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GENERAL INDUSTRY BACKGROUND AND TRENDS

Despite the turmoil that followed the global financial crisis, the Indian economy has remained and continues to remain buoyant and attractive to both foreign and domestic investors due to the robust domestic driven demand rather than an over dependence on international demand. In the same backdrop, real estate as an asset class in the Indian context has been a consistent outperformer riding on domestic demand and the Indian perception that 'real estate' will never disappoint.

As an industry, the sector has grown and transformed more than it ever has in the past decade, especially after the opening up of the sector to FDI in 2005. Clearly, a wider participation of institutional private equity (PE) beyond the traditional lenders has played a critical role in this metamorphosis, bringing about transparency and technology. PE investments in Indian real estate have penetrated deep into the industry, with both domestic and foreign funds fuelling the rapid growth of real estate construction in Indian cities. The opening up of the real estate (RE) sector for Foreign Direct Investment (FDI) in 2005 resulted in the transformation of the investment sentiment in the country.

As indicated in the recent study by Grant Thornton, close to 86% of the total PE investments in RE during 2005-2010 took place in the period 2006-2008.¹

Per a recent Jones Lang LaSalle report, "In most cases the objective was to achieve diversification through a portfolio of projects with a particular developer and eventually exit through the IPO route in 3-5 years. Real estate investment trusts (REITs) were widely expected to be the exit options for most investments in the IT and commercial office sector and were expected to be prevalent over the next 2-3 years. Large 100 acre plus townships also received a fair amount of interest from PE investors as developers were keen to de-risk and seek capital on the larger projects. Residential sector though generated huge interest from investors, but due to buoyancy in sales, developers rarely required external capital to execute prime projects."² With most of the PE funds structured with a fund life of 5-7 years, and most investments being made in 2007 - 08, current times mark the monetization phase of most of these funds.

Today, the focus of most fund managers seems to have shifted towards demonstrating exits from their investments. In our experience, attempts by some of the established players to raise global capital for real estate haven't evinced much interest. On the flipside, things have panned better on the domestic side and several of these funds have been more successful in raising domestic HNI money through wealth management and private banking channels. With interest rates peaking towards the second half of 2011, some of these funds also raised debt funds for real estate promising high yields to investors. Between 2005 and 2010, as per the JLL Report, 27% of the total private equity investment was in the real estate sector. ³

From the perspective of choice on instruments, the flavor of investments changed from preferred equity to structured debt, and several funds today are keen to act pure play lenders. There is also keen interest to look at real estate focused NBFCs and few players like Xander, Red Fort and others have set up their NBFCs, while a few of the other larger players are gearing up to set up the NBFCs. The listed NCD route that allows foreign institutional investors to purchase listed debt securities issued by a private real estate company has become increasingly popular.

From an exit perspective, unlike some of the developed markets where REITs play an important role in the exit strategy, exits in the Indian context are modeled in a combination of the following ways:

1. Self-liquidation: Typical for residential projects where the cash flows from the project are up-streamed to the shareholders.
2. Puts and buy-back: Investor may require their shares to be purchased by the Indian investee company or the founders.
3. IPO: Fairly rare as most investments are in project specific SPVs with self-liquidating assets. Real estate companies are not particularly in favour of IPO as an exit for several reasons such as stock price may not correctly reflect the value of the real estate asset held by the company, most real estate companies are closely held and are not keen at being regulated or having stakeholders they are not comfortable with.
4. Sale of GP interest: Not very common, but helps the GP to monetize their interests in the fund management business. For instance, IL&FS Investment Managers Ltd (IIML) acquiring Saffron Asset Advisors Pvt Ltd in 2010 and Blackstone buying out Merrill Lynch's Asia investment platform with assets of over USD 2 bn.⁴

Some of the challenges that we are witnessing from an exit perspective are as follows:

1. Partner issues: Uncooperative partners has been the largest issue for PE players. Promoter - investor expectation mismatch are now increasingly seen. Enforceability of tag along rights, drag along rights, put options or even 3rd party exits clearly hinge on the cooperation of the local partner. Besides, with exit price capped at the DCF valuation, cooperation of the investee company typically controlled by the Indian promoters is crucial as projections for DCF can only be provided by the investee company.
2. PN 2 ambiguities: Issues such as the transfer of shares from one non-resident to another non-resident with a fresh lock in of 3 years becoming applicable to the transferee non-resident, tranche by tranche lock in and the permissibility of exit where 50% of the project is not completed within 5 years of obtaining all statutory approvals (with ambiguity on what constitutes 'all statutory approvals') have made investors apprehensive.
3. Unenforceability of put/call options: Typically, exits are affected either by way of taking the company public by way of an IPO, or liquidating the company, or by a put on the promoters or the Company. Liquidation is not even considered as an exit option in the Indian context due to the time it takes. IPO is again fairly rare in the real estate sector as most investments are made in project specific single asset companies with the asset being self-liquidating in most cases. The only viable option that is left is either a put option on the promoters or a buy-back by the Company. With the RBI regarding 'puts' to be in the nature of ECB, and worse still regarding any put option as an over-the-counter derivative contract which can be traded in only by an FII, this crucial exit avenue available to offshore private equity funds is also blocked. The aggressiveness with which such unwritten policy has been used against private equity in the recent past has severely disappointed investors, who are concerned if it is even legitimate to expect return of (if not on) their invested capital in the country.
4. GAAR: Investors need to grapple with the new general anti-avoidance rules (GAAR). GAAR gives revenue the ability to re-characterize the nature of the income, essentially regarding substance over form. Enough has been written about GAAR, but what is important are the few recent decisions of the AAR that depict similar tendencies already pending GAAR, even though AAR rulings are binding only on the revenue and applicant. For instance, in Z Mauritius AAR re-characterized sale of CCDs to the promoters as interest; in XYZ India AAR held that scheme of buy-back was 'colourable device' to distribute dividends and avoid dividend distribution tax. These rulings have only accentuated investor apprehension. The Shome Committee, constituted to review the GAAR provisions, has recommended substantial dilution of the provisions and also deferral of the implementation of GAAR, which has assuaged investor sentiment in a large way - but to some extent, the damage has already been done.
5. Indirect transfers: Post budget 2012, the Indian revenue authorities have the power to tax capital gains arising from an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India. Consequently, sale of offshore entities having Indian assets has also become challenging.
6. Withholding: With the spectre of indirect transfers and GAAR looming large, foreign investors are concerned with the extent of withholding that they need to make when buying the shares of Indian companies from a non-resident. The buyer is apprehensive if he should withhold capital gains tax at the rate of 10% or 20% (as there is a debate that the reduced rate of capital gains tax for non-residents is applicable only when the shares are that of a public company), and importantly whether he should actually withhold or just take a tax indemnity, or tax insurance, or put the withholding amount in escrow, or go for an AAR ruling or procure a NIL withholding certificate from the tax authorities. Clearly, each alternative has its own set of challenges from a buyer and seller perspective, but at the end of it, such uncertainties definitely play down the marketability of Indian assets.
7. Litigation: Indian courts have been known for their lackadaisical approach to dispute resolution. Hitherto, even international arbitration was not free from the involvement of the Indian courts, which was a concern for offshore investors. Now, with the decision of the Supreme Court in the Balco case, the jury is out that parties in an international arbitration can agree to exclude the jurisdiction of the Indian courts. However, enforcement of such arbitral awards in India continues to remain a challenge.