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Infrastructure sector includes segments such as construction of roads, bridges, irrigation projects, power projects- generation, transmission and distribution, ports, airports and other such projects of social importance. Typically, infrastructure projects differ from regular projects in terms of their large investment, long tenures, and significant contribution of these projects to social goals and benefits. Besides these key differentiators, it has to be understood that infrastructure sector is wide in terms of the spectrum of industries and hence the nuances of the specific segment have to be appreciated while rating any entity. For instance, a thermal power project will differ significantly from an airport project in terms of its risk profile, regulatory environment, funding pattern, operational challenges etc.
Types of Infrastructure Projects:
Government Projects: Government projects include ports, irrigation projects of strategic importance, roads, bridges, school /office buildings etc. undertaken by the government.
PPP (Public Private Partnership) Projects: These are projects undertaken in Special Purpose Vehicles format (SPVs) in which the government and private parties hold stakes.
Private Projects: : These are projects promoted by private entrepreneurs.
Overview of the Business Model- EPC Contractors & SPVs
Generally, infrastructure projects are awarded by the government departments/ quasi government bodies/ ULBs / private parties etc through tenders. The various EPC (Engineering, Procurement and Construction) players participate in these tenders subject to fulfilment of certain technical and financial criteria stipulated in the tender documents. Among the bidder, the bidder with the least cost quoted is usually selected as the winner.
In an EPC contract, the contractor executes the contract and as per the milestones, raises running account bills from time to time, which are paid by the counterparty after the necessary due process. Besides plain vanilla EPC contracts, in certain cases like roads, the contracts are also awarded by way of BOT contracts. Under this model, the EPC contractor floats a separate SPV for each project. The EPC contractor invests in the initial equity of the SPV (i.e., sponsor of the SPV) and also arranges for debt funding. The EPC contractor thus has a dual role towards the PROJECT SPVs- as a contractor and as a shareholder. Generally, it is quite common for one large EPC contractor to have multiple SPVs. The SPV enters into a concession agreement for 15-20 years with the counterparty, which gives the right to receive annuity to collect toll. These concession agreements could be of different basis like toll or annuity or HAM.
These SPVs could be either wholly owned by the promoter or jointly with other stakeholders like Government/private equity investors. The SPV structure helps in ring-fencing the cash flows and assets of the project from the promoter's balance sheet. Debt is usually raised in the SPV against the strength of the cash flows. These cash flows could be toll charges for a toll-way company, transmission charges for a power transmission company or user development fees/rentals generated by an airport. Operational cash flows are generally collected in a separate account (Escrow Account) and a waterfall mechanism would be in place to decide priority of payments.
This document details some of these common parameters and their importance from a credit rating standpoint.
The rating framework for infrastructure entities takes into account the Business Risk Assessment, Financial Risk Assessment and Management Risk Assessment. Given below are the factors examined under each of these:
BUSINESS RISK ASSESSMENT
Business risks associated with infrastructure entities can be bifurcated into two categories- risks associated with the project until commercial operations (EPC stage) and risk associated with commercial operations thereafter.
Funding Risk:
Typically, an EPC Contractor’s major expenses include raw materials, labour expenses and other ancillary overheads. Since the larger EPC contractors often sub contract a portion of their work to other smaller subcontractors, it is fairly common to rely on trade credit (raw material suppliers) and credit from sub-contractors. The EPC contractor may also rely on advances received from customers for supporting the working capital requirements. Since the bills are raised from time to time based on project milestones and realised subsequently, the dependence on fund based working capital line is fairly limited except in case of exceptional growth situations or significant spike in working capital requirements. However, it is pertinent to note that EPC contractors require large non-fund based limits in the form of Bank guarantees at each stage in the revenue generation business- for bidding, performance, retention money etc. These guarantees need to be unwound in a timely manner through timely execution of projects. Any delays /disputes in execution may result in invocation of guarantees / rollover of guarantees thereby contributing to a stress and higher finance charges..
In terms of fixed assets requirements, the EPC contractors rely on mix of owned equipment as well as rented equipment to meet their business requirements.
Order Book (Revenue Visibility) Risk:
An EPC contractor needs to have a healthy order-book of executable projects to maintain revenue visibility. It has to be understood that the progress of each project may vary from period to period due to factors like availability of land/ right of way, regulatory clearances, labour issues, delays in receipt of machinery, environmental factors etc. In such a situation, a well-diversified order book of 2-3 times the annual revenues provides healthy revenue momentum. The diversity of the order book across counterparties and across geographies is the key aspect to be examined. In certain cases, where the player has a presence across various segments, a wider segmental diversity is preferred to an order book focussed on a single segment.
