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Projects Appraisal, Financing and ControlTrimester 4

Lecture XVI XVII

Financing of Infrastructural Projects

Venture Capital

Private Equity

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The Big Change

Traditionally, infrastructure projects in Indiawere owned and managed by the governmentor a government undertaking.

Given the massive investments required forinfrastructure, there is now a broad consensusthat private sector participation in this activitymust be encouraged

Private initiative in infrastructure projects cantake many forms, ranging from contractedoperation of public utilities to full ownership,operation and maintenance of these facilities

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What Is PPP?

Broadly PPP refers to a contractual partnership between the

public and private sector agencies in which the private sector is

entrusted with the task of providing infrastructure facilities

and services that were traditionally provided by the public

sector. An example of a PPP is a toll expressway project

financed, constructed, and operated by a private developer.

According to the Government of India, a PPP project is a

project based on a contract or concession agreement between a

government or statutory entity and a private sector company

for delivering an infrastructure service on payment of usercharges. A private sector company is a company in which 51

percent or more of equity is owned and controlled by a private

entity.

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Whats suitable for private sector involvement?

Projects designed to provide significant socialbenefits such as low cost urban transportation

system may be more suited to traditional

government ownership

Projects having strong commercial attraction,

like telecommunication, are more suited for

private sector involvement

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Infrastructure vs traditional project financing

The infrastructure financiers need to carefullyevaluate if the requisite regulatory, legal andfinancing framework exists to support theprivate sector initiatives in PPP (private public

partnership) framework In this context, think as to how the issues

bothering the private parties involved in powerprojects have been tackled in the last decade, in

the context of off-take of power by bankruptSEBs owned by bankrupt state governments inIndia

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Typical Project Configuration

The project is implemented by a Special Purpose Vehicle, which is a

distinct corporate entity. Project sponsors take an equity stake in the SPV.

The SPV enters into contractual arrangements with project

contractors, offtakers, operators, government, and project lenders.

The dependence on debt is usually high and lenders generally lend

on a non-recourse basis. This means that project lenders would not

have any fall-back on the resources/assets of the sponsors if the SPV

fails to meet debt servicing obligations.

The contracts are as ironclad as possible andare not left to subjective interpretation as much

as possible.

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Level of acceptable Debt Equity Ratio For large conventional projects, where project is

exposed to pure market risks, DER not > 2:1

In power projects where off-take was assured to

the extent of a certain Plant Load Factor, DER up

to 2.33:1 was accepted

In Indian road projects under BOT arrangement,

where there was an assured annuity from the

NHAI (National Highways Authority of India)

during the concession period, irrespective of the

actual level of traffic, lenders might accept DER

even up to 4:1

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Key Project Parties

Project sponsors

Project vehicle (the SPV)

Project lenders

EPC (engineering, procurement & construction)contractor

O & M (operations & maintenance) contractor

Government

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Project Contracts

Through a comprehensive web of contracts, every major risk

inherent in the project is allocated to the party / parties that isbest able to assess and manage the risk

The major project contracts are:

Shareholders Agreement

EPC Contract: while sub-contracting is acceptable, it remains the

sole responsibility of the EPC contractor to deliver the project to

the SPV

Project Loan Agreements O & M Contract

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EPC Contract An agreement between the SPV and the EPC

contractor, that establishes:

1. The latters role from designing all the way up to

commissioning the plant

2. Guaranteed minimum performance parameters3. Penalties/Liquidated damages payable in the event

of the plant failing to meet minimum parameters,

typically capped at 20-30 percent of the EPC

contract value

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Governments role

Provision of concession to the SPV

Ensures that proper legislative and regulatory

framework exists

In some cases, like in the electricity generationsector, state governments have guaranteed

the performance of the off-take obligations of

SEBs, and in certain cases, the centralgovernment has counter-guaranteed the

performance of the state governments

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Some problems with the 3 tier structure

LCs may not get opened by the bank in case of

default by SEB The escrow account may not work if there are

multiple projects feeding the same SEB and the SEB

is being run on non-commercial lines

State government guarantees may not be bankable

The above position led in some cases to reforms

linked financing of these projects, with the lenders

disbursing money on being satisfied with the statesprogress in the area of reforms

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Managing Risks in Private Infrastructure Projects

Construction Riskmanage through EPC contracts

Operating Risk - mitigate through competent O&M contractor

Market risk - govt. to guarantee minimum payment in road project

Interest Rate Risktransfer risk due to floating rate by tariff

formula to treat it as pass through cost

Foreign Exchange Risktariff formula to adjust for forexfluctuations impact on forex loans

