Financing urban infrastructure projects

It is estimated that our cities would require anything between $250 bn to $500 bn over the next five years to finance basic infrastructure needs, that are a precondition for them becoming vibrant growth centers. Here are a few methods, other than the simple government and private financing models, of funding urban infrastructure projects.

1. Project finance
Project finance for a capital asset, invloves creating a legally independent project company, typically a Special Purpose Vehicle (SPV), and then financing that company exclusively with its cash flows or non-recourse debt. The project assets are mortgaged to the SPV and the cash flows are escrowed into a separate bank account, with the first charge on its belonging to the investors or lenders. By financing the investment by an off-balance sheet entity, rather than on its own balance sheet, the company will be able to mitigate its risks and also finance larger investments than otherwise, by leveraging more external resources.

Further, it also helps even financially weak companies, with negative legacy costs, raise resources at lower cost for important and economically viable projects. Besides, it brings in greater discipline and professionalism to the process of project conception, execution and operation, thereby enhancing the value of the investments. Typical project finance debt is for long tenors of atleast 15 years. Apart from all this, unlike simple loans, project finance minimizes interest burden by releasing finances for the project according to requirements.

The large proportion of leverage in project finance, typically 70-80%, and the need to repay this, brings in financial discipline to both the project financing and the post-construction management process. It reduces the possibility of asset stripping and cash flow siphoning off by the parent company. Many infrastructure projects generate large cash flows, and project finance model ensures that the project cash flows are not wasted or squandered away and are optimally utilized to repay the debt. which can be utilized to repay the debt.

2. Value capture method
Typically used in land development. Urban Development Authorities across the country raise considerable revenues from land by selling after minimal or even no development of the land. From the seller's perspective, this is an inefficient method since the major portion of the value of an undeveloped land is embedded in the future revenue streams arising from its development. In other words, the seller exits at the lower end of the value chain.

The developer, in turn garners a windfall after full commercial development of the land. He benefits from both the land value shooting up and from the incoming revenue streams, whose NPV is in most cases many times more than the land value itself. The seller of the land (government agency) loses out from partaking a share in this future revenue streams.

The seller can maximize his returns by an arrangement wherein the land gets leased to the developer for a fixed period at an annual rental value and a share in the future revenues streams (a developement premium). Another model is where the developer transfers a portion of the developed commercial or residential built-up area.

3. Tax Increment Financing (TIF)
TIF is a mechanism that allows municipalities to earmark the increased tax revenues from property value growth, due to land re-development or renewal, within a designated area suffering from blight (a TIF district) in order to finance development in that same area. It dedicates the increased property tax and other revenues from redevelopment to finance debt issued to pay for the project. It is therefore a method of using future gains in taxes to finance the current improvements that will create those gains.

Re-development benefits the municipality by creating more taxable property (and hence tax revenues) and by increasing the values of land held by it. Vacant land, if any, can in turn be leveraged to earn more revenues and property tax.

After a municipality designates a TIF, local government units are barred from collecting taxes on the area’s property value growth. They can tax only the "frozen" property value and properties, as it stood when the TIF was designated. The tax revenue from growth – the tax increment – accrues instead to the TIF, to be spent on loan repayment, capital improvements, developer and rent subsidies, job training, and other expenditures meant to spur new development. The value of this new development is taxed, the taxes ploughed back into the TIF, and the TIF revenues spent on creating still more development.

TIF is a popular method of financing investments in poorer areas, since it does not involve any immediate increase in property taxes and also beacause it mandates the spending of money raised from the area in that area itself.

4. Pooled Finance Development
Is an approach under which an appropriate mix of urban infrastructure projects are bundled together, and the bundle is then posited before the debt market. The projects should be chosen so as to diversify away and mitigate the individual project risks. This can be achieved by choosing projects with robust enough cash flows, which imparts an element of credit protection against revenue shortfall in the other projects.

This method of financing is typically used to leverage investments into smaller municipalities, whose credit worthiness is often suspect, by mixing them with projects from more credit worthy and larger municipalities. It can also be used to finance projects with smaller revenue streams, by bundling them with those having larger revenue streams.

