WP 0307
WP 0307
WP 0307
Prithvi Haldea
PRIME Database
Praveen Mohanty
India Development Foundation
Prognosis Capital Advisors
This is a revised version of the paper presented at the Policy Roundtable on the Financing of
Highways, New Delhi, May 22 – 23, 2003. The proceedings of the roundtable are being
published as a book.
Market-based financing of highways in India 2
Introduction
The objective of this paper is to evaluate the different financing structures presently used by
National Highway Authority of India (NHAI) to implement the National Highway Development
Programme (NHDP) and suggest alternative structures to supplement those. The NHDP has
estimated a total funding requirement of Rs 58,000 crore (at 1999 prices), that is envisaged to be
funded through a variety of means – World Bank/ADB loans, oil cess, road tolls (or other user
charges) and market borrowings (see Table 1 for a break-up). Private contractors are being
appointed by NHAI under varying contracting structures to implement this Programme. These
include EPC contracts, annuity contracts1and BOT concession agreements2, each corresponding
to a varying degree of financial obligations in the future for NHAI.
The alternative financing options presented in this paper complements the current financial plan
and contracting regime. Our attempt is to place the proposals within the boundaries set by the
policy framework adopted by NHAI. The guiding principle of the proposals presented here is to
find structures that would help raise resources for the NHDP on “terms” more favorable and
viable to the current plans. To place the alternatives in the proper context, we first begin with a
review of the current financial plan, which then becomes the point of reference for our analysis
and identify issues that need to be addressed so as to make the alternative plans feasible. In
doing so, we make two important assumptions to guide the analysis. First, the financing
structure should limit the Government’s liability to the oil cess and the grants made from the
multilateral agency loans – i.e. a limited-recourse financing structure, and second, the private
sector participation is not limited to an access to funds but also extends to a participation in the
risks of the project.
The first part of the paper contains an evaluation of the present means of financing of NHDP
projects, and identifies the issues critical to bankers and investors in taking decisions on
financing any such project. We argue (with some evidence) that in its present form, the investor
is being provided with limited information to take an investment decision. An investor typically
analyzes the risks of the project and its allocation between the different types of investors before
reaching an investment decision. And then weigh the risks against the expected returns from this
particular investment, and decide to invest only if the expected returns are higher, for a given
level of risks, than other competing investment opportunities. In the absence of adequate
information, such analyses are difficult to make and, therefore, may limit investor interest. We
also express our concerns about the present methods of market borrowings and conclude that the
huge amounts being mobilized through bond issuances are not so much a factor of the project
viability, but of tax benefits and an implicit assured return that these bonds offer.
The second part of the paper identifies the steps that NHAI needs to take so as to generate
investor interest in financing NHDP. Inter alia these would include disclosures of business and
financial plans, revenue projections, risk analysis, financial structure, etc. We argue that a risk
analysis with clear risk identification and allocation is essential to attract investors to finance the
projects either through NHAI or directly assume some of the risks. NHAI’s capacity to
warehouse risks would consequently, determine the limits of any innovations in the financial
1
NHAI’s annuity concession contracts are structured such that the concessionaire receives a pre-
determined amount of money every year from NHAI in return for the obligation to develop and maintain
the highway for the duration of the concession period, usually 30 years.
2
BOT concession agreements gives the concessionaire the right to collect tolls and fees from facilities
developed alongside the highways in return for an obligation towards construction, development and
maintenance
Market-based financing of highways in India 3
The final section presents a conceptual framework for one such innovation in the financial
structure –Whole Business Securitization. We show that the highways projects in India are
amenable to this rather unique financial structure. The NHDP projects not only meet the
requirements of cash flow stability/predictability that securitization requires but also that the
Indian legal framework contains the basic ingredients that would ring-fence these cash flows
and the assets of the project in a special purpose vehicle to safeguard the interests of the
investors. The paper ends with a brief conclusion and a summary of recommendations.
We would also like to add a caveat to the analysis that follows. The paper lacks the benefits of
data/ information on NHAI. The analysis and the recommendations could perhaps have been
more incisive. Factual errors, if any, are the result of data inadequacy. The authors bear full
responsibility for all errors.
The NHDP consists of two mega projects – the Golden Quadrilateral (GQ) and the North-South-
East-West (NSEW) corridor – whose scope consists of construction of new highways and 4-
laning of existing highways adding up to a total road length of 13,146 kms at an estimated
project cost of Rs 58,000 crore. A significant part of this project cost would be met through
grants and soft loans from multi-lateral agencies like the World Bank, ADB and JPIC. An
equally large part would be met from the oil cess collected by the central government, while the
balance is intended to be raised from the market (see Table 1 below).
The funding plan for NHDP is rather complex and difficult to disentangle. The Rs 58,000 crore
figures represent the cost of the project in 1999 prices, while the projects will be implemented
till 2007, assuming there are no time overruns. Allowing for inflation and cost overruns due to
delays in project implementation, financial closure, and land acquisition the cost would be much
higher. Moreover, the interest cost during the project construction would also lead to an increase
in the funds requirement. In the absence of data to estimate the project cost in current prices on a
year-to-year basis, we will use these numbers for illustrative purposes, although the actual
numbers may probably be 30-40% higher.
