In what could cripple real estate companies? ability to raise capital, the government has closed a circuitous route which these firms have been using to attract foreign funds into their businesses. The department of industrial policy and promotion (DIPP), which anchors policymaking on foreign direct investment (FDI), has clarified that equity instruments like fully convertible debentures with in-built put options would now be treated as ECB, not FDI.
Although the DIPP circular is applicable to all sectors, this will primarily impact realty companies as ECBs are expressly barred in construction and realty business.
Billions of dollars in private equity funds and FII money have been flowing to Indian real estate companies through these instruments disguised as equity, virtually violating the spirit of the extant policy. Real estate companies are helped by Indian non-banking financial companies to strike deals with foreign debt providers.
The move comes at a time when the real estate players are already constrained by the high cost of domestic borrowings. Of course, FDI in real estate is allowed, but these are subject to riders that dissuade investors with risk capital.
Curiously, the DIPP?s move runs counter to the government?s recent policy initiatives, relaxing the ECB policy for corporate India. Last month, the government relaxed the ECB policy by hiking the limit for a company to raise ECB under the automatic route to $750 million from $500 million, subject to the $30 billion annual ceiling on the collective total of ECBs. Further, Indian companies were allowed to raise foreign debt in Chinese yuan for the first time subject to an overall ceiling of $1 billion. Companies were also allowed to use 25% of ECB to refinance their rupee loans.
Escrow instruments give the foreign investor a chance to salvage the investment and exit if the local firm fails to perform or meet certain conditions.
Here, the foreign investor, which can be a private equity player, may enjoy the right to sell its stake to the local promoter. Once the foreign investor exercises such a right (put option), the Indian promoter can arrange the funds by selling assets in the escrow account. These kinds of deals are mainly structured in real estate sector, which would be in deep trouble now, as developers are not allowed to access foreign debt most kinds of projects. Real estate firms which are allowed ECBs only in large projects have been resorting to CCD issuance and escrow account mechanism as easier funding options.
In many cases, PE players are demanding 30-40% assured returns on their investments in realty projects, failing which the PE firms would get lien over their properties. In the first six months of the year (January-June) PE investments in real estate have touched $444.77 million, 47% more than $303 million in the corresponding period in 2010, according to VCCEdge, the data division of PE and venture capital tracking firm VC Circle.
The restrictions in ECBs in real estate firms, has driven the market towards issuing compulsorily convertible debentures to foreign funds and also agreeing to buy back the securities after 2-3 years at a price which is fixed today. This is the put option that is tagged with CCDs. What?s interesting is that such CCDs (unlike the partly convertible instruments) are shown as FDI, even though the underlying structure is no different from a pure loan.
According to Rajeev Talwar, Group executive director of India?s largest real estate company DLF, this assured returns practice is happening on account of soaring home loan interests and loans coming hard for the developers. ?Small developers are left with no choice but to raise money from PE investors on their terms in such a scenario. But it would be very restrictive if the government closes this route for the realty players who are willing the take the risk of (having to offer) assured returns to the foreign investors. The sector needs funds and developers don?t get easy debt from Indian banks or financial institutions. With FDI rules also restrictive in nature, this route has been an easy way out,? he said.
Mumbai-based realty major Hiranandani?s MD Niranjan Hiranandani endorsed Talwar?s view. ?If the government closes whatsoever funding window is available for the sector, how will affordable housing take place? If the government deems this route as anti-FDI, it must ease other funding routes like relaxation in FDI, allowing easier and cheaper credit and allowing more floor price index. Otherwise small developers have no other option but to find circuitous funding routes. And developers are already selling their land bank to fund future projects.?
Current policy prohibits FDI in real estate companies but allows 100% foreign investment in projects of the real estate firms, such as construction and housing development subject to riders.
