Infrastructure Project Finance

Traditional opinion has it that infrastructure is the heart of the economy and investors prefer to invest their money in countries whose infrastructure is more developed. Rapid infrastructure development is thus one major way a country can take advantage of economic opportunities. Countries around the world focus heavily on building infrastructure.Developing countries like India have also announced plans to spend billions of dollars in order to build and upgrade their infrastructure. Hence, infrastructure and its financing are important issues all across the world regardless of whether the nation is developing or developed.

Subcontracts India provides project owners / sponsors / promoters a much needed infrastructure project financing gateway to investors and financiers. We have been at the forefront of several project financing transactions across various sectors of the economy around the globe. Our project financing services are particularly beneficial to shovel ready or green shoot projects. We have the means as well as the necessary expertise to approach numerous Banks, Investment Bankers, Non Banking Finance Companies (NBFCs), Financial Institutions (FIs), Venture Capitalists (VCs), Private Equity Investors (PE), Ultra High Net Worth Individuals (UHNWIs), Family Businesses, Hedge Funds, Pension Funds, Underwriters, Insurance Providers, etc. with great speed and efficiency. We understand how these fund providers and investors work and what are their main areas of interest. Targeting the right source is not just important but also crucial for achieving successful financial close. 

Subcontracts India offers:

• Identification of infrastructure projects with a Cash Flows Generating component and bankability potential;
• Support of infrastructure project development to achieve bankability;
• Preparation and structure of transaction by leveraging our consulting, financial and legal expertise; 
• Finding the right investor and achieving financial close;
• Support to the client through the project execution and construction phases. 

We can be present with our services across the entire project lifecycle:

1. Strategy and planning: Assisting long-term planning of individual projects or a portfolio by focusing on feasibility, alignment with corporate objectives and governance procedures in order to maximize return on investment.
2. Financing and procurement: Raising project finance; establishing and managing the procurement process to acquire services, material or equipment to deliver the project, and prioritizing capital allocation between projects.
3. Project organization, execution and construction: Setting up the project for success and strengthening client capabilities to deliver on time and to budget.
4. Operations and maintenance: Assessing ongoing lifecycle costs and providing insights around optimizing the performance and value of assets in operation.
5. Asset recycling, concession maturity & decommissioning: Determining when and how to discontinue investing in an asset, and transaction advisory services for investors in infrastructure assets.

The key reasons for the underdevelopment of project financing lie in insufficient project maturity and inability to develop projects to the level necessary to achieve bankability. Access to finance is one of the main reasons that infrastructure projects are not developing faster and the key stakeholders sometimes do not see a business case for financing. Moreover, lack of know-how and competence of key stakeholders require a complex multidisciplinary approach in order to guarantee project execution.

Projects, however, are funded solely on their merits. Although we do not make claims of 100% success rate in our pursuit of project finance, with our expertise and experience, our clients enjoy a definite advantage in terms of getting their projects successfully funded. The following are extremely important for achieving successful financial closure.

Business Plan & Pitch Deck

We have been consistently endeavoring to simplify the process of raising Project Finance for the project promoters and owners across the world. While discussing Project Finance, the significance of submitting a concise yet profoundly informative Project Proposal or Business Plan cannot be overestimated. Fund Providers as well as investors want to see a business plan that is short enough to engage investor interest and yet long enough to cover all vital project information.

We realize that it is not easy to put a winning Business Plan in place unless the Business Plan writer has been thoroughly acquainted with the project right from its inception. There are numerous consultants who would accept any Business Plan compiled by anyone. However, we generally do not. Project Finance is a challenging task and our experts would like to do it in a highly evolved manner so that chances of successful financial closure is extremely high. We accept a Business Plans compiled by either a competent project management team or a professional financial services provider with history of handling financial modelling for projects. Financial modeling combines accounting, finance, and business metrics to create an abstract representation of a company in Excel and has a wide range of uses, including making business decisions at a company, making investments in a private or public company, pricing securities, or undergoing a corporate transaction such as a merger, acquisition, divestiture, or capital raise. 

We also need a Pitch Deck. A pitch deck is a brief presentation, often created using PowerPoint, Keynote or Prezi, used to provide your audience with a quick overview of your business plan with visual enhancements such as graphs, charts, and pictures. You will usually use your pitch deck during face-to-face or online meetings with potential investors, customers, partners, and co-founders.

Financial Modeling 

Financial modeling, often considered synonymous to financial statement forecasting, is an effective tool for providing a clear picture of the forecasted financial performance of a company. The process results in the construction of a mathematical model that assists in firm’s decision making as well as financial statement analysis. The importance of financial modeling is mainly rooted in its capability to enable better financial decisions within a firm. It is widely used by organizations for the purpose of future planning. By simulating the impact of important variables, financial modeling allows for scenario preparation so that organization knows its course of action in various situations that may arise. Investors, banks and authorities require robust, reliable, flexible and easily understandable financial models to make key decisions. Our experts build customized models for your specific project following the industry’s best practices. Our models have successfully passed external audits and the closings of many project finance transactions are a testimony of their quality, accuracy and robustness.

Financial modeling also plays an important role in capital budgeting. Not only does it make financial statement analysis and resource allotment for the next big investment easier, but it also helps in determining the cost of capital. It provides a thorough analysis of debt/equity structure for this purpose, along with the returns expected by investors. 

We realize forecasting a company’s operations into the future can be very complex since each business is unique and requires a very specific set of assumptions and calculations. We generally focus on the following:

1. Historical data – input at least 3 years of historical financial information for the business.
2. Ratios & metrics – calculate the historical ratios/metrics for the business, such as margins, growth rates, asset turnover ratio, inventory changes, etc.
3. Assumptions – continue building the ratios and metrics into the future by making assumptions about what future margins, growth rates, asset turnover, and inventory changes will be going forward.
4. Forecast – forecast the income statement, balance sheet, and cash flow statement into the future by reversing all the calculations you used to calculate historical ratios & metrics. In other words, use the assumptions that you made to fill in the financial statements.
5. Valuation – after the forecast is built, the company can be valued using the Discounted Cash Flow (DCF) analysis method. 

Check some recurring valuation mistakes related to financial modeling

Structuring

The structuring of project financing is a framework in which ownership structure, project structure, risk structure, and financial structure decisions are made and tied together in the project's legal structure which, in turn, forms a foundation for funding the project on a limited recourse basis. The ownership structure is how the special purpose company/vehicle (SPC/SPV) is organized; that is, as a corporation, unincorporated joint venture, limited liability partnership, etc. Project structure on the other hand refers to the agreements defining responsibilities and transfer of rights and/or ownership of the SPC/SPV such as build, operate, and transfer of ownership (BOT), build, own, operate, and transfer (BOOT), build, lease, and transfer (BLT), etc.

Risk structure is the prioritization and mitigation of risks after the identification, assessment, and allocation process is completed. The project's legal structure is the web of contracts and agreements negotiated to make financing possible. Financial structure refers to the mix of financing used to fund a project, which includes equity, short‐ and long‐term loans, bonds, trade credits, etc. and the cash flows to equity providers and the lenders.

A special purpose vehicle (SPV) project company with no previous business or record is necessary for project financing. The company’s sole activity is carrying out the project by subcontracting most aspects through construction contract and operations contract. Because there is no revenue stream during the construction phase of new-build projects, debt service is possible during the operations phase only. For this reason, parties take significant risks during the construction phase. Sole revenue stream is most likely under an off-take or power purchase agreement. Because there is limited or no recourse to the project’s sponsors, company shareholders are typically liable up to the extent of their shareholdings. The project remains off-balance-sheet for the sponsors and for the government.)

Project Risk Identification, Analysis, Mitigation, and Allocation

We assist our clients with arriving at a comprehensive risk management strategy. The core of Project Finance is the analysis of project risks, namely construction risk, operating risk, market risk, regulatory risk, insurance risk, and currency risk. There are risks related to the pre-completion phase such as activity planning risk, technological risk, and construction risk or completion risk. Then there are risks related to the post-completion phase such as supply risk, operating risk, and demand risk. And then there are risks related to both phases such as interest rate risk, exchange risk, inflation risk, environmental risk, regulatory risk, political risk, country risk, legal risk, and credit risk or counterparty risk. These risks are allocated contractually to the parties best able to manage them. The process of risk management is usually based on the following interrelated steps:

• risk identification;
• risk analysis;
• risk transfer and allocation;
• residual risk management;

Essential to structuring a project finance package are the crucial elements of successful identification, analysis, mitigation and allocation of project risks. These risks are related to events that could endanger the project during development, construction and operation.

During the development stage the main risk is rejection by the host government or by the financiers – for reasons including commercial weakness, failure to obtain licenses, permissions and clearance. Sponsors can hedge their risks by obtaining technical assistance grants for project preparation and planning.

During the construction stage the main risk is failure to complete the project with acceptable performance levels and within an acceptable time frame and budget. Sponsors can hedge construction risks by purchasing various forms of insurance and obtaining guarantees from contractors with regard to costs, completion schedule and operational performance.

After construction, the main risk is ongoing operations and performance and include technical failures, availability of funds, market demand, prices, foreign exchange rates or environmental issues. The sponsors can hedge these risks through contractual and guarantee agreements that transfer some of the risk to other parties.

