Private equity (PE) funds are quick to seize attractive investment opportunities, and few deals in recent years have captured their imagination-and capital-more than infrastructure projects in India. Over the past five years, PE funds have invested approximately $13 billion-around one-fourth of their total capital flows to the country-into infrastructure. Annual PE investment in the sector has grown fourfold, from about $1 billion in 2006 to $4 billion in 2010.
Infrastructure activity looks set to accelerate. Optimism about investment in the sector was a major highlight in a survey of PE industry insiders, which Bain conducted with the Indian Private Equity and Venture Capital Association. Nearly all respondents forecast continued double-digit growth over the next six to 12 months, with around half saying they expected venture capital and PE deal-making in the sector to grow by 25-50%.
PE’s growing interest in the sector could not be better timed. With gross domestic product (GDP) growing at close to 9% annually, India’s stark infrastructure deficit is the biggest speed bump threatening continued economic expansion. According to one estimate, inadequate infrastructure cuts growth by as much as two percentage points each year.
The scale of India’s need and the public commitment to fund infrastructure projects should make private participation in the sector one of the most compelling investment themes over the next several years. Given its resource constraints, New Delhi is looking at public-private partnerships to become a core element of its strategy. Indeed, private outlays could make up around 40-50% of total investment in infrastructure in the government’s 12th Five-Year-Plan (2012-17). Assuming total investment of around $750 billion, and anticipating a standard debt-to-equity ratio of approximately 2.5 to 1, private investments would total around $80 billion worth of equity with borrowings of $220-295 billion making up the balance.
Recent regulatory changes have created a conducive climate for this private participation. For instance, the Electricity Act (2003) and its subsequent amendments make it easier for private players to invest in the power sector. Airports, roads and telecom have also benefited from pro-private sector policy changes.
As they capitalize on the expanding opportunities, PE investors are using a variety of investment approaches. Most take the form of standalone investments across several companies and developers, but some significant deals saw PE firms partner with companies to form joint ventures. For example, PE fund Actis joined forces with Tata Realty and Infrastructure Ltd last year to invest $2 billion in road projects. Others have pursued a blended model, such as IDFC Project Equity’s investments in several special-purpose vehicles (SPVs) that are structured to help PE investors to become majority owners. Another indicator of strong PE interest in the sector has been the increase in average deal size, with the share of equity investments exceeding $100 million.
PE funds’ increasing interest in infrastructure is drawing more favourable attention from promoters in the space, who have begun to recognise the significant role PE can play in facilitating their companies’ growth. In our survey, one promoter told us that PE firms could help start-ups and smaller companies, in particular, become more market savvy.Promoters can also tap PE funds’ networks to develop more robust revenue pipelines.
For PE to achieve its full potential as a productive source of capital for the sector, several issues need to be addressed. Regulatory complexity remains the biggest challenge. The tiered governance structure most projects use requires investors to obtain approvals from central, state and urban authorities, whose jurisdictions frequently overlap. To improve investment flows, the government needs to streamline the project bid-and-award process, as well as speed up and simplify clearances.
A second impediment is tax rules that severely cut into returns for SPV investors. Under the dividend distribution tax, for example, levies on income paid out to investors are deducted twice-first at the SPV level and again at the holding-company level. The government now assesses a minimum alternate tax that effectively slaps a 20% rate on income from infrastructure projects that are otherwise eligible for incentives.
Further, the range-bound nature of returns might be a deterrent to some PE funds and limited partnerships that are not focused predominantly on infrastructure and are not backed by long-term yield investors like pension funds.
Given the overall size of the opportunity, infrastructure will continue to be a critical part of the investment portfolio of PE firms. Respondents to our survey expect deal size to increase significantly, primarily as a result of industry consolidation, the growing size and complexity of projects, larger fund sizes, and investors’ plans to participate in more deals that result in their gaining majority control. Meanwhile, overseas funds available for investment in Indian infrastructure are set to grow.
Adding allure for PE funds has been the increasing frequency and value of exits in the infrastructure space. In 2010, PE investors divested some 21 infrastructure holdings worth approximately $1.3 billion-the most in five years. There are plenty more assets in the pipeline that are ripening for sale.
Over the next two-three years, more PE funds are likely to develop infrastructure-specific expertise in risk assessment and project management. While this would position them to contribute to-and benefit from-the rapid growth of the infrastructure sector in India, they will need to enhance their ability to spot potential winners.
Gopal Sarma & Amit Sinha are Bain and Co. partners in New Delhi, and leader and member, respectively, of its infrastructure practice
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