Projects Appraisal, Financing and Control Trimester 4 Lecture XVI XVII

Financing of Infrastructural Projects Venture Capital Private Equity

FINANCING INFRASTRUCTURE PROJECTS

Why important? Whats different?

Importance Good infrastructure supports high productivity Poor infrastructure impedes economic growth Whats different Highly capital intensive Long period to recover the cost Long operating life

Why the government?

Earlier in India, when there was dearth of entrepreneurship, capital as well as technology, provision of infrastructure naturally fell in the domain of the government

The Big Change

Traditionally, infrastructure projects in India were owned and managed by the government or a government undertaking. Given the massive investments required for infrastructure, there is now a broad consensus that private sector participation in this activity must be encouraged Private initiative in infrastructure projects can take many forms, ranging from contracted operation of public utilities to full ownership, operation and maintenance of these facilities

What Is PPP?
Broadly PPP refers to a contractual partnership between the public and private sector agencies in which the private sector is entrusted with the task of providing infrastructure facilities and services that were traditionally provided by the public sector. An example of a PPP is a toll expressway project financed, constructed, and operated by a private developer.

According to the Government of India, a PPP project is a project based on a contract or concession agreement between a government or statutory entity and a private sector company for delivering an infrastructure service on payment of user charges. A private sector company is a company in which 51 percent or more of equity is owned and controlled by a private entity.

Relevance of PPPs in India

Recognising the importance of infrastructure, the Government of India (GOI) has stepped up its spending on infrastructure through a series of national programs such as the National Highway Development Program (NHDP), Bharat Nirman, Providing Urban Services in Rural Areas (PURA), Jawaharlal Nehru National Urban Renewal Mission (JNNURM), the Prime Ministers Rural Road Program, National Rail Vikas Yojana, National Maritime Development Program (NMDP), airport expansion program, and so on. However, the estimated investment requirements are far greater than governmental resources. So, the Approach Paper to the Eleventh Plan had argued for reaching out to the private sector and private savings and aggressively promoting private partnership in infrastructure development

EXAMPLES OF PRIVATE INITIATIVE: CONCEPTS OF CONCESSION PERIOD, BOOT & BOT

A typical example is an electricity generation project which the private sector builds, owns, operates for a certain period of time (called the Concession Period) and finally transfers back to the government. This concept is called BOOT. For a road project, the private sector may be invited simply to build the facility, operate it during Concession Period and finally, at the end of the concession period, transfer the facility back to the government (BOT) without actually ever owning the same.

Whats suitable for private sector involvement? Projects designed to provide significant social benefits such as low cost urban transportation system may be more suited to traditional government ownership Projects having strong commercial attraction, like telecommunication, are more suited for private sector involvement

Infrastructure vs traditional project financing

The infrastructure financiers need to carefully evaluate if the requisite regulatory, legal and financing framework exists to support the private sector initiatives in PPP (private public partnership) framework In this context, think as to how the issues bothering the private parties involved in power projects have been tackled in the last decade, in the context of off-take of power by bankrupt SEBs owned by bankrupt state governments in India

Typical Project Configuration

The project is implemented by a Special Purpose Vehicle, which is a distinct corporate entity. Project sponsors take an equity stake in the SPV.

The SPV enters into contractual arrangements with project contractors, offtakers, operators, government, and project lenders.
The dependence on debt is usually high and lenders generally lend on a non-recourse basis. This means that project lenders would not have any fall-back on the resources/assets of the sponsors if the SPV fails to meet debt servicing obligations.

The contracts are as ironclad as possible and are not left to subjective interpretation as much as possible.

