decoding private equity real estate exits in india equity real estate exits in india ... decoding...

Decoding Pr ivate Equi ty Real Estate Exi ts in India

JONES LANG LASALLE INDIA CAPITAL MARKETS REPORT

India Real Estate Market- Growth Poised

Private Equity Real EstateInvestments in India

Exits in Private Equity Real Estate in India

� Private Equity Real Estate Exits in India

ForewordReal estate industry in India, over the last decade has grown and transformed more than it ever has.

Among other factors, a wider participation of institutional private equity (PE) investors in the capital

intensive business beyond the traditional lenders has played a critical role in this change. 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 transformation of the investment sentiment in the

country. Multiple investment transactions by both domestic and foreign funds happened in the 2005-2008

period. With most of the PE funds structured with a fund life of 5-7 years, coinciding with a typical project

lifecycle, the industry is in a phase that needs monetization of the investments.

The first round of fund raising post 2005, took place on the basis of the macro economic growth story of

India in a world operating differently before the global financial crisis. Many of the blue-chip global real

estate investors then have shut offices now and many smaller, homegrown investors have become key

investors in this market. The ability to successfully recover invested capital and returns will differentiate

the fund managers in the next round of fund raising and also bring the spotlight on ‘investment grade’

developers. It is an opportune moment to reflect on the experience of various stakeholders in the real estate

private equity industry to try and identify the track record so far and possibly the direction this sector is

headed in.

The theme of the whitepaper which is titled - “Reaping the Returns - Decoding Private Equity Real

Estate Exits in India” aims to gain and share a perspective on a PE fund’s exit proposition. With an aim

to understand the PE involvement in the Indian realty space, this thought piece touches upon the Who,

Where, When, Why and How of the investment and exit strategies of the PE funds as empirically observed

over the last 6 years. As advisors to domestic, foreign and listed private equity funds, LPs, lenders and

developers, and having successfully completed multiple private equity exits, we have tried to incorporate

experiences and learning of the various stakeholders in the industry in this report.

Sincerely,

Shobhit Agarwal

Managing Director - Capital Markets

Jones Lang LaSalle - India

Private Equity Real Estate Exits in India �

Content

Looking Forward

Major Channels of Financing Real Estate Development in India

India Real Estate Market- Growth Poised

Private Equity Real EstateInvestments in India

Exits in Private Equity RealEstate in India

� Private Equity Real Estate Exits in India

Investment Grade Real Estate Under Construction (2Q11)

COMMERCIAL 40.3 USD billionOffice �0.1 USD billionRetail 10.� USD billion

RESIDENTIAL 119.8 USD billion

TOTAL 160.1 USD billion

Residential 75%

Commercial �5%

Office 75%

Retail �5%

India Real Estate Market - Growth PoisedIndia Real Estate Market - Growth Poised

India is perceived as one of the attractive investment destinations globally on the back of multitude of factors such as - strong economic growth, rapid urbanisation, growing middle class population, demographic advantage and increased thrust on infrastructure. The India growth story would not have been possible without the policy and strategic level support from the central and the state governments. The much required impetus to the real estate sector was provided by the

Government of India when the market was thrown open to foreign investment

under Press Note 2 notification in 2005 meant to promote greenfield

development. The combination of inherent population led

residential demand, outsourcing led office and hospitality sector growth and rising income levels led retail consumption demand came together with availability of additional capital for greenfield projects in the sector resulted in the large scale development in the last few years.

As per JLL-REIS estimates, the market value of investment grade real estate in

India under construction has increased from

Figure 1: Value of Indian Real Estate Under Construction

Source: Real Estate Intelligence Service (Jones Lang LaSalle), 2Q11

1The analysis provides estimates for the total value of real estate under construction in the top seven cities of India - Mumbai, NCR, Bangalore, Chennai, Pune, Hyderabad and Kolkata.�Per International Monetary Fund, India’s nominal GDP in 2010 was USD 1,631.97 billion.

USD 69.4 billion at end-2006 to USD 160.1 billion at end-2Q111, which equates to 9.8% of India’s nominal GDP in 2010� (Figure 1). This implies a CAGR of 20.3% between 2006 and 2Q11.

Despite the turmoil that followed the global financial crisis, the Indian economy has remained buoyant and attractive to both foreign and domestic investors due to the robust domestic driven demand rather than over dependence on international demand. This will continue to be the case in the short to medium term ensuring interest by global participants to look beyond their low or negative growth economies for generating returns.

Private Equity Real Estate Exits in India 5



Traditionally real estate was financed in an unstructured manner through a set of high net-worth individuals (HNIs) that each developer closely worked with to fund acquisition or construction of a project. These could either be in the form of debt or equity. Over the past decade, new channels of sophisticated real estate financing from institutional sources have emerged in India

that co-exist with the unstructured ones, only reducing the over dependence on a particular means of financing (Figure 2). Availability of capital through a spectrum of instruments gives the ability to borrowers to calibrate their capital structure based on market conditions and their risk averseness. It also suggests an increasing maturity and depth in the financial markets of the country.

