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How to make take-out finance work

Saji Gopinath & Abhilash Nair
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Project implementation is subject to constantly changing risk factors. The financing of projects should reflect such changes.
Project implementation is subject to constantly changing risk factors. The financing of projects should reflect such changes.

Good infrastructure is essential to attain and sustain an economic growth target of 9 per cent. With this in mind, the Government has projected a huge infrastructure-related investment requirement of around $1 trillion in the Twelfth Plan (2012-17).

As compared with other loans, infrastructure-related advances are for a longer term and are big ticket in nature.

Thus, most financial institutions would not want to expose themselves to the risk of project implementation as well as possible Asset-Liability (AL) mismatch (for most institutions involved in raising deposits and investing in projects, while cost of lending can vary with time, the cost of raising funds is fixed).

To meet this investment requirement, Budget 2011-12 announced that banks and NBFCs could sponsor Infrastructure Debt Funds (IDFs).

However, currently, even IDFs are supposed to raise capital through rupee or dollar-denominated bonds for a stipulated minimum period. In addition, there are also tax-free bonds as well as infrastructure bonds raising money to develop infrastructure in the country.

While in the case of tax-free bonds, the interest earned is exempt from taxation, for infrastructure bonds an additional deduction of Rs 20,000 is provided under section 80 CCF.

In each scheme mentioned above, the minimum period is five years and they all carry sweeteners in the form of tax exemptions.

While a minimum tenure of five years does not necessarily rule out AL mismatch, the taxation-related sweeteners are like taking money out of one (government) pocket and putting it in another.

A more sustainable project finance mechanism was devised in 2005-06, even before the Eleventh Plan.

A FEASIBLE IDEA

The Central government, in 2006, had set up India Infrastructure Finance Ltd (IIFCL) to assume an apex role for financing and development of infrastructure projects.

One way to counter the perceived risk from AL mismatch and project implementation delays is to have a well-defined, take-out financing scheme. Even in the 2009-10 Budget speech, the Finance Minister referred to IIFCL evolving a good take-out financing scheme.

Under this scheme, the Take-out Financing Institution (TFI), i.e. IIFCL, guarantees to take the infrastructure advance out of the bank’s (primary lender’s) balance-sheet after a certain pre-agreed time frame.

Two alternative types of take-out financing agreements are: (i) unconditional and (ii) conditional. The unconditional agreement is exposed to moral hazard as well as the agency problem, which may make the financing institution tread very cautiously. Therefore, it is felt that a conditional agreement would serve the purpose better.

INSURANCE MODEL

Unfortunately, even in the conditional agreements, most of the conditions are set beforehand and adherence is evaluated periodically.

Hence, before the next periodic update, the TFI does not have information about the project’s progress, forcing it to lay down stringent conditions which might prove counter-productive.

In order to make conditions acceptable to both parties, the agreement should correctly reflect the project’s risk at every point in time.

Unless this is done, the take-out financing scheme will be no different from the refinancing schemes that have existed for ages.

Therefore, it is hardly surprising that though take-out financing has been in existence since 2006, the first take-out financing transaction took place as late as October 2010.

Accordingly, three issues need to be addressed: (i) the fees that the bank should pay to the TFI, (ii) dynamic measurement of project’s risk and (iii) making take-out financing as an option and not an obligation to the bank (especially when it is in a comfortable asset-liability maturity position).

The last issue is the easiest to address. Considering the lack of availability of finance for infrastructure projects, if a bank is comfortable holding on to the advance, it should be allowed to do so.

Such a transaction can be viewed akin to an insurance bought by the bank, against possible asset-liability mismatch.

It would, therefore, be paying ‘premiums’ to the insuring institution (TFI), a sum that would be adjusted based on risks involved in project implementation.

Put differently, the bank holds an option to sell the asset at the end of the agreed term (a put option). If it exercises the option, then the TFI would have to buy the asset at a strike price reflective of the risk of the project at that point in time.

But, how to price such an insurance product, which is characterised by a dynamic strike price?

Standard solutions, such as the Black Scholes Option Pricing (BSOP) formula, do not allow the strike price to change. But an extension of BSOP (Margrabe’s Formula), applied to exchange options, allows one to make the strike price dynamic.

Thus, we propose to analyse the take-out financing scheme as an exchange option, where the bank exchanges the loan asset for a dynamic strike price.

For estimating such a price, project implementation risk would have to be measured. This would need to take into account the budgeted and actual progress of the project, and the correlation between the two.

For this purpose, two indices need to be computed: (i) an index of budgeted costs and (ii) an index that measures both, the cost as well as physical completion of the project.

For the first year, a simple BSOP-determined premium for the entire term is recommended.

Thereafter, every year, one should calculate the two indices stated above (for the year that has gone by) and based on these indices, determine the premium and adjust the lumpsum premium deposited with the TFI.

COMPUTATIONAL ISSUES

The two indices, mentioned above, can be constructed by following the Earned Value Analysis procedure, commonly adopted in project monitoring.

Accordingly, the project should first be divided into a weekly planned schedule (to completion) and planned cost. This gives the budgeted value of the project for every week, based on which the index of budgeted costs can be constructed.

Similarly, once the first year is over, one can, with the actual cost and progress, construct to complete performance index (TCPI) which measures both the physical and financial progress.

More often than not these two indices will be correlated; in Margrabe’s extension of BSOP, there is a covariance term that adjusts for the interaction effect while calculating overall project cost variance.

Treating a take-out financing contract as an insurance bought by the bank and relating the premium to the completion of the project would bring symmetry in information related to the risk of the project.

Therefore, the premium would be less in the nature of a moral hazard.


The terms between the bank and the infrastructure refinance body should be modelled along the lines of an insurance contract.


(This article was published in the Business Line print edition dated July 30, 2012)
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