Level of acceptable Debt Equity Ratio

For large conventional projects, where project is exposed to pure market risks, DER not > 2:1 In power projects where off-take was assured to the extent of a certain Plant Load Factor, DER up to 2.33:1 was accepted In Indian road projects under BOT arrangement, where there was an assured annuity from the NHAI (National Highways Authority of India) during the concession period, irrespective of the actual level of traffic, lenders might accept DER even up to 4:1

Key Project Parties

Project sponsors Project vehicle (the SPV)

Project lenders

EPC (engineering, procurement & construction) contractor O & M (operations & maintenance) contractor

Government

Project Contracts

Through a comprehensive web of contracts, every major risk inherent in the project is allocated to the party / parties that is best able to assess and manage the risk
The major project contracts are:

Shareholders Agreement
EPC Contract: while sub-contracting is acceptable, it remains the sole responsibility of the EPC contractor to deliver the project to the SPV

Project Loan Agreements

O & M Contract

EPC Contract
An agreement between the SPV and the EPC contractor, that establishes: 1. The latters role from designing all the way up to commissioning the plant 2. Guaranteed minimum performance parameters 3. Penalties/Liquidated damages payable in the event of the plant failing to meet minimum parameters, typically capped at 20-30 percent of the EPC contract value

Governments role
Provision of concession to the SPV Ensures that proper legislative and regulatory framework exists In some cases, like in the electricity generation sector, state governments have guaranteed the performance of the off-take obligations of SEBs, and in certain cases, the central government has counter-guaranteed the performance of the state governments

Some Important Aspects

Separate SPVs ensure that multiple concessions with different or conflicting terms are not imposed on the same SPV. It also enhances the tradeability of these SPVs. As it is not possible to write comprehensive contracts (which can envisage every possible contingency) and monitor them effectively, equity participation of various stakeholders makes them more committed to the project.

Separately identifiable and assured cash flows facilitate a greater reliance on debt in the form of non-recourse or limited recourse financing.

Lenders evaluate the agreements with various Parties in a Power Project

EPC Contractor Sponsors/Other Shareholders Fuel Supplier

Project Company (SPV)

State Electricity Board (Offtaker)

O and M Contractor

Project Lenders

State Government

Important Features of a Power Purchase Agreement (PPA)

PPA establishes The

the conditions under which SPV will sell power to SEB

SEB guarantees a minimum off-take from the SPV or, if it fails to do, a minimum payment to cover all fixed charges inc. depreciation, interest on term loans, fixed O & M expenses as well as return on equity
A

payment mechanism and a security mechanism that ensures availability of payments on time is established. In India, several large projects have been financed on the basis of a 3 tier security mechanism Level 1 : Letter of credit Level 2 : Escrow account Level 3 : Irrevocable guarantee of the state government
The

formula for computing tariffs includes fixed charges, besides variable costs such as fuel cost, as well as performance incentive
Construction

of interconnection facilities, and lastly under conditions of sustained default by the SPV or SEB.

Termination

Some problems with the 3 tier structure

LCs may not get opened by the bank in case of default by SEB The escrow account may not work if there are multiple projects feeding the same SEB and the SEB is being run on non-commercial lines State government guarantees may not be bankable The above position led in some cases to reforms linked financing of these projects, with the lenders disbursing money on being satisfied with the states progress in the area of reforms

Telecommunication Projects

Telecommunication projects are characterised by large project costs, a virtually continuous project implementation (or rollout), long gestation periods, and a dispersed customer base that exposes the project to commercial risks and requires significant marketing and selling budgets. In telecom projects, in practice there can be no single COD ( Commercial Operations Date). In general, telecom projects incur cash losses in initial years and these need to be funded. Unlike a power project which generates reasonably flat revenues and profitability over its life, telecom projects, by virtue of their continued implementation and increase in subscriber base demonstrate increases in profitability over a period of time. Private telecom projects operate under a license from the Department of Telecom and the projects framework is determined by the conditions of the license.

Factors considered by Project Financiers in a Telecommunication project

Conditions imposed by the license Equipment supply contract(s) Financial strength of the project sponsors

Business plan assumptions: the project financiers need to be aware of the experience in other countries that have deregulated telecom markets and test the projects assumptions against empirical evidence available from these markets Competitive environment

Telecom regulations: since it is likely that regulatory framework would undergo continued shifts, the lenders need to take an educated view on how regulations would evolve rather than assume a stable environment in future

Financing Telecommunication Projects

In general, telecom projects incur cash losses in initial years and these need to be funded. In determining a telecom projects cost, lenders follow the concept of peak Negative Cash Flow Period, which determines the maximum period over which the project requires external cash infusion and the total external financing requirements during the period. Given the long gestation periods and the commercial risks, project lenders in India have funded telecom projects on a lower debt-equity ratio (DER) around 1:1

Infrastructure Financing Scenario in India

Due to their complex nature, infrastructure projects have historically been funded by banks and financial institutions, with SBI, IDFC, ICICI, IDBI, and PFC being the key financiers. In recent times, there has been an increasing interest from the capital markets in financing equity requirements in well-structured infrastructure projects. Banks have become more responsive and are now willing to lend up to tenors of 12 to 20 years. A large part of the Golden Quadrilateral is based on a fixed annuity payment to contractors on a build-operate-transfer (BOT) model.