Out of the Rs 58,000 crore needed for the project, Rs 20,000 crore would come in the form of
Market-based financing of highways in India 4
grants and soft loans from the government, while the balance has to be raised from the market
either directly by NHAI or by the concessionaires for the Annuity and BOT projects. While the
direct borrowings by NHAI and those by the Annuity concessionaires would be met through the
annual cess collection and toll charges collected by NHAI, the borrowings by the BOT
concessionaires would be serviced by the toll collections from those specific projects.
A review of the information memorandum issued to investors for the on-tap NHAI bond
issuance programme during 2001-02 and 2002-03 and of newspaper reports brings the following
facts to light:
• NHAI raised Rs 656 crore in 2000-01, Rs 806 crore in 2001-02 and Rs 5, 500 crore in
2002-03 from the market through private placement of Sec. 54EC bonds, rated AAA by
CRISIL3,
• The tenure of this debt ranges between 3 to 7 years, while the average cost of borrowing
is approximately 7.5% per annum range during 2002-03
• WB and ADB have sanctioned over USD 4 billion for the NHDP (maturity not known)
• NHAI is in the process of securing a line -of-credit from the Life Insurance Corporation
of India of approximately Rs 4000-6000 crore (maturity unknown) at a cost of 80-100
bps over the relevant Government security by escrowing the oil cess receipts.
Several issues arise when we try to evaluate the financing strategy being followed by NHAI in
face of the funds requirement and the financial characteristics of the project. At the cost of
brevity, we list some of the issues we consider to be important.
2. The nature of government support is unclear – although no explicit guarantee has been
extended to NHAI by the government, the AAA rating of the NHAI bonds assumes that
the government would extend its budgetary support to the borrowings made by NHAI3,
and is not entirely based on economic viability/cash flows.
3. Preliminary analysis suggests that the interest cost during the construction period (and
the first few years of revenue shortfall) has not been factored into the project cost and
the financing plan.
4. Most of the current market borrowings would start maturing just around the time when
the NHDP project would be getting into an operational phase, thereby exerting severe
strain on NHAI’s cash flow due to redemption pressures.
3
While assigning the AAA or “highest safety” rating to the NHAI bonds, CRISIL’s rating rationale states
that “In case of any financial stress, CRISIL expects the MoRT&H (GoI) to make resources available to
NHAI in advance to enable it to discharge its debt obligations on time.” (emphasis added)
Market-based financing of highways in India 5
5. Going by the current trend4, the oil cess revenue may not be sufficient to meet the
interest burden of the whole project.
NHAI has had significant success in garnering large amounts of funds through its bond issues.
The success needs to be ‘questioned’ in view of the high coupon rate, tax-benefits as also an
implicit sovereign guarantee built into these bonds. In any case, it is prudent to question the
sustainability of this borrowing programme, and to evaluate the cost efficiency of these
borrowings.
NHAI’s record of raising Rs 5, 500 crore in 2002-03 through the issue of tax-saving (under Sec
54EC of the IT Act) bonds should also be seen in combination with the falling interest scenario
in the country that resulted in the banking sector making significant capital gains. . It is therefore
not surprising that the demand for the 54EC bonds was high all through the year. This scenario
is, however, unlikely to continue, thereby making the borrowings programme unsustainable in
the short to medium term.
A 7.0% - 7.5% yield on tax saving bonds is equivalent to a 10.0% - 10.75% YTM for the
investor when adjusted for the tax effects. Table 2 gives the borrowing rates for some of the
other AAA entities during the year5. It is evident that the coupon offered by NHAI is higher
than those of the other issuers even if we do not consider the tax-free status of these bonds.
Moreover, the private placement of bonds (with a lock-in on transfer due to Sec. 54EC
requirements) distorts their pricing in two ways. First, private placements of bonds are usually
done at a premium to the price in the public debt market. And second, the non-tradable nature of
these bonds affects price discovery in the market. A widely held, publicly traded bond, on the
other hand, acts as a benchmark reference for pricing future issuances. Also, public issues
expose the borrower to the capital market dynamics related to financial transparency and
discipline. Furthermore, the secondary market prices also act as signals to the investors of
changes in the credit quality of the issuer.
NHAI is faces significant refinance risk and a corresponding interest rate risk due to the cash
flow mismatch that is created by the short maturity NHAI bonds. The NHDP requires funds
with a final maturity of about 20 years and an average life of 12-15 years. In the absence of
reliable data, we assume that the banking industry is the biggest investor in the NHAI bonds –
not the ideal provider of such long-term finance. Life insurance companies and pension funds
(including Provident Funds) would be better positioned to provide such financing since such
long duration bonds match the asset-liability profile of these institutions. Moreover, the low risk
(AAA rating) of these bonds would meet the risk profile target of these institutions. Retail
investors would also be a good source of long term finance, in spite of higher cost of issuances.6
The demand for safe, long term fixed income securities can be seen in the success of single
premium insurance products sold by most life insurance companies.
4
Cess receipts – Rs 1800 crore in 2000-01, Rs 2100 crore in 2002-03 and Rs 2000 crore in 2002-03. This
is expected to go up due to the additional cess introduced in the Central Government Budget for 2003-04.
5 The coupon rate ranges in Table 2 is quite wide due to the falling rate scenario all through the year.
Rates fell drastically after May-June and therefore the higher ends of the ranges may be misleading at first
glance.