6 Private Equity Real Estate Exits in India

Figure 3: Cost of Finance by Various Finance Options

Source: Jones Lang LaSalle, Capital Markets

Figure 2: Major Channels of Financing Real Estate Development in India

Source: Real Estate Intelligence Service (Jones Lang LaSalle)

Offshore Listing Offshore Listing Offshore Listing REIT/REMF/ AIF Offshore Listing QIP QIP QIP IPO IPO IPO IPO

Offshore Listing PE Funds PE Funds PE Funds PE FundsIPO ECB ECB ECBs ECB

NBFC Lending NBFC Lending NBFC Lending NBFC Lending NBFC LendingBank Lending Bank Lending Bank Lending Bank Lending Bank Lending

Private Lending Private Lending Private Lending Private Lending Private LendingPre-2005 2005-2007 2008-2009 2010-2011 2012F-2013F

INCREASING TRANSPARENCY Levels of Activity High Average Low / None

�5%

�0%

�5%

�0%

15%

10%

Pre �005 2005-07 2008-09 2010-11 2012-13F

Construction Debt Acquisition Debt Mezzanine Finance Equity

Means & Cost of Financing

Traditionally debt was available from nationalised banking channels for acquisition of land. With RBI restricting use of bank debt for land acquisition, equity and mezzanine capital became the favoured options for such use (Figure 3). Prior to the global financial crisis in the liquidity surplus era, equity capital was so freely available that it was priced closer to debt return levels. In the last year, the pre-recession perpetual optimism has turned to irrational fear for the capital providers resulting in debt being priced at equity levels. Unfortunately for the developer community, the slowdown in sales has only increased their dependence on external capital for acquisition of new projects and repayment of pre-existing debt liabilities. This demand for capital, combined with a sharp spike in interest rates compressed the spread between debt and equity, increasing the prevalence of high cost mezzanine debt and equity structures. Non-Banking Finance Companies (NBFC) are primary sources of such capital and have been instrumental in providing capital to developers for exiting


Source: Grant Thornton

Private Equity Real Estate Investments in IndiaPrivate Equity Real Estate Investments in India

Regulatory ImpactThe real estate sector has always been watched closely by policy makers and regulators as an indicator of sentiment, liquidity and speculation in the economy. Reserve Bank of India (RBI) has consistently discouraged banks to lend to the sector by assigning higher provisioning weightages to real estate loans and banning lending for land acquisition. To an extent some of the

cautious measures taken by the banking regulator kept the Indian banking sector insulated from the global financial crisis. The focus of the regulators is clearly to encourage financial institutions to provide capital for development of real estate and not to fuel trading and speculation. Introduction of Press Note 2 (PN2) defining FDI regulations for real estate investments

was also in line with the philosophy of the regulators. In essence, directing the FDI participants to take equity participation in large projects, invest in development of new projects and lock-in capital for 3 years rather than trade on quick profits. Since then, the real estate and infrastructure sector has attracted close to 27% of all private equity investments in the country (Figure 4)

The private equity funding gained notable momentum during the crisis of 2008-09 on the back of stringent lending norms set by the Indian financial institutions and banks. The entry of private equity participants in to the market has also brought in a much disciplined approach towards construction and delivery of the projects along with better transparency in to the market.

Figure 4: Sector-Wise Private Equity Investments in India - By Value (2005-2010)

Others 19%Automotive 2%

Textile & Apparels 3%

Media, Entertainment & Publishing 4%

Pharma, Healthcare & Biotech 4%

IT & ITES 7% Power and Energy 8%

Banking and Financial Services 12%

Real Estate & Infrastructure Management 27%

Telecom 14%


Investment Trend 2005-2008 In the first three years of the sector opening to foreign investments a large number of global financial giants allocated money from their books to be invested in the Indian real estate sector followed by multiple rounds of fund raising for their third party capital fund management business. Flush with funds, and looking for an early start fund managers invested aggressively in projects across asset classes and cities. In the early days, there were few FDI compliant projects that did not find foreign capital for investments. Domestic financial institutions like Kotak, HDFC, ICICI & IL&FS also raised and invested capital from domestic and/or international sources; the domestic capital having the added benefits of not being restricted by conditions under PN2. Seemingly endless capital availability pre-2008 was well capitalized by fund management business through investment-fund raising-investment cycles. 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 (Figure 5).

While a substantial number of transactions with developers were project specific, appetite for larger ticket size investments was provided by global financial institutions that targeted holding companies of

developers involved in multiple large FDI compliant projects. The likes of Morgan Stanley, Goldman Sachs, Citigroup, Wachovia etc. invested capital in unlisted developer entities. 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.

Promoter ‘cash-outs’ were fairly common in this period as the developer sold part of their project equity at market value to PE players. Post cash-out, projects were then dependent on funding through pre-sales, external debt or additional capital infusion by equity holders. While many investments were through pure equity route, structured

products containing downside protection with an upside share, structured waterfall (sequence & terms governing capital take out by developer and investor) and preferred return structure to investors were not uncommon.

This was also the period that saw substantial investment interest from investors out of some smaller European nations, Canada, South Korea, Israel and Middle East. Most of these funds were unable to conclude a significant amount of investment in the country due to lack of dedicated India focused investment managers who understood the dynamics and regulations in the Indian markets. These investors soon disappeared in the post 2008 era.

In 2008, Press Note 3 (PN3) was introduced permitting 100% FDI under automatic route in operating Industrial Parks, thereby providing a window for investment in completed IT Parks that were PN3 compliant. This was a much needed regulation in the absence of REITs and with no visibility on their introduction. Given these were early years for PE investments, very limited PE exits took place in this period. At best, a few residential projects with highly successful launches may have seen some capital flow back to the investors.

Source: Grant Thornton, Real Estate Intelligence Service (Jones Lang LaSalle)

Figure 5: Private Equity Investments in Indian Real Estate - By Value (2005-2011)

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0.88

0.94

0.85

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Investment Trend 2009-2011 In 2008-09 as a result of the market correction due to the global financial crisis, the project underwriting assumptions made by developers, fund managers, analysts, advisors and other participants suddenly looked unrealistic. Project timelines, sales assumptions, debt availability, and more visibly sentiment just seemed wrong. Some of the largest investors shut shop overnight and the others had an investment freeze from their management committees till at least their survival was secure. Many funds defaulted on their capital calls from the developers, and considered themselves lucky to have only signed term sheets for some of the largest deals the market had seen. Though, investments wherein the assumptions had been conservative got away with just project delays and some minor price corrections.