Realizing Benefits Of Project Finance

Financing projects through the project finance route offers various benefits such as the opportunity for risk sharing, extending the debt capacity, the release of free cash flows, and maintaining a competitive advantage in a competitive market. Project finance is a useful tool for companies that wish to avoid the issuance of a corporate repayment guarantee, thus preferring to finance the project in an off-balance sheet manner. The project finance route permits the sponsor to extend their debt capacity by enabling the sponsor to finance the project on someone's credit, which could be the purchaser of the project’s outputs. Sponsors can raise funding for the project based simply on the contractual commitments.

Project finance also permits the sponsors to share the project risks with other stakeholders. The basic structure of project finance demands that the sponsors spread the risks through a network of security arrangements, contractual agreements, and other supplemental credit support to other financially capable parties willing to assume the risks. This helps in reducing the risk exposure of the project company.

The project finance route empowers the providers of funds to decide how to manage the free cash flow that is left over after paying the operational and maintenance expenses and other statutory payments. In traditional corporate forms of organization, corporate management decides on how to use the free cash flow — whether to invest in new projects or to pay dividends to the shareholders. Similarly, as the capital is returned to the funding agencies, particularly investors, they can decide for themselves how to reinvest it. As the project company has a finite life and its business is confined to the project only, there are no conflicts of interest between investors and the management of the company, as often happens in the case of traditional corporate forms of organization.

Financing projects through the project finance route may enable the sponsors to maintain the confidentiality of valuable information about the project and maintain a competitive advantage. This is a benefit of raising equity finance for the project (however, this advantage is quite limited when seeking capital market financing (project bonds). Where equity funds are to be raised (or sold at a later time so as to recycle capital) through market routes (for example, Initial Public Offerings [IPOs]), the project-related information needs to be shared with the capital market, which may include competitors of the project company/sponsors. In the project finance route, the sponsors can share the information with a small group of investors and negotiate the price without revealing proprietary information to the general public. And, since the investors will have a financial stake in the project, it is also in their interest to maintain confidentiality.

In spite of these advantages, project finance is quite complex and costly to assemble. The cost of capital arranged through this route is high in comparison with capital arranged through conventional routes. The complexity of project finance deals is due to the need to structure a set of contracts that must be negotiated by all of the parties to the project. This also leads to higher transaction costs on account of the legal expenses involved in designing the project structure, dealing with project-related tax and legal issues, and the preparation of necessary project ownership, loan documentation, and other contracts.

Understanding The Dynamics Of Project Financing

From a broad perspective and general analysis, the financial viability (or commercial feasibility) of the project is assessed by determining whether the net present value (NPV) is positive. NPV will be positive if the expected present value of the free cash flow is greater than the expected present value of the construction costs. However, in addition to or in lieu of the NPV, lenders will use debt ratios such as the Debt Service Cover Ratio (DSCR) and Life Loan Cover Ratio (LLCR) as the main ratios to measure bankability.

The DSCR measures the protection of each year’s debt service by comparing the free cash flow (more precisely, the cash flow available for debt service – CFADS) to the debt service requirement. The DSCR requires that the cash flow available for debt service is at least a specified ratio (for example, 1.2 times) of the scheduled debt service for the relevant year. The LLCR compares the overall amount of free cash flow projected for the life of the loan, duly discounted with the amount of debt under analysis. The LLCR also reflects the capacity of the SPV to meet the debt obligations over the life of the loan (considering potential re-structuring).

On the basis of the projected cash flows of the SPV, including the debt profile under analysis, lenders and their due diligence advisors will observe the value of such ratios, and accommodate the debt amount so as to meet them, considering the maximum term at which they are ready to lend. Subsequently, they will run sensitivities analysis (including break-even analysis) on the project cash flows to test the resistance of the project to adverse conditions or adverse movements of the free cash flow figures from the base case.

In determining financial viability, and related to the reliability of cash flows and the guarantees offered by the contract (especially termination provisions), the lenders will analyze the risk structure of the contract. This will include determining how achievable the performance standards in government-pays projects, or the contractual guarantees in user-pays projects, actually are.Lenders will exercise tight control of all cash flows, limiting the ability of the private partner to dispose of them — through “covenants” (for example, no distributions may be made if the actual DSCR of the previous year has not meet a certain threshold). The bank accounts through which cash flows pass will be pledged and held with a bank within the syndicate; this is in addition to other provisions to be adapted in the loan agreement.

How Project Financing Solutions By Subcontracts India Helps

Project Finance is one of the key focus areas for Subcontracts India. We have access to several project financing groups and institutions that have institutionalized capabilities to successfully manage the unique and multidimensional process of project finance transactions led by customized project structuring approach.

These groups and institutions have been the lead arrangers and underwriters of a significant amount of project debt over the years. In the Indian project finance domain, they enjoy a leadership position and are acknowledged for their comprehensive domain expertise and knowledge in the infrastructure, manufacturing and mining sectors, having ensured timely financial closure of several big ticket projects.

Whether you're investing in renewable energy, telecommunications or water supply and waste water treatment – we develop the right solution for sustainably viable, flexibly structured financing to meet the needs of your transaction.

Backed by in-depth expertise you can benefit from our wide network in emerging and developing countries, our comprehensive knowledge of sectors and industries, and our 21 locations across North America, Europe, Asia, Africa, Oceania and Latin America. 

How Does One Apply For Project Finance

Once you have contacted us and shared your requirement for raising project finance, we will send you our FINANCIAL ADVISORY SERVICES TERMS AND CONDITIONS (FASTC) to review carefully. If and when you agree to our FASTC, you will receive the Client Agreement draft which you will have to fill, sign and return to us. Subsequently, you will need to submit relevant information pertaining to your project through our online Project Finance Application Form. 

Our services do not come for free and hence be prepared to pay our service charges when you decide to use them. Also, we are rather choosy about who we serve. We encourage only serious clients who understand what it takes to arrange finances for projects. Our seamless services start with our client sending us a formal Letter of Intent expressing his/her desire to hire our services and then following this up by entering into a formal service agreement with us and depositing the token Engagement Fee online prior submitting the Project Finance Application Form which is non refundable. That is not all. You would be further liable to pay a Success Fee (case specific) post successful closure of funding.

What Happens Next 

Our analysts evaluate projects individually, so if you have more than one project, you should complete one copy of the form for each project for which you are seeking funding. Once your Project Finance Application Form  is received by us, our analysts will review the submitted Business Plan in detail and quickly evaluate whether it is good enough to move to the next stage.

If our analysts determine that your project is unlikely to meet our criteria, we will quickly contact you, usually within a day or two, to inform you the areas of the Business Plan that needs further working.

However, if our analysts determine that your project Business Plan is bankable, we will immediately get in touch with you for further discussions to finalize the project financing strategy. 

Once the above have been taken care of, we move forward and present your Business Plan to target investors/financiers. 

Important To Note: 

We quickly respond to all inquiries. 

We do not delegate executive time to an inquiry until your project, as expressed in your fully completed Project Finance Application form, has been thoroughly evaluated by our analysts.

To ensure our executives do not waste time on unrealistic inquiries we do not enter discussions in any form until we have a full understanding of your project's potential and risks. We therefore do not offer meetings, hold telephone discussions or return telephone calls until we have thoroughly evaluated your project.

Please do not send us additional communications during the application phase as it delays the application process.

We do not finance projects valued at less than $5,000,000.00 (United States Dollars five million), we do not finance acquisitions and we do not finance projects in countries mentioned in this Restricted Nations list

All our official communications are in English. We do not offer a translation service.

Upon receipt of all the documents and information submitted by the applicant, a Funder would evaluate the project in greater detail. Generally an Appraisal meeting is convened where all the decision makers at the Funding Company officially review the project as presented to determine if the project is within their scope of funding. Subsequent to this meeting, a due diligence of the project is generally undertaken by the Funder and the the Project Sponsors/Applicant pay(s) for the expenses involved in carrying out the due diligence. Such expenses are project specific . 

Financial Due Diligence

Financial due diligence requires that, during loan preparation and processing, sufficient analysis is undertaken to enable an informed assessment to be made with respect to project financial viability and long-term sustainability, and that the borrowers’ financial and project management systems are, or will be, sufficiently robust to ensure that funds are used for the purpose intended and that controls will be in place to support monitoring and supervision of the project.

There are Guidelines that provide the framework for financial due diligence, namely completion of a financial management assessment (FMA) of the executing agency (EA) and/or implementing agency (IA), financial evaluation of the project, and assessment of implementation arrangements (from a financial perspective, including disbursement and auditing arrangements).

The methodology note provides specific guidance in four primary aspects of financial due diligence:

1. financial management assessment,
2. project cost estimates and financing plan,
3. financial analysis, and
4. financial evaluation.

It also provides guidance on assessing disbursement auditing arrangements. This financial due diligence methodology note offers a suggested approach for operationalizing the standard project preparation and loan processing requirements of the Guidelines. the Guidelines, together with the methodology note, should be seen as a reference guide to assist staff in conducting an appropriate degree of financial due diligence during project preparation and processing, and should guide staff in determining the appropriate level of financial management safeguards required for a given project and/or EA and/or IA. The advice, directions, and recommendations provided should not be regarded as a substitute for the professional judgment of SUBCON staff.

Financial Management Assessment

Effective financial management within the EA and/or IA is a critical success factor for project sustainability, both in the effective use of funds and in the safeguard of assets once created. Irrespective of how well a particular project or program is designed and implemented, if the EA and/or IA does not have the capacity to effectively manage its financial resources, the benefits of the project are unlikely to be sustainable.