6
In the past, financial institutions like IDBI and the erstwhile ICICI have had significant success in
issuing long-dated (up-to 25 years) deep-discount bonds to retail investor with and without periodic put-
call options. Given the low interest rate scenario in the domestic economy, it may be prudent to issue such
instruments to the retail investors without any optionality.
Market-based financing of highways in India 6
It should be mentioned here that public issuance of bonds, to institutional or to retail investors,
would require NHAI to disclose a lot more information about its operations and financial plans.
SEBI mandated format of the prospectus requires issuers to clearly disclose all the risks that the
organization is exposed to that might impact the safety of the funds invested. Accordingly,
NHAI would have to get an explicit government guarantee to put to ease any questions the
investors may have on the financial tenability of NHAI’s operations7.
In the initial years of its operation, tolls (from the highways under the NHDP that are not part of
the BOT concessions) would not be a significant source of revenue for NHAI, and in fact, be
mired under political controversies as well as operational problems8. NHAI would, therefore,
have to rely extensively on the annual oil cess to meet its debt-servicing obligations, including
the annuity payments. Therefore, ceding charge on these cash flows to support any single
borrowing could adversely effect the interests of the existing lenders and may also create
unfavorable conditions for future market borrowings. By rough (conservative) estimates, NHAI
would probably need to borrow (directly or indirectly through annuity like schemes) an
additional Rs 25,000 crore over the next 3-4 years to meet the funding for NHDP. It is
therefore, essential that it does not encumber any of its sources of revenue in the short-run.
In view of the above mentioned issues related to the current financing plans, we restate NHAI’s
financial objectives as follows:
• Raise Rs 58,000 crore for the financing of NHDP – at the lowest possible cost
7
The analytical framework used by Moody’s to rate Government sponsored entities (like NHAI)
considers the business fundamentals of the entity in line with a private enterprise in a similar business. An
explicit financial support from the government (sponsor) in the form of a guarantee or line of credit is
needed for recognition of the support in the rating of the entities liabilities.
8
According to the recent CAG report, NHAI has been indicted for revenue losses due to delay in toll
collection in the Gurgaon-Kotputli section of NH-8 (Business Standard, May 6th, 2003).
Market-based financing of highways in India 7
• Service this debt from internal accruals (including oil cess, tolls and other user charges)
and with minimal recourse to the Consolidates Funds of the Central Government
• Help garner private sector initiative in the provision of roads, highways, and
expressways
Selection of large infrastructure investment should ideally be based on two criteria: the financial
viability as well as the economic viability of the project. In the case of NHDP, since the decision
to implement the project has already been made, we can safely assume that the economic
viability has been established and therefore, concentrate only on the financial viability of the
project. From this perspective, there are three important inter-related determinants of financial
viability: project cost, project related risks and financing structure (interest cost, debt/equity
ratio, etc.). With limited degrees of freedom in changing the project cost or eliminating the risks,
the decision on the financing structure becomes paramount in establishing the financial viability
of the NHDP.
In the previous section we saw that NHAI’s funding plans contain a major role for the private
sector, both as a provider of funds and as an investment partner in the projects. There are two
alternative means to meet these goals. It can either take a public finance approach or take a
project finance approach in partnership with the private sector. The third approach of a purely
private sector initiative is clearly not tenable in India. While the plans for the NHDP are based
on a public-private partnership, we belabor the requirements to make it into a bankable model9.
There is a fundamental difference between infrastructure projects funded through public finance
or (private-public) project finance. While the costs of the public financed projects are paid from
public budgets or by sovereign borrowings, in project finance these costs are covered by a
combination of equity paid in by private investors/sponsors and from debt borrowed from the
market. The availability of resources (and associated terms and conditions) depends upon the
creditworthiness of the company and the revenue generating potential of the project. Put
differently, what this implies is that in the public financed projects, all the risks associated with
the project are borne by the sovereign and, therefore, attract the best terms of financing. In
project finance, on the other hand, the risks are borne by different types of investors in the
market. Financial closure may be difficult to achieve if market participants are not willing to
assume certain kinds of risks, thereby making project finance unviable. Therefore, a mix of
elements from both public and project finance structures may be required to make large
infrastructure projects like the NHDP financially viable. The analytical approach of project
finance – that is, a risk-based approach can be combined with recourse to public budgets
(through sovereign guarantee) to cover the risks of the project that the private investors are not
willing to take.
To arrive at an appropriate financing structure for NHAI to implement the NHDP, we need to
understand the risks associated with road projects and to identify which markets (and market
participants) are best suited to assume these risks A fair and equitable allocation of the risks
9
A project can be said to be bankable if all the risks associated with the project are clearly identified,
equitably allocated to parties willing to assume the risk. A bank (or a financial investor) would be willing
to assume some of the financial risks associated with a project, provided the risks are well understood.
Market-based financing of highways in India 8
would require proper identification, assessment and pricing (usually by the party accepting to
bear it) of the risks. This analysis has to be in the context of the current market conditions and
the opportunities it affords to mitigate the risks. The residual risk, i.e. the risks that can not be
placed in the capital markets, is borne by NHAI. Financial structures need to be evaluated in
terms of their risk transfer capabilities and not narrowly as matching the funds requirements
with funds availability. An explicit understanding of the risks has two clear advantages: allows
for a better estimation of the cost of capital for the project and quantifies the funds required from
public sources either as direct or contingent liability on the Government’s consolidated fund.
