Inevitability of defaults: Promoters gripe over loans being sold to ARCs

'Once the moratorium is lifted, we expect several companies to default. The bank will have no other option but to either restructure the loan or sell it to ARCs,' says a banker

With a large number of companies set to default in the coming months, asset reconstruction companies (ARCs) are expected to see sharp jump in loan portfolio purchase from banks. Promoters say some ARCs are delaying debt resolution to earn higher returns — often risking a company’s operations and long-term viability.

“Once the moratorium is lifted, we can expect several companies to default. The banks will have no other option but to either restructure the loan or sell the loans to ARCs at a massive discount,” says a banker.

Waving a red flag on the state of corporate finance, rating firm CARE Ratings warns that the credit quality of companies rated by the firm has declined to a 26-quarter low in the first quarter of 2020-21.  

The rating firm says due to the Covid-19 pandemic, there will be significant decline in the scale of operations, including deterioration in asset quality, delays in debt servicing, weakened capital structure, debt service coverage ratios, and liquidity position.

But sending a company to an ARC comes with its own pitfalls. While banks take a significant haircut while selling loans to ARCs, the latter aim at making hefty returns of up to 25-30 per cent on their investment, says a promoter of a mid-sized company.

“In cases where banks have already converted debt into equity due to earlier debt restructuring, banks are selling debt at a huge discount to ARCs. Banks are also selling promoter guarantees and other rights to ARCs. Once loans and guarantees are taken over, ARCs are not restructuring debt in a specific timeframe, leading to a stalemate,” says a promoter.

The Reserve Bank of India’s objective, while allowing the ARC-led debt restructuring, was to help restructure loans in time-bound manner, protects the interests of banks selling debt to recover their dues and help revive companies.

The chief executive officer of a large ARC says the cost of funds is very high at 15-18 per cent for them, when compared to banks, and factoring in their overheads, ARCs’ expectations of high returns are normal. “Not all accounts will do well. Some will make money, some won’t,” he says. The RBI regulation seeks resolution of an account sold to an ARC within eight years. This can be extendable with permission from authorities.

“ARCs are now asking promoters to repay loans at a higher debt level (pre-debt-to-equity conversion by banks). Promoters have to relent due to personal guarantees held by ARCs. With these structures, ARCs are getting 25-30 per cent returns,” says a company promoter. Some ARCs even sought 35 per cent returns from an account by taking surplus cash generated by companies during the Covid-19 period.

The promoters gripe about loans being sold to ARCs. They say there isn’t any regulation over what will constitute sustainable/unsustainable debt. “Regulation needs to ensure sustainable debt in the books of a target company is not in excess of the loan value at which the ARC purchases the loan. If the RBI fails to do this, ARCs will bleed companies dry,” says the promoter of another company.

Further, even when many banks converted debt into equity under strategic and corporate restructuring schemes, banks were left holding a large chunk of a company’s equity, which is still held by banks. Banks sell debt in such companies in the belief that ARCs will reconstruct debt, and equity held by banks in these companies will recover.

“But the larger ARCs are not interested in the equity value of banks. This results in huge losses to banks,” he adds.