Payment Riskescrow account

Regulatory Riskfavours countries with strong and independent

regulatory bodies

Political Riskcould be partially mitigated though political risk

insurance offered by some multinational organizations

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Recommendations of the Committee chaired by

DeepakParekh on Infrastructure Financing

1. Develop a deep and robust debt market

2. Tap the potential of insurance sector

3. Enhance the participation of banks, financial institutions and large

NBFCs

4. Provide fiscal incentives

5. Facilitate equity flows

6. Induce foreign investments

7. Utilise a small portion of foreign exchange reserves for

infrastructure development

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VENTURE CAPITAL

AND

PRIVATE EQUITY

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Wh t I VC I t t

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What Is a VC Investment

The popular impression is that VC is synonymous with financing of

technology-centric businesses or innovative and hitherto untried

business ideas. In reality, VC is a broader and much more flexibleform of financing.

VC investments usually involve

Business with high growth potential in terms of sales andprofitability

Investment horizon of 2 to 10 years

High risk levels

Equity or quasi-equity financing instruments

Active investor involvement

The Key is superior returns

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V l ti f VC T ti

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Valuation of a VC Transaction

Most used method of valuation involves the following steps:

1. Identify the amount of capital to be invested by the investor: I0

2. Identify the target rate of return expected by the investor: r

(depending on stage of invt., likely holding period, riskiness, etc)

3. Estimate the multiple of the original investment that will fetch therequired rate of return over the anticipated holding period:

Sn = I0 (1 + r)n

4. Project the market value of the firm based on performanceprojected during the proposed year of exit: this would be amultiple of an appropriate metric like EBIDTA: Vn

5. Estimate the percentage of the projected value that the investorneeds to claim in order to achieve his return objective

6. Express percentage of equity to be owned by VC as price/share

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Valuation ExerciseGiven the following:

Capital to be invested by investor (I0) = Rs 50 lacs

r = 50%

Anticipated Holding Period (n) = 3 years

Projected market value of firm after 3 yrs (Vn)=Rs 6.75 cr

Capital proposed to be issued = 10 lac shares of face

value of Rs 10 each

Assume that the market value of the firm is equal tothe value of the equity of the firm

Find out the premium per share which the VC investor

would be willing to pay

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Solution

Sn = I0 (1 + r)n = Rs 1,68,75,000

Percentage needed = 1,68,75,000/6,75,00,000 = 25%

No of shares required = 2,50,000

So, the investor will ask for:

2.5 lac shares for Rs 50 lacs

i.e. 2.5 lac shares for Rs 20 each

i.e. 2.5 lac shares at a premium of Rs 10 each

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The VC Investment Appraisal Process contd.

Deal structuring

While doing this, the VC investors also build in performance

incentives for management

These may include:

1. Options to subscribe to additional equity at low valuation

2. Allotment of new shares in recognition of managerial or

technological contributions, for considerations other than cash

3. These incentives would be tied to pre-identified milestones,

like profit targets, agreed upon

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The VC Investment Appraisal Process contd.

Investorinvestee relationship: As the motivations and

goals of the investors and the entrepreneur may differ, forexample the investor requiring a timely exit, the detailed

shareholders agreement provides for such eventualities

Postfinancing relationship: The VC involves himself

at 2 levels, both for strategic decisions such as constitutionof the board, and monitoring role to ensure that the investors

are not adversely impacted, say by a business diversification

plan. These are done by having directors on the board

Exiting from investments: While the common exitroutes are via IPO or bringing in a Strategic acquirer, the exit

option is secured through investment agreement

Six Stages of Venture Capital Financing

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Six Stages of Venture Capital Financing

1. SeedMoney Stage: Takes care of small volume of funds

to say develop a product

2. Start Up: Takes care of funds for marketing & product

development, typically for firms less than 1 year old

3. First-Round Financing: Additional money to begin salesetc.

4. Second-Round Financing: Funds required by a company

selling its products but losing money

5. Third-Round Financing: Post break even for expansion

6. Fourth-Round Financing: Financing a firm expected to

go public in about 6 months time

VC and PE A Comparison

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VC and PE A Comparison

The distinctions between VC and PE (private equity) are summarised below:

Feature VC

Investment

Target

Early stage businesses, expansion

Innovative products, services,

technologies

Heavily dependent on external

financing

Unlisted companies

Later stage businesses,involves

operational or financial

restructuring, with or without

management team and / or

ownership changes

Mature products,services

Generally have large cashflows

May be listed or unlisted

PE

Horizon Medium to long term: Three -eight

years

Medium: Two -five years

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Risks May be one or more of technology,

product development, market

response to product / service,

management, operational andilliquidity of investment

Usually limited to product- market

risks and does not involve the other

elements listed in the case of VC

Structure Equity or equitytype

instruments such as convertible

debt or preference shares

Syndication of investment, if

any, among fellow VCs

Equity and debt combinations.

