India’s large infrastructure deficit and the need for fixing it is almost universally known and accepted. I’ve also written about it in my book Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World.

Investing in India

The apathy of the previous government that ruled India for almost a decade and the myriad corruption scandals that have plagued the country resulted in a state of policy paralysis that scuttled almost all large infrastructure projects in India. It appears (at least for now) that the new government in India might reverse some of that policy paralysis and might speed up decision making and clearances. However, government support alone will not help build India’s infrastructure, it will also need to be financed. Even though India has a savings rate that exceeds 30% of GDP, a large portion of that savings is in the household sector. Within the household sector, a large portion of savings are directed toward physical assets like land and gold. Of the portion of household savings that is invested in financial assets, a disproportionate amount is invested in government savings schemes and bank deposits and less than 2% is invested in risk assets like fixed income securities and equities.

The Indian banking system has become completely disillusioned with lending to infrastructure given their experience over the previous seven years and is unlikely to participate in financing it . Households in India are unlikely to meaningfully participate in fixed income securities linked to infrastructure. The equity markets and private equity have fallen out of love with the stocks of so called infrastructure companies as they have existed in their earlier dispensation due to their track record of poor execution, poor capital structure and extensive financial embezzlement and siphoning. How then will India finance its much needed infrastructure build-out?

A similar problem existed for India’s commercial real estate industry about 15 years ago. Real Estate in India historically meant residential real estate. Builders would (almost always) buy plots of land, announce projects and sell apartments even before starting construction and would use the proceeds to finance the construction of projects. Bank funding for builders was not common. Commercial developments like offices and retail were few and far between and developed identically to residential developments. Builders would sell individual office units or individual shops inside larger developments to end users before starting construction and would use the proceeds for construction like in residential developments. All this started to change as India started liberalizing its economy and as India’s IT sector started growing. Multinational companies rapidly increased their presence in India and the office space requirements of India’s IT sector exploded. MNCs as well as IT companies preferred to lease space instead of buying space and they discovered that there was almost no supply of quality leasable space in India.

A few builders like RMZ in Bangalore, DLF in Gurgaon and Raheja in Mumbai realized the scale of the opportunity and focused on developments that were in tune with the needs of the evolving commercial real estate market. They hired salespeople with MBAs who wore suits and were comfortable making PowerPoint presentations. They spoke the language of their customers as air-conditioners became HVAC systems and diesel generators became power backup systems. They built commercial buildings to suit client requirements and financed the entire construction themselves. In fact, one of the reasons that cities like Chennai lost out to Bangalore in the growth of its IT industry despite having a deep talent pool was the absence of builders like RMZ and DLF and the non-availability of quality leasable space.

The growth of the for-lease commercial real estate market gave rise to entire new businesses like property management, security services, janitorial services, landscaping services etc. International real estate agencies like Knight Frank, Jones Lang LaSalle, CB Richard Ellis etc. rapidly expanded their India operations and started providing one stop solutions to their lessee clients.

Financing the boom in commercial real estate was a challenge for these new age builders as their internal resources were limited. Their model was to construct buildings using their internal resources, to lease them to high quality companies for long durations and then to sell the tenanted properties to investors. The reason I am familiar with this is because one of the first funds I tried to raise in 2002 was a real estate opportunities fund. Foreign capital had not seriously started looking at India, domestic risk capital was in limited supply and yields on tenanted properties (cap rates) were between 12% – 14% (8% to 9% today). Furthermore, thanks to Mr. Greenspan, interest rates around the world had plummeted and borrowing rates for 10 year money were between 8% – 9% (12% to 14% today). With banks willing to lend up to 75% of the value of tenanted properties, before tax returns on equity were in the region of 24%. I was not successful in raising the fund because I was looking overseas and foreigners were not ready to look at India … yet.

As we headed into 2003, 2004 and 2005, India started growing rapidly. The size of office spaces with single tenants became larger and domestic investors did not have sufficient equity capital to invest $3 – $4 million in buildings of 250,000 square feet each and larger. During this period India also witnessed the start of a retail / mall construction boom. This time around, malls like offices were built on a for-lease only model. Given that most malls were half a million square feet or larger, the capital requirements of commercial real estate continued to grow. The vacuum was filled with foreign capital. Private equity funds and proprietary foreign investors poured money into Indian commercial real estate. Singapore and London became favored destinations for listings of Indian real estate trusts.

