Thursday, October 4, 2018

Lessons from the IL&FS case

The post-mortem in the aftermath of the IL&FS crisis has unsurprisingly thrown up several suggestions. The IL&FS model, which assumed both the financing and execution risks, was inherently flawed. The time has come to discard the idea of development/infrastructure finance entity. And so on. 

I will disagree with all such unqualified conclusions. After all Macquarie and their infrastructure funds and asset management model is regarded as one of the most successful infrastructure financing and management models. Successful exclusively infrastructure finance focused institutions and going strong in countries ranging from Brazil to the US and Europe. 

It has to be said that IL&FS went beyond the Macquarie model and ventured into activities undertaken by the likes of Carillion with disastrous consequences.

Shaji Vikraman hits the nail on the head. The real problem is with corporate governance. 
As the government stakeholders and regulators go about trying to work out a resolution plan and contain the damage, they should also take a closer look at what appears to be the weakness in the Indian model of what were seen as professionally managed or run firms without a dominant promoter or diversified shareholding. Over the past year, there has been a serious dent to this model purely because of governance and leadership flaws, subservient boards and integrity issues... In the post reforms period, with delicensing and deregulation and with the state exiting many businesses, successive governments and regulators encouraged the diversified shareholding model and professionally run, board-managed firms. But over a period of time, as the original promoters in some of these listed firms — mostly government-owned banks or investment institutions — started diluting their holdings, with no dominant shareholder, the CEOs of some of these companies acquired a larger-than-life role helped by so-called independent boards meekly acquiescing to the decisions. Rather than the democratisation of wealth which is what was celebrated in the glory days of India’s top software services and other firms including some private banks, this was over the last few years limited to a small club of senior management professionals with little or no relation to the performance of their companies, thus widening the divide.
There is a strong path dependency associated with the trends in areas like private participation in infrastructure finance and management. The first phase was about simple long-term post-construction (with public finance) concessions, especially in countries like Latin America. Then countries like Australia, Canada, and England led with PPPs involving bundling of construction and O&M to initially construction contractors, then construction-cum-O&M consortiums, and finally finance-construction-O&M consortiums. The area of project finance and public bond issuances emerged to support PPPs. Then the likes of Macquarie created exit opportunities for construction contractors and a secondary market for infrastructure assets using privately raised infrastructure funds. Gradually, the private equity players found infrastructure assets a source of stable and reasonably attractive income stream, with ample opportunities for asset-stripping and pass-the-parcel game over the asset's long life-cycle. Now, there is a growing realisation in the developed economies, especially in Europe and the US that private participation is not only not cost-effective but also fraught with problems, and much greater public participation and strict regulation may be necessary in infrastructure projects. The full circle has been completed. 

As we can see, each stage of this evolution created the conditions for the next stage. We, in India, are perhaps just entering the Macquarie-like secondary market stage. We still have to travel the PE journey. The present problems are about NPAs and bankrupt construction contractors. The next phase will see asset-stripped utilities, over-burdened consumers, and bond market defaults. 

The political economy, market dynamics, and herd mentality mean that it will be very difficult for India to learn from the developed economies, short-circuit the journey, and avoid such pain. In fact, just the challenge of meeting the vast infrastructure financing requirements without the public fiscal space required to meet that demand is itself enough to make the reliance on any kind of private capital, even with all its long-term distortions, inevitable. 

Take the latest episode of infrastructure creation. It is true that we are today grappling with NPAs and bankrupt infrastructure promoters, both of which threaten to derail the economy itself. But on the other side of the balance sheet, the economy has added nearly 10 GW of power generation capacity, nearly 100,000 km of highways, 30-40 mt of steel capacity, about 100 mt of cement capacity, country-wide roll-outs of 2G, 3G, and 4G telecommunications within a decade? Would carefully calibrated and gradual policy actions have realised this? Without irrational exuberance, would contractors and developers have taken the plunge, lenders opened the credit taps, and government agencies lowered diligence standards? Maybe this is the creative destruction pathway in infrastructure sector. And such a creative destruction with a generation of infrastructure funds and PE money, even with all attendant costs and pain, is perhaps worth it. 

One of the things policy makers, market participants, and opinion makers can do is to keep this in mind while navigating the course. The more enlightened and perceptive among them do so. Unfortunately, they will be far and few. 

The intellectuals and consultants who peddle the narrative of PPPs and private equity have a vested interest in peddling these narratives. As Upton Sinclair said, "It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" This is just the hard reality of development. 

More tangibly, it is critical to focus on corporate governance. The likelihood of malfeasance increases significantly with secondary market asset transfers and private equity ownership. It is hard to believe that we have the requisite state capacity, civic-spirited and vigilant opinion makers, and acceptable enough corporate governance standards to provide sufficient checks and balances against such malfeasance. In fact, our encounters with infrastructure funds, private equity and the likes could degenerate to a level of asset-stripping and debt-loading far worse than in US and UK. 

How do we guard against the different types of value extraction and asset-stripping? How do we guard against leveraging up? How do we guard against value subtracting pass-the-parcel games? How do we guard against equity dilution? They are the second generation issues in infrastructure contracts which are upon us. Unfortunately we are yet to realise their importance. Nor is there any public debate about them.

Ideally there should be detailed project preparation, rigorous value for money analysis on a life-cycle basis, private participation choice based on efficiency gains than financing requirements, unbundling of construction and O&M, public financing of construction through arms-length entities, long-term O&M concessions, safeguards against asset-stripping and leveraging up, strong regulatory oversight, recurrent re-evaluations or flexibility for renegotiations, and so on. Each easier said than done. 

In the circumstances, the prudent objective should be to choose the least bad and distortionary option and structuring from among public procurement and competing variants of private participation depending on the context. This has to be coupled with stringent focus on corporate governance, and safeguards against egregious malfeasance.

Update 1 (13.10.2018)

This and this are good chronicles of IL&FS.

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