Project finance is a structure in which financing for the project is secured and serviced by the project’s assets and cash-flows. A typical project finance structure entails no recourse to the promoter’s existing business except that the promoter undertakes to set up the project as planned and invest agreed capital, including estimated cost overrun. Hence, the structure encourages the promoter to undertake larger projects relative to the existing business size.
Such large projects are risky due to uncertainties underlying future assets and cash-flow build-up. If these risks are fully mitigated, the project succeeds and benefits to all the stakeholders are substantial.
In project finance, particularly infrastructure projects, the investment decision is catalysed by financing decisions characterised by high debt levels. Salman Shah and Anjan V Thakor, in their seminal paper titled “Optimal Capital Structure and Project Financing” (1987), observed that high leverage for highly risky project financing is a reward by the lenders for the absence of information asymmetry. This means that in project finance, the lenders’ information of the project must equal that of the promoters. This entails rigorous due diligence by the lenders for project financing and any laxity can cause disproportionate losses to the lenders.
Properly implemented, project financing can help speedy addition of productive assets in the country and catalyse sustained economic development. No wonder, after independence, the country embarked upon project financing as a growth model for financing all types of projects, small and big, through development finance institutions (DFIs), while commercial banks financed working capital.
For small project financing, SFCs were set up, aided by refinancing. Industrial Finance Corporation of India (IFCI) was set up in 1948 to finance medium size projects. The Industrial Development Bank of India (IDBI) was set up in 1964 as an apex financial institution (FI) for large projects.
Industrial Credit and Investment Corporation of India (ICICI), the International Finance Corporation, Washington (IFC-W) backed by private financial institutions was set up in 1955, focusing on private sector project finance.
Growth in Infrastructure Financing
Before 1991, India’s project financing was predominantly in the manufacturing sector. After that, large infrastructure project financing began following the policy changes in the power sector. Later, other infrastructure projects were also awarded under public-private-partnership (PPP) structure.
The power generating capacity of 69,065 megawatts (MW) in FY1991-92 rose to 3,70,107 MW by FY19-20 aided by the private sector (PPP projects), whose capacity addition grew from 2,862MWto 173,308MW during the same period, clocking an 18-year CAGR of 15.8%.
Aided by private sector participation in National Highway Development Programme and state government project awards under PPP, the national road length, which aggregated 2.327mn (million) km in FY1990-91, spurted to 5.89mn km in FY20-21. The telecom revolution, which began with the announcement of the National Telecom Policy in 1994, also catalysed significant investment by the private sector and project financing.
Over the years, the PPP structure was extended to other infrastructure sectors such as airports, seaports, water distribution, railways and other public utilities such as hospitals bus terminuses etc.
Since the PPP projects are amenable to comprehensive risk identification and mitigation in a contractual bundle with government support, these presented enormous business opportunities for the banks and FIs. Hence, large infrastructure projects were undertaken in various sectors such as power generation, transmission, distribution, toll, annuity roads, seaports, airports, telecom services and water distribution with high debt levels from banks and FIs.
A debt-equity ratio (DER) of 70:30 or more almost became a standard for infrastructure project financing in anticipation of steady cash-flows from contractual off-take in case of power projects or anticipated demand or cash-flow levels from other infrastructure projects. As a result, the banks’ exposure to the infrastructure sector grew steadily from the mid-1990s.
In June 2020, the exposure of 14 scheduled banks in infrastructure projects peaked at Rs10.69 trillion (lakh crore), representing a 13-year CAGR of 16.4% (Figure-1).
Non-Performing Assets (NPAs)
Reserve Bank of India (RBI) periodically releases detailed data on the bank performance under the head “Statistical Tables Relating to Banks in India” (STRBs). Bar chart of gross NPA figures of Indian banks from STRB (Figure-2) shows continuing high NPA levels of the banks, whereas the tolerable NPA level is less than 5%.