The objective of the financial management assessment (FMA) is to ensure that the EA and/or IA has, or will have, sufficiently strong and robust financial management systems and procedures in place to ensure sustainability of project investments and benefits over time.

The FMA is a review of the entity’s systems for financial and management accounting, reporting, auditing, and internal controls. It also involves an assessment of the entity’s disbursement and cash flow management arrangements, and governance and anticorruption measures. The FMA is not an audit; it is a review designed to determine whether or not the entity’s financial management arrangements are sufficient for the purposes of project implementation.

Approach and Methodology

The first step is to determine whether an FMA has recently been completed by any other credible financial institution (Bank, NBFC, VC or PE agencies) , the objective being to avoid duplicating diagnostic work that already exists. If an FMA exists, this should be reviewed and, in particular, any work done to overcome previously identified weaknesses should be checked. The original FMA can then be updated accordingly.

While planning to rely on the work of another lender , SUBCONTRACTS INDIA would thoroughly review the agency’s assessment report to determine whether or not the results of the FMA are reasonable and can be accepted by SUBCONTRACTS INDIA.

If an FMA has never been completed, or if there have been significant on-ground changes which render an existing FMA obsolete, then the following approach to the FMA is recommended:

Review the Economic Sector diagnostic studies specific to the country where the project is located, including the country financial accountability assessment, country procurement assessment report, country governance assessment, and diagnostic study on accounting and auditing.

Early in project preparation, have the borrower/project promoter complete a Financial Management Assessment Questionnaire (FMAQ).

Review responses to the FMAQ, determine what (if any) additional information is required in order to be able to conclude whether or not the financial management arrangements (a) are capable of recording all transactions and balances, (b) support the preparation of regular and reliable financial statements, (c) safeguard the entity’s assets, and (d) are subject to audit.

Review past audit reports and audit management letters to assess what concerns have previously been raised on systems and internal controls.

Form a conclusion with respect to whether or not the financial management arrangements and financial and project accounting systems can be relied upon for the purposes of the project.

If issues and/or weaknesses are identified, determine the most appropriate mitigation measures (e.g., restructuring finance sections, increasing finance staff, filling vacant posts, developing new systems, developing financial reporting, training, etc.).

Determine whether, given the findings, it is necessary to include a project component to strengthen financial management in the EA and/or IA and/or establish or strengthen a project implementation or project management office via either technical assistance or consultant support within the project.

Due Diligence

Due Diligence service is rendered by an accredited Due Diligence service provider appointed by the Funding Partner Company. Due Diligence is by far the most important exercise in the funding consideration process.

The charges for the Due Diligence are to be borne by the applicant. These charges are specific for every case and the applicant is given prior notice of this.

It is extremely important that the applicant understands clearly the processes of Due Diligence is to secure a successful transaction and mutual business relationship between the applicant and the Funding Partner Company.

The Funding Partner Companies provide finance to viable projects on precise terms. There are no general terms. Everything is specific to the project under consideration.

Once the Due Diligence is successfully completed, a Funding Offer is officially made from Funding Partner Company to the applicant (Project Owner(s)/ Promoter(s)). The Project Owner(s)/Promoter(s) are issued an Invitation Letter for a table meeting in the Funding Partner Company’s office which can be in any country. Post a personal interview of the project owner(s)/promoter(s) ,the MOU is drafted and signed. Insurance requirements too would be discussed and finalized at this meeting.

Post successful completion of all of the above due diligence processes, JV agreements would be signed in case of equity participation by investor and/or fund disbursement would commence within the specified time frame.

Infrastructure Financing Definition

The financing of projects or companies involved in sectors which are given infrastructure status by respective governments around the world is called infrastructure financing.

This definition, however, is more for the government’s internal operations. This definition is used in order to provide tax breaks or subsidies that have been promised to the infrastructure sector.

There are certain shared characteristics among industries that are classified as infrastructure all over the world. Some of these characteristics have been mentioned below:

1. Industries which are given infrastructure status are considered to be central to the economy. This means that these industries provide the impetus for the rapid growth and development of other industries as well. For instance, industries such as roadways and railways enable faster movements of goods and services throughout the country. This helps the manufacturers in the country become more competitive as compared to other countries. The final result is an increase in exports. Other important sectors such as telecommunications and electricity are also considered to be central to the economy and hence have been provided infrastructure finance all over the world.

2. Since these industries are considered to be of strategic importance, too many private sector players are not allowed to operate in them. This creates a monopolistic market with very few players. As a result, investors are generally very keen on investing in infrastructure opportunities. However, it also needs to be understood that since these markets can be considered to be monopolistic, they are also highly regulated. Since there is only a handful of suppliers, the government fixes the prices that can be charged

3. Infrastructure assets are characterized by low risk and stable cash flows. These projects are generally built in areas where there is high demand. As a result, either the consumers or the government are willing to pay a relatively stable cash outflow for a long period of time.

The defining feature of infrastructure financing is the sectors to which money is being lent. The different types of loans such as overdraft, term loan, working capital loan, etc. are generally included in the definition of infrastructure financing

See Infrastructure sub-sectors

Types of Infrastructure Financing

Infrastructure financing has various sub-divisions. These divisions are generally based on the type of industry that the funds will actually be utilized in. The different types of infrastructure financing have been listed below;

Economic: infrastructure financing can be for purely economic reasons. For instance, when a new port is built in a country, it enables more foreign trade. These projects are generally funded using a public-private partnership. This is because these projects have net positive value. Hence, the value created can be shared between the government and the private parties. Economic infrastructure projects provide benefits to the larger economy of a region instead of providing benefits only to specific industries or people.

Social: Infrastructure funding is also given to many institutions for a social cause. For instance, several projects are undertaken to provide clean water to the people. Similarly, projects are undertaken to provide healthcare and education services to the people of a region. These projects are different because they have to be undertaken regardless of the fact that they might have a negative net present value. Hence, under other modes of financing, these projects would be left out. However, when it comes to infrastructure financing, the government does spend funds on these projects even though there may not be any immediate returns. Since these projects may have a negative net present value, they are undertaken mostly by the government.

Commercial: Commercial projects are just like economic projects. Except, these projects provide benefits to a set of people that can be directly identified. For example, toll roads and metro rail projects are considered to be commercial infrastructure projects. They are funded by charging the people who utilize the services.

The bottom line is that infrastructure financing is a vast field that encompasses many industries. Also, the funding models used here are slightly different since projects with negative NPV are also undertaken many times.

An asset class is a group of assets that have similar investment characteristics amongst themselves. At the same time, their investment characteristics are different from other asset classes. For instance, all stocks share certain characteristics amongst themselves, which they do not share with bonds. Similarly, there are certain characteristics that infrastructure also has as an asset class. These are the characteristics that make infrastructure financing an attractive investment option for investors.

 Infrastructure as an Asset Class

All financial instruments related to infrastructure financing have come common characteristics regardless of whether they are debt-based, equity-based, or even options. An investor needs to understand some of these characteristics before deciding whether to put their hard-earned money in infrastructure financing.

The defining characteristics of infrastructure as an asset class have been listed down in this article.

High Barriers to Entry:

Infrastructure projects generally comprise of public works projects. As a result, companies that bid for such projects are required to have a good amount of technical expertise in the relevant field as well as deep pockets. In many parts of the world, political connections are also required in order to land such projects. Hence, it would be fair to say that there are high barriers to entry in this field. As a result, if a company already has the approvals in place to implement an infrastructure project, investors are generally keen on investing their money. This is because of the fact that such projects have very little competition and hence provide stable, predictable cash flows.

Inelastic Demand:

Infrastructure projects are usually in industries where demand is very stable and does not change drastically in relation to small changes in price. For instance, people who pay for toll roads derive a lot of utility from their usage. They are unlikely to stop using the facility because of a minor increase in price. Also, in many cases, toll roads are the only option. Hence, demand is totally inelastic. Other infrastructure projects such as dams, power plants, ports, etc. also have an inelastic demand. This characteristic makes infrastructure financing an attractive investment class.

Economies of Scale:

Infrastructure projects are generally undertaken on a large scale. As a result, the company undertaking the project stands to benefit from economies of scale. For instance, when a company lays down a telecom network, it pays a fixed cost. The marginal cost of adding another subscriber to the network is almost negligible. This factor, along with economies of scale, means that investors stand to make hefty profits from infrastructure projects. In most cases, infrastructure projects only face limitations from the supply side. There is a significant amount of demand for such projects. This makes infrastructure financing a preferred asset class.

Tax Benefits:

Infrastructure financing is a priority for many countries worldwide. As a result, governments try to make it easier for infra companies to raise money. Hence, many tax breaks are provided to infrastructure companies all over the world. So much so, that tax breaks have become a synonym for infrastructure financing. These tax breaks are the reason that infrastructure-related investments provide a higher yield to individuals as well as to businesses.

Long Gestation Period:

Infrastructure projects are supposed to have a very long life. Roads, bridges, dams, and railway lines last for several decades. In fact, in many cases, infrastructure projects may take a decade or so to build. During the build phase, the project does not generate any revenue. However, the project still survives because of the long life of the debt which has been floated. Infrastructure finance bonds generally have a very long duration. A lot of times, perpetuities are used to finance such projects. Infrastructure projects have a long life, stable cash flows, and limited ability to generate returns. It is for this reason that many infrastructure companies use a lot of leverage in order to accentuate the return on their investment.