Pooled Finance Development Funds (PFDF), set up by governments, can also provide ratings enhancement facility by functioning as a Credit Rating Enhancement Fund (CREF) and raise the credit worthiness of the bond offerings (to finance a bundle of projects) to investment grade.

5. Credit Enhancement Facility
Given the virgin nature of debt market for urban infrastructure, it is natural that lenders have apprehensions about the riskiness of their investments. In order to facilitate the development of this market, it may be necessary to increase the credit worthiness of these investments by providing additional layers of credit protection. Such additional protection would make the project investment grade, and thereby lower the cost of capital.

Such credit enhancement can be provided directly through a guarantee fund, or by purchasing guarantees from financing institutions willing to underwrite the risk of a cash-flow shortfall. All this additional layers of credit protection, over and above the Project cash flows, is meant to mitigate the risks, lower the cost of capital and thereby encourage the growth of a debt market in urban infrastructure projects.

6. Construction risk transfer
Wherever, the construction risks are substantial, due to possible problems with land acquisition and work site clearance, the cost of capital tends to reflect this higher risk. The project (or the borrowing agency) is left holding this high cost debt, well after the construction is completed and the project operationalized.

In the circumstances, it may be cheaper to raise short term loan and complete the construction. After off-loading the construction risk, the short-term loan can then be swapped for long tenor structured debt at lower cost. This model has been elaborated here.

7. Venture financing model
This approach uses a higher equity share to leverage debt at lower cost, on the condition that the equity holder can progressively withdraw his equity. In other words, the equity is used to "crowd in" lower cost debt. Under this model, the project commits to achieve certain operational and commercial benchmarks in its performance, within a specified time schedule, thereby demonstrating its ability to counter its commercial and operational risks. Once the project stabilizes and the revenues streams get established, it becomes possible to attract debt at lower cost. The equity investor can then progressively exit with a handsome return. The equity can then be invested in newer projects.

This arrangement is similar to the venture financing or angel investing model, in which promising ideas and projects are financed by providing seed capital. The venture capitalist or angel investor, exits with a handsome profit once the project becomes established as a success. There can be institutions that specialize in making such investments.

8. Impact fee financing
Major infrastructure investments results in increased land and rental values in the area. Since the land owners do not contribute anything to this increase, it is only appropriate that they are priced for this unearned increment. The gains accruing to the landlord from the positive externality arising from the investment, is partially internalized by way of an impact fee. This impact fee can be by way of a higher property tax, a higher building permission fee, or a direct levy.

9. Tradeable infrastructure assets
The infrastructure assets can be created by short term debt or financed by government. An appropriate pool of such infrastructure assets can then be bundled together, securitized and sold off as a tradable financial product. Their price and true cost of capital will be determined by the market. These tradebale assets would be similar to the infrastructure funds that are floated in the debt market to raise capital for creating specific infrastructure project assets.

The O&M of the assets can then be auctioned off to franchisees by competitive bidding, thereby helping consumers get the best deal in service pricing. More about this model here.

10. Viability gap funding or bridge financing
This approach is suitable when an investment is financially unviable, since the investment costs are too large to be compensated (or repaid) by the relatively smaller revenue streams. In such projects, the government does the bridge financing required to make the project financially viable, most often as a grant. This amount can be offset against the subsidy provided by the government, by way of lower tariffs on water or sewerage systems.

11. Government guaranteed debt
In major projects, where the SPV accesses the debt market, the cost of capital is invariably higher than if the debt was raised by the government or any of its agencies. In emerging markets like urban infrastructure, no private entity, however established and credible, will be able to convince lenders that it has adequately addressed the issue of construction, commercial and operational risks. This inability to signal convincingly enough to lenders will translate into higher cost of capital for the project, thereby saddling the project with often unsustainable debt service burdens, under the weight of which it fails.

The portion of such government raised debt, can vary depending on the type of project and its financial viability. This debt can become a junior debt tranche, to senior debt raised in the regular debt markets. More on this is available here.