An operate-maintain-transfer (OMT) model is emerging for road financing. Under this arrangement, the government funds the road while the contractor operates and maintains it for a fee and then transfers it for a fee.
There has been a fair amount of action in seaports in the last few years Telecom operators in the private sector have been funded by debt and equity, coming in good measure from foreign sources.

Managing Risks in Private Infrastructure Projects

Construction Risk manage through EPC contracts
Operating Risk - mitigate through competent O&M contractor Market risk - govt. to guarantee minimum payment in road project

Interest Rate Risk transfer risk due to floating rate by tariff formula to treat it as pass through cost Foreign Exchange Risk tariff formula to adjust for forex fluctuations impact on forex loans Payment Risk escrow account Regulatory Risk favours countries with strong and independent regulatory bodies

Political Risk could be partially mitigated though political risk insurance offered by some multinational organizations

Recommendations of the Committee chaired by DeepakParekh on Infrastructure Financing

1. Develop a deep and robust debt market 2. Tap the potential of insurance sector 3. Enhance the participation of banks, financial institutions and large NBFCs

4. Provide fiscal incentives

5. Facilitate equity flows 6. Induce foreign investments 7. Utilise a small portion of foreign exchange reserves for infrastructure development

VENTURE CAPITAL
AND PRIVATE EQUITY

VC Investors

VC funds may be described as pools of capital constituted for investing in relatively high-risk opportunities in anticipation of potentially high risk adjusted rates of return. VC funds are usually committed for extended periods of time, ranging from seven to twelve years. Most VC funds are not listed on any exchange or do not have an alternative secondary market mechanism. Investors in VC funds are institutional investors and high net worth individuals. VC funds are usually independent in the sense that they do not represent or subserve the strategic interests of any of the investors in these funds. Managers of VC funds charge investors a fixed annual fee, usually 2.0 to 2.5% of capital under management. They also get a performance incentive, which may be about 20% of the capital gain realised from the investments.

What Is a VC Investment

The popular impression is that VC is synonymous with financing of technology-centric businesses or innovative and hitherto untried business ideas. In reality, VC is a broader and much more flexible form of financing.

VC investments usually involve

Business with high growth potential in terms of sales and profitability Investment horizon of 2 to 10 years

High risk levels

Equity or quasi-equity financing instruments Active investor involvement

The Key is superior returns

What Makes a VC Investment Different

High Uncertainty Levels

Technology risk
Product market risk Management risk

Most often the technology, product or management would be untried

The VC Investment Appraisal Process

Detailed assessment of business and management:

1. Sometimes, the performance parameters in the business plan are incorporated in the formal contractual agreements between the investor and the management 2. The management team is evaluated very carefully 3. The key question that is sought to be answered is whether the company will have a SIZEABLE share of a LARGE market OVER A 3-5 YEAR PERIOD, based on an UNASSAILABLE COMPETITIVE POSITION

Consequently, will the market share produce a super normal growth in profit and shareholder wealth?

The VC Investment Appraisal Process contd. Valuation of VC transaction

valuation of the investment is more important to VC than any other aspect

The method of valuation of a VC transaction is given in the next slide It is assumed therein that the market value of the firm is equal to the value of the equity of the firm, which is a reasonable assumption in a VC financed transaction

Valuation of a VC Transaction
Most used method of valuation involves the following steps: 1. Identify the amount of capital to be invested by the investor: I0

2. Identify the target rate of return expected by the investor: r (depending on stage of invt., likely holding period, riskiness, etc) 3. Estimate the multiple of the original investment that will fetch the required rate of return over the anticipated holding period: Sn = I0 (1 + r)n 4. Project the market value of the firm based on performance projected during the proposed year of exit: this would be a multiple of an appropriate metric like EBIDTA: Vn 5. Estimate the percentage of the projected value that the investor needs to claim in order to achieve his return objective 6. Express percentage of equity to be owned by VC as price/share