The mode of analysis being suggested here is not different from what is applied to evaluate the
level of sponsor support (usually in the form of equity or guarantees) to any private project. This
project finance approach can, therefore, be applied to arrive at a limited recourse financial
structure for public projects.
The type of financial instruments (debt as well equity) used to finance the project would
determine the extent to which these instruments transfer the risks associated with the project to
the investor. In the absence of any risk transfer, there is an unlimited recourse to the sponsor’s
balance sheet and therefore the terms of financing would reflect sponsor’s financial position to
withstand the risks associated with the project. At the other extreme, if all the risks are
contracted out to market participants (investors), the sponsor’s financial strength is not
important in achieving financial closure on the projects. Therefore, the risk analysis and its
assumption by the project’s different stakeholders is the key to achieving the most favorable
terms of financing. This is because through the use of appropriate capital market instruments the
risks get apportioned to market participants best suited to assume those risks.
The risk analysis is not only important to attract private sector participation in the project
through risk sharing, but is also equally relevant for the market borrowings on NHAI’s own
balance sheet. This is because, a lender/investor would be concerned about the aggregate risk
housed in NHAI’s balance sheet. They would look at NHAI’s capital structure to determine its
risk taking capabilities. Explicit guarantees from the government for specific outcomes are
needed to de-risk NHAI and to assuage the concerns of the investors.
The main risks facing road projects include pre-construction, construction, traffic and revenue,
currency, force majeure, political and financial. These risks must be allocated to private or
public entities to achieve financial closure of projects.
Construction: Design changes, unforeseen geological and weather conditions, and unavailability
of material, finance and labor during construction phase can cause delays and cost overruns. The
construction company typically assumes these risks, although those relating to design changes
that may need to be shared by NHAI.
Traffic and revenue: These risks are associated with insufficient traffic levels, toll rates, and
other sources of revenue to generate expected levels of revenues. Depending on the specific
highway segment, the private investors may be willing to assume this risk. On the other hand,
NHAI may have to underwrite this risk for other segments.
Currency: This risk becomes relevant only if foreign capital is used to finance the highways.
Force majeure: Force majeure involves risks beyond anyone’s control – fire, earthquake, floods,
Market-based financing of highways in India 9
riots, wars, etc. While private insurance can be used to cover natural force majeure risks,
political force majeure risks may need to be assumed by the public sector to attract capital on
reasonable terms.
Political: Political risk concerns government action that could impair a project’s ability to
generate earnings – termination of a construction or concession contract, imposition of tax or
unfavorable regulation, withdrawal of right to collect tolls or reduction in the toll rate, etc.
Governments generally agree to compensate investors for termination of the concession or
violation of the terms of the concession agreement, including agreed toll rates. However, the
private investor ultimately has to bear the risk that these compensation may not be timely paid
or the disputes arising from these violations would be resolved quickly.
Financial: Financial risk is the risk that the project cash flow may be insufficient to pay an
adequate return on private debt or equity investment in a project. The private sector is generally
responsible for this risk, but the government may decide to underwrite part of this risk by
providing guaranteed returns on debt or equity, or by providing subordinate debt, cash grant, etc.
that improves the expected return of the private investment.
Let us briefly review the three modes of financing being used for NHDP.
1. EPC contracts: The cost of the project is fully met from public funds (grants under the
World Bank/ADB assistance) and consequently all risks with the exception of
construction risk is borne by NHAI.
2. Annuity contracts: The financing of the project is based on a contracted annuity from
NHAI. Private funding against the annuity receivables of the concessionaire but the
financial risk remains with NHAI. Concessionaire assumes the construction risk of the
project.
3. BOT contracts: These contracts are project financed, whereby the special purpose
company (the concessionaire) assumes almost all the risks except for political risk,
which is borne by NHAI as per the terms of the contract.
While in the first two schemes, constituting the bulk of the projects, the NHAI is the sole
financier and the risk taker, investors in BOT projects base their projections on the toll revenue
(traffic risk) and are willing to finance (for instance by way of securitization of toll revenue)
such projects. The predictability of a certain volume of traffic is a precursor to project financing
and therefore, it is not surprising that there aren’t too many of such projects and till date, only
one of these projects has reached financial closure10.
In assessing the different alternatives to the current financing structure, we evaluated the
possibility of securitizing certain cash flows emanating from these projects11. Securitization as a
10
Jaipur-Kishangarh segment
11 Securitization is a mode of financing which entails that specific contractual cash flows are pooled
together and sold (or the rights transferred) to a bankruptcy remote SPV which then issues debt securities
backed by the said cash flows.
Market-based financing of highways in India 10
method of financing highway project has a number of limitations. First, the major source of
revenue is user charges, which depends on the volume of traffic or the number of users of the
highway. At the outset of a project, the volume of traffic is uncertain within a wide range. This
is because, while the new highways would typically increase the number of users, the user
charges may also lead to a reduction in traffic. Traffic estimations in the past have over
estimated the volume of traffic (NOIDA toll road for instance) and therefore, in the absence of
long-term traffic volume data to support the estimates, rating agencies would typically err on the
side of conservatism in arriving at the amount of tolls that can be securitized. Moreover,
applying these traffic volumes to generate cash flows over a long period (15-25 years) could
severely underestimate the true revenue generating potential of the highway.
