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Can Take-Out Financing Take off India?

Posted in Finance Articles, Total Reads: 5209 , Published on October 05, 2011

The Infrastructure Sector is of strategic importance to any Country… Because it drives Economic Growth!!! A robust infrastructure not only facilitates expansion of industry & trade, but also directly leads to job creation and a better standard of living. This in turns attracts further investment and growth.

However, infrastructure projects are characterized by unique risk profiles that add to the complexity in planning & execution.

These risks are --------:

Long gestation period

Huge financial requirements necessitating loan syndication

Contractually Driven, Regulatory & Legal Framework

Revenues tied to economic variables

Environmental Concerns

Infrastructure has these inherent risks which lead to time overruns and increase project costs, but real challenge lies in mobilizing funds for projects. Government had allocated 8.33% of GDP to this sector in 11th Five Year plan, and is likely to increase it to 10% of GDP in 12th Plan. This displays Government’s commitment to augment infrastructure capabilities in India. An increase in project order inflows indicates “demand”, but a paucity of long term funds has come in the way of execution.

Thus, RBI has taken the onus to channelize funds towards infrastructure, where it is a win- win situation for the project company and the financier. In 2004, it allowed banks to borrow from long term sources to fulfill long term project needs. However, at that time, the banks were hesitant to take such long term borrowing obligations and continued with short term borrowing. Whereas, infrastructure long term loans increased as a % of total loans. This gave rise to an acute problem known as “Asset Liability Mismatch”. This is the underlying principle of what we call as “Take - Out Financing”.

What is Take – Out Financing??

RBI established IIFCL for providing long term financial assistance to infrastructure projects. This SPV was used in the product design of Take -Out Financing, where long duration projects would be financed by medium term loans. Under this, bank would “take the loan out” from its balance sheet and sell it to IIFCL or IDFC. Thus, this allows lending banks to bridge the time difference & match their assets-liabilities. These government owned entities - IIFCL and IDFC can procure long term funds from the market and hence are in a better position to fund the projects. This serves a dual purpose as project company gets access to long term funds and banking system can have a healthy balance sheet.

Let us see an example: a corporate, which wants to borrow money for financing say an express highway, will approach a bank for say a 15 year loan. Bank will provide loan for 5 years and then approach IIFCL or IDFC to take over the loan from 6th to 15th year. Here, loan is transferred after the commercial operation date in 6th year. All parties enter into an agreement and the covenant is written for compliance of project milestones to avail this loan. Thus, there is a tripartite arrangement between Project Company, Bank and IIFCL/IDFC. However, bank is supposed to pay fees of upto 0.3% pa of the takeout amount to IIFCL.

The taking-over institution can take-out the liability of lending bank on an Unconditional or Conditional basis:

 I. Unconditional take-out finance:

It involves assumption of partial/full credit risk by the taking over institution from the original lender. Original lender bears the credit facility in its books till it is taken over while the taking over institution reflects it as a contingent liability till it actually takes over.

It is suitable for medium-sized banks which are unwilling to bear project risk due to their limited project appraisal skills.

 II. Conditional take-out finance:

Here, there is an element of uncertainty over transfer of assets to the taking over institution as it is subject to certain project-performance-linked conditions to be satisfied by the borrower. The obligation to take-over the assets, though conditional needs to be reflected on the books of the taking over institution as a contingent liability.

It is more suitable for banks which have adequate project appraisal skills BUT for the reasons of Asser-Liability mismatch and credit exposure constraints, would like to have the option to exit from project after a pre-determined period.

What is holding Take-out financing back??

  • RBI’s insistence that both the Lending institution and the Taking over institution must provide for the risk capital for the loans has rendered this instrument less desirable.
  • Opportunistic behavior of lending banks: Banks in India are conservative. They don’t want to sell those assets which are paying high interest rate after the construction risk is over and want to transfer only potentially bad loans thereby affecting the quality of assets on IIFCL’s balance sheet. While, banks are unwilling to sell those loans which are expected to meet their targets.
  • Take out fees to be paid by lenders availing take-out finance somewhat reduces the attractiveness of this scheme.

IIFCL’s plan of doing away with this take-out fee is expected to stimulate greater exposure to long gestation period infrastructure projects; but the impact will be short-term as lending institutions have sectoral lending ceilings.

  • IIFCL plans to reduce interest rate on the taken-out loan by 75-200 bps based on the revised risk profile of the project. But, majority of Indian infrastructure projects run behind their schedules which will make them ineligible to take advantage of this incentive.
  • The lending banks are apprehensive about capabilities of the taking over institution for assessing different infrastructure projects.
  • It is only the unconditional take-out financing which helps lending banks to resolve Asset-Liability mismatch.

Under conditional financing, long-term risk of the project still remains on the books of banks until the take-out actually happens. Moreover, it is subjected to high uncertainties with respect to achievement of the project milestones at the end of five years, which in Indian infrastructure scenario, are more often unfulfilled than not.

This articles has been authored by Misha Tyagi and Aditi Kaikini, MBA (2010-2012), NMIMS, Mumbai

Aditi Kaikini is currently in the final year of MBA at NMIMS, Mumbai. She is specializing in Finance & is particularly interested in the Banking Sector. Her hobbies are reading non-fiction & indulging in art work.

Misha Tyagi is currently in the final year of MBA and is majoring in Finance at NMIMS, Mumbai. She wants to pursue a career in the Banking Industry. She is passionate about cricket and has been a State Level Cricket player.

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