Debt is usually high risk, of

speculative grade

Syndicate may includeinstitutions such as insurance

companies and banks, who are

primarily lenders

PostFinancing

Engagement

Active-encompasses board

composition, top management teamrecruitment, strategy formulation

and internal systems processes and

controls

Active but less than their VC

counterparts. Involvement mainly

limited to ensuring high quality

governance

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PE firms Private equity funding has been gaining importance in India

during the last few years. The starting point of PE funding is a term sheet which

reflects the understanding reached between the PE fund (the

investors) the promoters, and the company. It summarises the

terms and conditions for the proposed investment in the company.

It is followed by due diligence and then by the Shareholders

Agreement and/or Share Subscription Agreement. Finally, the

provisions of the Shareholders Agreement are included in the

Articles of Association of the Company.

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Term Sheet

The standard termsheet covers the following:

Company

Promoters Investor

Quantum of Investment

Investment instrument

Pricing of instruments

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Pricing of instruments

Conditions precedent

Deployment of fund

Conditions subsequent

Shareholding pattern Board representation by the investor

Pre-emptive rights of the investor

Promoter lock-in and investors Right of First Refusal (ROFR)

Investors veto rights Investors exit rights

Non-compete and non-solicit

Representations and warranties

Auditors

Due diligence Definitive documentation

Confidentiality

Exclusivity

Validity

Governing Law

The Indian VC Industry

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e d a VC dust y

Prior to the formation of VC institutions, Indian development finance

institutions provided risk capital to industry. However, they did not follow

the rigorous processes that a modern day VC would follow.

ICICI Ventures (formerly TDICI Ltd) was the first VC institution in India

set up in 1988.

International investors emerged as more significant players from the mid

1990s. They introduced the western investment philosophy and processes

into their transactions with Indian companies. Rigorous due diligence, tightcontracting, active post financing involvement,and a sharp focus on timely

and profitable exit are among their more important contributions.

The investment preferences of VC investors have constantly evolved over

the years . Over the years there has been a shift in favour of financing the

expansion plans of firms already in operation as opposed to greenfield

ventures or start ups.

In the early years in India, the industry was characterized more by VC style

investing in small, early stage companies. More recently PE type

investments have become far more common.

Regulation of VC Industry in India

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g y

Broadly the SEBI (Venture Capital Funds) Regulations,1996 purport

to ensure that:

VC funds do not access public investors who may not have thecapability to assess the risks underlying investment in VC funds.

VC funds invest in unlisted companies that are not in a position

to access public financial markets.

Section 10(23FB) of the Indian Income Tax Act, 1961 exempts the

income of VCF funds by way of dividend and long-term capital gains

from tax. The tax exemption is available to VC funds registered with

SEBI.

The investment activities of funds registered outside India andinvesting in India are regulated either by the foreign direct

investment regime (FDI) in India or regulations governing foreign

institutional investors (FIIs) who are registered with SEBI.

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Li tti bl d P i t it fi t i i b t

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Lines getting blurred: Private equity firms turning incubators

While VC and PE firms have their respective spaces in the financial world, the

line between them gets blurred at times

In mid-2009, when the logistics-focused private equity (PE) fund TuscanVentures Pvt. Ltd, was looking to invest in a cold storage chain that it could

scale up, there was one glitch: there weren't any such firms around.

There weren't companies available with the scale and management depth to

create footprints. So Tuscan did the next best thing: it launched its own cold

storage chain, Cold Star Logistics Pvt. Ltd. In doing so, Tuscan went beyond the traditional role of PE firms--investing in

companies, preparing turnaround strategies, helping firms expand, backing

good management teams--into the preserve of VC firms: incubation.

The PE firms may start companies, when gaps in industries become evident.

Tuscan Ventures is not the first one to do so. In 2008, IDFC Private Equity Co.Ltd, the PE arm of Infrastructure Development Finance Co. Ltd, started a

renewable energy company called Green Infra Ltd after it failed to find any in-

vestment opportunities in the space it could scale up.

This only shows how the lines are blurring between PE firms and VC funds,

which are now often doing late-stage PE- type deals.

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If you are approaching a VC fund1. You could avail the services of investment bankers who

specialize in VC/PE fund raising.

2. Different VC funds have distinct investment focus

areas in terms of industry sectors, stage of evolution

of companies in which they would like to invest ,theamount of financing, and the extent of post financing

involvement that the investor wishes to adopt

3. More important than anything, present an exciting

and convincing story, as the VCs select a very small

number of companies to invest in, out of the very

large numbers of applications that they receive