Is India's Power Sector Worth Investor's Money?
India’s power sector attracted $2.1 billion in private equity (PE) funds last year, making up 46 percent of total PE infrastructure investments and 28 percent of all PE investments in India.
The largest PE deal in power to date was also inked in 2010. Asian Genco received a $425 million investment from an unusually large consortium of global investors led by Morgan Stanley Infrastructure Partners and including General Atlantic,Goldman Sachs, Norwest Venture Partners and Everstone Capital.
The investment was through a convertible instrument that would give the investors 44 percent stake when converted.
You may ask why this interest in a sector, which is perceived to have very poor corporate governance standards. Also returns at the asset level are expected between 15 and 17 percent, which is quite low, as PE firms typically look for 25 percent plus in returns. On top of this government licenses for power projects are always uncertain.
The answer possibly lies in the fact that large-sized deals in India (typically $100 million plus) are hard to come by and yet the quantum of “dry powder” held by PE firms in India is estimated to be somewhere around $20 billion.
As there are few large opportunities to invest in the power sector, with its expected stable cash flows in the future and continuing demand/supply mismatch, it is beginning to attract PE.
Although PE funds appear to be quite upbeat on this sector, this sector is not without its share of risks.
Investors came in at relatively high valuations on the back of optimistic assumptions of merchant tariffs. Merchant tariffs are determined through the demand and supply of electricity rather than through negotiated long-term pre-purchase agreements. In recent times, the markets have witnessed rationalization of merchant prices, affecting the profitability of power producers who have considerable merchant sales as part of their overall off-take arrangements.
Banks and financial institutions have also become more stringent in granting loans to new promoters raising funds for power projects. In the past because of the high power deficit, lenders expected key milestones required by projects to be cleared on a priority basis. But since that did not happen, lenders were forced to look more closely at the clearances developers already had before lending to them.
Another major hurdle is coal supply and environmental clearances. There have been virtually no allocations of coal mines by the Ministry of Coal in the past one and half years. Also Coal India (CIL), India’s largest coal producer is unwilling to sign fuel supply agreements with project developers due to environmental and efficiency issues.
CIL is currently able to meet only about 50 percent of coal demand from power companies while the remaining demand needs to be met with imports.
Interest rates are also expected to rise further in the future on the current backdrop of inflation and the central bank in tightening mode, such a rise will hurt the power sector. With utilities reluctant to revise their tariffs upwards, their financial positions are expected to experience further stress.
The power sector has also seen the emergence of a new class of developers, who are first timers. In such a case, managing projects becomes a critical factor for success. Historically, there have been delays on account of equipment supply, land acquisition, backward linkages etc.
Project execution risk is a major hazard especially when dealing with owners who do not have a track record of building power plants. Some PE firms employ specialist consultants to work closely with the portfolio companies to monitor progress and timelines and to keep an eye on cost. This trend needs to increase.
Firms should conduct extensive due diligence of the promoter family at the time of deal assessment. This will provide insights on the governance standards and business practices of the prospective company and its owners and will avoid unpleasant surprises post investment and reduce the risk of non-compliances with the US Foreign Corrupt Practices Act and other relevant legislation applicable to foreign PE firms.
Given that the sector’s outlook is stable and the attractiveness of the India “Tiger Awakes” story, PE firms will continue to have abundant opportunities to invest in the sector. However, be careful. In this industry, the Tiger can bite hard and the wounds could take a long time to heal.
Vikram Utamsingh is the head of private equity advisory, KPMG India, which was involved in seven out of the top 10 private equity deals in 2010.