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Infrastructure-focused private equity (PE) firms are tweaking their investment strategies for the Indian road sector, hoping this will compensate for a dearth of proper exit options and low returns. PE firms are willing to stay invested for a longer duration and are keen to pick up controlling stakes in individual road projects. Up to 2012, they were content with picking up minority stakes in holding companies or portfolios of multiple road projects and staying invested for about four years.

“A few years back, investing at the portfolio level allowed the PEs to diversify risks across various assets. Also, keeping in mind the vast opportunities for road developers in India, they expected to exit with higher returns either through secondary transactions or public listings,” said Suresh Goyal, chief executive officer (CEO) at SBI Macquarie Infrastructure Management Pvt. Ltd.

The road sector, however, has been facing challenges including project delays because of regulatory hurdles and high interest rates. According to a 14 October report by Emkay Research, 21 road projects worth INR 31,680 crore were stuck, affecting the overall portfolio quality of road developers.

“Significant delays in land acquisition by concession-granting authorities and problems pertaining to regulatory clearances are the two more common issues across projects,” India Ratings and Research Pvt. Ltd, a Fitch company, said in a 11 March report. “The issues have accentuated with the generally stressed financial and liquidity profile of road developers.”

This led to investor cherry-picking individual assets from a portfolio. “PEs now want to buy only clean assets that are operational and have no land acquisition and construction risks. The only risk that they are willing to take is traffic risk,” said M.K. Sinha, managing partner and CEO at IDFC Alternatives Ltd, the PE arm of IDFC Ltd.

In 2013, both Macquarie SBI Infrastructure Fund and IDFC Alternatives bought controlling stakes in multiple road projects. Macquarie SBI Infrastructure Fund bought 74 Percent stakes each in Trichy Tollway Pvt. Ltd and GMR Jadcherla Expressways Ltd, and IDFC Alternatives picked up a 74 Percent stake in GMR Ulundurpet Expressways Pvt. Ltd. Buying out road assets will require PEs to develop the bandwidth for road management. Both IDFC Alternatives and SBI Macquarie have put in place separate teams for managing the acquired road assets.

Meanwhile, Hyderabad-based Ramky Infrastructure Ltd has put up three of its assets for sale. Madhucon Projects Ltd is also looking to sell at least a 74 Percent stake in Madhucon Agra–Jaipur Expressways Ltd. Mint reported in October that nearly 50 road projects were up for sale as companies struggled with delayed approvals, land acquisition hassles and high borrowing costs. Aggressive traffic projections are another worry.

Ratings firm Crisil Ltd on Wednesday said its analysis of 15 national highway stretches showed traffic growth in passenger car unit terms had slowed to 3-4 Percent in fiscal 2012 and 2-3% in 2013 from 7-8% between 2006-07 and 2010-11.

“Our estimate is that overall traffic growth has remained weak in the current fiscal (2014) and will continue to languish around 3-5% over the next 12 months,” said Prasad Koparkar, senior director, industry and customised research, Crisil Research.

“Typically, a 100 basis points (bps) drop in traffic growth over the concession period can result in a 75-100 bps decline in project returns,” he said. A basis point is one-hundredth of a percentage point.

PE firms, therefore, have now changed their valuation strategy for roads. Instead of going by the portfolio size, valuations are now decided by cash flows generated by individual road assets. “Bigger the portfolio, higher the valuation was the trend. PEs invested in road-developing firms in anticipation that the developers would be able to get more projects and generate higher revenues, giving investors a quick exit,” said Goyal of SBI Macquarie.

In 2008-09, valuations for road projects were as high as three-four times the book size, he said. This has now dropped to 1-1.7 times the book size, according to infrastructure analysts. Sandeep Upadhyay, senior vice-president, infrastructure solutions group, Centrum Capital Ltd, said most PE firms are now taking cash flows into account to arrive at valuations.

“Most of the established infrastructure funds and investors have a threshold of striking 16-18 Percent equity internal rate of return on operating assets. This forms the basis of firming up asset valuation, which is arrived at by discounting future cash flows of the asset,” Upadhyay said.

This trust in cash flows was strengthened also by the absence of a flourishing initial public offer market or options to sell stakes in road portfolios to other investors. “Buying out individual road assets allows PEs to take control of roads and generate returns through the cash flow of these assets. This requires PEs to take a long-term view on investments, say up to seven years,” Goyal said, emphasising that secondary exits became difficult as valuations dropped.

“While the operational assets with robust cash flows still command a premium on the book value, I expect some transactions may also happen at a discount, depending on the stage of construction, traffic growth and means of financing,” said Upadhyay.

Road developers expect valuations to improve, with the government providing interim relief to them and expediting approvals. Early in March, the government cleared a proposal to rationalise the premium offered by road developers to the government, subject to certain conditions. Premium here is the money road developers agree to pay the National Highways Authority of India (NHAI) for building highways and collecting toll from users. The move allowed stressed road developers to reschedule their premium commitments for highway projects.

“The valuation of road assets will look better now,” said GVK Group chief financial officer Isaac George. GVK Power and Infrastructure Ltd was the first company in India to develop a six-lane road project under the public-private partnership model and has around 3,000-lane-km expressway projects under operations and development.

George said the premium rescheduling will make road assets attractive to investors as the developers will get some kind of relief in initial years. The government’s conditions for this rescheduling include limiting the definition of financial stress to shortfall in premium payments against cash shortfall on account of operations and maintenance expenses, and debt servicing.

The other conditions are that the road ministry should notify a cutoff date for the “special dispensation” beyond which projects will not be eligible for this relief, and enabling NHAI to impose any conditionality to protect the government’s interest.

Source-On Request