Second, the lack of diversification in the sources of the cash flow introduces risks that are
difficult to hedge. The leakage of traffic to alternate roads can lead to a dissipation of the
projected cash flows. This is a relevant cause of worry since NHAI reserves the right to build
alternate highways. For instance, the new National Expressway 1 between Ahmedabad and
Vadodara would compete with that segment of NH8 for traffic. Therefore, although
securitization is a possible mode of financing, its potential would be severely limited.
Finally, securitization of future toll revenue also may not be very efficient in terms of financing
costs. This is because in BOT projects the performance of the concessionaire is critical in terms
of the validity of its claim on the toll charges. In the event of performance related defaults by the
concessionaire, NHAI has the (unilateral) right to terminate the contract by paying off the
debtors to the project SPV. Moreover, in the event of bankruptcy of the concessionaire, the
receiver may establish a claim over the toll revenues. Such risks would impact the terms of
financing.
Securitization methods can also be used to secure financing of the Annuity projects. The cost of
financing would in this case depend on a couple of factors. One is the performance or the
bankruptcy risk of the concessionaire as discussed above. Additionally, the credit risk of NHAI
– the annuity payer, would be a factor in arriving at a credit rating of the securities backed by
these receivables and therefore shall impact the cost of financing.
NHAI can itself use the fuel cess receivables as collateral to raise finance (as under negotiation
with LIC). These receivables are from the sovereign and would therefore attract terms of
financing very close (maybe 15-20 bps) over the yield on direct sovereign borrowings12.
However, the beneficial borrowing terms should be seen in conjunction with the overall
borrowing program. This is because NHAI’s credit rating would likely be impacted if this
source of revenue were encumbered in such a way that it reduces the financial flexibility
available to NHAI.
We propose a conceptual model of financing that incorporates features that address most of the
concerns voiced above, while preserving the public-private partnership in sharing of the risks
and the rewards from these projects. However, such a financing model to be useful cannot be
separated from the organizational structure. Hence, an implementation of this proposal would
only follow NHAI’s reorganization into separate entities with independent management.
12
Since these are near sovereign borrowings, case can be made to RBI for capital relief for lending by
banks and financial institutions. The 15-20 bps estimate is based on the assumption of capital relief.
Market-based financing of highways in India 11
The mandate given to NHAI under the NHAI Act 1999 provides for it to undertake a number of
functions: road development and safety policy, contracting for road development, financing
authority for the inter-state highways, etc. Therefore, to segregate these functions, we suggest
that the financing for the NHDP be separated into a number of Special Purpose Vehicles
(SPVs). The SPVs will in essence be financing vehicles that will have a limited life till all the
debt raised through them is paid off and these would automatically extinguish thereafter. In
particular, we propose:
1. That the various types of projects – annuity, EPC and BOT, be merged into a single
project to be financed through a particular SPV;
2. That large segments of the roads (NH-8, for instance) be made into a single project and
financed through a single SPV;
3. That a detailed project cash-flow be prepared for each of these projects, with revenue
estimations, interest costs, CapEx (Capital Expenditure) and OpEx (Operating
Expenditure) stressed under different economic and business conditions;
4. That the NHAI’s share of the project cost should be determined after estimating the
market’s appetite for financing part of these projects;
5. That NHAI’s contributions (expect for the land) be treated as financial contribution
(equity/debt) of the SPV and be made subordinate to all other kind of investments;
6. That the toll collection be passed on to specialized toll operators (to be replaced at a
later date on the introduction of electronic tolling technology);
7. That the “Whole Business Securitization13” technique be used to secure financing for
these projects; and
8. That the SPV (NH-8 SPV, for instance) enters into a number of contracts with the
various parties to the transaction,
13
Refer to the Appendix for a brief description of whole business securitization and how it differs from
the other forms of securitization.
Market-based financing of highways in India 12
g. with a rating agency to rate the various types of instruments to be offered to the
investors to financially participate in the project.
Whole Business Securitization (WBS), pioneered in the United Kingdom, is a financing
technique that combines the features of corporate finance with those of securitization. Unlike the
traditional securitization methods that rely on specific cash flow, the entire spectrum of cash
flows generated by a business is used in structuring a WBS. Segregation and sale of specific
pool of corporate assets and associated “single-source” cash flows into a bankruptcy remote
SPV is the essential feature of a securitization transaction. A WBS transaction on the other hand
ring-fences the entire business of an issuer SPV and therefore all the cash flows generated by the
business. There is, however, no transfer of ownership of the assets, but a legal framework put in
place to provide creditors a “true control” over the income generating assets under stressed
conditions14. This has the advantage of avoiding transfer costs like stamp duty. Financial
covenants, corporate finance like, provide early warning triggers and restrictive covenants on
the nature of the business help mitigate the risk of dissipation of business focus.
The Issuer SPV issues different classes of securities that are credit enhanced in the form of over-
collateralization and sub-ordination (tranching of the different classes), plus a liquidity support
to meet payment obligations during periods of stress. The proceeds of these securities issuance
are on-lent by the issuer SPV to the operating business. As compared to corporate finance
alternative, such deals have been structured to achieve a higher leverage, low cost of capital
(“all-in” cost of borrowings) and longer weighted average life of the debt.
