India real estate sector Innocuous clause- serious implication ::Macquarie Research,

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India real estate sector
Innocuous clause- serious implication
Event
 The foreign investment policy update was released last week by the Indian
government. An innocuous clause in the document changes the classification
of any investment with an option from FDI (Foreign Direct Investment) to ECB
(External Commercial Borrowing). This has far-reaching implications for the
Indian real estate sector since ECBs are not allowed in real estate in India
and most foreign equity investments have built-in options.
Impact
 Clause reflecting the revised FDI policy stance: The clause in the policy
document says that “Only equity shares, fully, compulsorily and mandatorily
convertible debentures/ preference shares, with no in-built options of any
type, would qualify as eligible instruments for FDI. Equity instruments having
in-built options or supported by options sold by third parties would lose their
equity character and such instruments would have to comply with ECB
guidelines”. We present the implications of this move.
 Future flows would get impacted: ECBs are not permitted in Indian real
estate. Put options in private equity or compulsorily convertible bonds are the
norm while investing in real estate projects as they offer some protection and
an exit avenue. We think many investors would re-consider investing or
change their return expectations if these options are not offered.
 Policy has been a moving target: This move is the latest in a series of
changes which has started to frustrate foreign private equity investors. Last
week we attended a real estate industry conference. The encouraging aspect
was that a few funds have un-deployed capital. However they are finding it
tough to invest due to an “elevated risk profile”. Two private equity fund
managers mentioned that this is due to the fluid scenario of regulations and
their interpretation. They mentioned that the consistent news flow on the anticorruption
protests and “policy inaction” had led to their foreign investors
starting to re-consider their intention of deploying money in India. (See our
series of notes from 30 September to 3 October 2011).
 Typically, a private equity investor would be very active in the prevailing
stress. But the environment is making it tough for them to pull the trigger.
 Will past deals get impacted? Importantly, it is not clear whether this reclassification
will be applicable with retrospective effect. If that is the case, barring
very few exceptions, all private equity deals done in the real estate sector since
2005 would be affected. Some examples of developers who have received FDI
are DLF, Ansal, Parsvnath, Nitesh, Prestige, Ackruti and Godrej Properties. This
would also involve many unlisted developers. While we think this will get resolved
eventually, there may be near term concerns/ overhang regarding change in the
structure of deals or pressure from private equity investors to exit.
Outlook
 This latest change leads to further stress and uncertainty for the Indian real
estate sector, in our view. We would avoid players with high leverage and
weak cash flow yields