Valuation Exercise
Given the following: Capital to be invested by investor (I0) = Rs 50 lacs r = 50% Anticipated Holding Period (n) = 3 years Projected market value of firm after 3 yrs (Vn)=Rs 6.75 cr Capital proposed to be issued = 10 lac shares of face value of Rs 10 each Assume that the market value of the firm is equal to the value of the equity of the firm Find out the premium per share which the VC investor would be willing to pay

Solution
Sn = I0 (1 + r)n = Rs 1,68,75,000
Percentage needed = 1,68,75,000/6,75,00,000 = 25% No of shares required = 2,50,000 So, the investor will ask for:
2.5 lac shares for Rs 50 lacs i.e. 2.5 lac shares for Rs 20 each i.e. 2.5 lac shares at a premium of Rs 10 each

The VC Investment Appraisal Process contd.

Deal structuring
While doing this, the VC investors also build in performance incentives for management These may include:

1. Options to subscribe to additional equity at low valuation 2. Allotment of new shares in recognition of managerial or technological contributions, for considerations other than cash 3. These incentives would be tied to pre-identified milestones, like profit targets, agreed upon

The VC Investment Appraisal Process contd.

Investor investee relationship: As the motivations and goals of the investors and the entrepreneur may differ, for example the investor requiring a timely exit, the detailed shareholders agreement provides for such eventualities Post financing relationship: The VC involves himself at 2 levels, both for strategic decisions such as constitution of the board, and monitoring role to ensure that the investors are not adversely impacted, say by a business diversification plan. These are done by having directors on the board Exiting from investments: While the common exit routes are via IPO or bringing in a Strategic acquirer, the exit option is secured through investment agreement

Six Stages of Venture Capital Financing

1. Seed Money Stage: Takes care of small volume of funds to say develop a product
2. Start Up: Takes care of funds for marketing & product development, typically for firms less than 1 year old 3. First-Round Financing: Additional money to begin sales etc.

4. Second-Round Financing: Funds required by a company selling its products but losing money
5. Third-Round Financing: Post break even for expansion

6. Fourth-Round Financing: Financing a firm expected to go public in about 6 months time

VC and PE A Comparison
The distinctions between VC and PE (private equity) are summarised below:

Feature Investment Target

VC
Early stage businesses, expansion Innovative products, services, technologies Heavily dependent on external

PE Later stage businesses,involves operational or financial

restructuring, with or without

management team and / or ownership changes Mature products,services

financing
Unlisted companies

Generally have large cashflows

May be listed or unlisted Horizon Medium to long term: Three -eight years Medium: Two -five years

Risks

May be one or more of technology, product development, market response to product / service, management, operational and illiquidity of investment Equity or equity type instruments such as convertible debt or preference shares Syndication of investment, if any, among fellow VCs

Usually limited to product- market risks and does not involve the other elements listed in the case of VC

Structure

Equity and debt combinations. Debt is usually high risk, of speculative grade Syndicate may include institutions such as insurance companies and banks, who are primarily lenders
Active but less than their VC counterparts. Involvement mainly limited to ensuring high quality governance

Post Financing Engagement

Active-encompasses board composition, top management team recruitment, strategy formulation and internal systems processes and controls

Investment Management Team

Former managers and entrepreneurs with tremendous experience and vast, powerful networks to professional and industrial circles, primarily keeping in mind the post financing engagement needs Largely in the USA and to some extent in the UK, Canada, Singapore, Israel and Japan. What goes on in the name of VC elsewhere in the world is largely PE. Started as VC in India, evolved into distinct activities from late nineties

Primarily, former financial market professionals

Prevalence

Prevalent in the USA, Continental Europe, Asia Pacific, Japan and many emerging markets

PE firms
Private equity funding has been gaining importance in India during the last few years. The starting point of PE funding is a term sheet which reflects the understanding reached between the PE fund (the investors) the promoters, and the company. It summarises the terms and conditions for the proposed investment in the company. It is followed by due diligence and then by the Shareholders Agreement and/or Share Subscription Agreement. Finally, the provisions of the Shareholders Agreement are included in the Articles of Association of the Company.