Such structures are typically used for acquisition financing (LBO/MBO), recapitalization and
project finance (airport, business park). As far as we are aware, this structure has never been
used to finance a highway project. However, highway projects seem to meet the basic
characteristics that are common to such transactions:
14
Perfection of security to achieve a “true control” is perhaps the key to WBS. Creditors’ rights to enforce
security is weakened where a court intervention is mandated (Chapter 11 in the US for instance). The
passage of the SARFAESI Act, 2002 in India now makes it possible for secured investors to enforce their
rights to protect their security interests.
Market-based financing of highways in India 13
• operate in industries with relatively high barriers to entry, either due to regulatory
and/or initial capital expenditure requirements;
• operate in industries in which fundamental changes are expected to be limited and only
very gradual;
• are mature and highly cash-generative in nature and – by definition – have only
moderate net working capital requirements;
• have a narrow business mix, which makes the projection of future cash flows
comparatively easy; and
• have a strong underlying ‘hard’ assets element, essentially in the form of real estate and
other fixed assets, which are comparatively easy to value and can be charged as
security15.
Under the present scheme of things, the BOT projects would attract debt financing by
securitizing their toll receivables and the annuity projects would get it by securitizing the
annuity receivables. However, by merging of the projects along with the NHAI financed EPC
projects have two advantages. First, it allows for diversification in sources of revenue (current
tolls, annuity and tolls from segments of the highway that may not yield significant toll revenues
at present). And second, there is a pooling of traffic risks (toll revenue risk) over the longer
stretches of highways, due to the differing density of the local traffic.
This diversification would allow the projects to exhibit enhanced levels of cash flow stability,
even under stressed scenarios. Stability of the net cash flow (or lower volatility over time)
would ensure enhanced relative fundamental credit strength for whole business securitization.
However, as discussed earlier, a detailed cash-flow model is a necessity to simulate the topside
and downside scenarios affecting the cash flows. These stressed scenarios are then tested for
financial covenants (Debt Service Coverage Ratio and Loan to Value, over time) along with the
risk mitigants and the legal provisions to arrive at the quantum of debt finance and its
amortization schedule.
NHAI’s contribution to the projects under the Whole Business Securitization model can be
structured as both equity and debt, where the debt is subordinate to the other senior classes of
debt. The equity and subordination of NHAI’s debt would act as a credit enhancement to the
senior classes of debt, which can also be structured as securities with different investment grade
ratings ranging between AAA and BBB depending on the weighted average rating desired for
the whole structure and the appetite of the investors.
15
See UBS Warburg (2000).
Market-based financing of highways in India 14
Figure 1 gives the transaction diagram for the WBS structure. NH-8 SPV is a vehicle that is
created by combining the different segments of the highway (under BOT, Annuity and EPC
contracts) and all cash-flows are trapped at this SPV level. The Issuer SPV issues the bonds to
the Note-holders and on-lends the proceeds to NH-8 SPV, with the security of the concession
agreement(s) and over the cash flow. In each period, the pre-agreed payment priority mechanism
determines the distribution of the cash-flow. The NH-8 SPV for instance would make available
funds enough to service the debt of the Issuer SPV. After all the debt is repaid, the Issuer SPV
would fold automatically, thereby releasing the charge created at the inception of the
transaction. Since, the NH-8 SPV is not authorized to raise any further debt, the highways revert
back to NHAI (the sole equity provider) once the Issuer SPV is folded.
Moreover, there is a lot of flexibility in structuring the debt instruments. These can be structured
to have a maturity that corresponds to the economic life of these projects, say 20-30 years. By
matching the maturity and amortization of the debt with the projects cash flow, it is possible to
eliminate any refinance risk. Further, soft amortization (no fixed repayment schedule, whereby
the debt can be prepaid in parts without any premium or penalty) can be built into bond features
so that the debt repayment gets accelerated if the cash flows so permit. The different ratings for
the debt instruments also allow for private sector participation in sharing of the risks associated
with the projects.
At the inception of the project, the subordinate debt subscribed to by NHAI would have a non-
investment grade rating. However, once the project gets completed and starts to build a record of
revenue collection (inclusive of alternate sources of revenue like, use of right-of-way for
telecommunication cables, development of commercial facilities along the highways, etc.), the
rating of the sub-ordinate debt would improve in the future. NHAI can sell these debt securities
Market-based financing of highways in India 15
in the market at an appropriate stage to recoup part of its investment in the project. And, after all
the debt is repaid, the security interest created on the revenues of the NHAI SPV would be
discharged giving NHAI a full ownership over the assets.
The WBS structure is not very different from that of project finance with secured lenders. WBS
has two main advantages: (1) It is a tighter structure – takes full control of the cash flows while
leaving operational control in the hands of the SPV’s management; and (2) it can issue of
instruments with different ratings, each signifying a varying degree of risk sharing, and
therefore, can access a variety of investors whereas project finance loans are usually structured
with pari passu sharing of risks and are limited to participation by the banking sector.
The rating agencies play an important role in securitization transactions. They independently
assess the risks of the cash flow as well as of the structure to arrive at the rating of the
instrument. The explicit understanding of risk for each tranche of the cash flow calls for
sophisticated analysis of the cash flow using simulation techniques. It is not easy, even for
sophisticated investors, to understand the complex interplay of the risk factors and their impact
on the business cash flow. The investors, therefore, invariably rely on the analysis by the rating
agencies to know the level of risk they are exposed to (contained in the rating assigned to the
instrument). Since such structures are not designed for modifications at a later date, rating
agencies take cognizance only of enforceable legal contracts. For instance, they keep the
interests of the investor in mind while insisting on explicit government guarantee to reflect the
support in the ratings.