This was also the period in which there was unexpected pressure on funds to evaluate exiting their investments for various reasons such as restoring confidence in their LPs, liquidity pressures from parent company, recovering scrap value from investments gone bad or just demonstrating exit track record for a potential fund raising exercise. Discussions of GP platform sale of many failed investment banks were prevalent in the market. In words of a leading transaction structuring advisor who confesses, “….very quickly many realized that downside protection or put options have limited meaning if the project is a failure. Rarely would a developer dig into his own pockets to ensure such commitments are met”.

The year 2009 also saw some of the PE funds with local decision making and/or Indian parentage step forward to take advantage of the liquidity crunch in the market and spot opportunities. These funds were able to capitalize on the distress in the market by offering capital to the cash-starved developers to acquire prime projects at discounted values. Despite keen interest ability to invest in such projects, many FDI

funds couldn’t compete with speed of local decision making by some of the domestic funds. Most of the transaction volumes in 2009-10 were generated by such PE funds.

Given that the residential demand is local with almost no impact of global factors, residential sector saw a quick recovery in 2009-2010 while other asset classes lagged. Also being an asset class where liquidation of investment happens through sale of units to retail buyers, with no dependence on other institutional buyers to provide an exit, most fund managers realigned their investment focus towards residential. Many brownfield projects with shell structures in place and substantial sales of units completed were stuck as the developers had used all the capital available with them for debt repayments or faced many cancellations by apartment buyers. Some such developers did not have enough capital to continue construction to call for subsequent construction linked installments from buyers. Many such projects received capital for last mile funding of the project from PE investors. Such projects offered a low risk and quick exit opportunity to investors.

Post-recession, as the dust settled, in 2010-2011, funds were already in the 5th to 6th year of fund life that were launched

soon after opening of the sector for PE investments. As a result, the focus of most fund managers shifted towards demonstrating exits from their investments. Plenty of activity was seen on the exit front from PE funds, an aspect we have covered in much detail in later sections of this report. Global rounds of fund raising were prevalent but not hugely successful. Funds like Indiareit, Kotak, Milestone and ASK were more successful in raising domestic HNI money through wealth management and private banking channels. With interest rates peaking out towards second half of 2011, some of these funds also raised debt funds for real estate promising high yields to investors.

While PN2 has not changed significantly over the years, there were certain ambiguities in the interpretation of the conditions attached to FDI. Some of these conditions have been clarified. Extending the 3 years lock-in requirement to the entire investment rather than the minimum capitalization amount or introducing minimum alternate tax on SEZs do not give confidence to investors who have invested based on evaluation of certain policies. A lot of clarity is required in order to provide a more stable regulatory and less onerous platform for boosting FDI investments in the segment.


Figure 8: India Private Equity Real Estate Milestones

Source: Real Estate Intelligence Service (Jones Lang LaSalle)

2011

2010

2009

2008

2007

2006

2005

1999

1998

Road Ahead

SEBI approves draft regulations for REMF which would be governed by the provisions and guidelines under

SEBI (Mutual Funds) Regulations.

London AIM listing popular for RE Developers

Around 18 real estate and construction companies went

public by 2007

FDI policy amended to prohibit use of redeemable instruments

First major proposal on regulatory frameworks for Housing and Real Estate, Company Law,

Banking, Foreign Direct Investment.

RBI introduces FEMA, 1999 - Real Estate business prohibited for foreign investments

Press note 2 released - Construction / development opened up for FDI, although subject to investment and

project related conditions. Conditions were not applicable to Industrial Parks, Special Economic Zones and Hotels.

Scarce availability of capital for real

estate

Discussion ongoing for a RE bill to be introduced

FDI policy amended to extend lock-in requirements to entire invested capital

Press note � on FDI in Industrial Parks released

REMF draft guidelines issued

Industry awaits the implementation of REIT regime in the near future

Proposed Alternate Investment Funds Regulation by SEBI to come in to act

Draft proposal on SEBI (Real Estate Investment

Trusts) Regulations, 2008

Global financial crisis impacts growth of real estate sector in India

RBI valuation norms for foreign investors modified to minimum Discounted Cash Flow

(DCF) value (from earlier Net Asset Value) for investments and maximum DCF on exits


Exits in Private Equity Real Estate in IndiaExits in Private Equity Real Estate in India

While some fund managers prefer partnering with developers with whom they have had previous relationship, others have specified criteria of developer track record and execution capabilities while evaluating a potential deal.

Private equity investments in real estate have reached the Exit Phase. Most Fund Managers today have either hit the Exit Phase already or are readying themselves for exits. Our discussions with leading tax and legal advisors also have re-confirmed that “Exits” and not “Investments” seem to be the principal area of activity for most industry participants currently.

Out of private equity investments of circa USD 13 bn that were made in Indian RE, our analysis reveals that about USD 3.2 bn of exits have been recorded so far out of over 80 transactions. Our data sample covering about USD 3.2 bn of exits includes a variety of asset classes, geographies and fund types. The data pertains to partial or completed exits and does not include unrealised gains. In cases of partial exits, the capital pro-rata to the stake divested has been considered for the purpose of returns analysis. The data has been collected through primary research via surveys and discussions with funds as well as through secondary sources and media reports.

Over the next few sections, using our data as the base, we will delve deeper into what is driving exits, what exit strategies are available to fund managers and analyse data for completed exits to identify the key trends in the exit patterns.

Drivers for Exit

Private Equity Investing is all about Getting Out - Anonymous

Private Equity in Real estate sector is no exception to the above quote. Successful private equity investments require planning for an exit at the deal stage itself. The principal mandate of any General Partner (GP) of a PE fund is to generate returns through successful monetization of the investee companies and to distribute cashflows back to the Limited Partners (LPs). This becomes even more important in light of the restrictions for foreign investments in India as well as the lack of depth in a secondary market for transactions. The credit crisis of 2008-09 created an added pressure on fund managers to demonstrate returns through cashflows rather than through Net Asset Value (NAV) updations.

