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Projects Appraisal, Financing and ControlTrimester 4
Lecture XVI XVII
Financing of Infrastructural Projects
Venture Capital
Private Equity
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The Big Change
Traditionally, infrastructure projects in Indiawere owned and managed by the governmentor a government undertaking.
Given the massive investments required forinfrastructure, there is now a broad consensusthat private sector participation in this activitymust be encouraged
Private initiative in infrastructure projects cantake many forms, ranging from contractedoperation of public utilities to full ownership,operation and maintenance of these facilities
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What Is PPP?
Broadly PPP refers to a contractual partnership between the
public and private sector agencies in which the private sector is
entrusted with the task of providing infrastructure facilities
and services that were traditionally provided by the public
sector. An example of a PPP is a toll expressway project
financed, constructed, and operated by a private developer.
According to the Government of India, a PPP project is a
project based on a contract or concession agreement between a
government or statutory entity and a private sector company
for delivering an infrastructure service on payment of usercharges. A private sector company is a company in which 51
percent or more of equity is owned and controlled by a private
entity.
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Whats suitable for private sector involvement?
Projects designed to provide significant socialbenefits such as low cost urban transportation
system may be more suited to traditional
government ownership
Projects having strong commercial attraction,
like telecommunication, are more suited for
private sector involvement
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Infrastructure vs traditional project financing
The infrastructure financiers need to carefullyevaluate if the requisite regulatory, legal andfinancing framework exists to support theprivate sector initiatives in PPP (private public
partnership) framework In this context, think as to how the issues
bothering the private parties involved in powerprojects have been tackled in the last decade, in
the context of off-take of power by bankruptSEBs owned by bankrupt state governments inIndia
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Typical Project Configuration
The project is implemented by a Special Purpose Vehicle, which is a
distinct corporate entity. Project sponsors take an equity stake in the SPV.
The SPV enters into contractual arrangements with project
contractors, offtakers, operators, government, and project lenders.
The dependence on debt is usually high and lenders generally lend
on a non-recourse basis. This means that project lenders would not
have any fall-back on the resources/assets of the sponsors if the SPV
fails to meet debt servicing obligations.
The contracts are as ironclad as possible andare not left to subjective interpretation as much
as possible.
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Level of acceptable Debt Equity Ratio For large conventional projects, where project is
exposed to pure market risks, DER not > 2:1
In power projects where off-take was assured to
the extent of a certain Plant Load Factor, DER up
to 2.33:1 was accepted
In Indian road projects under BOT arrangement,
where there was an assured annuity from the
NHAI (National Highways Authority of India)
during the concession period, irrespective of the
actual level of traffic, lenders might accept DER
even up to 4:1
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Key Project Parties
Project sponsors
Project vehicle (the SPV)
Project lenders
EPC (engineering, procurement & construction)contractor
O & M (operations & maintenance) contractor
Government
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Project Contracts
Through a comprehensive web of contracts, every major risk
inherent in the project is allocated to the party / parties that isbest able to assess and manage the risk
The major project contracts are:
Shareholders Agreement
EPC Contract: while sub-contracting is acceptable, it remains the
sole responsibility of the EPC contractor to deliver the project to
the SPV
Project Loan Agreements O & M Contract
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EPC Contract An agreement between the SPV and the EPC
contractor, that establishes:
1. The latters role from designing all the way up to
commissioning the plant
2. Guaranteed minimum performance parameters3. Penalties/Liquidated damages payable in the event
of the plant failing to meet minimum parameters,
typically capped at 20-30 percent of the EPC
contract value
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Governments role
Provision of concession to the SPV
Ensures that proper legislative and regulatory
framework exists
In some cases, like in the electricity generationsector, state governments have guaranteed
the performance of the off-take obligations of
SEBs, and in certain cases, the centralgovernment has counter-guaranteed the
performance of the state governments
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Some problems with the 3 tier structure
LCs may not get opened by the bank in case of
default by SEB The escrow account may not work if there are
multiple projects feeding the same SEB and the SEB
is being run on non-commercial lines
State government guarantees may not be bankable
The above position led in some cases to reforms
linked financing of these projects, with the lenders
disbursing money on being satisfied with the statesprogress in the area of reforms
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Managing Risks in Private Infrastructure Projects
Construction Riskmanage through EPC contracts
Operating Risk - mitigate through competent O&M contractor
Market risk - govt. to guarantee minimum payment in road project
Interest Rate Risktransfer risk due to floating rate by tariff
formula to treat it as pass through cost
Foreign Exchange Risktariff formula to adjust for forexfluctuations impact on forex loans
Payment Riskescrow account
Regulatory Riskfavours countries with strong and independent
regulatory bodies
Political Riskcould be partially mitigated though political risk
insurance offered by some multinational organizations
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Recommendations of the Committee chaired by
DeepakParekh on Infrastructure Financing
1. Develop a deep and robust debt market
2. Tap the potential of insurance sector
3. Enhance the participation of banks, financial institutions and large
NBFCs
4. Provide fiscal incentives
5. Facilitate equity flows
6. Induce foreign investments
7. Utilise a small portion of foreign exchange reserves for
infrastructure development
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VENTURE CAPITAL
AND
PRIVATE EQUITY
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Wh t I VC I t t
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What Is a VC Investment
The popular impression is that VC is synonymous with financing of
technology-centric businesses or innovative and hitherto untried
business ideas. In reality, VC is a broader and much more flexibleform of financing.
