How Equity Lock-Ins Deter FDI In Indian Infrastructure

India has plans for big investments in infrastructure. To implement these successfully, it needs to make investing easier. One route to such investment is acquisitions but equity lock-in provisions in bidding conditions or contracts with the government hinder M&A activity. There is little logic for these provisions and they should be removed from government bids and contracts.

Much Investment Is Needed In Infrastructure

In 2021, the government announced plans to monetise up to Rs 6 lakh crore or $81 billion in government assets through the National Monetisation Pipeline. Further, the National Infrastructure Pipeline, announced in 2020, anticipates Rs 111 lakh crore or $1.5 trillion worth of infrastructure spending over 5 years, of which $300 billion is slated to come from the private sector. These plans have been impacted by Covid-19, but they remain ambitious.

...But There Are Problems

It will not be easy to fulfill these plans. Greenfield investment in India continues to be risky, and there are impediments to acquiring assets through mergers and acquisitions. For the above targets to be met, two things must happen: risk in greenfield projects must be reduced, and acquiring operating assets needs to become easier.

The first is a significant task and needs broad reform. Procedures to grant permits and consents need clarity and simplicity; environmental clearances need greater predictability; land acquisition requires facilitation; and the quality of and risk allocation in contract documents such as power purchase agreements and concession agreements must improve. This will take time.

Also, as many government-owned entities in India have poor payment histories, investors want to wait and see a regular flow of payments coming into a new project from state-owned contracting counterparties.

Domestic players are better able to manage such risks and as a consequence, greenfield FDI in many infrastructure sectors is lower than it could be.

Foreign investors have been busier picking up assets in the secondary market, as a consequence of which M&A activity involving FDI is reasonably robust. Renewables and roads are the most active sectors but there have also been foreign-owned buyers for airports, telecom towers, etc. Structures such as infrastructure investment trusts or InvITs, which make it easier for portfolios of assets to change hands, have helped.

However, there is a bug in the system that impedes M&A activity – the equity lock-in. This concept, also called a restriction on share transfer, finds its way into most bidding guidelines and associated project documentation.

Some Examples

Solar Bidding Guidelines, Wind Bidding Guidelines, and Round-The-Clock Project Bidding

The shareholding of the winning bidder in the company executing the PPA should not fall below 51% until 1 year from the commercial operations date or COD.

Goa And Navi Mumbai Airport Concessions

The selected bidder must retain shareholding of over 51% for the first 7 years, transfers may take place only with the written approval of the authority. Any transfer of shareholding of over 25% needs the approval of the authority or the government (with their decision being final and binding) from national security or public interest perspective.

Model Concession Agreement For Ports

The selected bidder must retain at least 51% until 1 year from the COD. The concessioning authority may be approached for a transfer of shareholding beyond this limit but has the sole discretion to approve the transfer.

Rail concessions

Similar to airports. 51% during the construction period, 33% for three years following COD, and 26% thereafter. Changes beyond this need the approval of the Ministry of Railways, at its sole discretion.

In addition, for solar, wind, round-the-clock, and hybrid renewables projects, restrictions on transfer also apply at the level of the shareholders of the selected bidder, making M&A in one of India’s sunrise sectors harder to execute.

Theoretically, approval for transfers can be sought but there is no guidance as to whether it will be given or not, or under which conditions. Nor is there any indication of any periods within which approvals will be given or denied. Practical experience shows that approval is not always forthcoming and even when given, can take a long time. This is a significant risk factor in acquisitions.

Why Have Lock-In Clauses?

The reason for having lock-in clauses is not clear or formally articulated anywhere. From personal experience, through discussions with various government authorities, while drafting contracts for them, I have come across two unsatisfactory explanations.

The first is that it is too much work to re-evaluate the background and financial and technical credentials of the potential transferee.

This is a weak excuse. It is not hard to envisage establishing an ad hoc or permanent entity to evaluate the credentials of a potential transferee, just as is done when the project is granted. And, as will be seen below, there in fact are good reasons to consider such transfers.

The other explanation is axiomatic: “we gave you the project, now we insist that you and nobody but you must execute it”

There is no logical response to this.

Why Lock-In Clauses Should Go

Capital in infrastructure projects tends to work in a specific way, particularly in markets such as India which exhibit high levels of regulatory and counterparty risk. The development phase of a project, involving bidding, securing permits, land acquisition approvals, and dealing with political economy issues is typically done by locally embedded developers, who are willing to bear high levels of risk. Leaving aside the very large Indian groups, these developers tend to be well-connected on the ground but often lack the technical ability and financial standing to see the project through construction, commercial operations, and beyond. Consequently, they either bring in a partner who has these attributes—which are often required to bid qualify for projects—or put up some of their own money to finance the development phase.

Once the development phase is over, they seek to flip the project or a significant chunk of their shares in it, to investors with deeper pockets and greater technical capability (for instance a private equity player), who will take the project through the construction phase. Once the project is built, commercial operations commence, and a payment stream is established, long term investors with patient capital, such as infrastructure and pension funds and utilities are more willing to take these projects, or significant stakes in them, off the hands of the developer and/or the intermediate investor.

The equity lock-in makes it difficult to implement this relatively well-understood cycle of capital. This, in turn, makes it difficult for a project to move from a developer with low financial and technical capability but a high-risk tolerance, to a utility or long-term fund with deep pockets and a low returns threshold, but a lack of willingness to take up-front risk.

It is in the interest of the concessioning authority and ultimately the government that stable players husband important infrastructure projects. While this should be encouraged, the equity lock-in does exactly the reverse.

Further, risk capital gets tied up in projects which don’t need it and prevents it from being recycled for new ones. Finally, owners with better credit ratings should also be able to renegotiate better interest rates with lenders. Lenders too, will prefer better credit-rated borrowers.

M&A in these projects does take place, despite these restrictions. But lawyers spend a lot of time, and clients a lot of money, structuring around roadblocks in law and regulation, although almost no solution provides perfect security. And even when a deal happens, authorities point to the profits made by sellers as evidence of inflated bids and gold-plating. In fact, such profits represent the premiums that more cautious investors are willing to pay for the reduction of risk. The higher premium an acquirer is willing to pay, the more stable and long-term an investor they are likely to be.

Conclusion

What we need is a drastic change of approach. The concessioning authority and government need to think of what they need to do to get the highest quality of investors in, particularly for the most important projects. If it can’t do so by reducing risks upfront, it should allow private players to step in, reduce the risk and collect their reward for it. The approach should instead be to allow any change in ownership as long as the transferee has similar or better financial and technical standing. Removing the equity lock-in and responsibly evaluating the credentials of the new investors will lead to greater M&A activity and help achieve the high levels of investment the country needs.

Akshay Jaitly is Principal, 262 Advisors; and co-founder of Trilegal.

The views expressed here are those of the author, and do not necessarily represent the views of BloombergQuint or its editorial team.