Mumbai: The stock market meltdown is affecting the “ancillary” businesses of Infrastructure Development Finance Co. Ltd, or IDFC, but its managing director and chief executive officer Rajiv B. Lall, 42, does not have any plan to change the business model. According to him, the firm has the right business mix but at the same time, he makes it clear, that investors and shareholders of IDFC should not expect very high returns.
In an interview, Lall talks on many issues, ranging from infrastructure financing to IDFC’s exposure to Unitech Ltd, Blackstone Advisors India Pvt. Ltd’s walk out from the proposed $5 billion (Rs23,650 crore) infrastructure fund with IDFC and its wish to merge with a bank. Edited excerpts:
Logic and reasoning :The country is facing a financial sector-led crisis, which will take sometime to get sorted out, says Lall
What’s the state of affairs in infrastructure financing?
It’s not for lack of domestic savings that we do not have the ability to fund our infrastructure projects. The challenge for us is to create the institutional intermediaries that can deploy the savings in infrastructure projects in a safe manner. By and large, such projects get funded on a non-recourse basis through special purpose vehicles. These projects require equity funding and long-term debt.
Aren’t banks offering long-term funds?
Over the last three-four years, there has been a rapid growth in infrastructure funding by the banking system. But there is a limit on how much the banks can lend to this sector as they can get into asset-liability mismatches. Indeed, there is a share of the deposit base, which is stable and a part of that can be deployed in long-term assets without creating liquidity risks. Maybe 20-25% of their assets can be long-dated assets, safely. But if they have to lend to the housing sector too, how much is actually left for infrastructure?
There is a second challenge. The infrastructure assets are concentrated in a handful of banks. So there is a huge concentration risk on top of the ALM (asset-liability management) risk.
Everywhere in the world, infrastructure financing gets done by the government. That’s the objective reality. In our country, we have to rely disproportionately on the private sector because we have a very large fiscal deficit and there have always been challenges in respect to the government’s execution capacity.
So, how do we get funding?
One avenue could be the corporate debt market, which has all kinds of participants and the second is the risk transfer mechanism or securitization. We don’t have a corporate debt market and securitization has got a bad name the world over after the recent credit crisis. We’ll have to develop a corporate debt market asap but that’s not enough. Banks buy the corporate debt papers and we need new investors. One can look at foreign investors but we cannot borrow in foreign currency and generate cash flow in rupees.
We need domestic investors such as insurance companies and pension funds. But they will not invest hugely as the infrastructure papers are triple-B risk, typical of non-recourse projects. They need credit enhancement to lift the paper’s rating to at least double-A.
In the US, the credit enhancement can happen in private sector and it requires an ecosystem of very complex investors who are willing to buy these papers. We do not have an array of investors who will buy these papers. So, the conclusion is: The government has a role to play as a catalyst to make infrastructure happen in this country. It just cannot abdicate that responsibility.
Can’t we have many more IDFCs doing this?
That could be a possibility. The government should give us some kind of capital and we will provide this service. That’s what we were set up for. We are a public-private partnership just like Fannie Mae.
Rating agency Crisil does not want you to grow unless you have more capital. You are not leveraging yourself as much as you want for fear of being downgraded.
IDFC is funding double-A- , triple-B kind of infrastructure projects and IDFC itself is triple-A rated. We are heavily capitalized because our net worth provides the credit enhancement. The debate is, how much capital does IDFC require and what is the nature of the capital?
Crisil’s view on tier I capital (equity) is a bit extreme. Today we have 22% tier I capital but the regulator requires us to have 15% total capital (both tier I and II) by 2010. Crisil feels that we need 20% tier I capital and this allows us five times leveraging.
On this capital, the return on equity from our lending business is not very compelling. So, to pursue our mission of funding infrastructure and at the same time dutifully serving the needs of our stakeholders by offering them a decent return, we require a business model that has several components to it. If we do just lending, the stand-alone return will be quite modest. So, we are into ancillary businesses to add to our return without absorbing too much additional capital. We have gone very aggressively into asset management, investment banking, and they contribute to our return.
That’s the Babcock and Macquarie model, right?
The Babcock and Macquarie is actually a very clever and important framework to learn from. Where they went wrong was that they started taking on too much indirect leverage. So, when the deleveraging started globally, they got into serious difficulties. I think the core of the Babcock-Macquarie model is not discredited. The lesson is one will have to be very balanced and disciplined about how you construct the business model without getting carried away by cheap credit.
