Exploring InvITs

Renewable energy companies look at financing alternatives

The Indian renewable energy sector aims to achieve a cumulative capacity of 175 GW by 2022, with an expected average investment of Rs 1.53 trillion per year or Rs 9.18 trillion by 2022. While 75 per cent of the investment will be in the form of capital, the rest will be in equity. In order to attract such substantial investments and help it achieve its target, the sector is looking for innovative financing tools.

Capacity additions are already breaking records, best practices are being adopted, created and followed to enable greater capacity installations, and technological and financial developments are taking a big leap. Moreover, obsolete practices are being done away with and policies are constantly being revised to best suit the needs of the sector and address key challenges.

Non-availability of finance has been a major deterrent to the development of the renewable energy sector. In instances where finance is available, the high cost of debt and erratic interest rates render it nearly inaccessible, adding to the project cost.The sector has so far relied mainly on finance from commercial banks, in the absence of more attractive instruments. It is only recently that the renewable energy market has opened up to foreign investment tools and instruments and is rapidly implementing these instruments.

The country has begun to see significant domestic and foreign capital being channelised into the infrastructure and renewable energy sectors. Favourable policies governing and protecting these investments, and the introduction of new investment procedures have helped further this growth. The infrastructure investment trust (InvIT) is one such special instrument that has been introduced in the renewable energy sector.

What are InvITs?

InvITs are financial vehicles that provide investors with liquid investment options for infrastructure projects. In India, where lending has been traditionally dominated by banking institutions, they help diversify the sources of finance.  InvITs are also useful for making developers’ tied-up capital available for investment, while attracting foreign equity and lowering the loan exposure of domestic lenders.

The Securities and Exchange Board of India (SEBI) introduced the InvIT concept in the Indian market in 2014, based on the best practices in developed countries such as Singapore and the US. As per the initial SEBI guidelines, an InvIT could be set up by a maximum of three sponsors for projects with a cumulative value of more than Rs 50 billion. However, in a revision of the regulations, the board has removed the limit on the number of sponsors and reduced the sponsor holding to 15 per cent from the previous 25 per cent.

The InvIT can get investments either directly from the sponsors or indirectly from special purpose vehicles (SPVs). Earlier, investors needed to distribute a minimum of 90 per cent of the cash flow. As per the latest revision, the holding company can distribute up to 100 per cent of the cash flow, but it has to dispense at least 90 per cent of it. Also, the trusts are allowed to appoint the majority directors in the SPVs while reserving the right to remove the project manager and trustee, as well as request for delisting.

InvITs have been divided into two mechanisms. First, InvITs holding 80 per cent of the assets in completed and revenue-generating projects will be allowed to publicly list themselves with a minimum subscription amount of Rs 1 million. Second, InvITs holding 10 per cent of the assets in projects that are under construction will be involved in the private placement mechanism and the minimum subscription amount would be Rs 10 million.

An InvIT has five major components:

  • Sponsors: As per the SEBI regulations, a sponsor entity must have a net worth or intangible assets of more than Rs 10 billion and at least five years of experience.
  • Investment manager: An entity can only become an investment manager for the InvIT if it has a net worth or intangible assets worth Rs 100 million as well as a minimum experience of five years. In addition, the entity should have at least 50 per cent of independent directors.
  • Trustee: An entity can become a trustee only if it is not a sponsor or investment manager of the InvIT and has sufficient resources as specified by the board.
  • Borrowings: Any borrowings, deferred payments, net cash and cash equivalents should not exceed 25 per cent of the InvIT’s value. Any borrowing beyond this limit and up to 49 per cent will need a credit rating and the approval of unit holders.
  • Related-party transactions: Any such transaction, if it exceeds 5 per cent of the InvIT value, would require the approval of 60 per cent of the unit holders, among other stringent conditions imposed by SEBI.

Why InvITs?

InvITs are financial instruments similar to yieldcos with two major attractions in the form of tax advantages and liquidity. While InvITs offer long-term predictable solutions for revenue-generating projects, they also open up a wide range of infrastructure projects to financiers and foreign investors for investing on easier terms. The tax advantages given to InvITs make them an attractive alternative to the traditional forms of investments. These include:

  • The income received by an InvIT from the SPV is exempt from tax regulations.
  • The tax levied on the capital gains from the disposal of assets will be in the hands of the InvIT. This translates into an exemption of long-term capital gains taxed at 20 per cent and short-term gains at the maximum marginal rate.
  • Interest received to be taxed at a concessional rate of 5 per cent for non-resident unit holders.
  • Capital gains for unit holders would be charged a security transaction tax at par with that of equity shares, short-term gains from which are taxable at 15 per cent and long-term gains are exempt.

