Foreign private equity funds which have invested in real estate and infrastructure sector and find themselves caught in a policy row between the Reserve Bank of India and the government, are lining up a bevy of ‘mezzanine funds’ for the Indian market. These funds, which are typically debt-dominated instruments with an equity “sweetener,”provide medium-to-long term capital to promoters without significant ownership dilution, reports Financial Express.
The RBI, which has taken the firm view that equity instruments with in-built options will be considered external commercial borrowing (not allowed in realty sector), is open to mezzanine funds. Foreign direct investment (FDI) is allowed in specified real estate projects, but not in realty firms.
While from the lenders’ perspective, mezzanine funds offer a measure of downside risk protection, these funds are widely predicted to favour mid-cap Indian firms, where promoters would not like to cede considerable shareholding while raising funds.
Mezzanine debt route is being charted out by the PE firms to mainly sidestep ‘put option’ route. Six out of every 10 private equity deals in the real estate sector have put and call options built into them. The confusion stemmed from a policy announcement by the department of industrial policy and promotion (DIPP) in the ministry of commerce and industry in the beginning of October 2011, which said that “equity instruments issued/transferred to non-residents having built-in options or supported by options sold by third parties would lose their equity character and such instruments would have to comply with the extant ECB guidelines”. But after a huge amount of negative feedback on the subject, DIPP later on October 31, 2011, deleted the clause. The RBI, however, continues to question deals that had in-built options, saying such investments will be considered debt. Mezzanine funding in India is moving beyond the periphery and getting into the mainstream. Niche mezzanine funds are coming in the investment fray and companies, too, are preferring these over pure equity investments.
Ajay Relan who garnered the reputation of having a midas touch with CVC International and now with his own firm, CX Partners is on road to launch a niche $500 million mezzanine fund. “It will be a separate fund with a separate team based out of Mumbai. We are looking at first closure in six months,” he says.
Comparing the investment potential of private equity vis-a-vis mezzanine funds, Relan says PE has no caps on upsides and structure of investments are much simpler, whereas in mezzanine fund, investments are more structured with assurance of certain fixed returns essentially in the range of 18-22 per cent with limited upside, and is a much stable product. For the new fund, Relan is approaching a different set of LPs who are looking at assured and structured returns.
Mezzanine funding looks at a preferred return of between 20 to 30 per cent IRR. Most transactions provide for a water fall structure wherein a large part of the available cash flow first goes to the PE investor and then the promoter receives the remainder or a significant portion of the remaining cash flow.
Ashish Joshi, managing partner, IL&FS Milestone Realty Advisors said the assured returns percentage depends on the risk appetite of the fund house and the viability of the project. If the market is overheated the assured return variable goes up. Essentially it is in the range of 20-24 per cent. The collateral backing these deals varies from equity shares, land and project. Such deals of late are becoming the flavour of the market, especially in the real estate sector.
Many private equity firms in India and globally are today focusing on debt financing and mezzanine funding. In September KKR Asset Management (KAM) raised KKR Mezzanine Partners I, a billion dollar fund to invest in mezzanine opportunities globally. In April Eight Capital launched Eight Capital Mezzanine and Special Situations Fund a $ 250 million fund to provide mezzanine capital to mid-cap high growth companies. As per reports, International Data Group is also floating a $400 million mezzanine fund for India. ICICI Venture was one of the first movers in Mezzanine funding in the Indian PE industry when it raised $51 million in 2007.