You have not lost confidence in the model?
We have not lost confidence but we will have to retool it to fit the circumstances not only of India but for a post-credit crisis world. Also, what it does mean—and our investors and shareholders may not be happy about it—is that no matter what business model we follow, the returns are going to be lower. If people expect 20-25% return on equity, it will be irresponsible for me to have our investors believe that.
What has been your average return in the past four years, ever since you took over?
About 16%. If they expect big returns, I would say in the post-credit crisis world, they are taking too much risks and we are the wrong party to invest in.
You have huge exposure to Unitech, India’s second largest real estate firm, and it can wipe out your entire net worth.
While we do have exposure to Unitech, our prudential management is such that there is no question of our net worth being materially impacted on account of lending to any one company or group. With more than 22% capital adequacy, it is very difficult to imagine any circumstances that would wipe out our net worth. Besides, our exposure to Unitech is comfortably secured and given the RBI’s (Reserve Bank of India) recently announced policy package in support of the real estate sector and the steps that the company is itself taking to restructure its balance sheet, we think that the risks have come down substantially over the past month.
You threw Blackstone out of the $5 billion infrastructure project.
Nobody threw any body out. When there are too many cooks in the kitchen, you can’t prepare any (broth). Basically, that was happening.
The total fund raising plan was $5 billion—$3 billion worth of debt and rest equity. IDFC and our affiliates have raised $1.6 billion. Then, we raised $890 million with Citibank—that’s where Blackstone was supposed to be in—and $700 million through another private equity fund. Through mutual understanding we decided that when we come back to raise another fund, we will talk to Blackstone again and may be the next fund we will do with them and not Citi.
You raised some concerns about special economic zones (SEZs) and they are coming true.
The theoretical concept of a special economic zone, and as successfully applied in China, has been to take advantage of economies of scale, economies of agglomeration. You create very large contiguous space of high-quality infrastructure and a certain type of investors, all concentrate in that area. In exchange for this, there is a theoretical case for giving some concessions.
But what ended up happening in our case was that it got mixed up with the old concept of export processing zones. The allegation is that SEZs have basically become a tax avoidance scheme. It has lost the balance between providing tax benefit and giving the public the benefit of the economy of agglomeration.
Is there any way to salvage it?
Ironically, the small SEZs are likely to function and succeed better than the large ones. The reason behind that is, to get the scale in a country like India and leave it to the private sector entirely is a bit tricky. It has all to do with land and who captures the value that is generated with changing pattern of land use—from agriculture to something else.
It’s a very interesting exercise of the political economy in India and yet another example of the state abdicating its responsibility. The state is supposed to collect the land for industry, get it notified, aggregate the land and pass on the land to industry. That immediately and rightly raised many questions. So, the government decided not to get in the middle of this and let it be a mutually negotiated transaction between the aggregator of the land and the farmer. Now the farmers have become wise and are being organized by different interest groups and are asking for more. In a chaotic democracy, it is not easy to resolve such negotiations.
The theoretical advantage of creating a huge space with high-quality infrastructure in the Indian context gets caught in the issue of the fairness of how land gets distributed or the value from change in land use gets distributed between those who have been asked to sell and those who have the capital to develop.
What’s your outlook on IDFC?
The prospects for IDFC are as strong or as week as the macro economy. If you believe that the macro economy is seeing a temporary slowdown, the same is true for IDFC. If you believe in the long-term prospects of Indian economy, then IDFC’s prospects are commensurately bright.
What’s your belief?
My own belief is the shortages of infrastructure services that have been plaguing the Indian economy in past few years will remain as acute as they were. So the demand for infrastructure services remain extremely strong. We are experiencing a financial sector-led crisis in the real economy, which will take sometime to get sorted out—maybe six months or eight months…
You are not talking in terms of years?
No. I don’t think we are seeing that kind of damage in India. For us, it’s time to consolidate our activities.
You wanted to take over Centurion Bank of Punjab. RBI rejected that.
Oh, we were so hurt.
Why do you want to become a bank?
We don’t want to become a bank. Yes, we wanted to merge with Centurion. The reason for that was again to find the balance between a business model that is safe and has decent return characteristics. Banking regulatory framework for us makes sense to the extent that it allows us to secure our liability base in a more stable manner and deliver returns in a more compelling way than an NBFC (non-banking financial company).
It’s a solution. It depends upon what kind of bank (we are looking at). Just any bank does .not make any sense.