Low Sensitivity To Economic Swings:

Lastly, one of the most important characteristics of infrastructure financing is that it has a very low sensitivity to economic swings. In simple words, this means that even if there is a recession, the number of people using infrastructure projects, as well as the revenue generated from such projects, remains more or less unchanged. This characteristic is very important for many investors since it allows them to use infrastructure to diversify their portfolio. Infrastructure financing can be accommodated in a portfolio where equity and debt are already present. When equity rise, debt falls, and vice versa. However, infrastructure-related instruments tend to remain stable regardless of the rise and fall in other investments. As a result, it can be used as a defensive financial instrument in a portfolio.

Infrastructure financing has some very attractive characteristics, which has helped it emerge as an important alternative investment asset class. Most funds across the world have some amount of money invested in infrastructure assets.

Infrastructure Finance Projects: Major Sources of Funding

It is a known fact that the world is in great need of infrastructure projects and, therefore, infrastructure finance. Developing countries need to build their infrastructure for the first time. This needs to be done in order to attract more investments. However, even developed countries need to build more infrastructure projects. This is because the population in the developed countries is growing steadily. As a result, the infrastructure which was adequate a few years earlier is no longer adequate. Also, normal wear and tear make it necessary to build infrastructure projects.

Infrastructure projects all over the world need a lot of funding. It is estimated that more than $96 trillion is required to fund infrastructure projects by the year 2030. At present, the annual budget available for infrastructure funding worldwide is close to $2.5 trillion to $3 trillion. However, the actual amount of funds needed is more than double the available amount. Also, the problem is that most of this shortfall of funds exists in low and middle-income countries.

Public Finance

Government funding is one of the biggest sources of funding for infrastructure finance. Tax dollars collected all over the world are spent in huge numbers on creating infrastructure. In general, countries spend anywhere between 5% to 14% of their GDP on developing as well as maintaining infrastructure. A lot of this money is spent on financially unviable projects which have social value for the community.

In many cases, the government does engage the private sector to execute the project on its behalf. However, this may be done to increase the efficiency of the project. The private sector only brings in the necessary expertise to deliver the project on time. In return, the government provides all the funding when developmental milestones are completed. In essence, governments worldwide use the services of the private sector as subcontractors.

However, it needs to be understood that infrastructure finance projects funded by the government are notorious for corruption. Since the taxpayer is paying the bill, a lot of the time, the development charges are highly inflated, and all the money spent on these projects ends up in the hands of mafia controlled by corrupt politicians.

 Supra National Financial Institutions

Supranational bodies such as World Bank, International Monetary Fund, Asian Development Bank, etc. are also important sources of finance for infrastructure projects. However, such organizations tend to only fund projects which are financially viable. As a result, urban projects like metro rails, bridges, flyovers, etc. tend to get funded by these institutions. The internal rate of return (IRR) required by these financial institutions is generally lower as compared to other private sector institutions.

Institutions like the World Bank and the Asian Development Bank also provide other services to enable the better execution of infrastructure projects. This means that even if they do not directly fund a project, they try to add value by providing advisory services such as loan guarantees, advisory services for the creation of suitable policies, etc. In many cases, these institutions also provide treasury services to infrastructure projects. This is done to enable optimal utilization of funds.

 Private Finance

Governments all over the world are desperately seeking the intervention of private money to help fill the funding gap being faced for infrastructure projects. As a result, many private mutual funds have been set up for this purpose. Governments try to make these investments more attractive by providing tax breaks to individuals who invest their money in such projects. A wide variety of financial instruments (both debt as well as equity) are being used to help channelize the savings of the general public towards infrastructure projects. Attempts are also being made to woo institutional investors such as insurance companies and pension funds to increase the amount of funding available.

 Public-Private Partnership

The public-private partnership model is also widely used in infrastructure funding. This model works differently than public funding. Here, instead of the government using its money for the initial outlay, the private sector does so. The idea is to create a partnership, where the government brings in land and other resources, wherein the private party brings in technical expertise. The private party then has certain rights over the asset it has helped developed. For some years, the government allows the private party to collect money in order to generate revenue and payback its investment plus a reasonable amount of profit. Then the asset is finally given back to the government, which can decide whether or not they want to continue collecting revenue for the upkeep of the project. The only problem with this model is that it can only be used to raise funds when the underlying project is extremely viable i.e., provides an IRR that is sought after by private investors. Otherwise, private investors will simply give it a pass.The simple fact is that extremely large sums of money are required for infrastructure projects. One source of funding cannot really help fulfill the gap. In fact, all the sources of funding, together, may also not be adequate. There are many governments in the world who are trying to set aside as much money as they can for infrastructure projects.

Why Doesn’t the Private Sector Invest In Infrastructure Projects?

As explained in the previous articles, the infrastructure sector is facing a significant funding gap. There is an urgent need to double the spending on infrastructure projects. One of the ways to fulfill this gap is by increasing the participation of the private sector in infrastructure projects. At the present moment, the private sector is not participating in infrastructure projects because of several reasons. Some of these reasons have been listed down in the article below.

Lack of Project Pipelines

Identification of viable financial projects which can be pitched to the private sector is a significant problem. Developing countries fail to identify infrastructure projects which are viable financially. If these projects are identified on time, they can be pitched to global investors, and funding can be generated. This problem is not confined to developing countries alone.

Even in developed countries i.e., the G-20 countries, less than 50% have a formal mechanism in place to identify projects which need to be pitched to global investors.

After all, investors cannot invest in projects which they don’t know about. A lot of time-critical needs stay unfulfilled because of this communication gap. Countries that have set up a formal mechanism of creating a project pipeline i.e., a way to identify and rank projects, have seen a remarkable increase in the private sector participation in infrastructure funding projects.

Lack of Controls

The private sector can only help if they receive some surety that their capital will be protected once they make the investment. The problem is that a lot of time investments have to be made in third world countries where there is a significant law and order problem. Africa is a perfect example of this. A lot of sub-Saharan African countries face problems with water. People have to walk miles to gain access to clean water. However, it is very difficult to get the private sector to fund infrastructure projects, which would improve access to clean water. Financial viability becomes a problem. This is not because the project is inherently unviable. Rather, this is because of the fact that there is a lot of leakage in the supply chain. Unmetered supply of water and even thefts are very common. If a better system is created, where investors have more control over their projects, the amount of funding can increase by leaps and bounds.

 Lower Adjusted Rate of Return

Governments all over the world claim that infrastructure projects have very little risk. However, private investors have a different point of view. There have been numerous cases wherein entire projects and investments made by the private sector have got stuck due to change in government policies. Also, many infrastructure projects have significant legal hurdles, as well. In many cases, land acquisitions get significantly delayed, and environmental clearances are hard to come by. In such cases, the gestation period of the project gets prolonged, and the returns do not increase proportionately. This ends up reducing the annualized yield for the project.

Infrastructure projects are notorious for high levels of corruption, and hence, there is an additional risk for the investors involved. It is for this reason that investors seek a higher rate of return. This return is higher in nominal terms. However, where the additional risk is factored in, the returns can be considered to be normal. Another problem is that infrastructure projects all over the world are under a lot of public scrutiny. Hence, if a firm is seen as taking advantage and gaining a higher rate of return, it could cause damage to their reputation. The lower IRR’s provided by the government are not very attractive for the private sector in the absence of any special tax incentives.

 Unstable Regulatory Environment

A lot of investor demand for infrastructure projects is created by providing tax incentives. Banks are also given certain concessions in their capital adequacy ratios if they invest in infrastructure projects. However, the problem is that if the demand can be created by policies, it can also be taken away by a change in the policies.

This has happened multiple times in different parts of the world, and investors are quite aware of the possible impact. Basel III and Solvency II norms have already impacted investors who had invested in infrastructure projects. Hence, investors are wary of such changes. Infrastructure projects require investors to put in significant sums of money upfront. As a result, investors are not comfortable unless they are reasonably certain that the policies which are working in their favor will not change drastically during the course of the project.

 High Transaction Costs

Private investors have to pay up a lot of money to obtain the right to work on an infrastructure project. For other investment classes, the transaction cost hovers around 2% of the project cost. However, in the case of infrastructure projects, the transaction cost may go as high as 10%. This is because a lot of advisory fees, lawyer fee, and the official?s time has to be invested in bidding for a project. Higher transaction costs eat into the annualized return making the project less viable.

Since private sector funding is the need of the hour, governments all over the world should try to reduce the impact of the above-mentioned problems. This will help increase the flow of funds to the cash-starved infrastructure sector.

 The SPV Structure in Infrastructure Finance

The Special Purpose Vehicle (SPV) or Special Purpose Entity (SPE) is one of the most used tools in infrastructure financing. It doesn’t matter whether the project is being constructed by a private company, a public entity, or in a public-private partnership. In most cases, special purpose vehicles are created for every infrastructure project.

In this article, we will understand what a Special Purpose Vehicle (SPV) is and also how a web of contracts is created in order to operate a business through the Special Purpose Vehicle (SPV) structure. The details have been mentioned in this article.

 What is a Special Purpose Vehicle (SPV)?

A Special Purpose Vehicle (SPV) is an entity created only for the purpose of execution of the project. This means that for legal purposes, the Special Purpose Vehicle (SPV) is different from the private company or the government body, which may be sponsoring it.

