Climate change currently is a central theme in the investing universe globally and we are witnessing record capital allocations towards sustainable investments. There is a clear focus on the transition to a lower carbon economy, and renewables as an asset class, provide investors long term cash flows contracted with creditworthy counter parties.
A significant portion of this capital has been allocated towards India which has witnessed a meteoric rise in renewable energy assets being created in the last decade or so. India has seen a significant amount of overseas investment in the sector and has received an amount of $4.8 billion through FDI in the past five years.
Renewable energy investments in India have become more suitable to foreign institutional investors as the sector has matured from small size, high risk-high return investment to large size, medium risk-moderate return investment. However, despite the increasing foreign investment flows, the renewable sector still primarily remains a market where the funding is largely available through bank, financial institutions and non-banking financial institutions (NBFCs).
This is where InvITs (YieldCos) are emerging as a vehicle to invest in renewable energy assets. Indian public markets do not provide many opportunities to access renewable energy assets, however, there is a significant pool of assets available in private markets.
The fundamental idea behind InvIT is to acquire low risk, operating assets and help developers recycle their capital. The market is witnessing a clear transition wherein existing renewable platforms are migrating/or are evaluating migration into an InvIT structure. The objective behind exploring InvIT migration is to provide a platform that is scaled up, offer access to long-term cash flows in a tax-efficient manner and adhere to high standards of corporate governance.
InvITs can be a game changer for the renewable sector in India and should be considered as an alternate mode of making an investment in this space in India. With increased governance and more clarity in policymaking, it is expected that the patient capital from large pension funds, insurance funds and sovereign wealth funds will also find its way into the renewable sector through InvITs.
InvITs were initially introduced as a listed vehicle with certain restrictions, which made it unviable for the renewable sector. Especially, the cap of leverage of 49 percent on Enterprise Value (EV), increased to 74 percent of EV with AAA rating along with other conditions. However, SEBI, subsequently, in 2019 came out with the concept of unlisted InvITs wherein only corporate and institutional investors were allowed to invest with reduced restrictions. Among others, the leverage cap was done away with for unlisted InvITs. In 2020, the Government also brought unlisted InvIT at par with listed InvIT from a tax perspective and thus, opening doors for investment through this vehicle.
The InvIT advantage clearly emerges from four fundamental pillars: 1. Governance and transparency; 2. Tax pass-through status and underlying distribution efficiencies; 3. Access to low-cost long-term capital; and 4. Debt mobilisation and related refinancing/tax arbitrage.
It is run by independent trustees and investment managers and is governed by SEBI regulations. The board of the investment manager comprises 50 percent independent directors to keep independence from the sponsors. The same certainly provides a lot of credibility to the overall InvIT product for marquee global investors.
The regulations consist of other safeguards/requirements on the governance side, such as semi-annual valuation requirements, disclosure requirements, unitholders approval of specific matters, etc. Secondly, the SEBI regulations have clearly laid down rules for mandatory distribution of 90 percent of cash earnings to investors at regular intervals.
The same forms the backbone of the whole InvIT story as it allows predictable returns to the investors and helps the yield investors to meet their commitments. Thirdly, it allows global investors to get a pie of the operating infrastructure assets in India without actually having to get into the construction/operations of the same.
Further, the tax advantage provides impetus to the InvIT product as it allows foreign investors to repatriate funds from India at a low tax rate of 5 percent for interest and NIL for dividends in case certain conditions are fulfilled. With predictable returns at low tax rates in India, the investor can make better returns on the same set of underlying cashflows. From the experience of existing InvITs, it is seen that InvITs are largely able to refinance the bank debt at the company level as well which allows the InvIT to create an interest arbitrage and further improve the returns for the investors.
The government has laid the groundwork for making InvITs a success in India and the recent increase in interest by the industry are encouraging signs. While the latest changes on the regulatory side (around clarifying and streamlining some of the SEBI InvIT guidelines like de-sponsorisation and rights issue for unlisted InvITs) have been a welcome move, certain other key changes are required especially on the regulatory side.
Allowing Foreign Venture Capital Investors (FVCI) to invest in the units of InvITs (including by way of swap of existing equity investments), simplification of the regulatory framework for private unlisted InvITs with an aim to provide greater flexibility for unitholders to decide upon the governance of private unlisted InvITs and opening up more avenues for debt investments in InvITs, are some of the key pending asks.
On the tax side, while a pass-through status has been provided, it is important that taxmen understand the nuances of this new regime and we see few successful rounds of tax audits for the InvIT platforms as well as the investors.
Streamlining tax provisions regarding applicable withholding tax on distributions thereby plugging resultant cash leakage, bringing the holding period for units of InvIT at par with shares for capital gain purposes and clarificatory amendments in domestic tax law vis basis of taxation of income in the hands of non-resident unitholders, are some of the additional changes needed on the tax front.
All of this would go a long way in establishing investor confidence and certainty around tax assumptions/positions taken while calculating yields.
InvITs in India are still far from achieving their potential given the operating infrastructure projects and the massive pipeline opportunity. We do have the right fundamentals in place for creating a successful InvITs play for the energy sector – with emphasis on the stable regulatory framework, the focus should be equally on creating better investor awareness, the deeper debt market and continually evolving the tax and regulatory landscape to keep pace with the changing investment trends and sectoral dynamics.
- By Nandita Tripathi, Partner, M&A Tax and PE – Deal Advisory & ENR Tax Lead, KPMG in India and Divyanshu Srivastava, Partner, KPMG in India