Two high-profile Indian road projects have hit the buffers. Bangalore-based GMR Infrastructure has walked away from the Rs77 billion ($1.43 billion) Kishangarh-Udaipur-Ahmedabad expansion, citing prolonged delays in government environmental approvals. GVK Power and Infrastructure, part of GVK Power, has also shelved its contract to build the Shivpuri Dewas Expressway in Madhya Pradesh for the same reasons, abandoning a concession that it won over a year ago.

The roads sector, although sluggish over the last year, has been far and away the richest seam in Indian PPP, with over 200 concessions awarded by 2011. So the termination of two such large road projects will cast a shadow over other concessions. The two collapses reflect a changed climate, where banks are reaching their lending limits to infrastructure, with total exposure estimated at $100 billion, and now avoid riskier greenfield developments. Sponsors increasingly struggle to negotiate stricter environmental criteria and confused government policy. Economic travails like high borrowing costs, inflation and falling traffic levels have also hit projects’ viability.

Sources familiar with the market suggest that India is paying the price of a country in a hurry and that the PPP dream has turned to a nightmare. But the need to finance an estimated $1 trillion infrastructure deficit, much of it in road building, over the next four years has not gone anywhere. The challenging climate still demands new, innovative financing structures and proactive government policy to get projects moving once again.

Rights of way wrongs

Developers GVK and GMR both say they terminated contracts because of unresolved environmental issues that affected their ability to acquire land. India’s growing environmental awareness has made land acquisition difficult, and sponsors rarely have rights-of-way acquired when deals close. This worries banks, since project delays stretching two years from financial close shift loans firmly into non-performing territory.

Confused government policy and the involvement of multiple agencies working alongside India’s National Highway Authority (NHAI) do not make for a smooth development process. “Forest and environmental clearance for road projects used to involve the same process but now they are two different things,” said one market observer. It means challenges are passed between different agencies working in the highways space, tying projects in tight knots of bureaucracy.

A land acquisition bill that outlines how landowners will be compensated should help, but it still has not gone through Parliament. And India’s road builders have usually endured long waits. More more complex challenges lurk beneath the many other pending and awarded build-operate-transfer (BOT) toll concessions. They could turn the trickle of terminations into a steady stream.

Traffic levels tenuous

Some bankers believe that many Indian road concessions are now unviable because their winning sponsors bid too aggressively. Tougher economic conditions are exposing traffic forecasts as overly optimistic. In a report published last year, ratings agency Fitch found “systematic traffic volume overestimation” with some projects experiencing traffic volumes 35% below estimates.

Steep payments to government attached to toll concessions add to the problem. Last year the NHAI awarded 49 bids, of which 32 fetched a premium, with winning sponsors agreeing to pay the government a predetermined amount, escalating by 5% a year. “If a project is unviable, with insufficient revenues, the government pays developers a grant. If revenues are thought to be in excess of costs, developers pay the government a premium,” explains Kuljit Singh, New Delhi-based head of infrastructure at Ernst & Young. Costly premiums are leaving many projects with negative cash flows and little money left to service loans, because NHAI payments take precedent over debt service.

This looming financial distress has led to calls from some sponsors for a comprehensive government bailout of unviable projects and an extension to concessions. Until a few years ago the length of time a developer could charge tolls stood between 20 and 30 years; but this has now contracted to 15 or even 12 years in some cases. An extension to concessions might give sponsors a better chance to eventually earn a return on their equity, but it may not improve projects’ debt service burden. Banks, already struggling with a mismatch between a short-term deposit funding base and the long-term commitments they make to the sector, may not be willing to go out as far as concessions.

Bonds as bail-out

Finding new sources of long-term debt for infrastructure lies at the heart of the latest initiative from the Asian Development Bank and India Infrastructure Finance Company (IIFCL), a government-owned infrastructure financing institution. In a pilot project, upgrades along the NH-7 winding between Hyderabad and Bangalore will be financed with a bond issue enhanced with partial guarantees. ADB and IIFCL guarantees should be sufficient to enhance the GMR-sponsored 12.5-year, $59 million (Rs3.2 billion) rupee-denominated issue to an AA rating, enough to tempt domestic pension and insurance funds.

Pension and insurance groups want exposure to long-term infrastructure assets but have been unable to access the sector because of projects’ low ratings. The hope is such credit enhancement will galvanise investors to increase their infrastructure allocations from 9% to 12% and 1%-3%, respectively, by 2016, freeing-up banks to lend at short tenors to early stage infrastructure development.

