IRB sweetens way for Indian infrastructure trusts

Secondary market buffer priced in to make sure the new asset class is a success.

IRB Infrastructure Developers has launched the country's first investment trust (InvIT) on a more attractive valuation than market participants had been expecting in an attempt to ensure the new asset class gets off to a strong start.

InvITs are spin-offs by developers of completed infrastructure projects, intended to free up much-needed capital to boost the country's infrastructure drive.

IRB's Rs46.5 billion ($724 million) deal is being pitched on a narrow price range of Rs100 to Rs102 per unit, which translates to a 2018 yield of 12% and lifetime yield of 12.4% (both on a post-withholding-tax basis).

The upfront yield represents an extremely attractive 540bp pick up to benchmark 10-year Indian government securities, which were yielding around 6.95% on Monday. Typically, real-estate investment trusts in other international markets offer 200bp to 250bp over risk-free rates.

Potential investors will also be aware that India remains on a declining interest rate trend, lending the transaction further secondary market upside potential.

From an equities point of view, the underlying market has also been on an upswing so far this year, with the BSE 100 rising 15.74% year-to-Monday’s close.

In addition, listed Indian companies are not renowned for paying cash back to investors through dividends, making IRB InvIT a stand-out among dividend yielding stocks. The new InvITs must distribute at least 90% of their net distributable cash flows as dividends, which can be fully passed through with no tax.

As such, IRB InvIT will yield almost twice as much as the BSE 30's highest yielding stock, Coal India, which is currently offering 6.3% on a forward basis. 

It also will offer more than twice as much as the country's highest yielding utility, hydropower operation NHPC, which was trading at 5.1% on Monday.

More importantly, IRB InvIT has been pitched on a forward enterprise valuation of Rs58.05 billion to Rs59.211 billion compared to the offering circular’s estimated Rs70 billion fair value. 

This puts the initial public offering at a 15.72% to 17% discount to fair value. Bankers said they expect it to yield around 10% to 10.5% once the deal beds down in secondary market trading. 

IRB InvIT marks a welcome breath of innovation for the Indian equity markets as well as for global co-ordinators IDFC Bank (lead left), Credit Suisse (which also led the first Indian corporate Masala bond), ICICI Securities, IIFL and Karvy.

Bankers said that while the new asset class has taken longer than expected to get off the ground, patience has been rewarded with a set of regulations which works for the entire market.

Deal terms

Institutions will be allocated up to 75% of the offering, with anchor and strategic investors potentially taking up to 60% of this tranche according to the deal’s termsheet.

Syndicate bankers said the deal has been attracting interest from all available pools of capital including foreign long-only and hedge funds, plus local insurance funds and mutual funds (which are exempt from the 15bp withholding tax).

There is also a quasi-retail tranche for high net worth investors, which accounts for the remaining 25% of the overall deal and carries a minimum $15,000 bid threshold.

The anchor order book will open and close on May 2, with other bids being registered from May 3 to 5 ahead of listing on the Bombay Stock Exchange 12 days later.

Post listing, IRB Infrastructure Developers will retain a 15% stake and should be able to reduce its gearing ratio from three to two times according to Macquarie estimates.

Underlying assumptions

Based on the IPO price range, IRB will also monetise its equity investment in the six project assets on a ratio of 0.94 to 1 times based on the Rs10.6 billion to Rs11.8 billion range. This is below analysts’ pre-launch fair value estimates of 1.1 to 1.5 times.

However, Kotak Institutional Equities suggests the IPO range is not that surprising given the lack of any precedent and the variable nature of the portfolio assets.

Over the past six months, bankers report that institutions have been holding out for an internal rate of return (IRR) in the low double digits, with Kotak noting one large institution pushing for a 14% assumption where mature road assets are concerned (1.5 percentage points higher than IRB is offering).

Syndicate bankers say the company’s cost of debt will fall about 150bp to 200bp post listing as proceeds are being used to re-pay Rs33 billion of external debt. Including subordinated debt, the company’s total debt pile stood at Rs47.46 billion at the end of April.

As a result, the debt-free InvIT should attract a triple-A rating, reducing credit costs from roughly 10.5% to 8.5%. Indian regulations allow companies to raise debt up to 49% of embedded value.

Syndicate bankers say they are also assuming a combined inflation rate and projected traffic growth rate of 8.5% to 9% through to the end of the concession period, which has a residual average life of 13.88 years. This is fairly conservative given historic traffic growth alone grew by a compound annual growth rate of 9.38% from 2014 to 2016.

Future capital appreciation will, therefore, be partly subject to toll road revenues beating these traffic estimates. But the company also has a pipeline of potential assets to inject into the vehicle including the Amritsar-to-Pathankot toll road section, which could boost embedded value by about 25%.

According to its offering circular, the parent has 16 concessions in operation, five under construction and three under development. Under the current regulations, toll roads must be operational for two years before they can be injected into an InvIT.

Over the short-term, the most valuable asset in the IPO vehicle is the Surat-to-Dahisar section of National Highway Eight, which links the states of Gujarat and Maharashtra, finishing close to Mumbai.

This accounted for 35.5% of the company’s overall FY16 net toll revenues of Rs9.648 billion (after payments to the National Highways Authority of India are taken into account). On a gross basis, this section’s toll road revenues grew by 10.55% year-on-year.

However, it only has a residual concession life of 4.8 years and accounted for Rs13.1 billion of the company’s IPO EV.

Over the longer-term, it will be eclipsed by the Jaipur-to-Deoli section of National Highway 12, which has a 23.2-year residual life and accounted for Rs17.58 billion of the upfront EV. It contributed 12.5% of 2016 net toll revenues, which grew 18.9% year-on-year.

Third is the Tumkur to Chitradurga stretch of National Highway Four in Karnatka, which accounted for 20.9% on a net basis in the 2016 financial year and saw toll road revenues increase by 9.64% year-on-year on a gross basis. It contributed Rs12.4 billion of the EV and has a 20.2-year residual concession life.

Over the very long term, few would doubt the potential for toll road growth in a country where highways account for only 2.9% of the roads, but carry 40% of the traffic. Funding and politics, however, have always complicated the issue.

But bankers believe InvITs offer investors and the country an important new mechanism to develop the sector further. As one concluded: “This new asset class will not only bring more private sector capital into the infrastructure sector, but also give them an exit vehicle as well.”

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