February 20, 2020
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Why Rajan Should Now Target Private Equity

Private equity funds have made huge investments in real estate companies. That's where the fun and games begin...

Why Rajan Should Now Target Private Equity
Jitender Gupta
Why Rajan Should Now Target Private Equity

What’s likely to happen if Reserve Bank governor Raghuram Rajan bumps into former hedge fund manager Martin Shkreli Even though chances are remote, there’s no harm fantasizing: Shkreli would probably be at the receiving end of some very sophisticated obloquy from Rajan.

Governor Raghuram Rajan has had some practice at raising hackles. He discomfited economists and smug central bankers at Jackson Hole by pointing to their manifest policy nakedness. His refusal to acquiesce has exasperated impatient government officials in Delhi. He has lectured on the need for tolerance in society. In August, he advised real estate promoters to sell their inventory of unsold properties, even if it’s at a discount, to help kickstart the economy as well as repay their outstanding bank dues. This was in response to their repeated demands for interest rate cuts.

Enter Shkreli.

What’s the relation between Shkreli and real estate promoters? Here’s a bit of a back-story: Martin Shkreli recently burst into news by repricing a drug from $13.5 per tablet to $750, an overnight increase of over 5400%! The 62-year-old drug, necessary for treating life-threatening parasitic diseases, was recently acquired by Turing Pharma, a start-up launched by Shkreli.

There’s one common thread that runs between the Mumbai real estate deals and Martin Shkreli’s imprudent pharma pricing strategy: it’s the private-equity-hedge-fund culture and the structured nature of most deals closed by their professionals. This class of investors is evoking mixed responses from across the world, prompting even Argentina president Christina Fernandez de Kirchner to call them “vultures”.

Let’s stick to the property example. Estimates are that upwards of 200,000 apartments in Mumbai remain unsold. More disconcertingly — according to  property consultants Jones Lang LaSalle — about 70% of these unsold properties cost over Rs 1 crore. The consultant’s report also shows that most new launches in the city are priced above Rs 1 crore.

This might sound counter-intuitive and self-defeating: why price new launches in the Rs-1-crore-and-above category when it’s also the slowest moving? You can call real estate promoters all kinds of names but certainly not dumb. Land — a scarce commodity in Mumbai and other metros — is one big factor behind high prices. Two, unabashed corruption in granting approvals and permissions also adds to overall cost. Thane builder Suraj Parmar’s recent suicide has focused attention on how corrupt politicians and officials wield a tight stranglehold over the property market.

In addition, bank loans are hard to come by. There are many reasons for this. One, real estate promoters usually have very little security or collateral to offer. Tying repayment of loan to apartment sales is risky because there are no certainties that all inventory will get sold. Two, on past projects, builders have to hand over ownership to people who have bought the properties; this restricts builder’s ability to mortgage an existing property to finance an on-going project. The builder can offer only land as security, but because it’s a fraction of total project cost (albeit a major fraction, but ownership of which is typically wreathed in complicated legal structures), bank loans are also a fraction of total project cost.

However, there have been exceptions: under pressure from builder-friendly politicians, and occasionally succumbing to financial allurements, many public sector bankers have in the past advanced building projects loans far in excess of their eligibility. With property sales stalling, these loans have not been repaid, blocking additional loans for building projects.

Add to this mix a new player.

Private equity funds have made huge investments in real estate companies. Mint reported in October that PE funds had invested $2.4 billion in 53 residential and commercial real estate projects in the first nine months of calendar 2015, compared with only $1.3 billion across 57 transactions in the same period last year.

The large flows provoke the usual sceptical, but unproven, comments about the questionable provenance of funds. It is also equally true that, given the economy’s slow recovery, investible choices have shrunk for private equity firms. For real estate firms — structured to deal with the triad formed between a violent land mafia, corrupt politicians and venal municipal officials — private equity firms represent an additional source of capital (over and above expensive bank loans) and contribute to an additional layer of legal structure. And, as is common practice, private equity firms usually obtain board seats in lieu of their investment.

What really makes the price go northwards is the internal structure of private equity firms. There are two categories of investors in private equity firms — general partners (GP) and limited partners (LP). Here’s how it works: a bunch of professionals create a firm (GP) which then launches a fund with some investors (LPs); in the fund, the LPs play a passive role, leaving GPs to do the investment picking activity. So far, so good.

The terms of trade get trickier with the details of the partnership forged between GPs and LPs, which includes tenure of the fund, management fee charged by GPs for administering the fund, rights, obligations, each party’s limitation of powers and, most importantly, the “distribution waterfall”.

The last mentioned is the source of all fun and games. This is an agreement between GPs and LPs on how to split the gains. The traditional route involves a hurdle rate and a formula for splitting gains, known in industry jargon as 80-20 rule. A hurdle rate is the minimum, annualised rate of return that GPs must ensure for LPs. Beyond this hurdle rate, the excess profit is split with LPs keeping 80% and GPs claiming the balance 20%.  This is over and above the 2-3% management fee (on capital employed) earned by GPs.

GPs train their sights on the 20% in the waterfall and use their presence on boards to ensure that final selling prices incorporate that vision. Occasionally, this is even part of the shareholding agreement signed between the GP and the real estate company, forcing builder rigidity on pricing.

Back to Governor Rajan, who has rarely spoken out against private equity, though the RBI’s Annual Report for 2013-14 does oppose the Financial Sector Legislative Reforms Commission’s proposal for a hands-off approach: “The proposals that certain financial service providers like hedge funds, private equity funds, venture funds and micro financial institutions need not be micro-prudentially regulated appear to overlook recent global developments in this regard.” Given RBI’s concerns about inflation and the real estate sector’s impact on the price line, Governor Rajan should perhaps re-focus his regulatory gaze.

The author is Senior Fellow (Geo-Economic Studies) with Mumbai-based think tank Gateway House.

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