What has happened in the Indian infrastructure sector in the previous 15 years? The previous NDA government (1999-2004) realized that the Indian government did not have the funds needed to build the country’s infrastructure. Therefore it decided to embark on a PPP (Public Private Partnership) model where the private sector was roped in to build infrastructure. The rush started with roads, followed by power, followed by ports and airports and later spilled over into everything. A number of companies entered the infrastructure space and became stock market darlings. By the end of 2007, many of these infrastructure companies with billions of dollars of debt with debt to equity ratios in excess of 3 and 4 were trading at more than 3 or 4 times price to book values.

There were mistakes that were committed on two fronts, one on the capital markets front and the other on the policy and government front. On the capital market front, infrastructure companies became infamous for their complicated business models and their opacity. It was not clear whether companies were pure EPC players (Engineering Procurement and Construction) that typically undertake construction contracts as service providers, whether they were infrastructure developers who typical conceive and manage projects or whether they were infrastructure owners who typically collect rents over long periods of time. Companies deliberately confused their message to investors and lenders and ran gigantic ponzi schemes where they raised equity capital at higher and higher valuations as the boom progressed. In their greed to grow many entrepreneurs padded capital costs of projects and siphoned funds during construction, sometimes bringing back siphoned funds as equity and sometimes stashing away the siphoned funds.

On the policy and government front, inexperience with PPP projects on the part of policymakers resulted in poorly drafted contracts that did not take into consideration many possible scenarios. There were many shenanigans that took place between corrupt government officials and bidders as well. Companies submitted unreasonably low prices to win competitive bids and subsequent to winning bids, goal posts were shifted and original contracts were modified sighting unforeseen challenges in the operating environment.

Indian markets as well Indian policymakers are smarter having learned at least some from their previous experiences. That India needs to build-out its infrastructure is unquestionable and inevitable. That this presents one of the biggest opportunities for investors in the world is also unquestionable. However, the business models that will work will be different from those of the past and are yet to be tested.

I draw upon similarities between the evolution of the commercial real estate sector and the emerging infrastructure sector in India. There are three distinct roles that are played by companies in the development of infrastructure. The first is the infrastructure developer, the second is the EPC company and the third is the infrastructure owner. Infrastructure developers have the expertise to conceive and engineer projects, take part in competitive bids, raise capital and manage the execution of the project. EPC companies participate in competitive tenders put out by infrastructure developers and have the ability to build and execute large scale projects in a cost effective and time bound manner. They have the capacity and depth of talent, labor, equipment and knowhow to operate in difficult physical environments and achieve project completion. Infrastructure owners have the capital base and the time horizon to own utility like infrastructure projects over long periods of time.

In the past, all three roles were bundled in a confusing and opaque manner inside so called infrastructure companies that did a poor job of building assets and generated terrible returns on capital. In my view, going forward, these three roles will be distinctly separated. Infrastructure developers have the ability to generate the highest returns on capital and will be lead by the smartest and most opportunistic entrepreneurs. A very important skill set they will possess will be the ability to raise foreign capital and to enter into partnerships with long term providers of capital. They will operate with the transparency, ethics and integrity that these successful and long term partnerships will require. Infrastructure owners will primarily be long term capital providers who will partner with successful infrastructure developers at the bidding stage with implicit agreements in place to buyout the infrastructure assets once successfully implemented. New businesses will emerge to support the servicing and management of completed infrastructure assets on behalf of owners similar to those in the commercial real estate industry (albeit at a different scale). EPC is an extremely difficult business and it requires skill sets that are very specialized and inordinately difficult to execute. The best EPC companies generate very high returns on capital because most average EPC companies lose money. Infrastructure developers and EPC companies will have to operate at arm’s length with complete transparency to inspire confidence in all stakeholders.

After fifteen long years, I am finally optimistic about the opportunities emerging in India’s infrastructure sector and believe that rich pickings lie ahead. Companies that do it right will become among the largest in the world and investors in these companies will be rewarded handsomely. Happy hunting !

Until next time …

Investing in India: A Value Investor’s Guide to the Biggest Untapped Opportunity in the World

As I’ve spoken about India and the Indian markets to investors both in India and around the world over the years, I’ve been asked numerous questions that have puzzled and perplexed investors about India. This book is my attempt at answering many of those questions as well as many others with real world examples. I call India the biggest untapped opportunity because it is completely misunderstood even by those who have intermittently been involved with it in the past. In my view, for investors who behave sensibly and have reasonable expectations, the real India opportunity lies ahead.

Financing India’s Infrastructure Build-out by Rahul Saraogi