Recently, banks and financial institutions have evinced interest in setting up Infrastructure Debt Fund (IDF) structures. However, doubts linger as to how many of them will be able to raise any capital from these proposed IDFs from domestic or foreign institutional investors. The acceptability of these IDFs in the capital markets is yet to take off. Sumantra Das discusses issues related to IDFs and how far it will work as a catalyst for infrastructure finance.The idea of IDF came in a situation when availability of funds through banks was at stake as the banking sector which is fast approaching its debt limits. Till date, banks have dominated debt funding for infrastructure projects. During the last decade 80 per cent of the infrastructure projects have been financed by banks. Recent data shows that in the first three years of the 11th Five Year Plan, the source wise funding was: Banks 56 per cent, Non-Banking Financial Companies (NBFCs) 24 per cent, insurance companies 9 per cent and External Commercial Borrowing (ECB) and others (11 per cent). Department of Industrial Policy and Promotion (DIPP) data shows that the infrastructure funding by banks as a percentage of gross bank credit rose from 1.7 per cent in 2000 to 11.7 per cent in FY 2010 and it will not be possible to follow a similar trend in view of the huge funding deficit in the 12th Plan. In the past eight years, banking sector’s exposure to infrastructure has gone up from 2 per cent to close to 13 per cent today with an exposure of Rs 620,000 crore.Above all, are bank term loans meeting the requirements of infrastructure projects? Here the moot question is that the infrastructure projects need long tenor funding like 20-25 years and also soft interest rate so as to keep cash flow. However, in India since the majority of funding is by banks, the tenor is generally restricted to 15 years and interest rates are kept linked to interest rate matrix relating to credit rating. Since the credit rating is barely investment grade, the projects suffer from higher interest rates.Why IDF?In this circumstance, the market is looking to new types of investors such as pension funds and life insurance companies who are generally well capitalised and seeking long-term returns.The IDF regulation has been announced more than a year back in two forms – NBFC and Mutual Fund (MF) routes with certain qualifying requirements for IDF sponsors. In the NBFC route, the credit risk of the downstream investment in infrastructure project bonds would be taken by the IDF and in the case of MF, the credit risk of the downstream investment passes through, making it more like a debt mutual fund with larger minimum investment and unit sizes.IDF specially in company route is a unique concept which would attract funds from pension funds, provident funds, wealth funds, gratuity and insurance companies, because IDF will invest only in projects those have completed Commercial Operations Date (COD) (no construction risk), one year of established operations (no cash flow risk), and supported by buyout guarantee from project authority by way of tripartite agreement (thus no risk in case of default by the concessionaire). Thus, in the NBFC route, the credit risk of the downstream investments in infrastructure project bonds would be taken by the IDF and in the case of MF, the credit risk of the downstream investment is pass through, which makes it more like a debt mutual fund with larger minimum investment and unit sizes.Issues with domestic fundsApart from the recent entrant Reliance Mutual Fund, SBI Mutual Fund along with IDBI Mutual Fund, Axis Mutual Fund and L&T Mutual Fund are already operating with various offerings in the market. There are however, concerns or doubts remain among various investors regarding the difference between various infrastructure schemes and IDFs and which can provide better returns.Some sector analysts believe that while IDF seems to be good for the infrastructure sector initially, there are certain areas need to consider. Dhruba Purkayastha, President & CEO, Financial Advisory Division, Feedback Infrastructure Services, says that there are unresolved structural and credit market issues which need to be resolved before implementation of IDF.Low credit ratings: So far, one of the key issues faced by the domestic insurance and pension funds (other than the current poor policy and implementation environment in infrastructure sector) has been the issue of low credit ratings of infrastructure project loans. The capital market players from an investor’s perspective are insurance companies, pension funds and Foreign Institutional Investors (FIIs). But, as per the IRDA norms it requires 75 per cent of their corpus to be invested in AAA assets. Now, the question is how many infra projects or developers have such ratings. Can they go to the capital markets and tap money for their project? As per norms, insurance companies do not fund SPV level projects because they (the insurance companies) do not have the ability to appraise the risk the way banks do.Where’s the money? Besides, as per the IRDA requirements, a major portion of insurance companies’ corpus is invested in government securities and bonds, so not much more is available to invest further in infrastructure or other private sector bonds. Similarly, only 10 per cent can be invested by pension funds in the discretionary sector and not compulsorily in the private sector. FIIs have invested close to a $60 billion limit in the Indian bond market, out of which $20 billion will go to government securities and the rest in corporate bonds. In this situation the real money has gone into short term bonds, not for long term infra funds.MF or NBFC route? The MF method effectively allows investors to pool their resources across a range of infrastructure assets in order to reduce their risk. Investments can be made in any kind of infrastructure project – from early stage through to late stage – and may be income tax exempt for participating sponsors.However, the mutual fund structure also has drawbacks. For example, the entire credit risk would effectively be shouldered by the end investor with no opportunity for credit enhancement guarantees. The funds will also be limited to rupee-denominated units, resulting in currency