What lies beneath – infrastructure companies in India

Infrastructure companies build grand roads, dams, bridges and buildings that are awe inspiring. But the same admiration is not felt for their listed stocks. At least not after the financial crisis of 2008. Animal spirits in the years leading up to the crash took infrastructure stocks to dizzying valuations. Companies only had to announce the next project and investors would push the stock price even higher.

A recent report by ICRA, dated 17 May 2012, has highlighted the dangers of leverage and risky practices in infrastructure companies in India. The report talks of double leveraging across holding companies and subsidiaries prevalent in infrastructure companies.

Holding company and SPV structure in infrastructure companies

For those who are new to the structure you see above, I have tried to simplify what the report says. Most infrastructure companies are structured with a holding company (HoldCo) at the top level. The HoldCo sets up multiple subsidiaries usually. Each subsidiary is usually a Special Purpose Vehicle (SPV) in financial parlance. One SPV might be involved completely in a road project. Another might take care of an airport project.

How do they get off the ground? Promoters pump money into the HoldCo towards equity. The HoldCo takes debt from banks and financial institutions (FIs).  So now we have equity and debt raised in the HoldCo. The resulting money is pumped into the SPVs as equity. On the basis of the infused equity the SPV raises debt from banks and FIs. This is a second round of borrowing different from the first round raised in the HoldCo.

What money flows into the SPV from the HoldCo is a combination of own money (promoters) and borrowed money (banks and FIs). Then again a loan is taken against this amount behind which there is already some borrowing element. If you count, there have been two sets of borrowing. The net result is that the actual money that the promoter contributes is relatively less!

You might ask what is the danger to the lenders to the SPVs? Its a matter of “skin in the game” as the phrase goes. Take an example of a housing loan taken for an investment in real estate (not for staying on your own). In India we are used to banks asking us to contribute 20% of the cost of the house. Balance 80% is lent by the banks. Take a case where home prices fall badly. We have 20% invested (equity contribution) in the house. There is less chance of us defaulting and letting go of this 20%. Now imagine if you had only 10% invested instead of 20% and the bank loan made up the balance 90% of the cost of the house. Surely the chance of you defaulting goes up if things go wrong with home prices.

The same logic applies for the companies. The lender to the SPV might give a loan as if it is just another company. But the equity in the SPV is actually “lesser equity + debt”.  The promoters or owners thus have lesser skin in the game. If the economic returns in projects are not great, what stops the promoters from dishonouring debt taken from banks and FIs? This is the danger of double leveraging.

Click here to see the report

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