India's booming infrastructure sector was given a further boost in the recent budget with the government committing to use the country's vast foreign exchange reserves to expand its building programme.
The Reserve Bank of India (RBI), which sits on nearly $200 billion of reserves, will support the infrastructure financing activities of two overseas subsidiaries of the state-owned India Infrastructure Finance Co. Ltd (IIFCL).

These vehicles are expected to start getting involved in infrastructure funding this year, according to industry sources. They may borrow directly from the central bank or the RBI will use its reserves as collateral for foreign exchange denominated loans which could create openings for greater participation in the local market by foreign banks, which have so far failed to make much of an impact.

Another possibility is that the IIFCL subsidiaries will issue bonds, which the RBI will buy. Although exact details as to how any of this will function have yet to be finalised, funding will be aimed at core projects, particularly those that have an external borrowing requirement such as when a projects needs imported equipment.

Some critics contend that the government would have done better to concentrate on simplifying bidding procedures to speed up development. Nevertheless, local reports suggest the scheme could make $5 billion-$10 billion available in funding each year, although not all of it would go towards domestic infrastructure projects.

Loans would be available at highly competitive rates. The IIFCL subsidiaries may loan the funds directly to project sponsors. Another prospect is that one of the IIFCL vehicles could act as a monoline insurer by guaranteeing foreign exchange borrowings of project sponsors.

The initiative should go some way to help meet the government's estimated need for $300 billion-$350 billion to fund infrastructure over the next five years. This is crucial to sustain economic growth rates of 7%-8% a year. However, the government is also committed to reducing its budget deficit by 0.3% GDP every year until 2009. So like other countries India is turning more and more to the private sector to help deliver on its infrastructure commitments.

PPP development

The Indian infrastructure story is gaining a following from private equity. The most high profile case is that of Blackstone Group, which has formed a $5 billion infrastructure fund with Citibank, IIFCL and the India Development Finance Corporation (IDFC). Others such as Warburg Pincus and Carlyle Group are also looking at infrastructure opportunities and with internal rate of returns (IRR) on infrastructure deals ranging between 15-20%, more will follow.

To date most of the country's PPP infrastructure development has been domestically financed with around 30 local banks active in infrastructure finance. But more foreign banks are getting comfortable with Indian risk again: India's sovereign rating was upgaded in January to BBB-, the lowest investment grade, from BB+ and even monoline insurers are studying the Indian market with interest.

The most mature and most active PPP sector is roads. Tender processes are more straightforward than for other PPP projects due to the National Highways Authority of India's (NHAI) experience in this area.

Debt tenors and margins are comparable across the infrastructure sector. The deciding factor is usually the quality of the sponsor, notably their record on delivery and their balance sheet. Consortia often involve banks and increasingly private equity firms, which can lend the strength of their balance sheets to projects. Indeed, a developer with a strong track record and robust balance sheet can shave 50 to 75 basis points off the cost of funding.The quality of the project is also important, particularly the strength and reliability of revenue streams.

However, road projects are achieving higher levels of borrowing. There have been instances where equity has reached as low as 5% with 20% subordinated debt and 75% senior debt. For other types of infrastructure projects the equity tranche can range from 25% to 40% with the balance being debt. Tenors are generally 12-15 years, although with roads there have been 20-year deals. Concession periods are also usually around 20 years and it is quite common for sponsors to refinance the project within the first five years post-construction. The surplus funds left over from re-paying the old loan are often used to fund equity stakes in new projects.

Margins range from 250bp to 350bp over 10-year government securities and the debt is normally floating rate. Within the last three years, margins have tightened by 50-100bp due to greater competition and the banking sector's increasing confidence in PPP. Subordinated debt tranches, which have been used more in the last two to three years, are 100-200 basis points more than senior debt.

Roads, ports, airports

PPP road concessions, which are done on a BOT basis, tend to fall into two categories – those that are on a tolled basis and those that are paid for on an six monthly annuity. In the first instance, the sponsor takes on construction and commercial risk. For these roads, depending on their commercial viability, the government can provide a grant up to 40% of the project's value.

For annuity roads, the consortium bears construction risk only. These roads are built more for social reasons and are not deemed to be commercially viable as toll roads.

The basis for winning the concession comes down to bidding the lowest toll rates and or grant. In the case of a annuity project, excepting the lowest annuity is the decisive factor. The combination of technical and financial competence is also considered.

In many cases where the commercial case for toll road is particularly strong, bidders often bid for "negative grants". They effectively pay the NHAI for the concession. This can occur with lane widening projects on highways with well-established traffic densities.