A Special Purpose Vehicle (SPV) has its own balance sheet and profit and loss statement. Lenders are supposed to lend to these Special Purpose Vehicles (SPV) based on their assets and liabilities and not the assets and liabilities of the parent firm. In most cases, the Special Purpose Vehicle (SPV) company takes non-recourse financing. This means that in the event of a default, investors can only seize the assets of the project and not the assets of the parent firm, which may be involved in the project.

As can be seen from the definition, the Special Purpose Vehicle (SPV) is a good mechanism to segregate the risks. The SPV mechanism makes it possible for each project to obtain finance based on its own risk. The existing debt of the company backing the project does not make financing more expensive for a project since the company’s finances are usually not that relevant.

 The Different Parties Involved In a Special Purpose Vehicle Structure?

Equity Investors: For the Special Purpose Vehicle (SPV) to come into existence, it has to receive some capital. This capital is provided by the equity investors. Generally, equity investors include private parties and the government. In the case of public-private partnerships, it could be both. This is the primary party that will gain or lose depending upon the performance of the contract. Since they own the equity of the SPV, they control its actions and who it gets into a contract with.

The fact that the investors have to put in money in the Special Purpose Vehicle (SPV) does not make the Special Purpose Vehicle (SPV) structure redundant. The benefit of using the structure is that the equity investors have limited exposure to the downside. The maximum loss that they could face is limited to the amount they apportioned as an equity investment to the Special Purpose Vehicle (SPV).

Debt Investors: Infrastructure projects usually require a huge amount of money. As a result, equity investors are not able to fund the entire project. Also, since the cash flows of the project are somewhat stable, and the returns provided are low, equity investors use a lot of leverage in order to magnify their returns. It is common for infrastructure projects to use a leverage ratio of 10 to 1. Debt investors include banks, investment banks, private equity firms, and even pension funds. Infrastructure companies have been providing a wide variety of financial instruments that the debt investors are using to invest their money in these Special Purpose Vehicles (SPV).

External Agencies: Since Special Purpose Vehicles (SPV) use a lot of borrowed money, they frequently require the help of third-party companies. The Special Purpose Vehicles (SPV) have to engage rating agencies to rate their debt instruments. This is important since many mutual funds and pension funds cannot invest their money in assets that are not above a certain investment grade. Also, the Special Purpose Vehicles (SPV) have to engage financial institutions like banks or insurance companies that provide bank guarantees to investors.

Construction Contractor: Finally, in most cases, the Special Purpose Vehicles (SPV) appoints its parent company as the chief construction contractor. Using this mechanism, the equity investors are able to plow back most of the funds that they had invested in as equity capital. However, they are only able to do so once they execute the projects. Debt covenants usually do not allow the SPV to give out money to the contractor until certain milestones have been met. However, using the SPV structure, the company is able to execute the projects without taking any undue risks.

Maintenance Contractor: Lastly, once the project is constructed, it is usually given out to a maintenance contractor. This contractor is generally another SPV which has the same set of stakeholders and follows more or less the same process. Even if the same parent company plans to maintain the project, they generally create a different SPV. In this case, the SPV is done to safeguard the revenues. The idea is to protect these risk-free revenues by segregating them from other risky investments which the company may be undertaking.

The Special Purpose Vehicle (SPV) structure is at the heart of infrastructure financing. It allows the equity investors to segregate revenues and protect them from risks that may be arising in other projects.

Financing Needs of Infrastructure Projects at Different Stages

Infrastructure projects typically last for many years. It is not uncommon for these projects to last for decades. These long term projects have different phases. Each of these phases has unique needs from a finance point of view, as well. In this article, we will explain how the financing needs of an infrastructure project depending upon the phase of the project in question.

 Phase #1: Planning

Infrastructure projects are not executed overnight. Since there is a large outlay of capital and many different parties are expected to work together, the planning of these projects is very detailed. During the planning phase, the deliverables and the dependencies of all the stakeholders are examined. Then all the parties try to negotiate to obtain more time or more resources in order to execute their part of the project better.

As a result of this constant back and forth, it is not uncommon for the planning phase of any project to last anywhere between 15 to 30 months! The long term financing of the project happens during this phase. Usually, the project planning authority finds equity investors. Generally, equity investors are stakeholders who have some sort of technical expertise required for the project. These equity investors are then entrusted with the task of finding debt investors for the project. At this stage, it is difficult to float any bonds in the open market. This is because cash flow is going to materialize at a later date, and also such projects are rife with uncertainty. This is the reason that debt financing at this stage is almost exclusively done by banks. In fact, any single bank is also not willing to take up all the risk during this phase. Debt financing at this stage is commonly provided by a syndicate of banks.

Phase #2: Execution

This is the longest phase of the project. Here, the various stakeholders are supposed to put the agreed-upon plan into action. It is common for delays to happen during this phase. Delays could be because of the negligence of the parties involved. Alternatively, delays could also be because of factors that are beyond the control of the stakeholders viz. legal hassles. It is important to draw up contracts in order to punish shoddy work. The proper execution can be ensured by assigning penalties such as demurrages for delayed execution or poor quality work. However, as far as factors beyond the control of the stakeholders are concerned, the only way is to ensure that additional funds have already been allocated to meet contingencies. Also, insurance can be taken to limit the loss arising from such a delay.

From a finance point of view, this is the most high-risk phase of the project. This is where all the negative cash flow sets in. Also, this is where mismanagement of the project by different stakeholders could have a huge impact on the equity investors. It is important to choose debt investors who can provide additional capital at this stage if required. If a company tries to obtain additional capital from the market at this stage, they will have to pay a hefty premium. This is because investors will be of the opinion that the project has run out of cash since the planning has already failed. Therefore the project will be perceived as a high-risk project even though it may not be the case.

At this stage, it is also difficult for both equity as well as debt investors to exit the project without taking a financial loss. This is because there are only a handful of other companies that may have the resources to take over such a project. Each of them may be looking for a significant discount to take over the project in the middle. Once again, this may be due to uncertainty.

Phase #3: Operations

This is the stage when the project has been completely executed. At this stage also, the project is cash flow negative. However, since the cash flows have already started showing, the risk of default reduces to a huge extent.

This is the stage where either debt or equity investors can exit the project by offloading their stake in the open market. Since the project is now a going concern, individual investors start investing in it. For instance, it is common for banks to securitize their exposure to the project at this stage and sell bonds on the open market. This means that if a bank wants to liquidate $100 worth of investment in the project. They can create 100 bonds of $1 each and exit the project.

If the debt investor doesn't want to sell bonds or other securities, a simple refinance arrangement can be made. Since the risky phase of the project is over, it makes sense to reduce the cost of capital so that the additional money can be diverted to increase the profits of the equity shareholders.

Infrastructure projects can have very different financing needs at different stages of the project. There are some tried and tested policies which need to be followed at different stages of the project. Financial innovation should also ideally be done within the framework of these policies.

Different Types of Contracts for Infrastructure Projects

Private-public partnerships are a common mechanism used while creating infrastructure projects. In general, a public-private partnership involves a joint venture between a government body and a private corporation. However, there are several different ways in which it is possible for these two types of companies to collaborate. In some types of contracts, the government bodies play a dominant role, whereas, in other types of contracts, the private parties play a dominant role. In this article, we will list down the types of contracts which are commonly used as well as their features.

Operation and Maintenance Contracts

Operations and Maintenance contracts are a very common mechanism used in infrastructure projects. Under this mechanism, the facility to be maintained is owned by the government. The private party is given periodic contracts in order to maintain these facilities in proper working condition. There are multiple ways in which this arrangement is carried out. For instance, in one type of arrangement, the government could provide a fixed fee to a contractor in exchange for maintaining the facilities. On the other hand, there are leasing contracts, in which the government leases the facility out to a private party. Hence, the government receives a fixed sum as revenue from the project. The private party is then given the right to collect money from the general public when they use the facilities.

From a private party’s point of view, the risk involved in this project is minimal. This is because all the money and the assets which are going to be used in the project belong to the government. However, this also means that the government is the dominant counterparty, and hence, they have maximum control over the project’s operation as well as its finances.

Rehabilitation Contracts

In many parts of the world, the infrastructure already exists. However, with the passage of time, it has become old and worn out. The revamping and rehabilitation of such infrastructure projects require a lot of capital to be invested upfront. Governments all over the world are generally short of money. As a result, such projects end up getting delayed.

Rehabilitation contracts offer a great mechanism to ensure that these projects do not get delayed and that no additional burden is added to the government’s finances. Under these contracts, the government cedes control of a publically owned asset for a predefined period of time. In return, the private party invests money in order to rehabilitate the asset. Normally, a rehabilitated asset creates greater cash flow. The private party is then entitled to this increased cash flow for the next few years.

In this type of contract also, the government is still the dominant party. This is because they own the asset and, therefore, the majority stake in the project.

Build Operate Transfer Contracts

Build operate transfer are Greenfield contracts. In these types of contracts, the private party is the dominant party. This is because, in such contracts, the government provides the land required to construct the project. However, the design, construction, and management of the project have to be done by the private party. These contracts are generally awarded because the private parties have certain skill sets that the government does not! Hence, the government is more dependent upon the private party.

Also, in most cases, the private party has to invest their own money to begin the project. Only after the project has reached certain milestones does the government disburse funds. Hence, the private party’s money is locked in the project for some time. It would, therefore, be fair to say that the risk associated with build operate transfer contracts is also higher.

