Hedge funds, PE deals make RBI see red

The monetary policy has bad news for hedge funds and private equity (PE) funds. The Reserve Bank of India (RBI) today expressed concern over investments by hedge funds in the stock markets and higher leveraging by PEs in international mergers and acquisition (M&A) deals and raised questions over the longer term sustainability of such investments worldwide.

The RBI's caution comes in the wake of rising PE investments in the country even though the role of such investments in domestic M&As is minuscule, prompting analysts to say that the RBI has taken a futuristic view in view of the increased pace of foreign money inflows through PEs, venture capital funds and foreign institutional investors.

In its first quarter review of the annual monetary policy for 2007-08, the RBI has described how the hedge funds are facing solvency threats in the wake of continued slump in the US housing markets and said the "contagion" could spread to other credit and corporate bond markets, in a spiral of repricing, tighter mortgage & borrowing conditions, falling house prices and slower consumption growth.

"With greater risk aversion going forward, with credit quality deteriorating and with the widening of credit spreads, the potential fragility of hedge funds could pose significant risks to financial market stability and to the prospects for financing and growth in the EMEs (emerging market economies)," RBI said.

At present, hedge funds cannot invest directly in the Indian markets. However, they could invest through PNs issued by Sebi-registered FIIs.

As per official data, the PNs account for 35 per cent of FII inflows. In 2007 thus far, the FIIs have invested a net Rs 42,954.20 crore ($10.2 billion).Market estimates, however, say more than 40 per cent of the FII money come through PNs. No official data on hedge funds' contribution to PNs is available.

"The hedge funds industry is passing through a tough time. Indian companies as well as investors are not aware of investment strategies of these pools of money, whose source is not known. Following the quick appreciation of Rupee, the Indian markets' attractiveness for these players could go up as they may chose to hedge their risks in these markets. The RBI has given a timely warning regarding this," Bhaskar Ghosh, managing director, IndusInd Bank said.

About the PE activity, the RBI said, "In view of the opaque nature of PE activity, high levels of leveraging has raised concerns about longer-term sustainability. Given the size of business accruing to private equity, they carry risks to overall macroeconomic stability and, in particular, to EMEs."

PE investments in global M&As stand up to 25 per cent while its share in the Indian M&A scene is negligible to the extent of two per cent. In 2007, the overall PE deals in India amounted for $2.3 billion.

"Indian money markets are partly reflecting the result of the still-opaque thinking on capital inflows and the rupee. The government continues to encourage capital inflows, including overseas borrowing by Indian companies, but doesn't appear desirous of further rupee appreciation, and is also concerned about higher sterilization cost," Rajeev Malik of JPMorgan Chase Bank, Singapore, said in his report over the policy.

"Most of the PE capital flowing into India is growth capital as against leveraged buyouts in the matured markets where PE Funds take on high level of debts and starve the companies of excess cash to pay-off the interest / debts. Thereby improving their overall return of equity. This issue is not very relevant in the Indian context. Moreover, the unsecured / subordinated debt market is not so well developed in India, therefore limiting the debt capacity of companies," Saif Dhorajiwala, vice president (investments), Avigo Capital Partners said.