In the first part, we saw how bankruptcy could occur due to market forces for a carefully crafted project and financing by the banks after requisite due diligence. That said, bankruptcies in project financed entities are relatively fewer since these are based on proven technologies and operate in mature industries with experienced promoters.
We also saw how power generation projects, amenable to effective risk mitigation, clearly show that project financing continues to fail in India.
Causes of Failure
To identify factors responsible for project finance failure, let’s look at the private sector’s approach to project formulation and financing.
Project finance is a risk management structure. The project risks must be allocated to the parties best placed to mitigate them. In the commercial world, however, the disproportionate risk gets shifted to a weak party in negotiating the risk away.
The lender is expected to minimise credit risk among the financing participants through adequate due diligence and a robust contractual structure. The promoters are expected to minimise their equity risk by mitigating all identifiable project risks and insuring the residual risks to enjoy the project upsides.
However, promoters also seek to overstate project costs to generate their equity contribution from the profit from construction contracts awarded to the group entities after initial 'pump priming' or other means to de-risk themselves partly or fully.
This results in the promoter’s investment risk shifting to the lenders in excess lending and increased financial risk. Further, such de-risking induces the promoter to grab several projects based on the mantra that while the project’s upsides would benefit him, the lenders would bear the downsides.
This is explained in Figure-4. Assume that an average debt service coverage ratio (DSCR) of 1.45 and debt:equity ratio (DER) of 3:1 is acceptable to the bank.
If the achievable DSCR is higher, the promoter would overstate the project cost and seek to maximise the debt, based on the banks’ acceptable DSCR of 1.45. At line Z-E with a DSCR of 1.49, he reaches zero equity though the nominal DER is 3.91:1. He would strive to achieve a debt level at DSCR of 1.45 represented by the line N-E, resulting in his negative equity with more than entire risk shifted to the bank.
By reaching line N-E, the promoter not only de-risks himself completely but generates cash for more such pump-priming. If such promoter becomes a serial developer after initial success, the probability of default and the loss has given default increase substantially. As a result, in the case of bankruptcy, credit recovery suffers, as seen in the table above.
The Lanco Infratech group exemplifies the malady of serial failure in infrastructure project financing. For example, Lanco’s power generation project launched under Lanco Babandh Power Ltd (one of the projects in the sample of 31 projects used for statistical test discussed later) received the sanction of long-term loans of Rs5,544 crore from 13 banks and Life Insurance Corporation of India (LIC) in 2010.
Subsequently, additional debt was sanctioned and the aggregate principal outstanding stood at Rs6,431 crore. The project construction was allowed to drag for eight years and the company was brought under corporate insolvency resolution Process (CIRP) in August 2018.
For the company with an incomplete project and admitted claim of project finance debt aggregated Rs8,217 crore (inclusive of principal outstanding of Rs6,431 crore), the average fair value and liquidation value stood at a paltry Rs1,800 crore and Rs900 crore, respectively.
The solitary bidder (resolution applicant) offered to the banks just Rs1 crore in cash and 5% equity for the project with face value of Rs51 lakh. The resolution plan was rejected and the company has been quietly liquidated for a total realisation of Rs290 crore in 2021. In comparison, Vijay Mallya looks saintly!
The flagship Lanco Infratech Ltd is under liquidation along with seven power projects and one toll road project, which are under CIRP (2), liquidation (3) or resolution (2).
Figure-5 shows unacceptably low recoveries from the NPAs (non-performing assets). While extreme tardiness of our credit recovery adjudication abets asset impairment, the project cost overstatement is a more significant contributor to low recovery, evident from meager recovery even from projects under implementation (table above).
To identify determinants of the costs of different projects, the data must be freed from project-specific factors. Further, the products and processes should be identical. This is possible in power generation projects whose power generating capacity (MW) and energy output (kWh) are the same everywhere.
Hence, a sample of 31 coal-fired power generation projects that were freed from the project-specific features were subjected to multiple regression analysis to see the variables impacting project costs. The research showed that the tariff (levelled) was highly significant with a p-value of less than 0.0001%, landed cost of coal (per 1,000 k.Cal.) was significant at 95.9% confidence level with a p-value of 4.1%, and the technology was significant at 97.6% confidence level with a p-value of 2.4%.
Interestingly, different years of debt sanction by banks were not significant and had no bearing on the project costs. Thus, the analysis established that the project cost was fixed to a level that the anticipated cash-flows could be justified.