Divestitures

Lastly, government and private parties collaborate using divestiture contracts. Under this contract, the government sells out its resources completely. Hence, if a government has land where they want a bridge to be developed, they would sell the land to a private party on the condition that the bridge is developed within a given time span. In many cases, the government simply sells its assets without any terms and conditions attached. This usually happens when the government is under a lot of debt and needs funds to pay back their loans. Alternatively, it could also be a way to reduce the focus on non-core areas and use the proceeds to increase focus on the core areas.

Here, the private party is the dominant player since they have a lot of freedom and autonomy. Also, since they have to invest their money in the project, the private party has to take a great deal of risk.

The above four contractual arrangements are mere representations of a broad spectrum of contracts that are used in public-private partnerships. However, the basis remains the same, the party which takes the most risk also gets the most control over the project.

Distribution of Risks in an Infrastructure Project

Infrastructure projects tend to have a lot of financial risks. In many cases, the risks are poorly managed. In fact, incorrect risk management is one of the main reasons behind the delay, which can cause cost overruns in the long term. It is difficult to reduce the total risk that any infrastructure project faces. However, the distribution of risk needs to be done in such a manner that both parties have the incentive to stop expensive delays and cost overruns. Therefore, risk management in infrastructure financing is all about deciding which party can manage which risks better and then allocating the same to them.

Some examples of poor risk management have been mentioned below:

In many cases, governments have started giving guarantees to the private sector. These guarantees provide a certain source of cash flow, which the private party can take recourse to in case of a cost overrun. The problem here is that such financing arrangements tend to make the private company overly complacent and even inefficient. These guarantees basically insulate the company from any losses which may arise as a result of their inefficiency. Hence, they do not have the incentives to achieve a higher level of efficiency. Also, research has shown that genuine private parties do not look upon the government to insure their risks. Hence, it doesn’t really add value to efficient contractors. Instead, such policies make infrastructure projects a breeding ground for corrupt and politically connected contractors.

In many cases, governments follow the exact opposite of the policy, which has been mentioned above. This means that they tend to transfer all the risks excessively to the private party. The problem here is that the private party is stuck with all the risks, many of which may not even be insurable. Prima facie, this may seem to be a good deal for the government. However, the reality is that it is not! This is because the private contractors end up charging a premium for taking up all the excessive risk. Hence, in the end, the government pays for it anyway!

It is, therefore, clear that giving too much or too little risk to the private sector is an inefficient way. Hence, risks need to be apportioned between the private party and the government. Some of the methods of doing so have been listed in the article.

Distribution of Risks

The best way to distribute risks is to ensure that the party also has a fair degree of control on the parameters which create risk.

For instance, infrastructure projects involve a lot of political risks. It would be incorrect for the government to assume that the private party would be capable of managing such a risk. The government is the party that has maximum control over political factors. Therefore, if a project gets delayed as a result of political issues, it would be unfair to penalize the private party. This is because the private party has no control over the matter. They cannot expedite the project when there are political protests happening or when there are environmental clearances missing. Instead, the project charter should ideally force the government to offer higher compensation to the private party in the event of political risk.

On the other hand, risks related to the execution of the project should be borne completely by the private party. This is because the private party should ideally have complete control over the cost and quality of the infrastructure which is being created. In many cases, the private party may claim that a delay by a third party supplier is causing the problem. However, in this case, also, the private party should be held responsible if it was given complete autonomy while selecting the third party suppliers. The bottom line is that if the private party has some degree of control over the factors which create risk, they will be able to obtain an insurance policy to protect themselves.

There are many risks that are beyond the control of both the government as well as the private party. These risks include interest rate risks as well as exchange rate risks. Interest rates, as well as currency rates, are determined in the international market. Hence, the government cannot really influence these factors beyond a certain extent. Fortunately, there are financial instruments available which allow these risks to be hedged. Derivatives like options, futures, and swaps can be used to mitigate these risks and ensure that the cash flow remains unhindered.

Lastly, since infrastructure projects go on for long periods of time, they may also face many force majeure events. Examples would include events such as floods, drought, cyclones, etc. It is important to account for such events while distributing risks amongst the stakeholders. In most cases, there are insurance companies that make good the loss is such events occur. However, if the loss is not covered by insurance, ideally the government should provide recourse. The government may itself charge a premium and act as an insurance company. However, the idea is to make sure that even acts of God should be managed in the risk management plan.

Hence, it would be fair to say that a private party is incapable of handling all the risks. Instead, the risks should be apportioned between parties that can handle them best i.e., private parties, government organizations, insurance companies as well as financial brokers.

 Risks Faced By Infrastructure Projects in Emerging Markets

Infrastructure projects are most needed in developing nations. These are the countries where infrastructure projects are able to create the most growth. This is because the spillover effects of infrastructure projects are felt significantly in emerging markets.

Ideally, emerging markets should create policies that attract more and more foreign investment on to their shores. However, in reality, this is not the case. Emerging markets have a lot of shortcomings. These shortcomings are accentuated during infrastructure projects because of the large scale and size of the investment. This is the reason why institutional investors tend to stay away from infrastructure projects in emerging markets.

Let's list down some of the risks faced by investors when they invest their money in emerging economies.

Currency Fluctuation Risks: Emerging markets tend to have underdeveloped banking as well as equity markets. As a result, they cannot provide all the capital which may be needed for the development of infrastructure projects. As a result, there is a need to involve foreign investors to fund the project. The problem is that foreign investors generally prefer to invest in an international currency such as the dollar or the Euro. However, in most emerging markets, the cash flows are in local currencies. This mismatch often signifies a huge risk for the investors. Since the projects are long term in nature, hedging is also not a viable option. One way to deal with the situation is to involve export credit guarantee institutions of other nations. For instance, countries like China do invest in projects and accept the local currency for payment. However, they insist that the contracts for the project be given to Chinese firms. In many cases, this raises costs and hence, may not be the best option.

Political Risks: Political risks are always present in each and every infrastructure project. However, when it comes to emerging markets, these risks are amplified. In many countries, governments or even rebels disrupt the proceedings of several projects. The disruption could be as simple as not granting permissions for the project. In many severe cases, entire projects have been expropriated by hostile foreign governments.

There are many corrupt governments in developing countries that know that once the infrastructure project is started, the stakes become very high. The projects cannot simply be uprooted and moved to another location. Hence, such governments try to take advantage of taking maximum money out of infrastructure companies in the form of higher taxes or even bribes! Mechanisms such as investment treaties have been created to mitigate political risk. However, they too seem to have limited applicability.

Capital Controls: Emerging markets are also known for imposing capital controls. This means that taking the money inside many emerging economies is easy. However, when it comes to taking the money back out of the economy, there may be several restrictions. Companies may not be able to return the profits earned to their parent company. This means that the investment opportunities for the cash flow generated are also limited. Limited options translate into lower returns and end up scaring away international investors. Also, the problem is that in most cases, capital controls are only put up just before the situation is about to get out of hand. For instance, in Greece, capital controls were stipulated days before the country saw a severe economic downturn.

Opaque Policies: Emerging markets are known to have opaque policies related to infrastructure development. Sometimes political parties keep the policies opaque and muddled up on purpose. This makes it difficult for companies to comply with the norms. Then, they ask for bribes to overlook the non-compliance. Companies that pay bribes are allowed to work, whereas those that do not pay strict legal action. Apart from being unethical, bribes are also known for having a severe financial impact. Many studies have shown that an opaque policy environment is equivalent to a 33% tax on the infrastructure project!

Legal Risks: Each infrastructure projects is a cobweb of several interdependent contracts. It would, therefore, be safe to say that the success or failure of a project depends upon the ability of the infrastructure company to execute the contracts. The problem is that in emerging markets, the legal system does not function efficiently. Hence, there is no downside for many rogue parties if they do not honor their contracts. The aggrieved parties do not have too many legal options. This is because the legal options may be complicated, time-consuming as well as expensive. Hence, the odds may be stacked against the infrastructure company. This obviously is a huge challenge since no investor wants to end up in a scenario where they have agreed to deliver a project with stringent deadlines but are not able to enforce their partners to hold up their end of the bargain. Legal issues can cause severe cash flow problems as it is not common for the payments to be held up because of quality issues or because a certain milestone was not met on time.

The bottom line is that executing infrastructure projects in emerging markets is full of risks. As a result, investors demand a higher return, which raises the cost of the project. It would, therefore, be better to reduce the risks so that the costs can also be reduced and the nation can benefit.

 Bank Loans vs. Bonds: Debt Financing in Infrastructure Projects

Debt financing is the most important source of finance for infrastructure projects. In most infrastructure projects, the majority of the project is funded using debt-based financial instruments. Equity holders invest a significantly smaller amount. However, they bear all the risks.

The size and scale of debt financing make it an important decision for any company engaged in developing an infrastructure project. When it comes to debt, companies generally have two options. They can either approach a bank or a syndicate of banks in order to obtain funding for the project. Alternatively, they could also issue bonds and sell the same off to private investors. Each of these methods has its own advantages as well as disadvantages. However, it is generally said that banks are a more reliable source of finance, particularly for infrastructure projects.

Let's compare the two methods of raising debt finance in order to understand what makes bank loans more viable.

