 "asset reconstruction business")
By 2026, asset reconstruction companies (ARCs) are required to augment their capital to Rs 300 crore from the current Rs 100 crore. Just how are they expected to do this? “This is the million-dollar question, given that ARCs are not able to get even moderate leverage through medium- to long-term finance,” says R K Bansal, managing director and chief executive officer, Edelweiss ARC.
He reckons that if ARCs have to work on pure equity play, the acquisition price of stressed assets will have to be lowered substantially to ensure a reasonable return on equity. “This will render the sale to ARCs a non-starter. And in the current circumstances, there may not be much interest among investors to inject funds into ARC equity,” he adds.
Life has turned tougher for ARCs after the Reserve Bank of India’s (RBI’s) revised framework for the business (October 11, 2022). It will test most of the 28 ARCs, since they need to attain a capital threshold of Rs 200 crore in FY23 itself — a runway of just five months (even as they get three years more to raise another Rs 100 crore).
Five ARCs accounted for 70 per cent of the assets under management (AUM) in FY21, per the latest RBI data. Only three of them had net-owned funds (NoF) of more than Rs 1,500 crore, and held 54 per cent of the total capital base of all entities in this business. As for the scorecard, recoveries were a mere 14.29 per cent of the stressed assets sold to ARCs during the decade ended FY13.
In these circumstances, who will supply capital to ARCs?
Bank-centric funding
“The definition of a ‘qualified buyer’ needs to be expanded. It should include high-net-worth individuals (subject to a minimum investment size), corporates, family offices and pension funds,” points out Divyanshu Pandey, partner at S&R Associates. It helps that the Securities and Exchange Board of India has allowed Alternate Investment Funds to be set up as special situation funds to invest in distressed assets.
Funding of ARCs has largely been bank-centric. A peculiar aspect was the transferor’s (lender’s) subscription to the security receipts (SRs) issued by the ARC’s Trust (a special purpose vehicle) for an asset. Of this, the transferor took 85 per cent, and the ARC the rest. In effect, the purchase of the stressed loan by the ARC was in large part financed by the transferor’s subscription to the SRs (the 85 per cent portion). And what was shown as a loan on the books by the latter would crop up on the investment side as SRs. This was top-class accounting.
On the ARCs’ subscription to the SRs, the RBI has now said that it will either be 15 per cent of the transferors’ investment in the SRs, or 2.5 per cent of the total SRs issued, whichever is higher. “This will free up capital for ARCs. As for their funding structure, not many ARCs are highly leveraged. My point is that if you are taking on exposure to high-risk assets on the balance sheet, the funding should ideally be largely through equity,” notes Krishnan Sitaraman, senior director and deputy chief ratings officer at CRISIL Ratings.
There is also a view that the government’s guarantee of Rs 30,600 crore provided for the SRs and issued by the National Asset Reconstruction Company (NARCL) privileges it over other ARCs. But, as Sitaraman explains, “NARCL is expected to be involved in legacy stressed loans of large ticket sizes of above Rs 500 crore, while many of the existing private sector ARCs are focusing on stressed loans to micro, medium, and small enterprises and the retail sector.”
Will it work?
In March this year, Minister of State for Finance Bhagwat Karad said in a written a reply to the Lok Sabha that 11 banks had recovered nearly Rs 61,000 crore (in 3,823,432 cases) by way of one-time settlements (OTS) over three financial years — up to December 2021 (that is, the third quarter of FY22).
Per RBI’s existing norms, banks are to have a board-approved loan recovery policy, which may cover negotiated settlements through compromise, including OTS, under which recoveries of bad loans are to be effected to the maximum extent possible at minimum expense. The OTS option raises a question: why should banks take the ARC route other than for the larger stressed credits? Here again, a large portion has anyway gone under the Insolvency and Bankruptcy Code (IBC).
