Market in distressed assets may be huge, but deal-making faces headwinds

Tucked away in the Reserve Bank of India’s (RBI’s) Trend and Progress of Banking in India for 2019-20 (T&P:2020) is this detail — the price paid by asset reconstruction companies (ARCs) to buy bad loans from banks, as a proportion of the book-value of assets, fell from 38 per cent in FY19 to 35 per cent in FY20. This is the lowest level in five years. Clearly, the realisable value of these assets is fast slipping.

With the Supreme Court vacating the one-year breather on the filing of insolvency proceedings, it’s back to the grind on the bad-loans front. At one level, the Bankruptcy and Insolvency Code (IBC) process is seen getting more clogged with a spate of suits expected to be filed. Will the other valves help release the pressure?

Is there money in the dustbin?

Says Niloufer Lam, partner at Mumbai law firm ZBA: “The distressed-assets space has gained huge traction in the last two years. There are broadly two regimes — the IBC, and outside of it, which is entirely contractual.” It also needs to be qualified here that while the RBI’s latest Financial Stability Report (FSR) has stated that dud-loans could rise to 13.5 per cent under the baseline stress scenario, it’s not that this pile is open for deal-making.

Lam believes that “new investors acquiring minority or majority stakes in companies outside of the insolvency process have to carefully consider both pricing and risk in a more nuanced way.” Distressed-asset funds are circling as well. The State Bank of India and the Carlyle Group propose to set up a distressed-asset fund with a corpus of nearly $1.5 billion. Others include Varde Partners and Brookefield.

“Our distressed-assets business operates as a single desk that functions seamlessly across all markets we are present in. That allows us the opportunity to not only draw global investors to transactions across geographies, but also allocate our own capital very efficiently,” says Rahul Chawla, head of global credit trading and co-head of investment bank coverage at Deutsche Bank (India). He adds: “If there is an opportunity to do bilateral deals, we will. It all depends on our level of comfort.”

Sharing space with Chawla is Sandeep Chandak, managing director at Varde Partners, who argues that the combined shocks of pre-existing bad loans, extreme volatility among non-banking financial companies, and Covid-19 have created a significant supply-demand imbalance for credit. “Across the spectrum of the need for one-time settlements on one hand, through to performing credit on the other, alternative credit has become increasingly relevant, because it’s flexible enough to provide the right type of solution, according to individual situations,” he points out. So, it makes sense to tread carefully.

Below the radar

The next steps after the proposal in the Union Budget to set up an ARC and an allied structure to buy out and turn around stressed assets will be keenly watched. Nitesh Jain, director, CRISIL Ratings, points out: “The capitalisation, ownership structure and limited secondary market for stressed assets in India are key issues to be addressed.”

The T&P:2020 noted that the share of security receipts (SRs) subscribed by banks fell from 80.5 per cent in FY18 to 66.7 per cent in FY20. This is because ARCs were incentivised to up their skin-in-the-game and diversify the investor base by bringing in other financial institutions.

“The ARC model has gone through multiple iterations over the last two decades and is still not settled. And banks are more keen on cash settlement than holding SRs,” says Tarun Bhatia, managing director and head of South Asia (Business Intelligence and Investigations practice), at Kroll. The SR model itself was a case of brilliant book-keeping: The sale of bad loans to ARCs was funded largely by banks themselves. And what was shown as “loans” moved to “investments” (treasury).

Bhatia adds: “Participants in the distressed markets will have to be flexible on the structure they use — ARC versus fund structure. ARCs will aggregate only if they think it helps in a faster resolution.” What is left unsaid here is that bankers will be reluctant to transfer dud loans at a steep discount. 

There is also no data on sales by banks to ARCs or distressed asset funds. “I suppose priorities changed due to the pandemic. Is it because banks feel that there is no interest in the market, or ARCs don’t have the money, or the foreigners no longer seem to be there? I don’t know,” says a banker. 

Then again, there is the inter-creditor agreement, which Divyanshu Pandey, partner at S&R Associates, says has not delivered. “For any resolution framework to be effective, creditors need to adopt an approach which facilitates a viable solution (even though sub-optimal for a creditor). If not, even the much-anticipated prepack route can turn out to be a non-starter.”

So, it’s back to the drawing board.

Just think about it

The RBI’s Financial Stability Report (FSR) of January 2020 had warned that systemic dud-loans may rise sharply to 13.5 per cent by September 2021, from 7.5 per cent in the same period of 2019-20, under the “severe stress” scenario. For state-run banks this is expected to rise to 16.2 per cent (under the baseline scenario), from 9.7 per cent in September 2020, and to a high of 17.6 per cent in a “severe stress” scenario.

What should be recalled is that the FSR had reverted to the regular three-scenario analysis, and done away with the “very severe stress” scenario introduced in the July 2020 FSR. Just what would that figure have been? Distressed assets, anyone?