The Advantages of Using Bank Loans

Experience: The biggest banks in the world are extensively involved in funding infrastructure projects. As a result, almost all of them have separate departments that have developed considerable expertise in infrastructure financing. Therefore, when a company executing an infrastructure project applies for a bank loan, they also get to benefit from this expertise. Anyone lending money to the project has an implicit role in monitoring the project in order to protect their own interests. The significant experience and resources in which banks have just make them more suitable to perform this task.

Flexibility: Bank loans can be significantly more flexible as compared to other sources of debt funding. This is one of the major reasons that bank loans are more suitable for infrastructure projects. For instance, infrastructure projects need money in phases. Once they complete a certain milestone, they want more money to be disbursed. Such complicated disbursement schedules can be easily managed by a bank. On the other hand, it is difficult to obtain this flexibility using bonds. In case of a bond issue, the infrastructure company will be forced to collect the proceeds from the sale of bonds all at once. Then, they will be forced to pay interest on the money even though they might not be using the same. If they want to obtain the loan amount in installments, they will have to raise money using different bond issues. Different bond issues will create their own set of complications viz. seniority of debt etc.

Restructuring: Delays, cost overruns, and such other difficulties are commonly experienced while executing infrastructure projects. If such a problem arises during a project, the infrastructure company would be glad to have taken bank loans instead of having issued bonds. This is because delays in the execution of the project also delay the cash flows to be received from the project. As a result, the repayment schedule has to be changed. Sometimes the loans become riskier as the infrastructure company may require a higher moratorium period. In such cases, if the infrastructure company is negotiation with a bank, they will find it easier to restructure the loan. This is because the bank is just one party, and their interests are completely aligned with that of the project equity holders. They are unlikely to receive any benefit from stalling the project.

On the other hand, if any sort of negotiations has to be done with bondholders, the process becomes extremely complicated. First of all, there are multiple parties that are included in the negotiation. Then, it is quite possible that these multiple parties have conflicting interests. As a result, when the cash flow structure is modified, all parties may not agree to it. This could create a legal hassle, and the issue could end up reaching court. Also, if the company is unable to pay its bondholders, some of them may file insolvency proceedings against the company and try to send the company into liquidation.

Evidence shows that when it comes to restructuring, banks are much easier to deal with as compared to bondholders.

Risk Profile: Also, it needs to be understood that bonds are mostly purchased by funds such as municipal funds, pension funds, and even insurance companies. The law requires these companies only to buy investments that have very low risk. The problem is that in many parts of the world, infrastructure investments are considered to be risky. Therefore, in these countries, companies do not have the option to issue bonds. Instead, they are forced to take bank loans by default.

Signaling Effect: Lastly, even if a company plans to raise debt using bonds at a later stage, they are better off using bank loans, to begin with. This is because when banks lend money to a project, the other investors who have limited monitoring capacity feel comfortable investing their money in the project. This is because they feel that since banks are involved, they will be monitoring the project. Hence, their money would be safer than it would have been otherwise.

The only disadvantage that banks have is that they are funded using relatively short term liability. Hence, they cannot make really long term loans. To overcome this, banks usually finance the construction stage of a project, whereas once the company starts to create positive cash flow, bonds are generally issued to repay the banks.

 Key Decisions to Be Taken During Infrastructure Bond Issuance

In the previous few articles, we have studied the distinction between bank loans and infrastructure bonds. We have also come to the conclusion that bank loans are more suited to the construction stage of the project, whereas infrastructure bonds are more suitable when the project has become operational and has started generating a certain amount of cash flows.

However, even the process of infrastructure bond issuance is not straightforward. Instead, there are several key decisions that need to be taken before the bonds are issued. These issues have a long term impact on the life of the entire project.

Let's have a closer look at some of these decisions and the alternatives faced by the company issuing infrastructure bonds.

 Fixed Interest Rate vs. Floating Interest Rate

The most important decision which needs to be taken by any company which is in the process of issuing bonds is regarding the type of interest rates that will be used by the bonds. Interest payments are the single largest payments for many infrastructure companies. Here the company faces two options. They can either opt for a fixed interest rate, which may be slightly higher since it provides the option to lock this rate for a long time. Secondly, the company can opt for a floating interest rate. The floating interest rate may be lower than the fixed rate in the short run. However, there is always a chance of the interest rate increase in the future.

Ideally, infrastructure companies prefer fixed interest rates. This is because infrastructure projects generally have a long duration. As a result, infrastructure bonds are known for having a long tenure. It is difficult for financial analysts to estimate the ups and downs in the interest rate over a long period of time. However, investors are also not willing to accept a fixed interest rate for the exact same reason. Also, investors do not like fixed-rate bonds because they provide an incentive for the company to refinance as soon as the interest rates reduce. Therefore even if investors agree to a fixed interest rate, they generally levy charges which prevent the company from refinancing the loan when interest rates drop. This creates a fundamental mismatch between the financiers and the infrastructure company. The financiers do not want to lend at a fixed rate, and the infrastructure company insists on having a fixed rate.

To counter this problem, most infrastructure companies use an interest rate swap. This means that they enter into a contract with investors wherein they offer floating interest rates. However, simultaneously, they also enter into a swap contract with a third party. This contract mandates the swapping of cash flows if the interest rates increase or decrease by a certain amount. Therefore, in effect, the infrastructure company has to pay a fixed interest rate.

In many cases, the revenue stream of the project is directly linked to the inflation rate. In such cases, the infrastructure company offers inflation-adjusted bonds wherein the interest rate is derived by adding certain percentage points to an underlying inflation rate.

 Amortization vs. Balloon Repayments

Infrastructure bonds can be amortizing in nature, which means that they pay back the principal as well as interest in every coupon payment. Alternatively, they can also be interest-only loans where the principal is paid back towards the end of the loan. This is called balloon repayment.

Both the arrangements have their pros and cons. For instance, if an amortization schedule is followed, then the principal amount is paid back in several small installments. This helps avoid the creation of a cash flow tail, which leads to problems in debt servicing later.

However, from the investor's point of view, balloon repayments are better. This is because they do not receive principal payments till the end of the tenure. Hence, they do not have to find reinvestment avenues for cash flows, which they receive on a periodic basis.

 Lump-sum vs. Development Linked Drawdown

Just like repayment, the timing of cash inflow can also be periodic or lump sum. Ideally, companies would prefer a development linked drawdown of cash. This way, they will only receive cash when they need it. Also, they will not have to pay interest on the excess cash. The problem is that investors do not find it convenient to disburse small amounts of cash each time.

Hence, infrastructure companies are forced to take in cash in one go, and they invest the same in low-risk treasury assets. However, in most cases, the interest that they earn from these low-risk assets is less than the interest they pay. Therefore, there is a negative interest carry which costs the company significant sums of money in the long run.

Some infrastructure companies are willing to offer higher interest rates if their investors are willing to pay them the principal amount in a phased manner.

 Historical Cost vs. Mark to Market

Lastly, companies also have to decide about how they will reflect the value of the outstanding debt on their balance sheet. If the bonds are traded in the open market, then they will have to be marked to market since there will be a market price available. However, if the bonds are not traded in the market, they may have to be marked to the historical cost! This decision may seem arbitrary, but the net worth of the entire company fluctuates with the fluctuation in the value of the outstanding debt.

Parties Involved in Infrastructure Debt Issuance

Bonds are commonly issued during infrastructure projects. The company holding the equity stake is generally the one issuing the bonds. This means that the company owning equity is the one actually borrowing money from the bondholders and, therefore, the one owing the money back.

Even though the responsibility of repaying the loan lies with the infrastructure company, it is not the only one involved in the issuance as well as servicing of debt. Infrastructure companies require a full team of specialists to help them in the various tasks required to issue and manage debt instruments.

The different parties which are involved in the process, as well as the role which is played by each party, have been explained in detail in this article.

Lead Arranger: Infrastructure companies usually hire investment banks to play the role of the lead arranger. The role involves taking the lead and being responsible for the underwriting and distribution of the entire debt issue.

Lead arrangers may or may not serve as the underwriter for the infrastructure bonds being issued. In case they do serve as underwriters, they are contractually bound to buy the bonds from the issuer. Usually, underwriters first enter into agreements with investors. Once they have these agreements in place, they use the same to enter into an agreement with the infrastructure company. In reality, they are only acting as an intermediary. The only risk that the bear is that they will be left with the bonds in case any of the parties that they signed the agreement with reneges on their promise.

Trustee: Most infrastructure bonds which are issued involves the use of collateral. It is important to monitor the collateral in order to protect the interests of bondholders. This role is played by the trustees. They are the ones who keep an eye on the collateral and ensure that the underlying assets are not liquidated, thereby harming the interests of the bondholders. In theory, a trustee is supposed to be an independent third party. However, in real life, trustees are appointed by the issuers and hence are more inclined towards them. However, in strictly legal terms, trustees have responsibilities towards the issuer as well as the bondholders.

Paying Agent & Fiscal Agent: Paying agent and fiscal agents are appointed by the issuer in order to track the proceeds which have accrued as a result of the sale of bonds. The difference between the two is that fiscal agents only have responsibilities towards the issuer, whereas a paying agent has responsibilities towards both the parties. These agents are responsible for ensuring that the special purpose entity has enough cash flow to make good its promise of timely periodic interest and principal payments to the bondholders.

Monitoring Advisor: The role of the monitoring advisor is to reduce the technical complexity and appraise the investors of the current financial situations. Infrastructure projects tend to be quite technical. On the other hand, investors have financial expertise and are not well versed with the technical side. Hence, a monitoring agent is appointed to act as a liaison between the two parties.