1� Private Equity Real Estate Exits in India

Completion of Project Lifecycle Natural exits through the completion of the project lifecycle have been demonstrated in residential projects, which by their very nature are self-liquidating. Our analysis reveals that over 21% of the exits recorded so far classify under this category.

•

Market-driven Opportunistic Exits Opportunistic exits are driven by buoyant market conditions or attractive unsolicited bids which compel the fund to exit well before the planned exit from the investment. A majority of the third party exits were driven by such positive market factors. Key transactions in this category include Trinity’s sale of stake to SachsenFonds, sale of interest in a Delhi residential project by Redfort Capital to JP Morgan, etc. Market factors have also been reflected in “sell-downs” by mezzanine providers such as Deutsche Bank.

•

Distressed Sales Post the financial crisis of 2008-09, several non-India dedicated funds with global pools of capital were under pressure from their LPs to liquidate their investments and distribute returns. Largely US based private equity funds, investment banks and hedge funds led this phenomenon in India. With the markets being more stable and with more maturity now in the private equity exits segment, we expect this factor to be less prevalent going forward.

•

Fund Raising Activities Priming for exits to demonstrate a track record prior to moving into the next round of fund raising is one of the key drivers for fund managers. LPs, both institutional and retail, look for a fund manager who has a demonstrated track record of success. Funds like Redfort Capital, HDFC, Kotak etc aggressively moved into Exit mode prior to hitting the market with their next round of fund raising. With over 15 funds currently either in fund raising mode or preparing for it, we expect exits to dominate the fund management business in 2012.

•

Completion of Fund Life Most real estate private equity funds in India have been set up with a 5 to 7 year investment horizon. Funds would typically initiate their exit phase between 4 to 5 years from the date of investment, in order to be able to wind up the fund well within the fund life without any distress sale pressures. Having illiquid investments at the end of the fund life and having to resort to “in specie” distributions to LPs tantamount to professional harakiri for the fund manager! Since the majority of investments in India were in the 2007-08 phase, the period of 2012-13 is the opportune time to push forward divestments.

•

The Indian market has so far seen all of the above drivers in play, but the dominant driver for exits in the near term will be clearly the end of the fund life.

There Can be Various Drivers for Exits by a Private Equity Fund:

Private Equity Real Estate Exits in India 1�

Project Cashflows: A project or investee company could generate sufficient cashflows, which are then used to return the capital and requisite returns to the private equity fund. Again, residential projects or commercial projects with strata-title sale lend themselves well to this exit strategy. With a 21% representation, only a small proportion of exits have taken place through this route.

•

Promoter Buybacks: Promoter Buybacks have been the dominant trend in the exits viewed till now. Over 54% of all exits till date have been through this route. Indian promoters are typically keen to provide an exit to private equity funds for a variety of reasons: a. Under contractual obligations of put/call options b. Mismatch of investment horizons between the fund and the promoter c. Difference in expectations of the valuation of the project, where the promoter expects a more optimistic market going forward d. Lack of a large secondary market for trading investment position to other PE funds

Promoter buybacks typically get structured either as company buybacks through the Investee Company or as purchase of shares through a group company of the Promoter / developer. In most cases, a combination of both these methods is used given the Indian Companies Act restrictions on company buybacks being restricted to only 25% of the networth of the company.

•

Public Market Sale/ IPOs: Sale through IPOs or through trading of listed stock has not been a very significant trend in the Indian context and has been just 5% of the total exits. This is a function of the performance of the stock markets in the last 2 years, where real estate IPOs as well as stock has lost favour with the many development companies trading substantially below their listing price. While 2009-10 saw multiple DRHPs filed by large developers like Lodha Developers, Oberoi Realty etc, few companies managed to successfully list. Many investors like Deutsche Bank, HDFC Property Fund etc who were banking on public listings for their exits had to opt for promoter buybacks instead. Once the REIT regime in India is in place, this trend should become stronger.

•

Third Party Exits: Trade sales or third part exits are also a small component of the exits at 19% of the total exits. Third party exits have been visible largely in land or in office projects. This market has had little or no depth so far due to the lack of REITs, PN2 restrictions on purchasing completed assets as well as the lack of core funds in the market. The buyer profile for these opportunities have been either opportunistic funds like Tata Realty and Blackstone who indulged in “core-style” investing or funds who were more risk-averse and chose to enter into projects which were approved and under development and already diligence by another fund.

•

Sale of GP Interest: This refers to the sale of the Fund Management or Investment Advisory Company to another fund manager or strategic buyer. While technically sale of GP Interest does not provide exits to the LPs, it certainly has become popular with fund managers wishing to monetize their interests in the fund management business. Kicking off this trend in India was IL&FS Investment Managers Ltd (IIML) acquiring Saffron Asset Advisors Pvt Ltd in 2010. The transaction gave IIML, a listed entity, access to additional Assets under Management (AUMs) of Euro 220 mn (committed Euro 160 mn) of Yatra Capital and USD 103 mn (committed of USD 24.7 mn) of Saffron India Real Estate Fund - I. Following close on the heels was Blackstone buying out Merrill Lynch’s Asia investment platform with assets of over USD 2 bn. The acquirer typically looks for increased AMC fees and a larger AUM as well as immediate access to the uncommitted funds of the target. With valuations of typically 3-5% of the AUM, only a small amount of capital is required for this play. We expect this trend to become much stronger as funds near the end of their fund lives.