VC investments usually involve
Business with high growth potential in terms of sales andprofitability
Investment horizon of 2 to 10 years
High risk levels
Equity or quasi-equity financing instruments
Active investor involvement
The Key is superior returns
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V l ti f VC T ti
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Valuation of a VC Transaction
Most used method of valuation involves the following steps:
1. Identify the amount of capital to be invested by the investor: I0
2. Identify the target rate of return expected by the investor: r
(depending on stage of invt., likely holding period, riskiness, etc)
3. Estimate the multiple of the original investment that will fetch therequired rate of return over the anticipated holding period:
Sn = I0 (1 + r)n
4. Project the market value of the firm based on performanceprojected during the proposed year of exit: this would be amultiple of an appropriate metric like EBIDTA: Vn
5. Estimate the percentage of the projected value that the investorneeds to claim in order to achieve his return objective
6. Express percentage of equity to be owned by VC as price/share
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Valuation ExerciseGiven the following:
Capital to be invested by investor (I0) = Rs 50 lacs
r = 50%
Anticipated Holding Period (n) = 3 years
Projected market value of firm after 3 yrs (Vn)=Rs 6.75 cr
Capital proposed to be issued = 10 lac shares of face
value of Rs 10 each
Assume that the market value of the firm is equal tothe value of the equity of the firm
Find out the premium per share which the VC investor
would be willing to pay
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Solution
Sn = I0 (1 + r)n = Rs 1,68,75,000
Percentage needed = 1,68,75,000/6,75,00,000 = 25%
No of shares required = 2,50,000
So, the investor will ask for:
2.5 lac shares for Rs 50 lacs
i.e. 2.5 lac shares for Rs 20 each
i.e. 2.5 lac shares at a premium of Rs 10 each
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The VC Investment Appraisal Process contd.
Deal structuring
While doing this, the VC investors also build in performance
incentives for management
These may include:
1. Options to subscribe to additional equity at low valuation
2. Allotment of new shares in recognition of managerial or
technological contributions, for considerations other than cash
3. These incentives would be tied to pre-identified milestones,
like profit targets, agreed upon
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The VC Investment Appraisal Process contd.
Investorinvestee relationship: As the motivations and
goals of the investors and the entrepreneur may differ, forexample the investor requiring a timely exit, the detailed
shareholders agreement provides for such eventualities
Postfinancing relationship: The VC involves himself
at 2 levels, both for strategic decisions such as constitutionof the board, and monitoring role to ensure that the investors
are not adversely impacted, say by a business diversification
plan. These are done by having directors on the board
Exiting from investments: While the common exitroutes are via IPO or bringing in a Strategic acquirer, the exit
option is secured through investment agreement
Six Stages of Venture Capital Financing
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Six Stages of Venture Capital Financing
1. SeedMoney Stage: Takes care of small volume of funds
to say develop a product
2. Start Up: Takes care of funds for marketing & product
development, typically for firms less than 1 year old
3. First-Round Financing: Additional money to begin salesetc.
4. Second-Round Financing: Funds required by a company
selling its products but losing money
5. Third-Round Financing: Post break even for expansion
6. Fourth-Round Financing: Financing a firm expected to
go public in about 6 months time
VC and PE A Comparison
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VC and PE A Comparison
The distinctions between VC and PE (private equity) are summarised below:
Feature VC
Investment
Target
Early stage businesses, expansion
Innovative products, services,
technologies
Heavily dependent on external
financing
Unlisted companies
Later stage businesses,involves
operational or financial
restructuring, with or without
management team and / or
ownership changes
Mature products,services
Generally have large cashflows
May be listed or unlisted
PE
Horizon Medium to long term: Three -eight
years
Medium: Two -five years
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Risks May be one or more of technology,
product development, market
response to product / service,
management, operational andilliquidity of investment
Usually limited to product- market
risks and does not involve the other
elements listed in the case of VC
Structure Equity or equitytype
instruments such as convertible
debt or preference shares
Syndication of investment, if
any, among fellow VCs
Equity and debt combinations.
