The TBTF risk with infrastructure companies

I blogged earlier about the problems facing GVK and the likely risks with the Adani Group. It is now being reported that the Adani Group will be acquiring GVK's stake in Mumbai International Airport Ltd (MIAL). Besides, it will also be acquiring the stakes of minority partners Bidvest Group and Airports Company South Africa (ACSA), thereby giving it a 74% state in MIAL (the remaining 26% being with Airports Authority of India (AAI). This also marks the exit of GVK from MIAL. 

With six airports already won in an earlier tender, Adani now becomes the second largest private airport operator after GMR Group, which operates Delhi and Hyderabad airports. Besides this acquisition gives the Adanis ownership of the upcoming Navi Mumbai airport, in which MIAL holds 74% share. 

This latest airport acquisition of Adani Group raises several concerns. For a start, unlike GMR and GVK which have well established credentials as effective airport operators, the Adani's have no experience of building or operating any airport. In fact, that the second largest airport operator of India will be a company with no experience in airports sector should be considered a matter of concern.

What makes this an even greater concern is that the MIAL deal, involving the AAI, comes even as the Adani Group have formally expressed their inability to the AAI to takeover the three airports awarded to them in 2019 (the other three airports are stuck in litigation). So effectively, while on the one hand Adanis are washing their hands off earlier bids on debatable grounds, on the other hand they are taking over the country's second largest airport.

An editorial in Business Standard wrote this,

The Adani group has now got control of as many as six airports in spite of having no real experience in the field and a debt pile that stood at Rs 1.3 trillion at the end of the last financial year, during which it also saw a 64 per cent decline in net profit year-on-year. Also, the Cabinet approved leasing three airports to the group — Jaipur, Guwahati and Thiruvananthapuram — even though it has sought to delay taking over the three other airports — Mangaluru, Ahmedabad, and Lucknow — for which it won bids in February last year.

In fact, with MIAL in their bag, the Adanis may now think of reconsidering their request to cancel the bids on the three airports. As we shall discuss latter, a balance sheet with six Tier II airports and two metropolitan airports (Mumbai and Navi Mumbai), even without any sectoral experience, presents several opportunities.

Furthermore, the Group's land-grab, in terms of winning tenders, is not restricted to airports. The Group has won big enough tenders in solar and city gas distribution, both areas where it has little or no internal expertise. The spectacular expansion in ports sector from just one port to being now in control over 45 berths and 14 terminals in ten locations in less than a decade is well-known. In fact, most of this expansion too has been in just recent times and through acquisitions.

In short, in just a couple of years, the Group has quietly imposed itself as large player in several important sectors of the economy with no prior experience. Neither does it appear that the Group has forged strategic partnerships with experienced operators (except Total SA in Gas distribution).

This is disturbing for at least two reasons. One, unlike the Reliance Industries, the Adani Group's track record of painstaking execution and operations, of the sort that is required in messy infrastructure sectors, is limited and questionable. Its track record (of relevance here) is largely restricted to running a port and a power plant. It has come to own assets or projects in several sectors in one big flush and it now remains to be seen how it can mobilise the capacity to execute or operate them. The failure to takeover the three litigation-free airports for more than a year after it won the bid and before Covid 19 struck only heightens the concerns.

Second, as I have blogged here, the Adani Group's growth has been characterised by disturbingly high levels of leverage. Many of the major scheduled commercial banks have significant exposures to the Group. And the nature of the exposure, arising from a feature of infrastructure financing in India, is a matter of concern. 

Infrastructure companies buy or bid for large projects. These projects require mobilisation of capital for financial closure. So, after winning the bids, they pursue different avenues to mobilise capital to achieve financial closure. This invariably involves raising bank loans or issuing bonds by leveraging the expected revenues and receivables from the contract as the collateral.

The underlying source of the contractual commitments vary across sectors. For roads, it is either the potential toll revenues or the annuity payments committed by the contracting agency. The latter naturally lowers the cost of capital. In case of power generation projects, the Power Purchase Agreements (PPAs) and Fuel Supply Agreements (FSAs) serve this role. In case of airports, like with the roads, the traffic estimates are the collateral. In case of ports and gas terminals, often there are long-term contracts with large port/terminal user companies that assure demand.

Never mind the uncertainties associated with such receivables, these commitments help developers achieve financial closure and start construction. In fact, it is a common practice for developers to undertake financial engineering and gold-plate their investments or inflate asset valuations to maximise what they can squeeze out from lenders. It does help that banks do not have the expertise to undertake serious due-diligence and price their loans accordingly.

In the world of balance sheet financing (as against project financing), especially by banks, this money is, in turn, rotated to acquire newer assets and so on. As the pile of assets owned by a company rises, a giant Ponzi scheme develops - you raise money for a project and use it to acquire new projects, or payoff liabilities and cashflow problems elsewhere in the group's holdings. In a context of weak diligence and monitoring by banks and deficient oversight by regulators, a complex web of highly opaque inter-company transfers takes place. Once the tide drops, as it should with such risky exposures, everyone stands exposed.

As an illustration, one can be certain that the Adani Group will have leveraged its winning of six bids to raise the capital to finance any acquisition of a controlling stake in MIAL. Why else would any financier lend to a company which has no experience whatsoever in the aviation industry, even if there is an underlying physical asset? It is difficult to disentangle such contributions and effects, but the reality will be easily acknowledged in private by everyone concerned.

