The distressed asset space in the country is abounding with opportunities. Certain adverse factors such as a serious liquidity crunch, slowing economic growth and the disruption caused by the Covid-19 pandemic have fuelled the number of stressed assets on offer, thus making it an ideal buyers’ market.
Distressed assets have attracted both large institutional investors as well as strategic investors that seek to gain from the acquisition and restructuring of quality assets. Institutional investors have been particularly interested in the infrastructure space due to their larger risk-taking capacity and excessive availability of liquidity. An asset reconstruction company (ARC) is the most suited vehicle through which investors can channel their capital to quality distressed assets. Investors are generally interested in projects that are already operational and can offer a stable and predictable cash flow for the foreseeable future. Under-construction projects are not favoured by many investors due to the risks associated with project completion. Another exciting opportunity is to cheaply acquire assets that themselves are not stressed but are being offloaded by distressed groups. Such assets can often provide stable cash flows and have an operational history, thus making them an ideal investment.
Road and thermal lead the way
The most popular infrastructure sectors among ARCs as well private investors are thermal power plants and roads. Thermal power assets have become exceedingly attractive to both strategic and financial investors. Their appeal lies in the fact that if purchased for a fair price, these assets provide outsized returns far exceeding the global average. Important features that most investors look for in these assets are stable fuel supply contracts (easy availability of coal) and established power purchase agreements (PPAs) in order to guarantee stable returns. Incomplete assets that do not have either of the above-mentioned features can also attract investors if their pricing can reflect these deficiencies. Thus, pricing seems to be the biggest factor that most investors look for in this space. However, foreign investors are often far more risk averse in the case of thermal power plants and prefer a plant with an established coal supply agreement and PPA before investing in the asset.
The road sector also offers an exciting opportunity for investors due to the relatively smaller capital investment needed and known risks. Another positive in this sector is the relative ease with which investors can determine the fair valuation of the project. This is possible due to regulatory certainty in the sector. Further, recent changes in the model concession agreement for hybrid annuity model-based projects has allayed some of the pressing concerns of investors and will help attract more capital into the sector in the future. There are two types of constraints that a road project normally faces. One constraint is regarding the financing of the project which arises due to lack of adequate capital with the sponsor. The other issue is related to execution of projects and arises due to regulatory changes or due to difficulties in implementing the project because of external factors. Investors typically invest in projects that are facing a liquidity crunch because apart from financing issues the performance of the project is sound, and it can guarantee a predictable return in the future. On the other hand, execution issues are difficult for investors to resolve because of a lack of domain expertise in the sector or due to lack of understanding of the true scope of the external risks involved. In either case, investors prefer completed and operational projects over under-construction projects due to the stable returns available in the former.
Factors to be considered
Minimising losses
A particular factor regarding the successful closure of many distressed deals is the level of haircut that the lenders are willing to accept. A deal with a large haircut (greater than 50 per cent) is often exceedingly difficult to close because of the reluctance among lenders to bear heavy losses on an asset. In many cases, the level of haircut acceptable is often related to the underlying asset. For instance, if an asset-light company is being auctioned, then a higher haircut may be acceptable to the lenders as compared to the alternative of revitalising the business of the company in order to achieve a higher liquidation price. However, for asset-heavy companies, lenders are willing to accept a smaller haircut due to the inherent belief regarding the strength of the underlying assets of the company. Another problem that lenders face is that of correctly valuing incomplete assets (assets missing certain features such as an invalid fuel supply agreement in the case of thermal assets) that are up for auction. As an incomplete asset could have a large range of potential valuations due to lack of understanding of its true value, it could lead lenders to incur losses if it is sold at a lower- than-actual value.
Return expectations
Return expectations differ among domestic and foreign investors depending on the risk they are willing to take and the amount of time they expect their money to be tied up for. Normally, return expectations are in double digits for both investor categories – for a stable infrastructure asset it can range between 12 per cent and 14 per cent. For a risky infrastructure asset, the potential return is more due to the higher upside. In such a case, returns are expected between high teens and 20 per cent. Further, foreign investors also need to include the expected depreciation or volatility of the rupee going forward and thus demand a currency premium for their investments. These premiums can range from 4 per cent to 7 per cent in addition to the above-mentioned returns.
A few legal complications
Another factor important for the successful closure of distressed asset deals is the effectiveness of the Insolvency and Bankruptcy Code (IBC) in resolving disputes. The IBC has elicited mixed reactions among investors, because of the time-consuming process of resolving disputes. The delay even with respect to successful resolutions leads to distrust among investors and hampers potential future investments. Further, the delay in implementation of the resolution coupled with the onset of the Covid-19 pandemic has prompted many investors to abandon their existing commitments in favour of other attractive opportunities that may have opened up, entangling the distressed projects in even more legal issues than earlier. In these cases, it is important to use the IBC to counter such attempts by invoking the “as is, when is” argument in which lenders can legally argue that the investors made commitments for the assets in knowledge of all the potential risks and are obliged to take over the assets as and when the implementation of the resolution transpires. However, lack of large penalties to deter such behaviour by the IBC has only encouraged such cases to increase in number. Additionally, there is increasing uncertainty regarding the enforcement of IBC regulations (which were created by the Supreme Court) as they are being frequently challenged in the lower courts. This uncertainty could be resolved by allowing the Supreme Court’s regulations to be set as precedents that have to be followed by the lower courts. Thus, a time-bound framework needs to be established in which IBC resolutions can be systematically resolved.
Bad banks to the rescue
An interesting way to streamline the resolution process by lenders is to create a ”bad bank”. A bad bank can raise large amounts of domestic and foreign capital in order to solve the capital deficiencies faced by many ARCs. It can also lead to greater aggregation by bringing together various lenders to determine a common price for a distressed asset. Increased coordination among various lenders will also lead to early resolutions in many cases and will free up time for lenders to focus on growing and creating new assets rather than trying to resolve old disputes.
Conclusion
The disinvestment and recapitalisation of distressed assets will prove to be vital for the health of the Indian economy and thus merits greater institutional support. The resolution of distressed assets has received a lukewarm reaction from investors and needs certain changes to fully realise its potential. These changes include time-bound resolutions and their implementation, robust legal security to both the buyer and seller of distressed assets and mutual coordination among various judicial entities in the country. w
Based on a panel discussion among Akshay Gupta, Executive Director, Infrastructure Funds, Kotak Investment Advisors; Vishal Gupta, Senior Vice President, SBI Capital; Aswini Sahoo, Chief Investment Officer, Arcil; and Ajay Shaw, Partner, DSK Legal, at a recent India Infrastructure Forum event