•

Trend Watch: The role of NBFCs - While NBFCs have been serious competitors to private equity funds as a source of funding especially in 2010-11, NBFCs have played a key role in supporting promoters of Indian real estate companies provide exits to their private equity partners. When project cashflows are not sufficient for financing promoter buybacks, promoters resort to raising debt from NBFCs either through the Investee Company itself of through one of the group companies. One of the first transactions showcasing this was India Infoline financing Wadhwa Group for buying out a US based bank in their Oshiwara residential project in 2009. NBFC funding rates were as low as 15-16% p.a until the end of 2010 and have shot to 19-22% p.a in 2011. However, with flexibility in usage of funds and with over 20 active NBFCs, they are the principal means of finance for buybacks

Mode of Exits

The exit strategies for private equity funds could take a variety of forms. While in more developed markets, where “core” and “core plus” style investing is more prevalent, exit routes are largely through third party exits of income generating assets or by sale to REITs. In India, as with the case of other emerging markets, given that the majority of the investments are in greenfield transactions, a wider array of exit options has emerged.

1� Private Equity Real Estate Exits in India

“The general regulatory / tax environment is getting harder for exits to take place smoothly. For e.g. change in regulation on the 3 year lock-in period to the entire capitalization (rather than just the minimum capitalization) is one of the biggest dampener to PE exits from the sector.” - Mr. Abhishek Goenka, BMR Advisors

“A key regulatory challenge is the 3 year lock-in period which restricts buy back within 3 years of investment. The intention behind lock-in is to ensure capital is available for development and not trading. So, if the project has generated cash flows through its natural life cycle, such cash flows should be permitted to be used to repatriate, whether it is within the 3 year period or otherwise. RBI should restrict only outside capital being used to repay the investor.” - Mr. Sriniwasan, Kotak Realty Fund

Exits - Challenges

Exits for private equity companies in India have not been an easy task so far. The fluid regulatory framework in India amidst its complexity acts as a key impediment at both the investment as well as the exit stage. The inconsistency in the policy along with the varied interpretation of the policy by different government agencies creates bottlenecks for the PE funds to execute their

exit strategies. The domestic PE players are marginally on a comfortable ground as opposed to the foreign PE players, particularly from an exit perspective. However, most of the other challenges are common to both domestic and foreign funds. A list of key challenges and its impact on the PE exits in real estate are presented in the below table (Figure 7).


Challenges Key Concerns Impact

FDI Conditions

• Lock-in period of 3 years for the entire investment amount rather than just minimum capitalisation

• Permissibility of Non-resident to Non-resident transfer of shares during lock-in period

• Permissibility of exit where 50% of the project is not completed within 5 years of obtaining all statutory approvals

• Impacts natural distributions through buy backs from project cash flows

• Exit only with FIPB approval where the project is shelved due to approvals not being secured or in case of partners dispute

• Uncertain holding period

Put/Call Options

• Enforceability of put/call options from a securities law perspective and fluidity on the policies around their permissibility

• Impacts mezzanine transactions as well as situations where put/call options are used as a consequence of default for non-performance by the developer

Lesser Exit Mechanisms for Completed Assets

• Narrow definition of Industrial Parks (requirements such as minimum 10 tenants, no single tenant to occupy more than 50% of the built-up area, narrow definition of industrial activity, etc.)

• Identifying a FDI compliant Industrial Park owing to ambiguous definitions and differing state policies

• Lack of REITs or REMF guidelines

• Exit for commercial assets, other than SEZs and Industrial Parks only through domestic sale

• Need for more depth in the domestic market through retail participation for completed assets

Partner Issues

• Ability to enforce drag-along rights

• Seeking partner cooperation for 3rd party exits without any corresponding equity infusion or cash-out for promoter

• Difficulty in re-negotiating service contracts, such as project management agreements given to the developer or his associates, on behalf of the incoming investor

• Makes exits of minority positions more challenging in both developed as well as under-construction projects

Currency Risk

• Currency Risk is one of the most significant issues currently with the Indian rupee seeing significant depreciation. Substantial investments in private equity came in 2008-09 when the Rupee/USD rate was in the range of INR 39-47�, while the rupee reached its lifetime low of INR 54.32 in Dec 2011

• Volatility in the currency makes underwriting difficult for investments and also reduces dollar returns from exits

Taxation • Ambiguities in the tax code on creating tax efficient structures through favourable tax jurisdictions such as Mauritius.

• New proposed provisions under the Direct Taxes Code such as controlled foreign corporations (“CFC”), place of effective management (“POEM”), general anti avoidance rule (“GAAR”) may make doing business in India for non-resident more expensive from a tax perspective

• Increased apprehensiveness of tax related risks on transactions.

• Purchasers seeking Nil Withholding Tax certificates from the Income Tax departments (which is not forthcoming) and / or requisite tax indemnities

• Greater focus on building substance in the tax jurisdiction used and perhaps, Singapore could emerge as an alternate chosen destination

Figure 7: Key Challenges and its Impact on PE Exits in Real Estate

�1 USD = INR 39.22 as of Jan 2008; 1 USD = INR 46.59 as of Dec 2009


India has Witnessed USD 3.2 bn� of Investor Exits Over 80 Deals from the RE Sector in the Last 4 Years

In comparison to the global scenario, where the distributions by real estate private equity funds of 2006-07 vintage have been approx. �.5%5 of the capital called, Indian RE investors have returned close to 24% of the capital invested. This indicates that Indian RE performance has been, to some extent, less affected by global events than other countries. Contrary to the industry perception that most PE investments in Indian realty market reaped lower returns than that envisaged during entry, our study unearthed that PE in real estate industry, like any other industry, had examples of both good and bad exits from a return point of view.