Conclusions
Till recently, the provision of some services was considered to be the domain of the public
sector. These economic activities were seen as pure public goods and it was believed that the
private sector (private initiative and markets) would fail to provide these services in adequate
quantities. This market failure possibility led governments across the globe to produce these
goods and services. Power, telecommunications, postal services, transportation, water and
sewerage, etc. are some services that were produced and distributed exclusively by public
utilities owned and operated by the government.
Privatization in India has slowly but steadily liberalized the provision of these services. Private
capital in India has not shied away from the challenge. The success of privatization of the
telecommunication sector has prompted the initiation of this process in many other sectors.
Gangopadhyay and Mohanty (2003) discuss the role of appropriate regulatory and policy
frameworks to support this process.
NHAI Act 1999 has, by instituting NHAI with a clear mandate, created an enabling environment
for private sector participation in the roads sector – till recently a preserve of the public sector
and a victim of binding fiscal constraints. This sector does not have a pre-existing private sector
expertise (in contrast to the power sector where companies like Tata Power and BSES had the
expertise to generate and distribute power). The private sector nonetheless has exhibited a
willingness to step up to the challenge. While banks and financial institutions have supported a
number of such projects, the debt capital market too has responded in some measure (e.g.
NOIDA toll road project, MSRDC projects etc.). Debt market has provided capital with varying
risk profiles. The equity markets, on the other hand, is perhaps not yet ready to assume too much
risk. This is because the risks in road projects are not well understood, especially policy changes
that come in the wake of political risk. Equity investors are probably not very excited about the
financial risk for the expected returns from investment associated with these projects. Alternate,
Market-based financing of highways in India 16
Infrastructure funds – fashioned after private equity funds – have stepped up to fillip equity
participation, a role that public financial institutions had performed in the past. The investment
in these funds belong to large diversified portfolios of their sponsors who have better capability
to assume the risks. It may, however, be prudent to ask, how much of risk capital is available for
the highway projects?
In the current structure, the annuity and BOT concessions awarded by NHAI are at the two
extremes of risk sharing by the public and the private sector. The difficulty in reaching the
financial closure of BOT concessions and the ease with which annuity projects closed is an
indication of the market’s ability to absorb the financial risk. The proposal of Whole Business
Securitization is a financial engineering technique that allows the equity risk to be moderated
into acceptable levels by parceling part of the risk to the debt market.
Recommendations
• Target private placements to long-term players like insurance companies and provident/
pension funds
• Clearly identify and allocate all risks to be able to develop a bankable, and efficient model
for public-private partnership
• Various types of projects-annuity, EPC and BOT, be merged into a single project to be
financed by a particular SPV
• Large segments of roads be made into a single project and financed through a single SPV
• Whole Business Securitisation’ technique be used to secure financing for these projects;
simple securitization would not work
Market-based financing of highways in India 17
Appendix
For a number of years securitization has provided an innovative means for certain companies to
raise finance in a cost-effective manner. Its origins date back to the securitization by US
mortgage lenders of their loan books but in recent years all manner of assets have been
securitized to raise capital. These include credit card receivables, healthcare receivables,
royalties and even media revenues. Virtually any business which has an asset or pool of assets
which can produce a recurring income stream may be a suitable candidate for securitization.
What are the benefits that a whole business securitization can offer?
In contrast to a traditional securitization, the borrowing company does not have to sell the assets
securitized to a special purpose vehicle and therefore is able to retain operational control. The
whose business securitization is particularly attractive for a business which has significant value
attaching to assets which it is unable to reflect on its balance sheet, such as brands or other
intellectual property rights. A whole business securitization enables such a business to realize
the value of those assets in a way which would not be possible using more traditional financing
methods. As is the case with the traditional securitization, the whole business securitization
allows funds to be raised in a cost-competitive manner through the capital markets and provides
access for the borrowing company to a potentially wider base of institutional investors. Whole
business securitization has been used successfully by a number of UK businesses with one of the
first being the London City Airport in 1999.
In the case of a traditional securitization, the borrowing company sells a pool of assets to a
newly established special purpose vehicle (SPV) which pays for the assets by issuing fixed or
variable rate interest-bearing bonds to investors through the capital markets. The SPV finances
the payment of principal and interest under the bonds from the income stream derived from the
pool of assets purchased from the borrowing company. The SPV will also normally grant
charges over the pool of assets securitized in favor of a security trustee acting on behalf of the
investors.
In a traditional securitization the borrowing company, by selling the pool of assets to the SPV,
removes those assets from its balance sheet. For both legal and tax reasons the SPV is normally
located in an offshore jurisdiction. The Cayman Islands is the domicile of choice for most
securitizations and structured finance transactions. This is because of the breadth and depth of
the professional infrastructure, particularly the law firms, and the significant experience in this
Market-based financing of highways in India 18
area, thereby providing the critical speed of response necessary for transactions of this nature.
The SPV is a special purpose vehicle in the sense that it is established for the sole purpose of
acquiring the pool of assets from the borrowing company and issuing bonds to the investors.