GMR will use the bond proceeds to refinance original bank debt on the $92.2 million (Rs5.2 billion) concession that it won in 2006. “This product will replace existing bank loans allowing banks to recycle capital to other projects,” says Siddhartha Shar, a Manila-based senior investment specialist in the ADB’s private sector operations department. For now the GMR issue awaits sign-off from NHAI, though GMR is also timing launch to catch any last minute cut in interest rates.

The structure involves the IIFCL guaranteeing 24% of the issue on a first loss basis. This enhancement, which superficially resembles the European Investment Bank’s 2020 project bond initiative, will increase the bond rating from a standalone A with no credit enhancement, to AA. In turn, the ADB will issue a guarantee to IIFCL for 50% of its exposure.

The IIFCL charges a fee according to the amount of credit enhancement that it provides. Sponsors whose bonds have a higher underlying rating will require less cover, and pay less for their guarantee. “It will depend on the quality of the project,” comments Vivek Rao, also at the ADB, who adds that although India’s established road projects will be the most obvious beneficiaries of credit enhancement, the structure could be just as easily applied to other sectors like power or ports. Together the ADB and the IIFCL plan on providing $128 million (Rs7.168 billion) in partial loan guarantees to rupee denominated bond issues for different projects, with the toll road the first of three slated by 2015.

The guarantees won’t be used for greenfield projects and will favour assets that chime with bond investors’ preference for plain vanilla, de-risked ventures without complex PPAs or structural issues. This pilot project features traffic risk but has no completion risk and minimal operations and maintenance risk. “To qualify, sponsors will need a project with 1-2 years operating success and high standalone ratings,” says Rao.

Even with the enhancement, there is still some uncertainty over whether an investor base will materialise for project bonds. So far the only significant investor in India’s still shallow infrastructure bond market has been the Life Insurance Corporation of India, LIC. “It’s good for the market but is there an investor base ready to take it on?” questions one critic. Other factors may also affect take-up. Banks, which also like well-established, risk-free infrastructure assets, will need to be close to their exposure limits and reset dates, to be willing to be refinanced. They may be unwilling to make substantial primary debt commitments, but may be tenaciously attached to performing existing loans.

Success is also dependent on other financial entities like development finance institutions coming forward alongside the IIFC to offer guarantees, because banks cannot offer such guarantees under Indian law. “The IIFCL can’t keep providing unlimited guarantees, the mantle will need to be taken up by others,” says Shah, adding that ADB guarantees are also finite and only there to kick-start the process. Success also hinges on a steady pipeline of projects. High long-term bond yields could make sponsors reluctant to issue bonds, so the availability of low-cost bank financing will also affect the instrument’s popularity.

Outside equity, outside debt

Credit enhancement may be unproven but is the type of proactive approach the government needs to apply to other corners of the road market, particularly allowing sponsors to free up more of their equity. Concessions require the construction groups that lead sponsor groups to stump up 51% of a concession’s equity, and keep it locked in for three years even if a project has been commissioned. Only after the third year can they sell down their allocation to 26%. The government has softened the 51% lock-in but most road projects still haven’t benefited from the change, says Ernst & Young’s Singh. Equity release on projects would allow sponsors to put equity into other new projects, and attract fresh investment from private equity, developers and non-banking finance companies. “Buying a controlling stake in an Indian highways project is still very difficult,” says Singh.

Even if the door opens to new investors foreign banks remain sceptical of the sector. Unable to compete on pricing, few have participated in Indian road projects. Long tenors and rupee revenues have put them off, and they lack the sponsor relationships that Indian banks enjoy. “The Indian market isn’t really in line with what international banks expect,” said Richard Ginks, a partner at Linklaters, adding that shouldering traffic risk, as Indian deals require, is particularly unpalatable. “Internationally it is very hard to pass on traffic risk; in emerging markets it’s even harder because there is no traffic data.”

Levels of external commercial borrowing (ECB) have grown since the government allowed sponsors to raise greater quantities of overseas debt and benefit from lower interest rates. But power sponsors have been the biggest beneficiaries of this increase in ECB activity, and if their problems with rising fuel prices continue they may test foreign lenders’ patience.

The changed economic climate, over-optimistic traffic studies, rising raw material prices and banks’ reluctance to make new construction loans threaten to hamper growth in India’s road sector in coming years. A well-managed exit for sponsors GMR and GVK could bolster the market. But in a worrying trend, legal battles between the government and quarrelling sponsors have been increasingly protracted and costly. “Legal recourse is slow; it can take years,” said one banker. If NHAI decides that sponsors are using rights-of-way difficulties as a pretext to walk away from concessions for which they bid too aggressively deadlock is guaranteed.

But the stakes for the two terminated projects could have been higher – neither saw any disbursement of funds. A swift resolution would strengthen the argument for PPP in India, proving that it can work through the worst as well as the best of times.