March 2010

Foreign debt, banned in real estate, is finding its way into property firms, as bankers and lawyers help builders cobble together new deals to raise money. Even though foreign loans, better known as external commercial borrowings (ECBs), are not permitted in construction, property firms have spotted a mechanism where the debt can be provided by foreign institutional investors (FIIs) registered with Sebi. No rules are broken and the deals, involving a three-way transaction, come across as normal private placements in the corporate bond market. It begins with a real estate company placing non-convertible debentures (NCDs) with a local entity like a non-banking finance company (NBFC) to borrow. The next step involves listing the debt security, soon after which an FII steps in. Once the NCD is listed in the stock exchange, the NBFC offloads the paper to a foreign fund. Since FIIs cannot invest in unlisted debt, the NBFC warehouses the NCD till the paper is listed and then recovers the money by selling the debentures to a foreign fund. The two transactions are parts of a back-to-back deal struck among the NCD-issuing firm, the local NBFC and an FII. At least four developers, three from Mumbai and one from Bangalore, have raised over Rs 1,000 crore in the past few months through this route. “It does not directly violate the Press Note on foreign investment in property, and such FII investment is within the overall corporate bond ceiling applicable to foreign funds….but it’s against the spirit of the regulation,” admits a senior banker who has advised one such NCD issuance. Indeed, a few foreign banks have made presentations to property firms on the convenience of such fund raising that has become more attractive since the government plugged a loophole in the foreign direct investment (FDI) norms in real estate. In the past few years, FDI worth billions of dollars came in, as overseas investors subscribed to equity and quasi-equity products, often with put options, sold by real estate firms which were starved of bank finance. But a chunk of this inflow was based on an interpretation that the three-year lock-in on FDI applied only to the “original” amount brought in and not the full quantum of FDI in a project. Many investors took advantage of this: an offshore fund, which decided to pump in $25 million, split the inflow, first bringing in $5 million, the minimum amount, and the balance $20 million subsequently. The understanding was that the lock-in applied only to the $5 million and not the $25 million. This flexibility in interpretation disappeared after the government clarified last year that the full amount, irrespective of whether the money comes in tranches, would be locked in for three years. The move, which came as a jolt to several foreign investors, paved the way for the more recent NCD route that’s catching on among local developers. “There are advantages…first, there is no lock-in because an FII can sell NCD as and when it wants; secondly, the debt is secured against mortgage of assets, pledge of shares etc; and thirdly, unlike FDI, here the foreign investor can fund even those projects which are not FDI compliant,” said a lawyer familiar with such debt raising. For foreign equity or FDI in real estate, a project cannot be less than 50,000 square metre of built-up area among other things. “These conditions don’t come in the way when a foreign fund buys NCDs,” he said. Interestingly, such NCD issuance has also been done by a leading NBFC, which like property firms are restricted from tapping the ECB market. According to a real estate fund manager, some of the foreign investors, who are reluctant to increase their equity exposure after the downturn, prefer secured debts with a decent interest return. Sebi’s listing regulations extend to debentures that have been privately placed; and, NCDs can be listed, even if the real estate company or a project-specific special purpose vehicle (SPV) floated by it is a private firm or an unlisted public entity.