Private Equity in Infrastructure: A Balancing Act of Risk and Reward

Posted On - 16 February, 2024 • By - King Stubb & Kasiva

Introduction

From transportation networks to energy grids, resilient infrastructure is one of the major factors on which India’s growth hinges. However, massive funding deficits pose a threat to the continuous advancement of the infrastructure sector. Private equity (“PE”) has the potential to play a crucial role in bridging these funding gaps.

Unlike stock markets, PE firms raise funds from institutional investors, directly financing projects like toll roads and renewable power plants. Investors are drawn to stable, long-term returns, inflation-resistant assets, and diversification benefits. Since 2018, the infrastructure and real estate sectors have attracted a significant US $83 billion in PE/VC investments, out of which 56% is in infrastructure.[1] Despite the success, challenges like regulatory complexities and political uncertainties persist, which need to be addressed.

This article aims to the role that PE investments play in infrastructure in the Indian context, in the following manner:

Current Landscape of Private Equity in Infrastructure in India
Regulatory Framework
Key Considerations for Investors
Opportunities and Challenges

Current Landscape of Private Equity in Infrastructure in India

The infrastructure sector significantly drives the Indian economy. Historically, over 80% of India’s infrastructure spending has been for transportation, electricity, water, and irrigation. Now, the spending is getting even more diversified with renewable energy projects, etc.

The Government has shown significant support and initiative towards building the infrastructure of the future such as the US $1.3 trillion master plan for infrastructure, Gati Shakti[2], the National Infrastructure Pipeline[3], etc. This shows a significant potential for investors in the infrastructure sector.

Momentum for PE Investments in Infrastructure in India

The momentum for PE investments in infrastructure in India is driven by several factors such as:

Attractive returns: Long-term infrastructure projects offer stable cash flows, inflation-hedging assets, and attractive risk-adjusted returns, appealing to global and domestic investors.
Diversification: Infrastructure assets diversify investment portfolios, offering a shield against market volatility.
Government push: Initiatives like the National Infrastructure Investment Fund (NIIF)[4] and Infrastructure Investment Trusts (InvITs)[5] are creating attractive investment avenues.

Key Examples

Virescent Infrastructure, backed by KKR, launched India’s first renewable energy infrastructure trust raising INR 4.6 billion from investors like AIMCo.
Greenko Energy secures $700 million from PE giants GIC, ORIX, and its founders to fuel its expansion of long-duration, carbon-free pumped storage projects.
Canadian PE giant Brookfield acquired India’s entire telecom tower infrastructure for $3.4 billion, boosting Jio’s 5G potential, in a 30-year Master Services Agreement with Jio and acquiring 1,35,000 communication towers.[6]

Regulatory Framework

Regulatory Authority: Private Equity (PE) funds in India must be set up as Alternative Investment Funds (AIFs) and registered with the Securities and Exchange Board of India (SEBI) under the AIF Regulations.[7]
Categories of AIFs:
- Category I AIFs: Invest in VC sectors, early-stage sectors, social ventures sectors, or infrastructure sectors.
- Category II AIFs: Majority of PE funds fall into this category.
- Category III AIFs: Employ diverse or complex trading strategies, including leverage.
Key Features of AIFs:
- Minimum corpus of INR 200 million per scheme.
- Permitted to solicit or collect funds except by way of private placement.
- The minimum investment by an investor is INR 10 million.
- The manager’s or sponsor’s continuing interest must be at least 2.5% of the fund or INR 50 million, whichever is less.
- Minimum tenure of three years for Category I and Category II AIFs; Category III AIFs can be open or closed-ended.
- No scheme can have more than 1,000 investors.
Lock-in Period and Minimum Investment: Certain types of investments, like PE funds registered as Category II AIFs investing in listed companies, require a lock-in period/minimum investment of one year.
Recognition of “Accredited Investors”: Investors with knowledge of financial markets and sufficient net worth, enjoy benefits like lesser minimum investment and extended investment terms in closed-ended schemes.
Penalties for Unregistered Activities: If a PE fund operates without registration, SEBI can levy penalties and bar it from further activities.
Exemptions from AIF Regulations:
- PE funds existing before AIF regulations.
- Existing funds unable to comply may apply for exemptions.
- Existing PE funds not seeking fresh commitments, subject to providing activity information to SEBI.
- Funds managed by securitization/asset reconstruction companies registered with the Reserve Bank of India (RBI).
Investor Restrictions:
- AIFs formed through an investment vehicle other than a company cannot have more than 1,000 investors.
- If set up as a private limited company, an AIF cannot issue shares to more than 200 shareholders.
Foreign Investment Regulations:
- Compliance with Foreign Exchange Management Act, 1999[8] , and related rules and regulations.
- Foreign investment in AIF units is permitted to residents outside India, subject to conditions.
- As per Press Note 3, Government approval is required for foreign investment from specific countries, including China, Pakistan, Bangladesh, Bhutan, Myanmar, Afghanistan, and Nepal.[9]

