Another TTDMSTM

Here’s another one for Things That Don’t Make Sense To Me.

In Indian restaurants, why is the quarter plate kept on the left of the plate? Think about it. We’ve been brought up eating with one hand – the right hand. Assuming the rotis go on the quarter plate shouldn’t they be on the right? Why should the table be set by Western customs?

And while we’re on the subject, should the glass be on the right or the left? My vote is it goes on the left.

Indian Real Estate Funds

The world of business is fascinating. There are parts of it that are science – you can predict outcomes based upon the conditions and a set of rules. Or you know that you could if you knew enough about the rules and could measure all the conditions. And there are parts of it that aren’t science. Or if they are, they are more of a ‘social science’. I find joy in both CAPM and Leadership theory. Both make sense to me.

But then, I have another category – Things That Don’t Make Sense To Me. Over time I have generally found that most things in the TTDMSTM category don’t make sense to me only because I haven’t found the answer to my question, or haven’t found the right person to ask. But sometimes they just don’t make sense. The Indian Real Estate Funds question is one I have put to many people and haven’t yet found a satisfactory answer. So if anyone out there has a good answer I’ll be eager to hear from them. Here it is:

In the US there is a vehicle called REIT, which is essentially a publicly listed company that invests in real estate. Management fees are low and they are available to the public to invest in (both facts are linked in a way).

In India in the last few years real estate funds have been mushrooming like rabbits. Every company that has an asset management side of the house, and many that don’t, either has a real estate fund or is starting one. Which is not surprising, since the thesis that real estate is a good investment in a booming economy with crowded cities is reasonable. However, all these funds are structured so that they make a lot of money for the fund managers at the expense of the investors. Most of them have the economics of a Venture Fund – 2% Management Fees; 20% Carry. (20% Carry means that the Fund managers will keep 20% of the returns of the Fund over a certain hurdle rate of return).

There is a big difference between the risks in a Venture Fund and a Real Estate Fund. VC thumb rules say that a third of a VC’s investments go bust, a third are chart-busters with the remaining third somewhere in between. This is a high-risk business. It is also a business where the expertise of the fund managers in attracting and backing good ventures hugely determines the success of the fund.

Investing in real estate is not like that at all. The risk on individual properties is much more contained. Also, the level of expertise is not that high. A local real estate broker will know far more about a property than an MBA who manages the fund. I am not saying that the quality of management, the reputation of the firm and so on doesn’t add value, but 20% carry for just diversifying one’s real estate holdings sounds like a ‘get rich’ scheme – for the Fund managers.

As you may have guessed, I have so far not bought into any Indian real estate fund. If they come up with a REIT like instrument that is publicly traded, regulated and has low mutual fund like fees, I will gladly invest in that. Or if someone can explain what justifies the fees. If it is simply supply and demand for such funds, that’s not a good enough reason. I’ll wait.

Before you get influenced by this post, let me tell you about another TTDMSTM of mine – GOOG (Google). For a long time, my wife was on my case to buy GOOG. I didn’t. My reason – its P/E didn’t make sense to me. Where were they going to get that kind of growth from? Recently, when GOOG dropped over 20% from its high of $475, I told my wife that I felt vindicated about not buying GOOG. She sneered "I told you to buy it at $180!"

Company structure – Cross border issues

When we set up our company we went through some very detailed thinking on how to structure the company. Our business model involved research operations in India but our markets were going to be largely in the US and other developed markets outside India. We ended up incorporating in the US with a wholly owned Indian sub, which is kind of the vanilla solution, but in the process went through a decision process that may be interesting to other entrepreneurs.

Some people we talked to had set up a corporate structure that was designed for tax efficiency. They had a holding company in Mauritius or some other zero tax country, with subs in every country that they operated in. This gave them a very flexible corporate structure with great tax efficiency. Any of the subs could be sold or go public independently without an incidence of capital gains. And so on.

Another thought was to incorporate the parent company in India and have a wholly owned sub in the US. That had corporate income tax advantages as well as tax advantages in the event of a liquidity event. Also, doing an IPO in India would have a lower bar and probably get a better valuation as well.
In the end we decided to incorporate a Delaware company and have a wholly owned sub in India. While this is almost certainly less tax efficient it has other advantages that don’t show up on a spreadsheet exercise. If you are looking to get quality venture money into the company (and we are), you can’t go wrong with a US company. US VCs are comfortable with a US legal jurisdiction and not all of them are completely open to an Indian jurisdiction. Indian VCs on the other hand regularly fund US incorporated companies.

Also, the management of the company is largely in the US (4 out of 5 founders are here). Being an Indian company makes it operationally a tad more difficult. For instance, under Indian company law, board meetings must be attended in person, not on the phone.

In the end, the argument that tipped the scales for us was ‘simplicity’. The US-parent-Indian-sub structure was simple and a natural fit. Anything else would have made things complex to manage and complex to explain to an outside investor. Sure, we would probably have liked to have been more tax efficient. But then you have to make a whole lot of profit before you start worrying about the income tax on it!

While this solution works for us, everyone has a different business model and their own preferences. Be sure to talk to a lawyer and an accountant who know cross-border issues. And don’t forget to check within your network of entrepreneurs.