Execution Risk:
It is fairly common to assume that projects will undergo time overruns due to a wide variety of reasons. These execution challenges can result in erosion in project profitability, reputational losses, claims for liquidated damages etc. Acuité factors in the following while assessing Execution Risk:
Counterparty Risk
The nature & credit profile of the counterparty also has a bearing on the credit profile of the EPC contractors. Since infrastructure development is mostly a domain of the governments, the counterparties typically include departments of Central Government, State Governments, Public works departments, Urban local bodies, NHAI etc. It has to be understood that most of the infrastructure projects are projects of strategic importance and governments are expected to provide these infrastructural facilities within their fiscal constraints. Against this backdrop, timely progress & execution of any project depends on its relative strategic importance vis a vis other projects and also on the availability of adequate fiscal flexibility with the government. It is quite common to encounter delays in execution and delays in realisation of bills even in case of certain government projects in times of fiscal stress. It is pertinent to note that usually these projects are awarded to the larger contractors on a tender basis and they in turn sub contract a part of their contracts to smaller EPC companies. In such cases, the credit profile of the immediate counterparty and the final counterparty becomes relevant. In case of contracts awarded by private parties, the credit profile of the company and its past track record in honouring commitments may be considered as a surrogate for assessing counterparty risk.
Legal Risk:
In any infrastructure project, the scope for litigation/disputes always exists. These disputes could be with subcontractors, vendors, joint venture partners, clients etc. Hence, it is quite common to find disclosures regarding claims/counter claims/penalties/liquidated damages etc. in the financial statements of the infrastructure players. While there are detailed agreements such as PPAs (in case of power projects) or Concession Agreements (in case of road projects), the possibility of litigations in infrastructure projects always exist. Any significant adverse outcome of these litigations, can have a bearing on the financial health of the company. The analyst examines the impact of these litigations on the financial health of the entity.
Offtake Risk
Once the project attains COD, the cash flows generated from the project is a function of the offtake levels. The nature of the project becomes important here. For instance, in case of a road SPV (toll) project the revenue streams over the concession period will largely be exposed to the volume of traffic whereas if the developer has opted for an annuity model, the revenue projections would be insulated from traffic volumes. Similarly, for a green energy project, the revenue profile could either be based on long term PPAs (Power Purchase Agreements) or in case there are no long term PPAs, the revenues will be linked to movement of merchant power rates on the energy exchanges.
Offtake risk assessment entails a study of the adequacy of operating cash flows vis-a-vis debt servicing commitments. The following aspects will be examined:
O & M Risk (Operations & Maintenance) Risk:
Generally, the infrastructure facilities once developed, require ongoing maintenance. For instance, the toll-way developer is responsible for timely maintenance of the toll road, which is assessed under Operating Risk. In case of wind energy projects, usually the original EPC contractor handles the operations and maintenance. The lack of proper maintenance on the part of the EPC contractor for say a Solar Energy project may impact the future plant load factor (PLF) of the project. The following are the factors evaluated with regard to operation and maintenance of infrastructure projects:
Based on the specific characteristics of the concerned infrastructure projects, Acuité evaluates the risks associated with operations, the impact on revenue generation and debt servicing capabilities.
Counterparty Risk:
The counterparty risks exists even after the project has attained COD, depending on nature of the project. A strong counterparty like NHAI or Government of India will significantly mitigate counterparty risk inherent in a project. However, in the event of a relatively weaker counterparty for instance, a State Electricity Distribution Company (Discom) - the counterparty risk is significantly elevated due to higher possibility of delays/defaults in payments or legal issues. A strong counterparty to a project increases the ability to raise funds at favourable pricing.
Risk arising out of Force Majeure Condition:
Force Majeure conditions arise due to earthquakes, fire, damages during construction/operations, which can have an adverse impact on the project. Acuité ascertains whether adequate insurance cover exists to cover such unforeseen losses. Besides, emphasis is also laid on the provisions in the legal agreement on termination of the contract between the sponsor and the purchaser and compensation for the same.
Credit Enhancement Assessment:
Generally, the lenders to Infrastructure Projects stipulate covenants such as guarantees from promoter entities enjoying high investment grade rating and/or maintenance of adequate safeguards by way of DSRA (Debt Service Reserve Account), Escrow Account etc. In such cases, Acuité may adequately factor in the credit enhancement while considering the rating.