risks for foreign investors who will need to include hedging costs into their calculations. “This structure may be useful for investors who are willing to bear some additional risk in exchange for a higher return,” says Arvind Mahajan, Head, Infrastructure Practice, KPMG India.Moreover, an IDF set up in the form of MF (or trust) structure is not likely to have the expertise to properly assess project risks before providing financial assistance for project implementation. It may also not be able to raise long term funds needed to finance project implementation, as the risk and return will be a pass-through to the investors. While there will be some reduction in risk from pooling of assets, it is unclear if this will be enough to reduce the risk from a typical infrastructure project rating of BBB- to AA or AA+, and if it is unable to do so, this structure may not succeed in attracting domestic long term investors like insurance companies and pension funds who may perceive these units as too risky. As international investors have been typically more risk-averse than their domestic counterparts, they may not be willing to invest in schemes meant for project finance assistance. Thus, under the trust structure, practically IDFs may not be in a position to provide financial assistance for projects under implementation.The second planned structure would see the creation of an NBFC that is effectively restricted to investing in PPP projects that have passed the one-year COD and can therefore offer a very focused investment outlook. The structure is likely to be able to achieve a credit rating that would be acceptable to risk-averse investors. The NBFC may also issue bonds in both rupee and foreign currencies, thus further reducing the risk for international investors.However, the NBFC route is also saddled with challenges. For example, the sponsor will be limited to less than 50 per cent of the shareholding, meaning that other institutional investors will be required to take a stake in the fund. The forced focus on late-stage assets also means that investors are effectively limited to government sponsored assets and the market opportunity will therefore be reduced accordingly. KPMG’s Mahajan projects that the structure is likely to operate on thin spreads, with income tax exemption and lower capital adequacy norms expected to stimulate returns.Other issuesOther issues include refinancing risk. Where the loans by commercial banks are not taken out by the NBFC route, the banks may continue to book debts of long tenor, thereby tying up capacity. Besides, at the time of refinancing, the project will carry a pricing risk equal to the difference between the pricing of commercial bank debt and the bonds that refinance this debt. If the overall cost is lower that the commercial debt based on which the revenue stream is derived, there would not be an issue. However, if the cost of debt is higher than the commercial debt, the refinancing would normally not occur unless suitable mechanisms for addressing the issue are spelt out. The interest rate risk and exchange rate risk also another issue which needs to sort out. One option is to hedge these risks but it will have a cost associated with it. This issue needs to be addressed to encourage foreign investors to invest in IDF.With the recent guideline IDF-NBFC could co-finance an infrastructure project to the extent of 80-85 per cent after appraisal by a commercial bank which can take exposure to the extent of 15-20 per cent. This way IDF (NBFC route) will be able to raise adequate long term resources through the corporate bond market. However, the constraint of insurance companies not being allowed to invest more than a certain percentage of the investees capital may limit the scale of domestic investment in this kind of fund.Also, it may not be able to attract foreign long term investors as it will be constrained by India’s sovereign rating of BBB- and further credit enhancement mechanisms may need to be put in place to deal with this issue. “I believe at present global economic scenario IDF is the best option left in front of Indian infrastructure companies for funds. But government should come out with more such debt instrument to give a push to infra funds,” says DV Prasad, Head of Finance, Essar Projects.Conflict of interest? There are two points to observe in relation to the implementation of IDFs: First, the scheme for IDFs as it stood before the Budget 2012 was attractive enough – tax incentives for investors, lower withholding tax for the fund itself, and so on. However, despite all this, no IDFs have, in fact, been launched still. Second, the attractiveness of the direct ECB window to the infrastructure operators may weaken the case for IDFs.After all, if international investors invest in infrastructure sector directly, rather than through IDFs, it may only lead to disintermediation. It would take some time to see the impact of the Budget on the infrastructure finance sector in general, and on IDFs in particular, says Vikas Sharma, Director of Supreme Infrastructure.However, Sandesh Kirkire, CEO, Kotak Mutual Fund, says that as IDF is a type of scheme and can be in high demand for high net worth individuals (HNIs) and mature investors. “Initially it may have certain hiccups on implementation and may take some time to attract investors but we are hopeful that IDF will have a greater impact on infrastructure sector over the period. So alternative avenues such as IDF for funding will emerge and the funding side also has to fall in line with what happened internationally.”Way ForwardNo doubt there is a dire need of participation in IDF for the infrastructure sector particularly in a global downturn. The next few months will be a turning point for the government’s IDF plans as key players review their options and gain clearer insight into the guidelines that have been articulated by the Ministry of Finance.When Globally PF/Pension/Insurance/Wealth Funds are participating in infrastructure development which provides long term stable funding at most convenient interest rates, then why not in India? From a regulatory perspective, IDFs are present at market but their acceptability by the capital market will depend on a variety of factors that this article has explained.