While a good number of PE exits were executed upon completion of their natural investment cycle, the market witnessed fewer forced exits resulting in lower returns as compared to that of a fund manager’s expectation. In the subsequent section, we have analyzed the general trends of the exits observed and attempted to draw out future trends that we believe may be witnessed based on our empirical experience.

Exit by Source of Funds

Larger Exit Values by Offshore Funds Largely Due to Higher Ticket Size The level of exit activity between domestic and offshore investors / PE Funds has been almost equal in terms of the number of deals. However, in terms of value, 74% of the total exits were attributed to foreign funds (Figure 8). This divergence is primarily because of the larger deal sizes in case of offshore investors. The average ticket size of offshore investor exit has been 3 times the deal size of the domestic investors.

Almost 86% of the total exits have been executed in the last couple of years indicating higher traction on the exit front rather than fresh investment activity in 2010 and 2011. We expect this trend to continue with more and more funds nearing end of their fund life. However, investment activity is also expected to pick up in parallel as fresh capital already raised / being raised by various PE Funds will soon be deployed. Sourcing offshore capital will continue to be more challenging on account of US and European crisis.

�1 USD = INR 465Preqin data base


Mode of ExitsHeavy Dependence on Put Options / Promoter Buy Backs for Exit With nearly 69% representation of the total exits (in terms of value), promoter buy backs dominates the PE exit landscape as the most prevalent exit route for investors (Figure 9) even in terms of number of transactions. Promoter buy backs include mezzanine and debt structured transactions which are settled through repayment of capital and returns by the promoters. For equity structures, this mode of exit reflects lack of sufficient price discovery mechanisms in the exit process or possibly lack of secondary investors. Also, having experienced the practical and legal challenges in executing put options, going forward, PE Funds are preferring and negotiating varied forms of exit modes and this should indicate more exit activity in the form third party exits in future. However, this will need to be supported by appropriate regulatory reforms which expand the base of new potential buyers of completed assets such as REITs, etc.

Delving deeper, promoter buy backs are more prevalent in the commercial segment (Office, IT and SEZ) as over 33% of all Promoter Buy Backs are for this asset class. If we exclude large ticket transactions which have seen exits through promoter buy backs, commercial assets are close to 45% of the total Promoter Buy Backs. Also, nearly 62% of all commercial exits take place through the promoter buyback route. This is reflective of the restrictive FDI policy for exits from completed assets where Promoter Buy Backs is the most convenient mode for exiting given the current regulatory framework. However, going forward, with the likely penetration of REITs / REMFs / Alternative Investment Funds (AIFs) as well as with the entry of new category of investors including domestic yield funds, pension funds and insurance companies, PE investors would be provided with more avenues to exit over the longer term. Promoter buy backs have also been more prevalent in asset classes like mixed use portfolios and townships where the investment horizon of the Investor is significantly shorter than the Project lifecycle.

Third party exits and project cash flows emerge as the other prominent exit options in Indian realty space. While project cash flows offer a simpler mode of exit through self liquidation of residential projects over the project life, third party exits are prevalent in some PN3 compliant income yields assets or land. These two exit options together constitute nearly 40% of the total exits in terms of volume (Figure 9). Going forward, as we see significant exits from residential projects, which were invested in the last few years, project cash flows as an exit mode should see a significant increase vis-a-vis Promoter Buy Backs

Our analysis also shows that more than 90% of all exits (in terms of value and volume) have been facilitated onshore (either out of the project cash flows, or by the promoter himself or through third parties based in India). One of the largest drawbacks of the RE sector regulatory policy is that it is not conducive to investor exits and restricts the offshore exit options available to PE Investors.

Exits by Asset Class

Residential Focus - A Post Recession Paradigm Shift Clearly residential segment has been able to provide a majority of the exits to investors followed by the commercial office segment. However, the financial meltdown during 2008 brought in a paradigm shift in the way PE funds strategise their investments. Prospectively, we believe that the focus of PE Funds going forward will be largely on residential projects. This was also re-affirmed by one of the prominent domestic fund managers during an interview conducted by Jones Lang LaSalle who mentioned that there has been a shift of focus of successive funds from commercial to residential sector. This largely owes to ease of exit through project cashflows and low impact on the sector demand due to global factors.

Figure 10: Share of PE Exits by Asset Class

Source: Jones Lang LaSalle Survey

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Entity vs. Project Level Exits Higher Preference for Project Level Transactions The total exits recorded between 2008 and 2011 comprised a majority of the project level deals with 95% representation as compared to the entity level deals that recorded fewer exits during the same time period (Figure 14).

Certain fund managers prefer portfolio level investments in asset classes such as hotels, warehousing, etc. as in such asset classes, investment in a single asset will require dependence on the promoter for exit. Assets such as warehousing and hotels are more difficult to trade as single assets and attract more value as a portfolio of assets from PE funds. For other asset classes, PE Funds prefer investing at an asset level.

Figure 14: Entity vs Project Level Exits


Entity Level Project Level

Exits by Geography

Mumbai and NCR have Significantly Dominated the Preference of PE Funds NCR-Delhi and Mumbai together account for nearly 72% of the total value of PE exits there by contributing heavily to the exits recorded in north and west parts of the country. As the political and financial capitals of the country, these two large cities attracted a good proportion of the investments since 2005. These results are also a function of the high capital values in Mumbai and Delhi NCR (Figure 11).

While the exits in south zone was dominated by activity in Bangalore and Chennai, recording close to 23% of the total exits, other cities such as Pune and Kolkata in west and east, respectively, also recorded PE exits (Figure 12).

Given the predictability in demand in the key metros, the trend of investment managers focusing on the top 4-5 metros will continue to be leaders in attracting investments and providing successful exits.

Location of Decision Making - A Critical Factor?

Many of the funds that existed in India prior to 2008 are no longer present in India. The fund manager with final decision making in India turned out to be a lot more proactive in getting transaction exits, accounting for over 74% of total transactions (Figure 13).