It also fuels a dynamic of the bigger companies being able to attract more financing, purely on the basis of their size. In case of the Adanis in airports, despite all other risks and concerns, a balance sheet with eight possible airports is a strong attraction to prospective lenders.

But this concentration of projects with a developer also raises moral hazard concerns. Unlike regular commercial companies, infrastructure operators manage assets and deliver services that are essential, often some form of public goods. It is not possible to let these assets disappear or be liquidated away. So, even if the operator runs into problems, in public interest governments will be pressured to step in and bail them out. The large exposures of the banking system to the developer only adds to the moral hazard. This is the Too Big to Fail (TBTF) moral hazard with large infrastructure contractors.

Make no mistake, based on all information available as on date, and even with generous optimism, it is hard not to allocate a very high risk rating to the Adani Group and all its portfolio of projects. There is a serious risk of all these projects being delayed inordinately, if not having to be re-bid. And we've been here before numerous time across the world and in India itself to have not learnt the lessons.

This entire episode is in line with the global practice and trends in the infrastructure sector as outlined in this paper.

Update 1 (31.08.2020)

Adani Group formally takes over the Mumbai airport. A Business Standard editorial lays down the disturbing issues with the Adani Group's take over of  the GVK share in MIAL.

Update 2 (01.09.2020)

The biggest risk with all the greenfield projects that the Adani Group have accumulated concerns the Group's ability to raise the financing required to execute them. This article highlights the problems with its debt exposure.

Update 3 (03.09.2020)

Talking about aggressive bids, sample this,

At Rs 115 per passenger for Mangaluru and Rs 171 for Lucknow, the group’s bids were over 500 per cent more than the ones received from the GMR group and PNC Infratech, respectively. Similarly, the Adani group placed a bid of Rs 177 for Ahmedabad airport, nearly 200 per cent more than that of Autostrade Indian Infrastructure Development.

So we are talking about bids for six airports, all made by one operator and all offering fees in multiples of that offered by nearest competitor! Even assuming any strategic or grand intentions behind such bids, it is hard to believe that only one company could see so much money lying on the sidewalks!

And this.

Update 4 (12.09.2020)

With the MIAL acquisition, one in four airline passengers in India will pass through Adani owned airport. This article is a good summary of the lead up to the Group coming to acquire seven airports.

This article raises questions about the bidding process followed for the six airports privatised in the first round of PPPs, and how it could make flying expensive and hurt the sector's growth prospects. Unlike the existing airports, where AAI gets a share of the revenue, in these six airports, the winning bidder pays a per passenger fee. AAI has 45.99% revenue sharing with DIAL (Delhi) and 38.7% with MIAL. The concession agreements signed for Ahmedabad, Lucknow and Mangaluru airports, Adani will pay AAI Rs 177, Rs 171 and Rs 115 respectively for every domestic passenger, and double these for every international passenger. The concessionaire has these revenue streams - charging passengers a user fee, charging airline operators, real estate development, and maintenance, repair, and overhaul (MRO) activities for commercial aircrafts.

The bid parameter does not incentivise the operator to improve efficiency and keep costs down, and allows them to maximise fees from passengers and airlines.

The airport sector regulator, AERA has pegged a cap of 30% of revenues as royalty that can be allowed as ‘pass-through expenditure’ (that is passed on to the consumer) for all ground-handling and cargo-handling and other aeronautical services. “This means that the operator can outsource these services and charge the subcontractors high royalties. If not royalty, operators will charge a licence fee," said the lawyer. “The fact is that subcontractors are more than willing to pay as much as 200% of their revenues while bidding shows a big anomaly in the system. Obviously, this will lead to overcharging the customers and underreporting their revenues," he added. The reference here is to AAI cancelling bidding of ground-handling services for 76 airports in June, 2019, following concerns over some short-listed bidders offering steep royalties as high as 226%. There is also no cap on royalties on subcontractors providing non-aero services such as hotels, duty-free shopping and liquor sales since they don’t come under the purview of AERA. Airport operators continue to levy huge royalties or licence-fee on those service providers. “Strangely, in most cases, the bidding and selection is based on royalties—meaning how much revenues will the subcontractor share with the airport operator, and not on technical parameters and financial strength of bidders," the lawyer quoted above added.

AERA had in 2018 capped the royalty charged by airport operators on independent service providers (companies dealing in ground handling, cargo handling, and fuel services) to 30% of the latter's gross revenue. Given that the ISP's charge the airlines for their services, a high royalty by the operator naturally gets passed through to airlines, who in turn pass them on to passengers.

Update 5 (23.09.2020)

Adani is also the world's largest solar developer by capacity,

According to a ranking renewable energy consultancy Mercom Capital Group, Adani Green is currently the top global solar developer with 2.3 GW of operational projects, 2 GW under construction, and 8 GW of awarded projects (with contracted PPAs) for a total capacity of 12.3 GW. Hong Kong-based GCL New Energy is the second largest global solar developer with 7.1 GW, followed by SB Energy, Enel Green Power, Brookfield Renewable, First Solar, AES Corporation, Invenergy, Lightsource bp, and ENGIE. In June, Adani Green Energy Ltd bagged a manufacturing-linked solar contract from the Solar Energy Corporation of India (SECI) to develop 8 GW of projects. The transaction is valued at ₹45,000 crore, or $6 billion.

Again, the vast majority being projects awarded, and with a far smaller track record of execution. And as it goes ahead with execution, it will face the problems of land acquisition etc, as outlined here.