S&P assigns 'BBB-/A-3' ratings to IDFC; Outlook stable

Standard & Poor's Ratings Services had assigned its 'BBB-' long-term and 'A-3' short-term counterparty credit ratings to India-based Infrastructure Development Finance Company (IDFC). The outlook on the long-term rating is stable.

"The ratings on IDFC reflect the company's strong capital and earnings profile, strong management, and adequate credit risk management," said Standard & Poor's credit analyst Geeta Chugh. "IDFC's moderate market position and higher market risk emanating from equity investments constrain the ratings."

High internal accruals, measured growth, and conservative policies characterize IDFC's strong capitalization. The company's ratio of adjusted total equity to assets of 20% is higher than the industry average. Its high earnings, with return on assets of more than 2.5% over the past five years, and a modest dividend payout ratio of about 25% support strong internal accruals. While we expect IDFC's capital ratio to decline over the next three years due to the company's growth, we believe the ratio will remain strong.

IDFC's high margins, healthy fee income, and low operating and credit costs bolster its strong earnings. The company's high net interest margins reflect the high yield on its infrastructure loans, its competitive borrowing costs, and low gearing. IFDC's fee income is high and well diversified across loans, asset management, investment banking, and institutional broking. In addition, the company's capital gains from principal investments are high, which will bring volatility in earnings. The company has lean operations and a small network. Its operating costs are therefore low and form only 20% of its revenue (net of interest expense). IDFC's credit costs have been low, and reflect its adequate credit risk management and unseasoned loan book.

"We expect IDFC's margins to come under pressure in the medium term, as the infrastructure sector matures in India, though earnings will remain high," said Ms. Chugh.

IDFC has an experienced and conservative management team. The company's management has adopted prudent policies with respect to capital, liquidity, and risk management. While IDFC has grown through acquisitions of asset management and broking businesses in the past, these acquisitions have been small in size and synergistic. We expect IDFC to maintain conservative capital ratios, prudent underwriting standards, and adequate asset quality even as it expands.

The company's credit risk is adequate and reflects its superior risk management practices, which limit the inherent high risks in infrastructure projects. While IDFC has a narrow focus on infrastructure lending, as of March 2011, it has diversified its exposure within the unrelated segments of energy (46%), transportation (29%), and telecom (16%). Moreover, over half of the firm's project loan exposure is already operational. We consider such projects as having lower risk than those under construction.

IDFC has also contained its exposure to relatively riskier segments of independent power projects linked to natural gas and domestic coal (7% as of Sept. 30, 2011) and greenfield toll roads. As of March 31, 2011, the company has only 0.2% gross nonperforming loans and 0.1% net nonperforming loans. These ratios are superior to financial sector peers' and reflect the company's superior risk management and high share of unseasoned loans. We expect IDFC's nonperforming assets to increase with seasoning, reflecting the inherent risks in infrastructure project lending. Nevertheless, they should remain within reasonable limits.

"IDFC is exposed to higher market risk because it has high equity holdings, largely in the infrastructure sector," said Ms. Chugh. While the company is limiting its exposure to direct equity and preference shares, it will continue to make investments through seed investments in venture funds.

IDFC is almost entirely dependent on wholesale markets for funding. The company has diversified its funding profile across domestic bond markets, external commercial borrowings, and rupee loans. IDFC is further diversifying its funding base by issuing retail long-term infrastructure bonds. These account for 4% of IDFC's borrowings and the company expects this share to increase moderately over the next two years.

The company's assets and liabilities are well matched, and inflows exceed outflows. IDFC manages its outflows for the next 60-90 days by drawing down credit and these funds are in the interim period redeployed to treasury to reduce negative cost of carry. IDFC's treasury assets were high at 13% of total assets as of March 31, 2011.

IDFC is one of the smaller financial institutions in India. Its key competitors include commercial banks and other infrastructure finance companies. Commercial banks have an advantage by way of lower funding costs and ability to give large-ticket loans. Nevertheless, IDFC has been able to compete well in the private sector infrastructure development because of its expertise in understanding the risks in the sector, its ability to syndicate loans, and by providing diverse services to customers.

The stable outlook reflects our expectation that IDFC's superior risk management practices will limit the inherent asset side risk that comes from lending to the infrastructure sector. We could lower the ratings if the company's asset quality and capital weaken substantially. Conversely, we could upgrade IDFC if the company's business position improves.

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