Also, the equity multiples achieved by such fund managers have been 30% higher than the PE Funds with off shore decision making.

Figure 13: Share of PE Exits by Fund Manager Domicile

Number of Exits


Foreign26%

Domestic 7�%


Reaping the Returns The Indian RE story has been a mixed bag while decoding the returns delivered by the sector. Our analysis shows that the RE investments have been largely ‘in- the-money’ at the time of exit (Figure 15). This is a positive indication as the ratio is likely to improve as partial exits executed till date move towards complete divestment.

The exits have been recorded at an average multiple of approximately 1.24x. The investments have been broadly in- the-money at the time of exit; however, the returns have been depressed by the global recessionary trends.

Further, commercial sector has demonstrated positive return multiples of 1.2x on an average, whereas the returns on residential have largely been close to 1.1x.

Within commercial office sector, non-IT office assets have displayed a multiple of 1.9x as compared to IT and SEZ which have made subdued returns. SEZs have largely been fraught with regulatory issues surrounding change in ownership which have dipped their performance (Figure 16). Land shows a multiple of 4.7x largely skewed primarily owing to outlier transactions recorded and therefore, the recorded returns does not necessarily reflect the expected return. Of the cities, Mumbai has displayed better equity multiple of 1.6x followed by Chennai and Bangalore. Of the metros, only Hyderabad has shown negative returns, whereas other cities have lagged behind the top seven metro cities (Figure 17).

Figure 16: PE Exit Multiple by Asset Class


Figure 17: PE Exit Multiple by City


Key Players Influencing the Market Dynamics Some of the notable transactions which have yielded exceptional returns in the sector have been completed by Wachovia, HDFC, Kotak Realty, ICICI Ventures and Indiareit primarily on commercial office assets. On the contrary, significant losses have been posted by certain Offshore PE funds largely on south India based transactions.

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�0 Private Equity Real Estate Exits in India

Looking ForwardLooking Forward

The changing dynamics of the real estate sector in India has changed the way the stakeholders of real estate have operated in the past five years. The bull run of the Indian real estate market during 2005-2007 followed by the recession hit years of 2008-2009 and a phased recovery during 2009-2011 summarises the India real estate story in brief. The learning from such short industry cycles of the sector has been immense. While the market dynamics has offered plethora of opportunities for the developers and private equity investors to invest and reap higher returns, such avenues have come with a significant risk to the stakeholders given the challenges to exit from an investment in the country’s real estate sector.

The key trends that will govern private equity investments include the following:• Local Market Expertise and Stable Asset Management Teams will be Valued - Both retail and institutional investors will place a

premium on local market understanding and strong on-ground teams. The pre-Lehman era saw a lot of “Real Estate Tourists” from Europe and USA who would spend a few days in India and evaluate a host of transactions and either conclude no deals or conclude a token transaction to “flag” the country. The pressures of the global financial crisis and the resulting issues have educated LPs about the necessity to have an experienced fund manager with full-fledged India operations. Another interesting trend experienced after the global financial crisis was a flurry of changes in Fund Heads for a substantial number of the active funds in India. Turnover at the Fund Head/Principal level at any private equity setup doesn’t augur well - it destabilises the investment strategy for the fund and also is a signal to the market that there may not be any carry to be made in the fund! LPs, going forward, would value funds which align the interest of the fund manager with that of the LPs through contributions or through employment lock-ins.

• Direct Investment by LPs or Separate Account Structure - We also anticipate that a lot of LPs would put indirect investments on the back-burner and prefer either making direct investments or evaluate a presence in India through a separate account structure with a strong local fund manager. The initial round of funds out for fund raising are already getting this feedback, especially from large sovereign funds who would want to exercise greater control and have a customised investment program. Simultaneously, we also expect to see existing LPs of performing funds make small investments in the new fund and negotiate co-investment rights with the fund. With increased performance expectations on the part of LPs, the fund raising environment is set to get tighter.

• Smaller Fund Sizes and Niche Funds - The fund raising market will also see more niche funds with focussed investment strategies vis-a-vis general opportunity funds - the IndiaREIT Redevelopment Fund, the Kotak debt fund, etc are steps in this direction. The other significant change that we anticipate is smaller fund sizes so that the entire investment cycle is completed quickly from the LP’s perspective and so that the GP sees earlier monetization of carried interest along with being freed from the pressures of having uncommitted funds.

• Increased Execution Oversight - With more seasoned fund managers who have seen the entire lifecycle of an investment, deal dynamics are expected to be more rational with sensible underwriting, active oversight of execution and a larger allocation towards residential and structured deals.

• Third Party Exits will Gain Momentum - A majority of the exits currently are through buybacks which is not a healthy sign. Buybacks may not provide the opportunity for a market driven price discovery mechanism. Going forward, we expect that there would be more exits through third party exits and therefore funds will steer towards a process-based approach of identifying the best price for their investments.

• Entry of REITs/AIFs and a New Class of Investors - Our interactions with multiple stakeholders of real estate reconfirmed the need and usefulness of REIT regime along with AIFs that would enable the private equity industry to take a big stride towards a healthy future. Additionally, we also foresee new categories of investors such as insurance companies and pension funds becoming active in the space for completed assets.

Private Equity Real Estate Exits in India �1

The last couple of years have posed some key economic challenges internationally. India has been stable and has not witnessed critical worrisome moments, except for weak political environment which creates ambiguity and inertia in policy making. In the medium term, we believe the outlook for RE sector and specifically from an exit perspective, will be positive. With a higher concentration of residential construction and investments, where the demand is dependent on Indian savings and consumption story, the performance is likely to be steady subject to moderation of price levels in certain geographies. The residential projects that have commenced post the global financial crisis will start churning out cashflows in the next two years offering partial to complete liquidation to several PE Funds. On the commercial front, there is likely to be more long drawn negotiation between sellers and buyers on valuation aspects due to expectation mismatch. There may be a more top down approach to buying activity in future with the global

phenomenon impacting the valuations to some extent; however, we believe this should not be an impediment for closure of the deals for good projects.