Port projects are structured on a revenue share basis. These projects along with airports are still attractive to sponsors simply because their is so much pent-up demand. Indeed, many are already operating close to full capacity and need to be expanded urgently.

However, there have been difficulties with structuring concessions. Sponsors have complained that risk sharing agreements need to be made more equitable and bidding procedures are complex and time consuming. Tackling entrenched labour practices within some of the ports has also been challenging.

One project that has undergone a tortuous process towards PPP is Dhamra Port. It has taken years to sort out the concession although it finally looks set for financial close around May when ECA funding, arranged by BNP Paribas, will likely sign: a lending consortium led by Industrial Development Bank of India (IDBI) agreed terms on the commercial debt in late February.

Sponsored by Larsen & Toubro and Tata Steel, the project is expected to cost an estimated Rs24.6 billion ($573 million). The port will have 13 births handling over 83 million tonnes of cargo a year.

The equity part of the funding will be 40% and will be sourced from the sponsors in form of promoters' equity, preference shares and mezzanine debt. The project is structured on a build, own, operate, share and transfer (BOOST) basis. The concession period spans 34 years including a construction period of four years. There is also an option to extend the concession by another 20 years.

Interestingly, the State Government adopted a variable revenue share model for funding the development and operating of the port. For the first five years, the sponsors will share 5% of annual operating revenue with the Orissa government. It then steps up to 8% and after 10 years will reach 10%. From the 16th year until the end of the concession period, the revenue share will reach 12%. Also, tariffs will be market driven as this is classified as a minor port – larger ports come under the jurisdiction of the Tariff Authority for Major Ports (TAMP) and thus minor ports have more pricing flexibility to respond to market changes and are therefore more attractive to project sponsors.

"An area of concern for the authorities has been the revenue share which has been going up in favour of the sponsors," says Arvind Mahajan, Head of the Infrastructure Advisory Group with KPMG.
For example, upgrading Chennai Port, which was awarded in 2002 and led by P&O Ports (now Dubai Ports World), is on a 37% revenue share basis. The Kandla Port – sponsored by ABG Heavy Industries and Voltri Terminal of Italy – awarded around 2004 is on a 49% revenue share basis.

In the airport sector two major deals are awaiting imminent financial close. In December the Ministry of Civil Aviation agreed to a greenfield site for a new airport for Mumbai. It is to be developed on a 30-year concession at an estimated cost of Rs42.35 billion ($1 billion). UDBI and UTI Bank are lead arrangers. Mumbai airport revenue share is 38.7%.

The Airports Authority of India (AAI) and the City and Industrial Development Corporation of Maharashtra hold 13% each while the private investor GVK-Airport South Africa will take 74%. The concession is expected to generate an IRR of around 18% over the life of the concession.

The New Delhi concession was won by GMR-Fraport with ICICI Bank being the sole lead arranger. This will involve a Rs85 billion ($2 billion), upgrade. This will involve building a third terminal constructed within the next three years and a new runway by 2008 to ease congestion.

The revamp will enable to airport to handle 37 million passengers, compared with 16 million currently. The revenue share component is 46%. It is higher than for Mumbai airport as New Delhi is not a greenfield project and therefore seen as less risky.

Funding guidelines

As PPP expands, central bank rules could constrain lending in the future, according to developers. Generally speaking Indian parent companies carry little debt and enjoy high credit ratings. Debt is generally carried on the books of subsidiary companies.

In the case of infrastructure financing, developers usually form SPVs, which hold the project debt. Even though the loans are on a non-recourse basis central bank guidelines nonetheless still classify these loans as group exposure. This therefore limits the amount commercial banks can lend to these firms. "In three to four years time companies could start hitting their borrowing limits," says Shekhar Damle, Head of Project Finance with engineering and construction group, Larsen & Toubro Ltd. "We have lobbied the government so that project loans should not be shown as group exposure, because the loans are government-backed anyway." In case of a force majeur the government would buy out a high percentage of the loans. On the other hand equity holders would not be compensated.

Although this is an issue, sponsors can pool their SPVs into specialist companies and float them on the stock market. And this is already beginning to happen. Currently, the main motivation is to recycle capital. In future, if central bank guidelines aren't changed, the main driver would be to free up the balance sheet for further borrowing.

Also, as the pool of projects grows industry sources expect a significant market to emerge for bonds backed by project revenues. The country has a large insurance and pension company sector eager to invest in higher yielding, but safe investments.

The number of new infrastructure projects coming through the pipeline this year and beyond will be considerable. This implies huge demand for funding. Indeed, if the government uses the country's foreign reserves to make it cheaper and easier for the domestic market to tap external borrowing, the possibility of a boom in , and demand for, foreign bank infra lending to Indian projects is very real.