Asset reconstruction companies: An outlook

Through introduction of various guidelines, the regulatory authorities have been constantly working on encouraging alternative sources of capital to come into the Indian stressed assets market, which is a step in the right direction

Image: Shutterstock

The Parliament paved the way for the formation of securitisation and restructuring companies under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002. Consequently, the Reserve Bank of India (RBI) has granted certificates of registration to 14 Asset Reconstruction Companies (ARCs). These companies have been created to bring about a system for unlocking value from stressed loans. Before this Act came into existence, lenders could enforce their security interests only through courts, which was a time-consuming process.

Initially, the system was popular with lenders wherein certain banks offloaded big chunks of stressed loans to ARCs via the security receipt (SR) route. However, in the past few years, this option has not been exercised by the banks due to the expectation gap in the realisation of SRs. Poor performance of ARCs in resolution of these stressed loans has affected the industry in two ways: First, the overall deals between ARCs and banks have reduced considerably; second, more banks prefer cash sale to SRs.

In view of this, exit through sale of stressed loans to ARCs has been underutilised. We strongly feel that the current guidelines on the valuation of non-performing loans by banks need to be improved so as to offer a fair valuation. During early 2014, the RBI released a regulatory framework for early recognition and revitalisation of stressed loans, which details steps for early recognition and quick action upon the first signs of stress in any account. We believe that the guidelines will aid in arresting the deterioration of economic value of the stressed loans and increase deal flow to ARCs, special situation funds and stressed asset investors.

Sharp rise in sale of stressed assets to ARCs during FY2014 With a view to clear up stressed loans, Indian lenders resorted to sale of such assets to ARCs at a mutually agreed price. According to RBI estimates, Indian banks sold stressed loans worth $2.8 billion during FY2014 as against $0.2 billion during FY2013. In the first quarter of FY2015, banks sold more than $2.5 billion to ARCs prior to change in ARC investment guidelines by RBI. Since then, the transactions dropped significantly and media reports suggest that more than 1,000 NPAs with aggregate principal dues of $4 billion were put on auction by various banks. Of these, only $0.3–0.5 billion were successfully sold to ARCs.

Challenges
Funding for ARCs continues to be the biggest challenge. The RBI released guidelines in August 2014 that stipulated minimum cash component in the acquisition price of a stressed loan by an ARC at 15 percent, from the earlier 5 perccent. In a way, this could lower competition for deals, as the capital requirements would preclude some of the ARCs having lower capital bases.

As per industry estimates, the current capitalisation of all ARCs put together adds up to $5 billion. With the cash component increased to 15 percent, the net worth of all ARCs would be sufficient to acquire only $3.3 billion of stressed loans. Assuming ARCs acquire stressed assets at 60 percent of book value, all the ARCs put together can garner $5.5 billion of stressed loans. The stressed loans of Indian banks are of the order of 14 percent of gross advances ($161 billion) as of March 2015. Thus, ARCs can acquire only 3.5 percent of such loans from banks.

Other Challenges
There has been a significant valuation mismatch between the expected value by banks and bids by ARCs, primarily on account of the discounting rates. While banks use discount rates in the range of 10 percent to 15 percent given their access to cheap capital in the form of public deposits, ARCs use much higher discount rates of 20 percent to 25 percent, as their cost of funds is relatively higher than that of banks. Without realistic valuation guidelines, there is no incentive for ARCs to participate in auctions as the reserve price tends to be high. As a result, banks are forced to continue holding these positions until most of their value has deteriorated, resulting in larger losses.

Another key challenge for ARCs is the ability to fund the working capital needs of stressed loans to enable a revival. In view of this, global distressed asset funds are increasingly seeing an opportunity here, but this option comes with a rider. To enable them to take high risk, distressed assets funds require a cash flow priority, a clear first charge on assets and returns in excess of 25 percent. With a consortium of lenders who often act independently, bringing all the parties together and convincing them to agree to a plan will be a major challenge for a distressed asset fund.

Way forward
Through introduction of various guidelines, the regulatory authorities have been constantly working on encouraging alternative sources of capital to come into the Indian stressed assets market, which is a step in the right direction. We feel that the move by the regulators will rationalise recent trends in the industry and will benefit the various stakeholders. Valuations will become more realistic, and ARCs will focus more on asset quality and less on building up their asset under management. It could also be the most apt time for ARCs to place greater emphasis on revival and strengthen capabilities around restructuring and reconstruction.

The ceiling on foreign investment in ARCs is now increased to 74 percent. Thus, although the sector is ripe for foreign investment, distressed asset funds have traditionally been wary of this market due to legal and regulatory issues. However, this scenario appears to be changing, with the recent investment by a Hong Kong-based distressed and special situations hedge fund in one of the ARCs. Further, a leading global investment PE firm is in the process of acquiring majority ownership in another ARC in a multi-stage transaction.

- By Dinkar Venkatasubramanian is partner–restructuring, EY.  Rahul Srivatsa, director - restructuring, EY, contributed to the article

The views expressed in this article are personal to the authors

The thoughts and opinions shared here are of the author.