Managing ‘expectations’ – asset management for private equity in Indian real estate
April 2014 | SPOTLIGHT | PRIVATE EQUITY
Financier Worldwide Magazine
With the benefit of hindsight, private equity’s involvement in Indian real estate can distinctly be seen as a story of two halves. The first was an outburst phase characterised by the heady days of 2006-08 leading up to the global financial meltdown of 2008 and its immediate aftermath. The second, going on now, is a more reflective, mature phase that explains the behaviour of PE firms from 2011 onwards. The last few years have been especially difficult for the private real estate market from the perspective of foreign investments – a far cry from 2006-08, when enthusiasm for real estate was much greater. As a matter of fact, 86 percent of all real estate transactions in India involving FDI took place between 2005 and 2010.
Before we embark on a soliloquy on investment and attempt to deliberate the current situation on behalf of all stakeholders, we would have to reconcile the paths that the various stakeholders have charted over the years in real estate – the developer, the investors, the managers, and the end user or target audience. In particular, in the heady days of 2006-08, less emphasis was placed on management of an investment post infusion of funds. The first wave of capital that came into India backed a lot of untested and unproven fund managers. Few tangible successes during that period have led to a dearth of foreign capital raisings since. The common perception today is that Indian real estate has already absorbed meaningfully more private equity than it has given back. Thus, institutions willing to commit resources to India today are fewer than they once were. In addition, a significantly devalued rupee has further aggravated matters for foreign investors, even if the fund manager has performed.
The failure of real estate PE to show success (in most cases) has been due to many reasons. If one was to analyse these, a common theme would be incentive misalignment – developers being cashed out upfront, unequal revenue sharing, no execution control on the project and the absence of effective ongoing asset management from the project management as well as finance functions perspective. These ingredients, along with time delays in the approvals process, in many cases due to a lack of understanding of the regulations and in others due to factors such as delayed approvals, unsuccessful land aggregation or incorrect zoning, greatly impacted realisations and returns.
In the early days, the exuberance of the investor community based on the future development of tier I and tier II cities in India led to a significant amount of capital chasing too few investible assets. The capacity constraints that PEs are facing today were completely overlooked at that time. The developers who attracted such capital had previously neither seen such large quantum of capital nor had the prior experience or execution capability to show for their business plans. Indian developers saw FDI as nothing more than easy money without properly understanding and later honouring the protocols and commitments required for such investments. The glut of capital that came in led to situations where managing the expectations of the other party became a challenge for both the investor as well as the developer. In addition, the investors, when faced with difficulties, were unable to get adequate relief and recourse by way of seeking legal remedies. Even with an Anglo Saxon legal system underlying our legal framework, the opacity and myriad ways in which the Indian legal system works hindered time bound solution to any genuine grievances.
In order to understand where the issues for PE stemmed from, one needs to emphasise and understand the challenges that PEs have faced in India. Typically PEs face challenges on a multitude of fronts, including: the challenge to manage a portfolio of geographically dispersed investments; challenges in monitoring the performance of an investment; challenges in managing the operational, strategic and financial aspects of an investment; opacity in communication; challenges in receipt of timely information; no control over the construction approvals process; challenges in optimising returns; estimating the fair value of investments periodically, marked to market value; challenges in dealing with fraud, misappropriation or misconduct in the investee companies; the attitude of developers and long drawn-out legal processes; and challenges in managing a timely exit and realisation of value.
These issues were aggravated due to the lack of emphasis on proper asset management practices including portfolio monitoring and the finance function. Typically, post investment, the asset management activities were performed in-house by the investment team or one or two people from within the investment team. Furthermore, asset management activities were monitored by a global team that did not have adequate knowledge of realities on the ground. The consequence has been underperforming investments and a toxic environment wherein vintage investments have not delivered underwritten returns. More often than not, the investments have outlived the targeted hold period – in some cases even the entire life of the fund. Investment managers, in many cases, had to rely on third party assistance to extricate value from the many deeply stressed assets under such circumstances, or the entire investment management arms of underperforming funds were taken over by larger investment managers (such as Merrill Lynch AREOF, bought by Blackstone; Wachovia, bought by Wells Fargo; Milestone, bought by IL&FS; and so on). Increasingly, therefore, in the current scenario, a number of investment managers and the LPs themselves have realised the importance of engaging independent third party asset managers or portfolio monitoring agencies to manage their investments in India. These independent third party asset managers play a very significant role in both project oversight and ongoing asset management and portfolio management to ensure that developments and projects stay on course from a cost, quality and timeline perspective.
What do independent, unbiased asset managers bring to the table?
Third party asset managers provide solutions to support private equity investors in meeting their objectives of optimising returns. They try to address the challenges being faced by investors in managing the operational, strategic and financial aspects of the latter’s investee companies as the PEs are not able to obtain the right management information in time and are concerned about fraud, misappropriation or misconduct in their investee companies. For smart investors who know that it is prudent if investments are followed up with a continuous monitoring of key business risks, these asset managers become the eyes and ears on the ground and help PEs manage multiple risk factors and the challenges mentioned above. These asset managers, being independent, ensure that an unbiased, outsider perspective is brought into asset management protocol and that investors’ interests are protected and optimised without jeopardising relations between investors and investees.
Being independent and unbiased, the asset manager acts without being prisoner to the history of the investments and brings into focus the actual realities of the investments by acting as a bridge between the stakeholders. As service providers, they understand the importance of each investment to the investors and realise that every piece of information relating to the investment is critical. These managers act as an overseer, communicate key information and observations, and also suggest solutions to managing potential risks.
From the perspective of investors, it is widely agreed that India is not a short term play. In order to optimise returns from existing investments in India, and to also have a long term, larger exposure, institutional investors are gradually taking long term, strategic positions in the market.
The idea of engaging a local third party asset manager with the requisite experience of managing transactions and investments, along with post investment monitoring, is to make sure that the expectations of the various stakeholders in the investment cycle are properly managed. If we speak about certain vintage funds having achieved their target returns, then there are a majority of the FDI funds which have not returned even their capital to their LPs and investors to date. For those underperforming investments, the role that the asset managers could play to protect or salvage value for the investor is significant. In many instances, the appointment of third party asset managers has led to streamlining information flow from the investee companies to the investors and also improvisation of the finance vertical and risk management functions of investee companies. The fact that these asset managers are not related to the investment, the investor or the investee increases the credibility and independence of the monitoring process and creates a positive environment for information and ideas to flow between the stakeholders.
To this end, the Indian real estate market is gradually becoming more mature and sophisticated. Investors who have a long term perspective of India are putting in place a system that will ensure investments are reasonably protected from situations which are ‘controllable’. The addition of a layer of monitors to this process ensures that any pitfalls that may happen over the lifecycle of the investments are attended through timely intervention of the project monitor or asset manager. Private equity has always walked a tight rope in India – one that constantly tries to balance the needs of all the stakeholders concerned. Engaging third party asset managers can make that rope a lot thicker.
Rajarshi Datta is Lead – Asset Management and Sumchit Anand is the Managing Director at Acquisory India Consulting Pvt Ltd. Mr Datta can be contacted on +91 11 4644 3011 or by email: firstname.lastname@example.org. Mr Anand can be contacted by email: email@example.com.
Rajarshi Datta and Sumchit Anand
Acquisory India Consulting Pvt Ltd