The role of the monitoring agent is to understand the project from a technical point of view and explain the same in financial terms to the investors. Monitoring advisors are supposed to help special purpose entities comply with financial terms and covenants which have been listed in the bond agreement. Monitoring agents conduct on the ground checks for the investors, which is important in order to safeguard their investments.

Listing Agent: As their name suggests, the job of a listing agent is to help the infrastructure company list their bonds on different exchanges. Each exchange has rules and regulations which need to be complied with in order to allow listing. In larger bond issues, such listing is considered to be very important since it provides secondary market liquidity to the investors. Listing agents have expertise with the rules of stock exchanges and hence can make the listing process much easier.

Attorneys: Both the investors as well as the infrastructure company generally have their own team of lawyers, which help them draw up a contract. Each side tries to include clauses that protect their interests. The final agreement is the result of several rounds of negotiations between both the legal teams. In some cases, the same lawyers represent both the issuers as well as the investors!

Auditors: The services of auditors are required extensively in infrastructure projects. This is because whenever bonds are being issued, the issuer provides certain financials. The accuracy of these financials needs to be verified in order to ascertain the creditworthiness of the project. Similarly, during periodic reviews, the issuer submits the income statement and the balance sheet of the project. This also needs to be verified in order to assure the investors that their investment is being safeguarded.

The bottom line is that bond issuance is actually a complex process that requires several roles to be played. It is not necessary that each role has to be played by a different party. Sometimes the same company can play three or four different roles. However, all these roles also involve costs that make bond issuance an expensive process.

 External Credit Enhancement in Infrastructure Financing

Infrastructure projects continue for a long period of time. Sometimes these projects continue for decades. Hence, they need long term finance. On the other hand, there are entities such as insurance companies and pension funds which are looking to invest their money for long periods of time. Ideally, insurance companies and pension funds should be the biggest source of infrastructure financing since their needs are complementary to that of infrastructure companies.

However, in most cases, insurance companies and pension funds are unable to invest their money directly into an infrastructure project. This is because such investments may be risky and since these organizations have a lot of public money, they are required by law to be careful about the riskiness of the investments that they make.

It can therefore be said that the higher risks inherent in an infrastructure project prevent it from getting finance. Therefore, if there was a way to somehow de-risk the cash flows, it would open a new avenue for infrastructure companies which would help them raise funds much faster and at a lower cost.

The mechanism of de-risking the cash flows is called credit enhancement. Credit enhancement can be done either internally or by external parties. In this article, we will understand what external credit enhancement is and what the various methods of implementing external credit enhancement are.

The Anatomy of External Credit Enhancement

External credit enhancement is a mechanism of involving a third party with a stronger credit profile than the issuer in the finances of the infrastructure project. The basic idea is that all the responsibilities of repaying the debt related to the project will still remain with the infrastructure company itself. However, in the event of a crisis, its finances will be supported by a different party with a much stronger credit profile. Since external credit enhancement is a kind of guarantee, it can only be provided by organizations which have good financial strength such as banks, insurance companies and governments.

Also, for credit enhancement to be effective, it is important that too many terms and conditions are not built into the contract. This means that in a crisis situation, the infrastructure company must be able to drawdown the finances from the guarantor with relative ease.

The funds provided by external credit guarantors are generally provided after some sort of a trigger. However, it is important that these funds are provided proactively i.e. to prevent a default rather than reactively after a default has already taken place. The timeliness of the external credit guarantee is one of the most important factor which helps de-risk the cash flows and make them more palatable to institutional investors.

Methods of External Credit Enhancement:

The different methods of external credit guarantees commonly used by infrastructure finance companies have been listed below:

Bank Guarantees: In many infrastructure projects, a syndicate of banks is the main financier. Sometimes, infrastructure companies will ask one of these banks to guarantee their cash flows in return for a fee. For the other creditors, this improves the situation drastically. This is because they no longer have to rely on the cash flow generating potential of the underlying infrastructure company. Instead, they can rely on the cash flow generating potential of a stronger institution such as a bank. However, banks will only agree to offer a guarantee if they are provided some control over the process. In most cases banks want the authority to constantly monitor the project as well as the books of the company before they give out a bank guarantee.

Monoline Insurance: There are many insurance companies which specialize in providing insurance to external debt holders. This means that these insurance companies accept a premium and promise to make good the investor's loss in the event of a default. Many infrastructure companies pay the premiums of behalf of their investors. By doing so, the company makes its own credit profile irrelevant in the short run as investors are directly dealing with the insurance company.

Mezzanine Finance: Mezzanine debt is another mechanism which can be used to enhance the credit of the infrastructure project. Mezzanine debt lies between senior debt and equity loans. If the company does not face a cash flow squeeze, mezzanine debt continues to exist as a high yield debt instrument. On the other hand, if the company does face a cash flow squeeze, the debt may be converted to equity. Since it poses no risk to senior creditors, it allows companies to sell senior bonds at considerably low rates of interest.

Supplemental Income: In some cases cash flow from other projects is bundled along with the cash flow from the underlying project. The certainty of the cash flow of another project reduces the inherent riskiness of depending upon the cash flow from one project. This is similar to the concept of over collateralization in bond issuance. It reduces the risk for prospective investors and as a result reduces the interest rate which needs to paid out in order to avail the funds.

To sum it up, there are many ways of enhancing the credit profile of the infrastructure bonds in order to make it more palatable to institutional investors.

 Revenue Bonds and the Cash Trap Mechanism

Infrastructure projects last for many years. As a result, different sources of funding are used at different points of time in the project. As mentioned in the previous articles, most of the time, bank loans are used during the construction phase of the project. However, at the same time, bonds are the preferred source of debt funding after the project has become operational.

A special type of bond called a revenue bond is commonly used in order to fund infrastructure projects. In this article, we will have a closer look at what revenue bonds are and how they function.

What are Revenue Bonds?

Revenue bonds are debt instruments that are commonly floated by infrastructure companies. Their name is derived from the fact that these bonds are secured by the revenues of an income-producing project. It needs to be understood that since revenue bonds are almost exclusively issued by government entities, there is a misconception that these bonds are secured by the government. The reality is that in most cases, the bondholders only have a right to the cash flows of the project or the portfolio of projects for which bonds have been issued. In the event of a default, people holding revenue bonds will not be able to ask the government to make good their loss.

This is the major difference between government debt and revenue bonds. Government debt is secured by the tax revenue generated by the government. On the other hand, revenue bonds are secured only by the cash flow, which will be created by the infrastructure project being securitized. Since the risk profiles of both bonds are different, the yields provided by both bonds are also quite different. Government debt symbolizes almost risk-free investments. Hence, their interest rates are also quite low. On the other hand, revenue bonds may be quite risky, and hence, sometimes, their yield can be quite close to the ones which are provided by private companies.

How Do Revenue Bonds work?

The cash flows being controlled by revenue bonds are not managed by the government or the special purpose entity which has been created to manage the infrastructure project. Instead, a special trust is set up to act as a neutral party and balance the interests of the bondholders as well as the shareholders. This trust oversees the cash flow, which has been generated by the project as well as how the cash is being disbursed.

The trust governing the revenue bonds has clear guidelines about how the cash flows of the project need to be prioritized. This is often referred to as a cash flow waterfall. This is because cash flows to the top levels, and only when the levels are full does the cash flow downstream. A typical cash flow waterfall would first fund the operating and maintenance expenses required to keep the project in good shape so that the revenue stream continues. In many cases, capital expenditure is given second priority. Then the leftover money is used to service the outstanding debt. Once that task has been completed, the leftover money is used to fill up reserves and surpluses. Only after all these payments and appropriations have been done can the equity investors distribute any money amongst themselves.

Revenue bonds work like private companies. This means that the debt service coverage ratio becomes a very important number when it comes to revenue bonds. The covenant which governs the bond prescribes a minimum debt service ratio that needs to be maintained. This ensures that too many bonds are not issued while the cash flow backing the bonds may not be too little.

In the case of revenue bonds, generally, there are clear and well-defined guidelines regarding the debt coverage ratio. There are restrictions regarding the historical debt service ratio, which has been maintained as well as the projected debt service ratio, which may have to be maintained in the future. Generally, a debt service ratio of 1 can be considered to be adequate. However, most revenue bonds prescribe the maintenance of a ratio of anywhere between 1.3 to 1.7. The extra money acts as a cushion and protects the bondholders from unforeseen events. The process of creating these extra reserves, which can be kept as a rainy day fund, is called the “cash trap” mechanism.

The extra money is kept as a reserve. In the future, if the cash flows from the project are not sufficient to meet the obligatory debt payments, money can be taken from these reserve accounts. The drawdown of the reserve accounts is considered to be a proactive step, which means that it prevents default. However, the act of withdrawing money from a reserve account could itself constitute a default since it means that the cash flows generated by the project were not enough to cover the debt service payments.

If there is no drawdown from the reserve fund for a stipulated number of years, this fund can then be used to retire the senior-most debt. Once the debt is retired, the amount requires to service the debt reduces. As a result, it becomes easier to maintain the debt service coverage ratio.

To sum it up, the revenue bond is a financial tool that has been created specifically for the purpose of funding the operational phase of infrastructure projects. Hence, it has many features that are useful for infrastructure companies.