ICRA: Recent changes to Hybrid annuity model aids in improved cash conversion cycle and protects the returns of HAM developers

Recent changes in model concession agreement with shift to marginal cost of funds based lending rate (MCLR) from bank rate earlier for computing interest on annuities is a very positive development. As per revised concession agreement dated November 10 2020, interest rate on annuities will be equal to the average MCLR of top 5 scheduled commercial banks plus 1.25% instead of bank rate. ICRA in its earlier release dated July 22, 2020 highlighted the challenges faced by the hybrid annuity projects due to low interest rate regime. The interest on annuities for HAM projects is sizeable, amounting to around 45% of overall inflows during the concession period. Currently, the prevailing low bank rate is expected to reduce the overall inflows for a HAM project thereby adversely affecting its debt coverage metrics and returns to the investors. The second problem is related to delayed interest rate transmission. The transmission of reduced interest rates happens with a lag for the project loan (linked to MCLR of banks). This is also evident from the widening difference between weighted average lending rate and RBI bank rate in the current year (refer exhibit 1).

Elaborating further, Rajeshwar Burla, Vice President, Corporate Ratings, ICRA says, “Linking interest on annuities with RBI’s bank rate has been a pain point for developers due to inefficient transmission of interest rates. With the average MCLR replacing the bank rate, there will be a natural hedge between the annuity inflows and interest costs thereby reducing the interest rate risks to a large extent. This is a positive move that will protect the returns of the HAM developers and improve the overall attractiveness of the model.”

The other major revision is the grant payment from the authority which will now be paid in 10 installments instead of five earlier, thus the spacing between the payment milestones is reduced. Every 10% physical progress is eligible for 4% release of grant (earlier 8% of grant was released for every 20% progress, refer Exhibit 2), this will aid in improvement of the cash conversion cycle for the contractors executing the HAM projects as their payments are back to back in nature.

“While these changes will be applicable for future awards, the fate of the existing HAM projects is hanging in balance. Change in applicable interest rate on annuities is critical even for existing projects. This will not only improve the coverage metrics for these projects and consequently aid in refinancing but also helps the developers to unlock the capital by selling these assets and redeploy the capital in new BOT projects which is the need of the hour,” Burla added.

Exhibit 2: Summary of key changes made to the model concession agreement for Hybrid Annuity Model
Clause	Revised	Earlier
Payment during construction	10 instalments of 4% each amounting to 40% of BPC (adjusted for price index multiple) 1) First payment milestone - on achievement of 5% physical progress 2) Second payment milestone - on achievement of 10% physical progress 3) Third payment milestone - on achievement of 20% physical progress 4) Fourth payment milestone - on achievement of 30% physical progress 5) Fifth payment milestone - on achievement of 40% physical progress 6) Sixth payment milestone - on achievement of 50% physical progress 7) Seventh payment milestone - on achievement of 60% physical progress 8) Eighth payment milestone - on achievement of 70% physical progress 9) Ninth payment milestone - on achievement of 80% physical progress 10) Tenth payment milestone - on achievement of 90% physical progress	5 instalments of 8% each amounting to 40% of BPC (adjusted for price index multiple) 1) First payment milestone - on achievement of 10% physical progress 2) Second payment milestone - on achievement of 30% physical progress 3) Third payment milestone - on achievement of 50% physical progress 4) Fourth payment milestone - on achievement of 75% physical progress 5) Fifth payment milestone - on achievement of 90% physical progress
Interest on annuities	Interest shall be due and payable on the reducing balance of Completion Cost at an interest rate equal to the average MCLR of top 5 scheduled commercial banks plus 1.25% Authority shall declare the list of top 5 scheduled commercial banks on 1st September every year based on the balance sheet size declared in their annual reports. The 1-year MCLR of these banks shall be taken at the start of every quarter.	Interest shall be due and payable on the reducing balance of Completion Cost at an interest rate equal to the applicable Bank Rate plus 3%