Bailing out Banks: ARCs to play a greater role in stressed asset resolution

ARCs to play a greater role in stressed asset resolution

In the recent past, there has been a slowdown in the sale of stressed assets by banks to asset reconstruction companies (ARCs). Valuation mismatches and slow recovery rates have retarded the deal consummation process. Banks have preferred to address the problem of stressed loans through debt restructuring under the aegis of the corporate debt restructuring scheme. However, the trend is set to change with the improving market sentiment and regulatory push including the Insolvency and Bankruptcy Code, 2016, which will ensure a time-bound settlement of insolvency and faster turnaround of assets.

Stress in the banking sector

The problem of stressed loans of banks has worsened significantly over the years. The overall stressed advances ratio increased from 11.5 per cent to 12.3 per cent between March 2016 and September 2016. A sizeable proportion of stresed assets in the banking sector is accounted for by the infrastructure segment. The stressed advances ratio to the sector increased from 16.7 per cent to 18.6 per cent between March 2016 and September 2016. Owing to this, bank lending to the infrastructure space slowed down from Rs 9.65 trillion as of March 2016 to Rs 8.67 trillion as of March 2017.

 ARCs in India

Currently, there are 23 ARCs in the country and it is estimated that perhaps 10 applications for new licences are pending for approval with the Reserve Bank of India (RBI). As per CRISIL estimates, the total outstanding assets under management with ARCs are worth about

Rs 750 billion as of March 31, 2017. Of the registered companies, assets of the top three players – Asset Reconstruction Company (India) Limited (Arcil), JM Financial ARC and Edelweiss ARC – account for more than two-thirds of the total assets under management with ARCs. The ARC industry has structurally transitioned from the agency business model (focus on management fees) to the fund-based business model (focus on recoveries and realistic pricing).

Historically, sale to ARCs was a popular route among banks to address the issue of non-performing assets (NPAs). The sale of distressed assets by banks to ARCs witnessed a significant surge in 2013-14. However, aggressive bidding and unrealistic pricing by the latter led to a tightening of guidelines by RBI in August 2014, which (among other things) increased the ARCs’ minimum upfront cash payment from 5 per cent to 15 per cent. It has been observed that recoveries by ARCs have been low – about 36 per cent – with average resolution taking about five years. Consequently, asset sales to ARCs by banks registered a decline due to the expectation gap in the pricing of security receipts (SRs).

Key challenges faced by ARCs

Limited capacity of ARCs: As per Arcil estimates, the level of NPAs (including restructured assets) is about Rs 14 trillion, whereas, collective debt acquired by ARCs is around Rs 1.5

trillion and their combined net worth is approximately Rs 50 billion. Thus, constrained capital has retarded the stressed asset resolution activity. Another key challenge for ARCs is their inability to fund the working capital needs of stressed loans to enable a revival.

Valuation mismatch between ARCs and banks/ financial institutions (FIs): New capital norms (increasing investment by ARCs from 5 per cent to 15 per cent) have significantly escalated the cost of asset acquisition for ARCs. To offset this, these entities have been seeking higher discounts to buy NPAs but banks are unwilling to take high haircuts, resulting in an expectation mismatch. This has led to a sharp decline in the transaction closure rate.

According to RBI, the acquisition cost of NPAs for ARCs as a percentage of the book value of assets has increased sharply. In other words, the discount rate at which ARCs are acquiring NPAs from banks/FIs has decreased considerably. With newer ARCs on the anvil, competition could drive up asset prices further. The increase in cost of acquisition has been mainly because the assets in question were largely from the real estate, steel and power sectors where there is less scope for discount.

Consensus amongst joint lenders and legal issues: Debt aggregation takes time; and sometimes it does not take place at the desired level. For large assets, there are multiple lenders involved and in the absence of consensus, the resolution gets delayed. Moreover, multiplicity of litigations by borrowers and interference by civil/company courts delays recoveries by ARCs further.

Regulatory support

In view of the enhanced role of ARCs and the greater number of cash-based transactions, RBI, in April 2017, proposed raising the minimum level of net-owned funds (NOF) for ARCs from

Rs 20 million to Rs 1 billion. The move will increase the scope for consolidation as ARCs which are struggling to raise funds and are short on specialist manpower will get marginalised.

In Union Budget 2017-18, the centre proposed allowing the listing and trading of SRs (which are offered by ARCs to banks in lieu of the underlying asset) on the stock exchanges in a bid to boost liquidity in the securitisation industry and enable banks to exit the unsold portion of the bad loans that are held as SRs on their books. Previously, access to such loan portfolios was available only to qualified institutional buyers.

The easing of foreign investment norms in the ARC segment is a welcome move. In May 2016, 100 per cent foreign direct investment (FDI) in reconstruction companies was allowed under the automatic route from the earlier 49 per cent under the same route. Moreover, foreign portfolio investors can invest up to 100 per cent in each tranche of the SR issued by ARCs. This will provide much-needed capital to the securitisation industry.

The Insolvency and Bankruptcy Code, 2016, coupled with the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act), will be a game changer in the ARC industry and will further ease the recovery process for existing and new ARCs in India.

Opportunities galore

At present, the banking system is saddled with around Rs 14 trillion worth of distressed loans, a gigantic opportunity for ARCs and global stressed funds to tap into. Gross NPAs are expected to rise continuously in the foreseeable future, given that sizeable NPAs are in highly leveraged companies, particularly in the power and steel sectors.

“In our view, there is a big opportunity in the stressed asset market, particularly for large investors. The favourable legal environment for lenders and the improving macroeconomic scenario of the country will act as tailwinds for speeding up the resolution process,” says Sanjay Jain, president and chief operating officer, Arcil.

The relaxation of the FDI limit in ARCs, along with the introduction of the Bankruptcy Code, is set to open up significant opportunities for global private equity (PE) players to invest in ARCs. For instance, JC Flowers and Co. has formed a joint venture (JV) with Ambit Holdings to launch an ARC. The collaboration between ICICI Bank and Apollo Global Management to set up an ARC and the proposed stake purchase by KKR in the International Asset Reconstruction Company are other notable developments in this direction.

Moreover, foreign investors are eying the stressed assets space by setting up stressed asset funds in partnership with banks/FIs. The most recent example is Infrastructure Leasing and Financial Services Limited partnering with global PE firm Lone Star to jointly invest $550 million in stressed infrastructure projects in India for asset purchases of up to $2.5 billion.

The year 2016 witnessed several such tie-ups to address the problem of troubled assets. These include the Piramal Enterprises-Bain Capital Credit stressed asset platform, the Kotak Mahindra-Canada Pension Plan Investment Board distressed asset fund ($525 million), and the State Bank of India-Brookfield Asset Management JV fund, among others.

That said, there have been only a handful of large transactions by ARCs due to capital constraints and the absence of skill sets for a potential turnaround. With a supportive regulatory framework in place and an abundance of stressed assets available, it is an opportune time for ARCs to transform themselves into special situation funds with operational capabilities to bring about a long-term revival in the business.