporation of India as well as a number of other Indian banks like the Industrial Development Bank of India. It is also expected to include the Asia Development Bank as a multilateral and possibly a large foreign bank such as HSBC.
Both options may be pursued in parallel as investors will more than likely find attributes of each that reflect their investment strategy and risk profile. But regardless, the Indian government will almost certainly need to intervene in some way in order to attract the types of stakeholders and investors that will be necessary to overcome the sovereign credit challenges and provide guarantees on bonds for overseas investors.
The path ahead
The next few months will prove to be a critical watershed for the government’s IDF plans as key players review their options and gain clearer insight into the guidelines that have been articulated by the Ministry of Finance.
It seems more than likely that the first batch of IDFs will be dominated by domestic investors but – with growing interest from international investors seeking exposure to the Indian infrastructure marketplace – there is every indication that significant international players will also participate in these structures, both to test the waters and to gain more experience in this rapidly emerging and potentially highly rewarding marketplace.
By Arvind Mahajan, KPMG in India