Debt is usually high risk, of
speculative grade
Syndicate may includeinstitutions such as insurance
companies and banks, who are
primarily lenders
PostFinancing
Engagement
Active-encompasses board
composition, top management teamrecruitment, strategy formulation
and internal systems processes and
controls
Active but less than their VC
counterparts. Involvement mainly
limited to ensuring high quality
governance
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PE firms Private equity funding has been gaining importance in India
during the last few years. The starting point of PE funding is a term sheet which
reflects the understanding reached between the PE fund (the
investors) the promoters, and the company. It summarises the
terms and conditions for the proposed investment in the company.
It is followed by due diligence and then by the Shareholders
Agreement and/or Share Subscription Agreement. Finally, the
provisions of the Shareholders Agreement are included in the
Articles of Association of the Company.
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Term Sheet
The standard termsheet covers the following:
Company
Promoters Investor
Quantum of Investment
Investment instrument
Pricing of instruments
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Pricing of instruments
Conditions precedent
Deployment of fund
Conditions subsequent
Shareholding pattern Board representation by the investor
Pre-emptive rights of the investor
Promoter lock-in and investors Right of First Refusal (ROFR)
Investors veto rights Investors exit rights
Non-compete and non-solicit
Representations and warranties
Auditors
Due diligence Definitive documentation
Confidentiality
Exclusivity
Validity
Governing Law
The Indian VC Industry
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e d a VC dust y
Prior to the formation of VC institutions, Indian development finance
institutions provided risk capital to industry. However, they did not follow
the rigorous processes that a modern day VC would follow.
ICICI Ventures (formerly TDICI Ltd) was the first VC institution in India
set up in 1988.
International investors emerged as more significant players from the mid
1990s. They introduced the western investment philosophy and processes
into their transactions with Indian companies. Rigorous due diligence, tightcontracting, active post financing involvement,and a sharp focus on timely
and profitable exit are among their more important contributions.
The investment preferences of VC investors have constantly evolved over
the years . Over the years there has been a shift in favour of financing the
expansion plans of firms already in operation as opposed to greenfield
ventures or start ups.
In the early years in India, the industry was characterized more by VC style
investing in small, early stage companies. More recently PE type
investments have become far more common.
Regulation of VC Industry in India
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g y
Broadly the SEBI (Venture Capital Funds) Regulations,1996 purport
to ensure that:
VC funds do not access public investors who may not have thecapability to assess the risks underlying investment in VC funds.
VC funds invest in unlisted companies that are not in a position
to access public financial markets.
Section 10(23FB) of the Indian Income Tax Act, 1961 exempts the
income of VCF funds by way of dividend and long-term capital gains
from tax. The tax exemption is available to VC funds registered with
SEBI.
The investment activities of funds registered outside India andinvesting in India are regulated either by the foreign direct
investment regime (FDI) in India or regulations governing foreign
institutional investors (FIIs) who are registered with SEBI.
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Li tti bl d P i t it fi t i i b t
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Lines getting blurred: Private equity firms turning incubators
While VC and PE firms have their respective spaces in the financial world, the
line between them gets blurred at times
In mid-2009, when the logistics-focused private equity (PE) fund TuscanVentures Pvt. Ltd, was looking to invest in a cold storage chain that it could
scale up, there was one glitch: there weren't any such firms around.
There weren't companies available with the scale and management depth to
create footprints. So Tuscan did the next best thing: it launched its own cold
storage chain, Cold Star Logistics Pvt. Ltd. In doing so, Tuscan went beyond the traditional role of PE firms--investing in
companies, preparing turnaround strategies, helping firms expand, backing
good management teams--into the preserve of VC firms: incubation.
The PE firms may start companies, when gaps in industries become evident.
Tuscan Ventures is not the first one to do so. In 2008, IDFC Private Equity Co.Ltd, the PE arm of Infrastructure Development Finance Co. Ltd, started a
renewable energy company called Green Infra Ltd after it failed to find any in-
vestment opportunities in the space it could scale up.
This only shows how the lines are blurring between PE firms and VC funds,
which are now often doing late-stage PE- type deals.
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If you are approaching a VC fund1. You could avail the services of investment bankers who
specialize in VC/PE fund raising.
2. Different VC funds have distinct investment focus
areas in terms of industry sectors, stage of evolution
of companies in which they would like to invest ,theamount of financing, and the extent of post financing
involvement that the investor wishes to adopt
3. More important than anything, present an exciting
and convincing story, as the VCs select a very small
number of companies to invest in, out of the very
large numbers of applications that they receive