The Hindu Business Line : PEs want ‘preferred returns’ clause

With funding hard to come by, given the high interest rates and banks going slow on realty lending, developers are wooing PE firms, which look to hedge against risk.

Moumita Bakshi Chatterjee

With the property market in the midst of a downturn and banks tightening the purse strings on realty projects, the real-estate sector is now witnessing Private Equity (PE) transactions that come attached with a ‘preferred returns’ clause, a debt-like structure aimed at ensuring guaranteed return for the investor.

“PE Funds made a beeline for India around 2005, with a return expectation of about 35 per cent in the then-booming market. These funds had raised finances from international investors and made promises to deliver returns. With the downturn in the market and the slowdown in demand, that situation has now changed dramatically across all segments,” says Mr Sanjay Dutt, Joint Managing Director, Cushman and Wakefield India.

Many PE firms now appear to be worried about exposure to risk beyond a certain limit, and are keen on ‘preferred returns’ while picking up equity in projects.

Such deals are also being fuelled by prevailing market conditions where real-estate developers are finding it hard to raise capital given high interest rates, and also the fact that banks are going somewhat slow on realty lending. Starved of funds, developers are wooing PE firms with offer to guarantee an average 22 per cent return, say industry sources.

“The risk has gone up due to the uncertainty in the market. Against a standard structure, where developer and investor share profits in proportion of their participation, a preferred return means that the investor would take the full profit till such time that he recovers the original capital and the pre-determined return,” says Mr Subhash Bedi, Director and Partner, Red Fort Capital Advisors. Red Fort Capital has struck deals with preferred return clause in six-seven projects in 2008, he adds.

‘With collaterals too’

While most of the builders remain tight-tipped about negotiating such deals, industry insiders claim that these clauses, in certain cases, come with collaterals.

“In extreme cases, if the project fails to take off, the investor can even force the developer to go for an asset sale to a third party. For instance, this could be true of a commercial project where the developer has not found takers for leasing space even in the second year.

“In such a case, if things do not go as per business plan, the investor has the right to step in and ask for an outright sale,” points out the Fire Capital managing director, Mr Om Chaudhary, adding that his fund steered clear of such deals as it “does not believe in equity returns without equity risks.”

Mr Sanjeev Srivastav, Chairman and Managing Director of real-estate company Assotech Group, feels that preferred return is being talked about mostly in the context of mid-sized projects that do not have prior established benchmarks at a particular location.

“We are not in favour of getting into deals that stipulate ‘preferred returns’. We feel that while funds getting into it negotiate a minimum return, the clause does not stop them from availing the benefits of an upside,” he says.

However, according to Mr Chaudhary of Fire Capital, such pre-conditions are not restricted to small and medium-sized players only.

“Some large developers, in anticipation of hitting the capital markets, had accumulated huge parcels of land or announced high-profile projects after aggressively bidding for land. These players have now built a pressure on themselves to tie up funds. However, we have kept ourselves away from such deals as being a real-estate specific fund, we understand the risks involved.”

In addition, Fire Capital says it has been investing in Tier 2 projects where the developers have not ‘spread themselves thin’ and are more comfortable. “The squeeze is mostly in projects in larger metros,” he concludes.

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