Key Considerations for Investors

Contractual & Commercial Considerations

Risk Allocation: Deals should clearly define risk allocation across various stages (construction, operation) and consider factors like regulatory changes, force majeure events, and performance guarantees.
Exit Strategies: Predefined exit mechanisms like secondary sales, buyouts, or IPOs are crucial for investor liquidity and value realization.
Tax Implications: Understanding complex tax laws, including infrastructure-specific exemptions and incentives, is vital for optimizing returns and ensuring compliance.

Due Diligence & Legal Compliance

Thorough Due Diligence: Extensive due diligence encompassing financial, technical, legal, and environmental aspects is paramount to mitigate risks and identify potential red flags.
Legal Compliance: Adherence to regulations covering land acquisition, environmental clearances, labor laws, and sector-specific rules is crucial to avoid legal hurdles and penalties.

Environmental Impact Assessments: Investors must assess potential environmental impacts and ensure projects comply with regulations and sustainability standards.
Social Impact Assessment: Evaluating potential social impacts on communities and vulnerable groups, and incorporating responsible practices, is increasingly important for investors and stakeholders.

Opportunities and Challenges

Opportunities

Efficiency & Innovation: Private capital brings best practices and fosters innovative solutions, leading to faster, more efficient project execution.
Long-term Capital: PE firms provide crucial long-term funding, alleviating government pressure and unlocking large-scale projects.

Challenges

Long Horizons & Liquidity: Infrastructure projects have long investment horizons, challenging PE exit strategies and investor liquidity.
Regulatory & Political Uncertainties: Complex regulations and unpredictable policy changes create risk and deter investment.

Recommendations

Streamlined Approvals & Clear Policy: Expediting approvals and providing stable policy frameworks reduce investor uncertainty.
Standardization & Transparency: Standardizing contracts and promoting transparency in project information attracts larger PE participation.
Exit Strategy Options: Enabling infrastructure investment trusts (InvITs) and other exit routes encourages investors and facilitates capital repatriation.

Conclusion

The reciprocal relationship between PE and infrastructure in India has the potential to contribute significantly to India’s economic growth. Although diversified spending, attractive returns, and government assistance all contribute to the momentum of PE in infrastructure, challenges such as regulatory difficulties persist. It is critical to strike a balance between long-term commitments and investor liquidity. Moving forward, this collaboration can be strengthened by a streamlined regulatory environment, diversity of exit strategies, and more efficient operations.

[1] https://www.ey.com/en_in/news/2023/10/investments-in-the-infrastructure-and-real-estate-sectors-have-helped-offset-the-yoy-decline-of-25-percent-in-pure-play-pe-vc-investments-in-2023-till-date-ey-ivca-report#:~:text=Since%202018%2C%20the%20real%20estate,PE%2FVC%20investments%20since%202018.

[2] https://www.india.gov.in/spotlight/pm-gati-shakti-national-master-plan-multi-modal-connectivity.

[3] https://pib.gov.in/PressReleseDetail.aspx?PRID=1598055.

[4] https://www.niifindia.in/uploads/NIIF%20Factsheet_April%202021[33].pdf.

[5] https://www.nseindia.com/products-services/infrastructure-investment-trusts-invit.

[6] https://bip.brookfield.com/press-releases/bip/brookfield-infrastructure-announces-closing-indian-telecom-towers-transaction.

[7] https://www.sebi.gov.in/legal/regulations/jul-2023/securities-and-exchange-board-of-india-alternative-investment-funds-regulations-2012-last-amended-on-july-4-2023-_74146.html.

[8] https://www.indiacode.nic.in/bitstream/123456789/1988/1/A1999_42.pdf.

[9] https://pib.gov.in/PressReleasePage.aspx?PRID=1808806.

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