As the Indian economy makes its way out from a balance sheet driven slowdown it would be prudent to learn some lessons from past mistakes. The most important aspect about creating contracts that underlie infrastructure projects is allocating returns and risks in the right proportion between equity and debt investors. One must ensure that high quality risk taking is encouraged and yet one must avoid moral hazard issues revolving around excessive risk taking that leads to debt holders getting left with Non-performing assets (NPAs). Going forward a lot more focus needs to be paid to the exact structure of the contract that specifies how cash from the project is paid to the various stakeholders involved. Any contract design for an infrastructure project must ensure that neither the equity investor nor the debt investor has any incentive to deviate from a path that is the most optimal path for the project’s success. While in practice this is harder to achieve, the contract design must aim to achieve this as much as possible. In the recent past infrastructure projects in India failed due to three main reasons: (i) excessive debt was used to finance the project, (ii) debt at very high interest rates was used for project financing and (iii) projects that were poor projects to start with were invested into. Having more structure, clarity and discipline around the exact cashflow from the project can help mitigate the problem of poor project selection and poor financing decisions. At the outset before the project starts certain “financial ratios” must be agreed upon between the equity and the debt investors. These ratios will broadly be based on the ability of the project cashflows at any given time and the value of the future cashflows to service the underlying debt of the project. The “financial ratios” must be well defined, and the inability of the project to meet these pre-determined conditions will lead to a “cash lock-up” i.e. the equity investor will get no cash from the project cashflows being generated. All cashflows that the project generates will go to a special account. If the project fails to meet the pre-determined “financial ratios” for a specific pre-agreed time-period, then the debt holder will be allowed to access the entire cash sitting in the aforementioned account. This cash will be used to pay the debt holder interest and pay off the principal amount of the debt. Till the project does not meet the pre-determined “financial ratios”, the resulting cashflows from the project will only accrue to the debt holder. The essential point here is as the project enters a challenging financial period as indicated by the inability to meet the pre-determined “financial ratios”, the debt holder should be able to use the project cashflows to de-risk.
The main aim of the cash flow discipline mechanism mentioned above is to incentivize equity investors to avoid a situation where they lose access to the cash flows. Hence this should incentivize equity investors to both choose high quality projects and make the best financing decisions with regards to debt usage. For the above-mentioned mechanism to succeed we must ensure that the contract negotiation and agreement is done with great precision. “Financial ratios” that are agreed upon at the outset must be very clearly defined with no scope for obfuscation. Different types of infrastructure projects will require variants of the above cashflow model to be applied, yet the basic essence of having the right incentives in place for the various stakeholders is very important in effectively financing infrastructure investments. In summary, defining risks involved in a project, allocating the risks to the correct risk-taking party and rewarding the risk-taker with the correct return is the most basic component of a robust infrastructure project. For India to move ahead with filling the infrastructure gap, creating jobs and boosting the economy it is important that cashflow management in the contract structure be looked at in greater detail.