The industry is at a crossroad, where it has already witnessed a sizable number of exits and is expected to experience a larger number of exits in the near future. The exits so far has been a mixed experience for PE funds with some funds making excellent multiples while few others having bled profusely. Overall, though, one can deduce that the investor performance has been reasonable in a global economy which otherwise has been displaying brinkmanship with many investments devalued by over 50%. At this zero hour,

the industry needs to forge ahead to 2012 by taking cues from the stakeholders’ recent experiences, which however, may not be a thoroughly irreproachable basis for identifying future trends. As we now invert the hourglass, its a wait-and-watch until the key players checkmate and pen the conclusion of the first complete cycle of the India real estate story.

�� Private Equity Real Estate Exits in India

Contribution by

Authors

Shashank Narayan Assistant Vice President, Capital Markets [email protected]

Devi Shankar Assistant Vice President, Capital Markets [email protected]

Hariharan Ganesan Manager, Research and REIS [email protected]

Ujwala Rao Head - Capital Markets (West India), [email protected]

Himadri Mayank Assistant Vice President, Research & REIS [email protected]

Ashutosh Limaye Head - Research and REIS [email protected]

Private Equity Real Estate Exits in India ��

COPYRIGHT © JONES LANG LASALLE All rights reserved. No part of this publication may be published without prior written permission from Jones Lang LaSalle. The information in this publication should be regarded solely as a general guide. Whilst care has been taken in its preparation no representation is made or responsibility accepted for the accuracy of the whole or any part. We stress that forecasting is a problematical exercise which at best should be regarded as an indicative assessment of possibilities rather than absolute certainties. The process of making forward projections involves assumptions regarding numerous variables which are acutely sensitive to changing conditions, variations in any one of which may significantly affect the outcome, and we draw your attention to this factor.

For More Details, Contact

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Himadri Mayank Assistant Vice President, Research & [email protected]+91 22 3307 1500

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About Jones Lang LaSalle JJones Lang LaSalle (NYSE:JLL) is a financial and professional services firm specializing in real estate. The firm offers integrated servicesdelivered by expert teams worldwide to clients seeking increased value by owning, occupying or investing in real estate. With 2011 globalrevenue of more than USD 3.6 billion, Jones Lang LaSalle serves clients in 70 countries from more than 1,000 locations worldwide, including200 corporate offices. The firm is an industry leader in property and corporate facility management services, with a portfolio of approximately1.8 billion square feet worldwide. LaSalle Investment Management, the company’s investment management business, is one of the world’slargest and most diverse in real estate with USD 47.9 billion of assets under management.Jones Lang LaSalle has over 50 years of experience in Asia Pacific, with over 20,800 employees operating in 77 offices in 13 countries across the region. The firm was named the Best Property Consultancy in Asia Pacific at ‘The Asia Pacific Property Awards 2011 in association with Bloomberg Television’. For further information, please visit our website, www.ap.joneslanglasalle.com

About Jones Lang LaSalle India Jones Lang LaSalle is India’s premier and largest professional services firm specializing in real estate. With an extensive geographic footprint across eleven cities (Ahmedabad, Delhi, Mumbai, Bangalore, Pune, Chennai, Hyderabad, Kolkata, Kochi, Chandigarh and Coimbatore) and a staff strength of over 4800, the firm provides investors, developers, local corporates and multinational companies with a comprehensive range of services including research, analytics, consultancy, transactions, project and development services, integrated facility management, property and asset management, sustainability, Industrial, capital markets, residential, hotels, health care,senior living, education and retail advisory. For further information, please visit www.joneslanglasalle.co.in

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In the complex world of Real Estate, making right investment decisions demands perspective. It takes expertise and insight to keep up with the dynamic scenarios. At Jones Lang LaSalle, we view the world from all angles. For over 220 years now, our teams have been monitoring the real estate market pulse, decoding the data and tracking the trends to serve the investment needs of users, developers and investors of real estate.

An illustrative list of clients whom Jones Lang LaSalle Capital Markets team helped find what they were looking for in 2011.

IndiaReit: Private Equity Fund Exit, INR 4280 mn, Mumbai

Omkar: Private Equity, INR 2000 mn, Mumbai

Rajesh Builders: Debt (ECB) Syndication, INR 2400 mn, Mumbai

Pacifica Companies: Private Equity Fund Exit, INR 1090 mn, Pune

Watermark Residency: Joint Venture, INR 540 mn, Chennai

Phoenix Forever: Investment Sale, INR 8550 mn, Hyderabad

Heinz: Land Divestment, INR 365 mn, Bangalore

For handling complexities of real estate investments, our clients said, you were a simple choice

• Wide network within the developer and private equity community.

• Advised on investments worth INR 5000 Cr in 2011 and over USD �.5 billion in last 5 years in India.

• Expertise across Office, Retail, Residential, Infrastructure and Land projects.

Omkar: Debt Syndication, INR 1500 mn, Mumbai

Patel Realty: Investment Sale, INR 930 mn, Mumbai

Kotak Realty Fund: Private Equity Fund Exit, INR 5250 mn, Mumbai

Paramount Constructions: Strategic Joint Venture, INR 2250 mn, Vizag

Adarsh Developers: Private Equity, INR 750 mn, Bangalore

Ambience: Private Equity, INR 2000 mn, Gurgaon

Mafatlal Industries Limited: Land Divestment, INR 6058 mn, Mumbai

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