InvITs for renewable energy

Renewable energy is one of the fastest growing sectors in the country with significant investments already in place and more waiting to find their way into the sector. However, regulatory provisions that are supposed to act as filters often become roadblocks, stalling the flow of money. Experimental regulations, changing policies and uncertainty over financial parameters are challenges that need to be sorted to achieve the targeted growth in the sector.

Cost-intensive renewable power projects require effective financial instruments with attractive provisions. Also, the cash-generating nature of these projects makes it important for the financial instrument to have better terms for improved management of funds. InvITs offer sector-specific solutions, harnessing the steady cash flow of renewable projects through power purchase agreements, thereby giving constant returns to unit holders.

A key challenge faced by project developers is the absence of profits during the initial years of project development owing to depreciation. This affects their ability to reinvest the money into the project for various operations. With multiple tax provisions available for InvITs, the saved cash could find its way back into the project, reducing the dependence of the project on external factors for continued operations.

As the sector becomes increasingly competitive, multiple new entities are being formed to harness the potential gains from the renewable energy opportunity. Although finances are available, the lack of prior experience often compels these companies to either form joint ventures and partnerships or stay away from the operational aspects of projects. For new companies with no prior experience, InvITs are an attractive option that can provide access to funds for greenfield projects. The previous mandate of having a minimum experience of two projects for private and public InvITs has now been removed, making it easier for companies with little or no experience in the field to invest, generate and distribute profits.

SEBI took almost two years after the introduction of InvITs in December 2014 to permit the first entities to launch InvITs for infrastructure development in September 2016. This was mostly to iron out the regulatory wrinkles in tax procedures and make InvITs more attractive. Four companies – IRB Infrastructure, GMR, MEP Infrastructure and Sterlite Power – have been granted permission to launch InvITs. Meanwhile, companies in the renewable energy sector are looking to participate in the initial race and thereby gain a first-mover advantage. To this end, in May 2016, IL&FS initiated the process of listing its wind energy assets as an InvIT in a bid to raise nearly Rs 20 billion. The company’s efforts to raise money through an initial public offering (IPO) in 2015 were not entirely successful. However, in March 2016, Japan-based Orix picked up 49 per cent stake in the company, boosting investor confidence. The Adani Group made a similar move to create InvITs that would serve its various purposes.

Mytrah Energy Limited, in July 2016, expressed its intention to list a renewable energy InvIT to develop its wind energy assets. Through the InvIT, the company aims to seek $400 million to enhance its current portfolio of 920 MW of installed capacity and 90 MW of under-construction capacity. Also, Mytrah is looking at InvITs as an option to allow early investors, such as IDFC which had invested Rs 3.5 billion in the company, to exit. Compared to raising money through the private equity or IPO routes, InvITs provide an unexplored alternative with attractive tax benefits for companies.

Issues and challenges

The InvITs market is expected to mature over the next few years but for now, it faces multiple challenges that could restrict its penetration in the infrastructure and renewable energy sectors. The lack of prior experience in InvITs and uncertainty over its success have kept investors at a distance.

InvITs come with special challenges for the renewable energy sector:

  • High minimum value: Based on the SEBI guidelines, an InvIT must have a minimum asset value of Rs 50 billion, whereas most operational projects in the country are valued at Rs 25 billion-Rs 30 billion, allowing only developers with multiple projects to launch InvITs. This significantly restricts the market for InvITs.
  • Cash flow generation: InvITs require 90-100 per cent cash flow to be distributed regularly. However, issues regarding payments by discoms could significantly hamper cash flow, defeating one of the primary purposes of InvITs.
  • Risk diversification: Since power generation from renewable sources of energy is uncertain as it depends on various external factors, the inflow of money is erratic, making it a risky proposition. Also, most renewable energy developers do not have geographically diversified portfolios, leading to a concentration of risk.

The way forward

InvITs have gained some traction with SEBI approving at least four InvIT applications over the past few months. A conducive regulatory environment has been created, with constant revisions being made, to further promote InvITs. With the availability of other options such as green and masala bonds as well as traditional sources of financing for the infrastructure sector, the InvIT model will have to prove itself for increased uptake.

The renewable energy sector, which has been struggling with access to finance, will benefit through InvITs, considering the constant return on investment for investors. However, challenges such as ensuring a steady flow of cash could be detrimental to its adoption. The future of this financial mechanism depends not only on the government policies for InvITs and renewable energy but also on market conditions, including tariff trends, cost patterns and developer sentiment. The government will need to specify its policies on the tax-efficient and seamless transfer of already-developed renewable energy assets, without compromising on other financial incentives available to them. Meanwhile, the sector will have to deal with its inherent cash flow issues for InvITs to be successful. For now, it is wait-and-watch to see whether the InvIT model will work or not.

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