For the CFO chalking out a project financing strategy, the basic building-blocks--debt and equity--will remain the same. As will the dilemma of ensuring promoter control while expanding the equity base. But with deregulation multiplying options and convertibility multiplying markets, they can be rearranged to create complex, yet flexible, structures. BT presents the CFO's guide to project finance in 2000.

By Dilip Maitra

There is only one silver lining to an economic downturn: it precipitates financial innovation. Project financing used to be boringly bland. A standard mix of internal accruals, equity, and term loans, with an occasional sprinkling of debentures, could be relied on to do the trick. No longer. A combination of financial sector liberalisation and lacklustre equity markets has spawned a rush of innovation that is now rewriting project financing techniques.

Indeed, to wring funds out of the torpid primary markets, CFOs are being forced to devise an array of ingenious, if not outright exotic, financing solutions. As innovation pushes out the opportunity frontier, project financing strategies must be redefined to meet corporate finance requirements. Just what are these requirements? And what instruments need to be deployed to fulfil them?

The CFO's Need:
Expansion Of The Capital Base Without
The Dilution Of The Promoters' Stake

Multiply the scale of the average project and, hence, the financing requirement. As India Inc. navigates the increasingly- choppy waters of liberalisation and globalisation, size will be a definite advantage. Confirms Anil Surekha, 40, the president of the Rs 1,400-crore Ispat Industries: "Survival in a fast-globalising environment will require global-size plants. And that will, invariably, translate into a larger equity base." As economies of scale demand large investments, the traditionally-large share of internal accruals in project financing will shrink. To fund its Rs 4,800-crore hot-rolled coil project, the equity capital of Ispat Industries will balloon from the present Rs 148 crore to Rs 1,200 crore in a few years.

By international standards, the equity bases of most Indian companies are small, leaving ample room for expansion. Says Anil Nayar, 47, the COO of the Rs 277-crore JCT Electronics: "As companies restructure their balance-sheets, we will see more dependence on equity-flows." Agrees Nimesh Kampani, 50, chairman, JM Financial & Investment Consultancy Services: "Once the primary market revives, most capital-intensive projects will have to depend primarily on the equity route." And the ban on bridge loans has been lifted by the Reserve Bank of India (RBI), which should help pave the way for a primary market revival.

But large-scale equity mobilisation can mean the substantial dilution of the promoters' stake. Even a boom in the secondary market is unlikely to trigger a repeat of the euphoria that led to record premia as a result of the abolition of the Office of the Controller of Capital Issues. For the same project size, a lower premium results in the issue of a larger number of shares and, therefore, a potentially-larger loss of control for the promoters. No wonder, then, that conservative business houses have often shied away from large equity issues. Take the Mappillai family, which controls the Rs 2,029-crore MRF with an equity base of a paltry Rs 4.24 crore--and holds the distinction of visiting the equity market just once in the last 10 years.

Expect the conflict between resource-raising and control concerns to hot up with the institutionalisation of the markets, and the consequent entrance of a more vocal and sophisticated set of investors. True, the growing institutional presence has, in part, been driven by the retreat of the small retail investor, but it also reflects the trend worldwide. Notes Jayant Thakur, 32, director, Jayant Thakur and Co.: "In the US, the mutual and pension funds hold 60 per cent of the shares of listed companies. We, too, will have to make the inevitable shift to indirect retail participation via the funds."

That shift will accelerate once the pricing formula for firm allotments is dispensed with. To stamp out the pernicious practice of promoters awarding themselves large chunks of equity at rock-bottom prices, the Securities & Exchange Board of India (SEBI) requires that the issue price for such allotments be pegged to the six-month average price of the scrip. But this also rules out discounts to institutional investors--an unnecessary restriction on financing flexibility.

THE STRUCTURED SOLUTIONS: In line with the pattern displayed by the more mature capital markets, promoter holdings are bound to come down. A BT study of 3,176 Indian companies reveals that promoter holdings as a percentage of total equity average 40 per cent--way above global levels. Nevertheless, CFOs will still seek out equity instruments that do not violate control equations.

PREFERENCE SHARES. Although preference shares have been around for a while as a minor source of finance, this instrument is set to enjoy a burst of popularity. For, preference capital combines the features of both debt and equity to generate a low-cost, high-yield hybrid. Like common stock, dividends on preference capital are not obligatory. Moreover, dividend payments are not tax-deductible. Like debt, preference shares offer a fixed rate of return to investors. And preference shareholders, like those who hold debt claims, do not enjoy the right to vote. Says S.M. Parande, 60, the former managing director of Ispat Finance: "Preference shares circumvent dilution problems."

The fear that the benefits of Section 80-M of the Income-Tax Act, 1961--which exempts 60 per cent of inter-corporate dividends from the tax-net--would be done away with had checked investments in preference shares. Budget 97 has, indeed, done away with Section 80-M, but it has also abolished the system of dual taxation on dividends. Since dividend income is now entirely tax-free, the fixed rate of return that equates preference yields with the post-tax returns on other taxable instruments is lower, translating into cheaper funds for the CFO.

To the tax benefits, add the stimulus of a widening investor base. The Monetary & Credit Policy For The First Half Of 1997-98 (M&CP, 97) has excluded preferential shares, along with corporate debentures, from the cap limiting a bank's exposure to corporate securities at 5 per cent of its incremental deposits. With cash-flush banks already lining up to invest in these safe shares, canny CFOs have been able to issue preferential share capital at 100-150 basis points below the prime lending rate.

NON-VOTING SHARES. Closely akin to preference shares, non-voting shares are without voting rights. However, unlike preference capital, non-voting shares do not carry a pre-determined dividend. The pay-off to the investor for the assumption of higher risk levels minus the compensation of control: smaller issue premia and fatter dividends.

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