FINANCIAL RISK ASSESSMENT
The Financial Risk analysis of an infrastructure entity takes into account the existing financial position, future financial position and resource raising ability.
The existing financial position examines aspects like size of Net worth, Debt/ Equity or TOL/TNW, Interest Coverage Ratio, NCATD (Net Cash Accruals to Total Debt), DSCR (Debt Service Coverage Ratio), GCA days, Current Ratio & profitability margins.
The projected income statement and balance sheet is drawn based on discussions with the client and the likely movement in the above ratios over the near to medium term is assessed.
Notwithstanding the importance of the above mentioned ratios, Acuité notes that timeliness and adequacy of cash flows vis a vis debt servicing commitments is crucial while rating an infrastructure entity, hence high emphasis is placed on cash flow assessment and adequacy while assessing an infrastructure proposal as opposed to the conventional metrics of Networth, gearing, etc.
The financial flexibility in terms of unencumbered cash balances, unutilised bank lines and adequacy of non-fund based lines is assessed.
MANAGEMENT RISK ASSESSMENT
The factors considered include:
This is a very important aspect of the evaluation. The quality of management has a crucial bearing on the performance of an enterprise. The assessment focuses on management integrity, competence, risk appetite and governance. The risk framework for assessing the same has been laid down below:
The integrity and credibility of the management is a key aspect influencing the decisions of any lender or investor. In the absence of credibility, the management will always face a certain level of trust deficit which will have a bearing on its access to credit and pricing of loans. The manner, in which a company conducts business, has a bearing on the market’s perceptions about the company and its standing. Key aspects examined here are:
Promoters influence management selection, decision making and future course of the company. The promoters’ demonstrated ability in navigating the business across various business cycles is examined under this parameter. The various points examined are as under:
The management‘s risk profiling is extremely critical from a lender’s perspective. The key aspect to be examined and understood here is whether the management is a risk seeker, risk averse or risk neutral. This can be gauged from the management’s approach to debt (gearing), hedging of currency/ commodity exposures etc. The management’s approach to growth vs profitability is to be understood from the risk standpoint. An aggressive management will pursue growth at any cost irrespective of its impact on profitability, whereas conservative management will be focussed on profits and cash flows. Again, some managements may prefer organic growth rather than inorganic initiatives, which reflects their risk disposition.
Along with a capable management team and an effective strategy, it is necessary for the management team to adopt best practices in corporate governance. This gets reflected in the composition and functioning of the board, attitude towards stakeholders and disclosures among others. It is also important for the management team to undertake a systematic planning exercise that sets organizational priorities and ensures that those priorities percolate to the middle and lower management helping the organization's review mechanisms and track progress of plans and re-evaluate strategies and goals. Key Factors to be considered are:
Group and Parent Support
The rating based on analysis of above mentioned parameters is a standalone rating. However, it is commonly observed that an enterprise belonging to an established business group or a company is on a different footing compared to a stand-alone entity. The former could benefit from the parent/group in terms of credibility, brand equity, managerial, business and financial support. Notching the standalone ratings of individual companies up, is based on the assumption that a company's credit worthiness, apart from its own business and financial strengths and weaknesses is also dependent on the backing it enjoys with the group/parent/government.
The degree of linkage between the entity and its group companies/parent/government needs to be ascertained to decide the extent of notching. Some of the factors influencing the degree of association are usage of common name, size of investment and holding in the entity by its parent/group/government, past instances of support etc.
Please click here to access the criteria on "Group and Parent Support”
Assessment of Environmental, Social and Governance (ESG) Risks
In addition to the above mentioned Rating Framework, Acuité also comments on the ESG parameters in case of certain listed entities in its Rating Rationale.
The primary goal of any commercial entity is to maximize the value for its owners/ shareholders through profit maximization. However, it has to be recognised that besides profit maximization, any business entity has certain responsibilities towards the society in which it is operating and towards the environment. Hence, an ESG assessment of a business entity assumes importance. ESG is a framework for measuring the performance of the company across three specific categories: Environmental, Social and Governance. ESG as a concept has been around for more than a decade. However, it has recently gained in prominence with large international investors tracking the ESG scores before taking the investment decisions. The regulators have also recognised the importance of the ESG framework. A SEBI circular on Business Responsibility and Sustainability Reporting dated May 10, 2021, requires the top 1,000 listed corporates to disclose significant non-financial information voluntarily in fiscal 2022 and compulsorily from fiscal 2023.
Acuité believes that the current trend among institutional investors of considering ESG scores along with the other conventional parameters like the credit rating will gain in importance over the near future.
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