– Part One: Infrastructure Risk Perception Shifts
The GDP estimates are down to 5.1%, the Index of Industrial Production (IIP) has turned negative, food inflation is high and there are murmurs of stagflation in the pink papers.
Amidst all the gloom, is it possible to examine whether this could have been predicted? Have the investors, corporate managements, banks and governments missed the early warnings signs that arose much before the auto sales numbers and unemployment numbers.
The answer perhaps lies in understanding the availability of risk capital and risk perceptions of large investors, lenders and perhaps even the general public at large. Also is there a possibility of predicting this movement, which in many ways contrasts with the unleashing of "animal spirits" the market expects from the government.
I attempt to explore the risk capital and risk perception shifts over the last two cycles in three inter connected articles with the first one exploring the shifts in infrastructure, the second one in financial services and the third concluding article focused on external factors impacting risk perceptions and the current scenario
Risk Capital conventionally means venture or private equity capital allocated for high risk and high reward investments. In reality the sources for such capital especially in the Indian context are diverse. It includes the equity capital the Indian entrepreneurs are willing to invest in new business ventures, the higher risk bank lending for these ventures, the higher risk lending by Non Banking Finance Companies (NBFC) to both retail, Small & Medium Enterprises (‘SME’) and wholesale customers and lastly the money invested by millions of retail and High Networth Investors (HNI) in high risk assets. It should be noted however that most participants in this risk capital ecosystem perceive themselves to be taking much lower risk or perhaps no risk as compared to what they are actually taking.
In some ways market cycles are a result of the correction of these perceptions and at times a swing to the other end of the pendulum's arc. Today as we stand a retail or HNI investor has a heightened risk perception of even the simplest of investment products such as deposits; bank risk managers and underwriters fear loans to even healthy corporates and entrepreneurs would rather keep money liquid and deleverage than invest in businesses or new ventures. Consequently consumers, on account of fear of employment or salary growth would rather delay or trade down their consumption.
In the first article lets us have a look the risk perception shifts in the infrastructure sector and compare it with the actual eventual outcome
I. Infrastructure
The private sector participation story in infrastructure is in many ways co-terminus to the rise and fall of IL&FS. Post 2006 investors and entrepreneurs had found a perfect recipe of making high IRRs in what is intrinsically a low steady returns sector.
This recipe had a few cornerstone assumptions
1. Low Equity and high leverage to boost Return on Equity (ROE)
2. A never-ending recycling of cash into newer projects at similar or high ROE, so to say a compounding effect
3. Contracts were presumed to be flexible and any challenges that arose could be overcome by re-negotiating contracts (i.e. cost escalations/ PPAs/ debt restructuring) or by managing approvals. This was the forte of certain industrialists, who were presumed to be at an advantage
This resulted in several intrinsically low ROE infra sectors (barring ports, logistics & airports) securing valuations multiple times their book value for still on paper vision projects and in case of EPC companies still on paper order books.
Risk underwriters in banks and highly paid private equity investors accepted that the three assumptions would never change or trusted themselves to find the greater fool in time. Initially the ability to find the greater fool, itself self perpetuated the efficacy of the underlying assumptions till it was too late.
In reality a decade down the line all three assumptions were proven to be false
The Risk Perception Shifts
1. The low equity, high leverage assumptions failed with cost escalations, stricter regulatory oversight on restructuring and later to the other extreme point of pushing even survivable companies into bankruptcy under IBC. Instead of high ROEs, investors lost even the equity invested
2. The massive faith and low risk perception on infrastructure investments brought massive equity investment into the sector and a large number of new players. Resultant competition on bids went up manifold and entrepreneurs often bid for "loss" projects to keep the ball rolling
3. Let alone renegotiate contracts even those signed at times were not honored by governments. Delays in land acquisitions, approvals and payment delays from government pushed projects into cost escalations. The continued low risk perception ensured most players did not cut their losses to abandon projects and at times they were completed even at a substantial loss. At times courts played their own role in setting aside contracts, telecom being an important example.
A good indication of how even the ‘planning commission’ failed to envisage this is in the last five-year plan (before the system was relegated to the dust bins by Niti Aayog) majority of the road investments were to be done under PPP mode. In reality it has been majority funded by NHAI leverage and budgetary expenditure.
Very few infrastructure funds/ entrepreneurs from that vintage turned up unscathed from the aftermath.
Today the risk perception pendulum has swung the other way where even operational projects under a Toll Operate Transfer (TOT) mode often find limited number of bidders. Hybrid Annuity Models (HAM) projects where-in the equity contribution is designed to be low, where substantial land acquisition is in place in advance and an assured annuity post construction eliminates tolling risk too find limited bidders. This is a reflection of the heightened risk perception not just of the infrastructure companies, but also of lenders (a few leading lenders have shut down their project finance departments) and investors who are unwilling to fund under construction contracts or minority investments in infrastructure players.
Objectively speaking while the risk in several infrastructure segments has actually gone down from the hey days of 2008-2012, the risk perception has gone up many folds. Thus, risk perception shift and risk capital availability now cause the government to fund the riskiest part of infrastructure construction in several infrastructure sub-sectors.
While questioning past decisions is always easy in hindsight, we will see in the Part Three of the article on whether this could have been foreseen if you were an investor/ entrepreneur or lender and perhaps avoided if you were a regulator or government. In Part three we will examine how a few players did not fall in this risk perception trap. It is also time to figure out if the pendulum has swung the other way for infrastructure.
In Part Two we examine risk perception shifts in Financial Services, a sector in which the journey has been just as interesting.
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