It is important in a traditional securitization that the SPV is set up as an orphan company by
which is meant that it is not part of the borrowing company’s corporate group. This is achieved
by control of the SPV being vested in either an offshore charitable trust or an offshore non-
charitable purpose trust, again usually in the Cayman Islands. The SPV is also structured in
such a way as to make it bankruptcy remote and therefore ensure that the pool of assets is not
placed at risk by insolvency of the SPV or of the borrowing company.
The key feature of a traditional securitization is therefore a sale of the assets securitized by the
borrowing company. As mentioned above, this is not the case with a whole business
securitization. In this case, the securitization takes the form of a secured loan structure and there
is no sale of assets to the SPV. Instead of purchasing the pool of assets, the SPV makes a loan
to the borrowing company and takes security for that loan over the pool of assets retained by the
borrowing company. The SPV funds the loan to the borrowing company by issuing fixed or
variable rate interest-bearing bonds to investors through the capital markets. These bonds are
also secured by the SPV creating a charge over all its assets in favor of a security trustee on
behalf of the investors. The only material asset of the SPV will be its right to receive principal
and interest under its loan to the borrowing company. Generally, the loan is made in a series of
tranches corresponding to each series of the bond issue offered by the SPV. Most whole
business securitizations (as is the case with a traditional securitization) will utilize both liquidity
enhancement and credit enhancement. The bonds are always rated by a rating agency such as
Standard & Poors and Moody’s for both regulatory and marketing reasons. A securitization can
usually be structured in such a way as to ensure that a high credit rating can be achieved.
In contrast to a traditional securitization, in the case of a whole business securitization, the SPV
will not be an orphan company but will in fact be a member of the borrowing company’s
corporate group. In addition, the SPV will, in the case of securitization involving a UK
borrower, commonly be UK resident for tax purposes. This is driven by UK tax considerations
which are beyond the scope of this article. Even though the SPV will usually be UK tax resident
it is still normally incorporated in the Cayman Islands or another suitable offshore jurisdiction.
The principal reason for this is to avoid the problems posed by the financial assistance
prohibitions of the UK Companies Act in the case of a whole business securitization.
It will therefore be clear that there are certain fundamental structural differences between the
two forms of securitization, notably in the case of the whole business securitization, first the
absence of a sale of the assets to be securitized but instead a secured loan structure and second
the corporate grouping of the SPV and the borrowing company.
As explained above, the commercial nature of the two forms of securitization are fundamentally
different. In the traditional securitization a discrete pool of assets is the subject matter of the
securitization. The management of those assets should generally be straightforward involving
the collection and enforcement of a receivables ledger. A whole business securitization involves
the securitization of not just a discrete pool of assets but of the income stream of an entire
company or business unit. The management of a business as compared to a specific pool of
assets is obviously far more complex. As a result, investors in the case of a whole business
securitization have to acknowledge that the covenants imposed on the borrowing company need
to allow sufficient flexibility for management with regard to operational and cash flow matters
in order that the business can function properly. However, this is not to suggest that the
Market-based financing of highways in India 19
covenants will not include robust provisions preventing management from straying beyond
business parameters agreed at the outset. Because of the more flexible approach that has to be
adopted a whole business securitization is unlikely to achieve a triple A rating from the rating
agencies.
A key issue for the investor in a whole business securitization is to ensure that if the borrowing
company were to become insolvent the assets securitized continue to be managed for the term of
the bonds by an administrative receiver so that the income streams necessary to service payment
of principal and interest under the bonds continue to be generated. In other words, the integrity
of the income generating assets should not be prejudiced or put at risk by any financial
difficulties of the borrowing company. Provision for the appointment of an administrative
receiver will be contained in the loan documentation.
The simple answer is, no. It will only be appropriate where the business can demonstrate stable
and predictable income streams. As mentioned above, it is an essential requirement that a
suitable credit rating for the structure is obtained. The rating agencies will analyze carefully the
ability of the business to generate consistent and sustained revenues in a variety of economic
climates. For that reason, a whole business securitization will be of particular interest to
businesses which enjoy a particularly strong position in their market and where competitive
threat is not acute (for example, regulated industries where the entry of new players is difficult)
and businesses which are not materially affected by a general recession (for example
bookmakers). Particular UK examples to date are businesses involved in motorway service
areas, residential care homes, theatres and ferry operators.
During its relatively short lifespan to date the securitization concept has shown itself to be a
highly adaptable and flexible financial method. Nowadays the common observation seems to be
“if it can generate a steady income stream, it can be securitized.” Whole business securitization
is merely a further stretching of the boundaries of securitization and is likely to become more
common as businesses with operations suitable for securitization look for alternative, cost
effective means to raise capital. The year 2001 has brought with it a US down market and one of
the results of this has been that new traditional equity funds have diminished in number, with a
corresponding increase in the number of new hedge funds being initiated. Many are start-ups as
money managers leave large institutions and see an opportunity to capitalize on non-traditional
investment techniques.
Market-based financing of highways in India 20
References
Gregory Fisher and Suman Babbar (??), “Private Financing of Toll Roads”, World Bank, RMC
Discussion paper series 117
PRIME Database
Andras Timar (??), “Financing of Roads, in Particular Public Private Partnerships”, European
Conference of Ministers of Transport
UBS Warburg Credit Research (2000), “Whole Business Securitization: The new corporate
finance?” UBS Warburg, London