The sceptics may contend that the significance does not necessarily imply causation. But a comparative analysis of the individual projects also confirms the tariff’s impact on project cost. Here is one example (of many) of two coal-fired power generation projects based on super-critical technologies.
$$ Normalised by removing project-specific costs on coal mine, coal transportation, township, rehabilitation & resettlement, etc which do not generally form part of project costs
The companies awarded the engineering, procurement, and construction (EPC) contracts to group companies to derive the project company’s equity from EPC profit. However, EPC profit for project B was constrained due to low tariffs bid under transparent ultra-mega power projects (UMPP) bidding, which reduced project cost. With a muted bidding, project B could manage high tariffs, which could justify high project costs, based on debt serviceability and, thus, generate the promoter’s equity capital.
In 16 projects out of 31, coal was to be supplied by government coal fields. The debt was sanctioned without evaluating the feasibility of requisite coal supply from government coal fields. Of these 16, the bankable fuel supply agreement (FSA) requirement was not stipulated as a condition precedent to drawal of project finance debt in 12 projects. For the remaining four projects, a condition precedent to drawal was prescribed only to acquire a letter of assurance (LoA) from the government for coal supply.
The lenders deemed the coal supply risk mitigated, based on the assumption that the LoA issued by government coal fields would automatically result in bankable take-or-pay coal supply agreements.
Similarly, at the time of project financing, PPAs (power purchase agreements) were not signed for 20 projects, revocable PPAs were signed for five projects, PPAs for part capacity were signed for three projects and PPAs for full capacity were signed for three projects. The creditworthiness of the off-takers, i.e., the distribution companies, was not ascertained by the promoters and project financing banks.
No wonder, many of the projects in the sample have failed and turned into NPAs. It would be naïve to assume that the promoters who launched the projects were unaware of the fuel supply and off-take risks. They launched these because the mantra was to enjoy the probable upsides and leave the downsides to the lenders.
Project finance in the country has failed due to the triple moral hazard of the promoters due to their ability to shift risks to the public sectors banks (PSBs), of the PSBs due to ownership and incentive problems, and failure of the government to meet the deliverables without any accountability.
While the sample of 31 coal-fired power projects has exposed the practices adopted by some promoters and government authorities’ failure to meet their deliverables on fuel supply and power purchase, similar losses in other infrastructure, manufacturing, and mining sectors also exit.
In short, the project finance failure in the country is attributable to a flawed echo system. To rectify this, the government will have first to ensure that its commitment for facilitation and implementation thereof is speedy, the banks are incentivised and enabled to undertake comprehensive due diligence of the promoters and projects, ensure that all identifiable risks are effectively mitigated, and monitor the project construction efficiently to make sure that the assets in the book match with those on the ground.
These steps will ensure that the promoters develop confidence in the system and have no incentive or opportunity to leverage information asymmetry and banks’ management moral hazard to indulge in project overstatement and risk shifting.
DFIs (development finance institutions) are known to serve developmental objectives worldwide by carefully mitigating risks and catalysing project financing.
The Mozal project in Mozambique developed, evaluated and structured by IFC Washington in the 1990s, has lessons for the DFIs worldwide and India, whose experience with DFIs has been mixed. While the Industrial Development Bank of India helped develop some epoch-making projects such as the bagasse-based newsprint project of Tamil Nadu Newsprint Ltd and the rutile grade titanium-di-oxide pigment of Kerala Minerals and Metals Ltd in the early 1980s, it eventually failed due to deficient echo-system and management inadequacy.
IFCI’s and ICICI’s cases were not too different. Launched with fanfare in January 1997 with fat pay-packets, IDFC also failed, despite diversified activities such as merchant banking and asset management aside from financing projects in infrastructure and core sector (manufacturing), primarily due to deficient echo-system. IIFCL survives without much impact.
The current government has displayed the resolve, and the banking reforms and clean-up launched by it is a work-in-progress. It is hoped that the banks, irrespective of ownership, will be freed from employee moral hazard and the yawning gap in performance between the public sector and private sector banks would be bridged.
While banking reforms are necessary for project finance revival and speedy asset addition for economic development, it will have to be complemented with a sufficient condition of the government bureaucracy being made responsible for swift deliverables.
Last, but not least, the dispute resolution will have to be very fast (more about this in my next article). The new DFI will repeat the murky history, if the causal factors are not eradicated.
(Dr Rajendra M Ganatra was managing director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He has over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in the above article are personal.)