Term Sheet

The standard term sheet covers the following: Company Promoters Investor Quantum of Investment Investment instrument

Pricing of instruments Conditions precedent Deployment of fund Conditions subsequent Shareholding pattern Board representation by the investor Pre-emptive rights of the investor Promoter lock-in and investors Right of First Refusal (ROFR) Investors veto rights Investors exit rights Non-compete and non-solicit Representations and warranties Auditors Due diligence Definitive documentation Confidentiality Exclusivity Validity Governing Law

The Indian VC Industry

Prior to the formation of VC institutions, Indian development finance institutions provided risk capital to industry. However, they did not follow the rigorous processes that a modern day VC would follow.
ICICI Ventures (formerly TDICI Ltd) was the first VC institution in India set up in 1988. International investors emerged as more significant players from the mid 1990s. They introduced the western investment philosophy and processes into their transactions with Indian companies. Rigorous due diligence, tight contracting, active post financing involvement,and a sharp focus on timely and profitable exit are among their more important contributions. The investment preferences of VC investors have constantly evolved over the years . Over the years there has been a shift in favour of financing the expansion plans of firms already in operation as opposed to greenfield ventures or start ups. In the early years in India, the industry was characterized more by VC style investing in small, early stage companies. More recently PE type investments have become far more common.

Regulation of VC Industry in India

Broadly the SEBI (Venture Capital Funds) Regulations,1996 purport to ensure that:

VC funds do not access public investors who may not have the capability to assess the risks underlying investment in VC funds. VC funds invest in unlisted companies that are not in a position to access public financial markets.

Section 10(23FB) of the Indian Income Tax Act, 1961 exempts the income of VCF funds by way of dividend and long-term capital gains from tax. The tax exemption is available to VC funds registered with SEBI. The investment activities of funds registered outside India and investing in India are regulated either by the foreign direct investment regime (FDI) in India or regulations governing foreign institutional investors (FIIs) who are registered with SEBI.

Current Concerns of the Indian VC and PE Industry

Uncertain implications of the current slowdown in the global economy. Dilatory contract enforcement. Shortage of managers.

Lines getting blurred: Private equity firms turning incubators

While VC and PE firms have their respective spaces in the financial world, the line between them gets blurred at times In mid-2009, when the logistics-focused private equity (PE) fund Tuscan Ventures Pvt. Ltd, was looking to invest in a cold storage chain that it could scale up, there was one glitch: there weren't any such firms around. There weren't companies available with the scale and management depth to create footprints. So Tuscan did the next best thing: it launched its own cold storage chain, Cold Star Logistics Pvt. Ltd. In doing so, Tuscan went beyond the traditional role of PE firms--investing in companies, preparing turnaround strategies, helping firms expand, backing good management teams--into the preserve of VC firms: incubation. The PE firms may start companies, when gaps in industries become evident. Tuscan Ventures is not the first one to do so. In 2008, IDFC Private Equity Co. Ltd, the PE arm of Infrastructure Development Finance Co. Ltd, started a renewable energy company called Green Infra Ltd after it failed to find any investment opportunities in the space it could scale up. This only shows how the lines are blurring between PE firms and VC funds, which are now often doing late-stage PE- type deals.

Private equity firms turning incubators .. Contd.

Faced with a marketplace that is low on deals, or only has deals at high valuations, but offers niche and sunrise sectors that have a higher growth potential, it might make sense for PE firms to step into the gap. It is important to note that incubation allows a firm to capture 100% of the economics and retain all the value. But sector expertise is a pre- requisite for such incubations. IDFC Private Equity and Tuscan Ventures are specialists in infrastructure & energy and the logistics spaces, respectively.

If you are approaching a VC fund

1. You could avail the services of investment bankers who specialize in VC/PE fund raising. 2. Different VC funds have distinct investment focus areas in terms of industry sectors, stage of evolution of companies in which they would like to invest ,the amount of financing, and the extent of post financing involvement that the investor wishes to adopt 3. More important than anything, present an exciting and convincing story, as the VCs select a very small number of companies to invest in, out of the very large numbers of applications that they receive