The Road To Bankability

In road projects where the investment risks are unknown, financial engineering and packaging are the key to making them bankable. Some projects have done just that. These include highways, bypasses and bridges in the state and central sectors.

So far, about 81 projects have been offered for private investment. Of these one has been financially closed, and another two are nearing financial closure. This is despite financial institutions (FIs) initial reluctance in funding such projects. The projects that has been financially closed is the 16 kilo metre stretch on National Highway 6 -- the Durg bypass. For the remaining, which include both four laning and new bypasses/bridges, there are a series of bidders -- including the big names like Larsen & Toubro, Gammon Engineering and Reliance Industries Limited.

 

FI s have hesitated funding such projects on a without recourse format. This would imply that FIs would receive revenues only from the revenue streams of the project. Accordingly, they would have to take project-specific credit risks. Given the current state of the financial markets, none of them are prepared to assume such project-specific credit risks

This is especially because road projects do not strictly involve any underlying assets. Typically, in road projects, the operators have no ownership of the land. The title deed of the land belongs to the government. Consequently there are no physical assets that can be mortgaged. But not all FIs are looking only for physical assets.

There are essentially three methods that have been used in project financing highways -- full recourse methods reinforced with guarantees, a partial recourse method and a completely non-recourse method. The latter two methods imply that creditors would have to take a part project risk or take a risk on the project promoters or rely on the traffic guarantees for minimum cash flows. It would not have all three. In the last structure, there are no guarantees of any kind.

FIs like HUDCO have chosen the full recourse method. HUDCO which financed the Pali bypass in the state highway in Rajasthan used a negative lien method and combined it with a state government guarantee and a corporate guarantee. The corporate guarantee for the borrowings of Rs 5 crore by the special purpose vehicle or holding company for the project was provided by Transport Corporation of India. The state government guarantee for the project is in the form of a traffic guarantee. This guarantee is to assure a minimum cash flow to generate an internal rate of return of about 17 per cent.

Big companies, however, do not prefer this kind of funding method. L&T, for instance, has used a completely non-recourse format for funding two of its projects. L&T's project costs for the two road projects, the Coimbatore bypass and the second Narmada Bridge, have been estimated at Rs 212 crore. Neither of these projects has a guarantee from the National Highways Authority of India. In addition, the debt portion of the funding will also not be guaranteed by the parent company. And it is in this format that the project is at the stage of being financially closed.

For L&T, the key to keeping costs down is to keep the capital costs to the barest minimum. It has accordingly decided to take advantage of Section 10(23G) of the Income Tax Act which permits certain infrastructure projects to pass the benefits of tax breaks to debt investors. Accordingly, L&T now proposes to raise debt finance, which is upto 70 per cent of the project cost, through tax free bonds of upto Rs 150 crore. So the debt financiers, or in this case the bond holders, would have to completely rely on the cash flows of the project.

But such structures are possible only in projects in which the cash flows are assured. In the Coimbatore bypass project these cash flows are virtually assured since L&T enjoys a virtual monopoly structure on both National Highway no 47 and the second bridge over the Narmada on National Highway number 8. Although the project concession is for a period of 30 years , L&T has chosen only a 12-year concession period before which it hopes to recover a project IRR of 18 per cent and an equity IRR of over 23 per cent.

L&T has chosen this structure because it would have had to share revenues with NHAI if it opted for a traffic guarantee mechanism. NHAI's method of meeting its obligations as a guarantor is by offering a five per cent cut off limit, which means it will step in to meet the cash flows of the project operators if traffic flows fall below five per cent of the initial projections. On the other hand, if the traffic flow is above five per cent, then the operator is expected to share as much as half the revenues with the guarantor.

Project operators who have high IRR targets have preferred to opt for the completely non-recourse structure, which is based on the maxim of high returns for high risks, which is exactly what L&T has done.

But smaller operators, like those involved in the Durg bypass which has just been financially closed, have adopted a structure close to a limited non-recourse format (see chart: The Durg Option). This project has a total cost element of Rs 70 crore. The project operators -- Shaktikumar Sancheti Ltd -- have invested about Rs 16.8 crore and another Rs 4.2 crore is to be invested by NHAI. The limited non-recourse format has been in such a way that the project operator does not have any traffic guarantees.

However, for the comfort of the lenders, NHAI is to be one equity partner. In addition, NHAI is to provide a backstop facility which would be used to meet the creditors payments in case of a shortfall in the project revenues. These funds are to be provided in the form of subordinated debt to the project.

This would ensure that the bankers have the first right over the revenue flows of the project, and NHAI would function only as a secondary creditor with a secondary lien to the project's revenues. The NHAI backstop facility would be priced at the weighted average cost of all debt, sources said. This kind of a structure has made the project bankable even without any guarantees. Accordingly debt finance for the project was syndicated by the State Bank of India (SBI) for Rs 49 crore.

However as far as investors are concerned what also makes the difference is the cost escalation factor, especially operation and maintenance (O&M) costs. In road projects, depending on the location the O&M costs could vary. In coastal areas and flood prone regions it could be as high as 30 per cent, whereas in other areas it could be as low as 10 per cent. Accordingly tariff structuring has been done on the basis of high weightage of fixed costs which include a minimum return 18 per cent on the capital.

For ensuring this, projects have an escalation factor, which allows operators to increase tariffs based on the kind of cost escalation. In the case of foreign currency funding, the escalation could come in the form of currency fluctuations and in the case of domestic funding , the escalation could come in the form of interest rate increases, wherever the funding has been provided on a floating rate basis.

In addition there are bound to be increases in O&M. These escalations are however done not on a direct pass through basis . Instead the tariff hikes are linked to the wholesale price index. Each year, tariff increases are permitted to the extent of cent per cent neutralisation of the WPI.

It is given this kind of format that investors are beginning to look at for highway projects. Despite the misgivings, the risk return ratios for road projects are proving to be extremely attractive.