Valuing a regulated infrastructure asset

Debashis Basu draws attention to the Lanco Babandh power project,

The initial project cost was Rs 6,930 crore, of which the promoters’ contribution was supposed to be 20 per cent with an 80 per cent debt component (cash credit, term loan, and a letter of credit/bank guarantee) to come from 14 Indian banks and Life Insurance Corporation. CRISIL upgraded the credit rating of Lanco Infratech’s bank facilities to “A/stable/P2+” in March 2010 from “BBB+/StableIP2” in August 2008. This represented an “improvement in Lanco Infratech’s overall business risk profile”. Primarily, this was based on the expectation of a substantial increase in the operational asset base from 500 Mw in 2008 to 2,680 Mw by December 2010.

In March 2015, the project cost was revised to Rs 10,430 crore and further to Rs 11,949 crore in June 2016. Even in 2019, when Lanco came under a bankruptcy resolution, the project remained incomplete. While Lanco’s admitted claim of project finance debt aggregated Rs 8,217 crore, the average fair value and liquidation value stood at a paltry Rs 1,800 crore and Rs 900 crore, respectively. The sole bidder for this heap of junk was Vedanta Group, which offered cash of Rs 1 crore and 5 per cent equity i.e. Rs 51 lakh out of the paid-up capital of Rs 10.27 crore after capital restructuring. The bankers rejected the offer and Vedanta refused to improve upon it. The project had gone into liquidation for a realisation of just Rs 290 crore...

A banker in the know says there were various issues in how banks dealt with project risk. For instance: There was no pre-commitment condition requiring the company to mitigate project development risks; conditions precedent to the first disbursement were perfunctory and reflected the banks’ eagerness to release debt; the promoters’ operating results and financial position were not analysed to ascertain their ability to deliver; banks’ blind reliance on so-called “lenders’ independent engineer” reflected a cavalier attitude of the banks. In short, the banks’ accepted the promoter’s proposal without any serious appraisal. The sanction memorandum was prepared in a perfunctory manner and there was no project monitoring. The banker concludes: “Banks including LIC disbursed money without any risk mitigation.” No surprise that more than Rs 3,000 crore was diverted from the project, including a Rs 1,000 crore excess advance paid to the EPC (engineering, procurement, construction) contractor. The flagship, Lanco Infratech, is itself under liquidation along with seven power projects and one toll road project, mainly funded by PSBs.

This offers some important takeaways and reminders.

1. Bad governance should not be confused with lack of expertise. It's widely held that the excess of lending to infrastructure companies in the 2000s which ended up as NPAs was due to poor capacity of banks to appraise infrastructure projects. 

But that view may only be partially correct for multiple reasons. For a start, any long-term contract is by nature incomplete. There is only so much that can be anticipated and mitigated. It's for this reason that renegotiations are intrinsic to PPP projects. The main sources of NPAs, highways and power generators, had become de-risked areas long ago, and appraisal risks were well-known. Further, while the assessment of the traffic projections and tariff revenues suffered from optimism biases, these have been the global norm in such projects. 

2. Gold plating of infrastructure projects is an ever-present reality. Unless the political economy of infrastructure projects changes, this type of inefficiencies and frauds are unavoidable. Only their degrees or scale can be controlled.  

3. Finally, the value of most regulated assets are only the value of their revenue streams and not the physical investment per se. It's intuitive to look at a power plant and feel that it's a solid investment and worth its original value. But without a power purchase agreement (PPA) or a fuel supply agreement, its value is actually only its meagre liquidation value. For all practical purposes, the asset value of a generating station is the discounted value of its PPA.