The STRs do not contain NPA levels specific to the infrastructure sector or type of financing, i.e., project finance, corporate finance, asset finance, etc. However, periodic statements by RBI show that the infrastructure project finance NPAs are disproportionately large.
For example, in his address to the ASSOCHAM’s Sixth International Summit on Infrastructure financing on 15 November 2016, NS Viswanathan, deputy governor of RBI, had stated that “the gross NPAs of the infrastructure sector is about 8% of the total advances to that sector and accounts for nearly 13% of the NPAs of the banking sector.”
Applying the figure of 8% as NPA in infrastructure projects in Figure-1, NPAs in infrastructure projects work out to Rs85.52 billion (Rs85,520 crore) in June 2020. The NPAs primarily relate to the power and road sector, which accounted for 71.5% of the banks’ total exposure to infrastructure project financing.
The gross NPA figures exclude the loans written off and, hence, are understated. Figure-3 shows a spurt in the banks’ bad debt write-offs from FY14-15 onward. The write-offs aggregated a whopping Rs9.08 trillion during the period FY2011-21. If loan write-offs are included, the scenario becomes more alarming. It entails speedy remediation of assignable causes since the economy cannot endure the burden of ongoing bank recapitalisation from taxpayers' money due to perpetually excessive NPAs and abysmal recovery (shown later) from the failed project financing.
RBI’s Asset Quality Review (AQR) of the banks’ assets in FY15-16 uncovered hidden NPAs of the banks. In February 2018, RBI withdrew debt restructuring schemes such as corporate debt restructuring (CDR), flexible structuring of long-term project loans to infrastructure and core industries (5/25 structure), strategic debt restructuring (SDR), and scheme for sustainable structuring of stressed assets (S4A), which aided evergreening of essentially the infrastructure project loans. Hence, the NPA levels now are realistic.
The apparent tapering off of NPAs in FY18-19 was due to the highest ever write off by the banks. The NPAs are primarily attributed to defaults of project finance loans.
But does this confirm the project finance failure? Let us analyse further.
A successful project is one whose enterprise value (EV) exceeds project cost by a good margin. The EV of the project financed company is the present value of free cash-flow to the firm for the economic life of the project company. The value of equity is EV minus debt. This can be represented by a formula as under.
Equity = Min (EV – Debt, 0)
Bankruptcy results when the debt exceeds EV. If the EV exceeds the liquidation value of assets, bankruptcy resolution with debt, equity or assets restructuring is possible. Bankruptcy can occur due to market forces for a carefully crafted project and financing by the banks after requisite due diligence.
However, bankruptcies in project financed entities are relatively fewer, since these are based on proven technologies and operate in mature industries with experienced promoters. The probability of bankruptcy of infrastructure projects, particularly with bankable off-take contracts such as power purchase agreement (PPA), is even lesser except if the PPA is revoked or some unmitigated force majeure events occur.
Bankruptcy of project financed entity during project construction can happen if the project is abandoned due to the business viability for a product being lost, as was seen with the launch of smartphones 20 years ago, but is rare.
In all these cases, the credit recovery depends on EV or liquidation value. Since the project financed entities operate based on current technologies in mature industries with experienced promoters, the credit recovery must be substantial even based on asset values.
Credit recovery in power generation projects should be better since the technologies and engineering do not vary significantly. Do the recovery expectations match the actuals?
Nine projects are resolved out of over 40 power projects admitted for insolvency resolution process under Insolvency and Bankruptcy Code, 2016 (IBC). The anticipated average recovery of the banks from these insolvency resolutions is a paltry 28.9% (table below).
About 30 power projects are under liquidation. Going by the experience of recovery under liquidation (Lanco discussed later), the recovery from these projects is expected to be a fraction of the above.
Such failures in power generation projects that are amenable to effective risk mitigation clearly show that project financing continues to fail in the country.
(Dr Rajendra M Ganatra was managing director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He has over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in the above article are personal.)