This leads us to another issue. The RBI has allowed ARCs to be a Resolution Applicant (RA) which, under section 5(25) of the IBC, refers to a person or entity that submits a resolution plan to the resolution professional. However, there are preconditions: the ARC must have a NoF of Rs 1,000 crore; a board-approved policy relating to its role as an RA; a committee composed of a majority of independent directors will take decisions on submission of resolution plans under the IBC; and the ARC is required to explore the possibility of preparing a panel of sector-specific management firms and individuals.
“This (RA aspect) would work particularly well in cases where the corporate debtor belongs to an industry which would require some time to revive and warehousing such assets could substantially enhance the value of resolution like, say, thermal power plants,” notes Bansal.
He reckons that if ARCs have to work on pure equity play, the acquisition price of stressed assets will have to be lowered substantially to ensure a reasonable return on equity. “This will render the sale to ARCs a non-starter. And in the current circumstances, there may not be much interest among investors to inject funds into ARC equity,” he adds.
Life has turned tougher for ARCs after the Reserve Bank of India’s (RBI’s) revised framework for the business (October 11, 2022). It will test most of the 28 ARCs, since they need to attain a capital threshold of Rs 200 crore in FY23 itself — a runway of just five months (even as they get three years more to raise another Rs 100 crore).
Five ARCs accounted for 70 per cent of the assets under management (AUM) in FY21, per the latest RBI data. Only three of them had net-owned funds (NoF) of more than Rs 1,500 crore, and held 54 per cent of the total capital base of all entities in this business. As for the scorecard, recoveries were a mere 14.29 per cent of the stressed assets sold to ARCs during the decade ended FY13.
In these circumstances, who will supply capital to ARCs?
Bank-centric funding
“The definition of a ‘qualified buyer’ needs to be expanded. It should include high-net-worth individuals (subject to a minimum investment size), corporates, family offices and pension funds,” points out Divyanshu Pandey, partner at S&R Associates. It helps that the Securities and Exchange Board of India has allowed Alternate Investment Funds to be set up as special situation funds to invest in distressed assets.
Funding of ARCs has largely been bank-centric. A peculiar aspect was the transferor’s (lender’s) subscription to the security receipts (SRs) issued by the ARC’s Trust (a special purpose vehicle) for an asset. Of this, the transferor took 85 per cent, and the ARC the rest. In effect, the purchase of the stressed loan by the ARC was in large part financed by the transferor’s subscription to the SRs (the 85 per cent portion). And what was shown as a loan on the books by the latter would crop up on the investment side as SRs. This was top-class accounting.
On the ARCs’ subscription to the SRs, the RBI has now said that it will either be 15 per cent of the transferors’ investment in the SRs, or 2.5 per cent of the total SRs issued, whichever is higher. “This will free up capital for ARCs. As for their funding structure, not many ARCs are highly leveraged. My point is that if you are taking on exposure to high-risk assets on the balance sheet, the funding should ideally be largely through equity,” notes Krishnan Sitaraman, senior director and deputy chief ratings officer at CRISIL Ratings.
There is also a view that the government’s guarantee of Rs 30,600 crore provided for the SRs and issued by the National Asset Reconstruction Company (NARCL) privileges it over other ARCs. But, as Sitaraman explains, “NARCL is expected to be involved in legacy stressed loans of large ticket sizes of above Rs 500 crore, while many of the existing private sector ARCs are focusing on stressed loans to micro, medium, and small enterprises and the retail sector.”
Will it work?
In March this year, Minister of State for Finance Bhagwat Karad said in a written a reply to the Lok Sabha that 11 banks had recovered nearly Rs 61,000 crore (in 3,823,432 cases) by way of one-time settlements (OTS) over three financial years — up to December 2021 (that is, the third quarter of FY22).
Per RBI’s existing norms, banks are to have a board-approved loan recovery policy, which may cover negotiated settlements through compromise, including OTS, under which recoveries of bad loans are to be effected to the maximum extent possible at minimum expense. The OTS option raises a question: why should banks take the ARC route other than for the larger stressed credits? Here again, a large portion has anyway gone under the Insolvency and Bankruptcy Code (IBC).
This leads us to another issue. The RBI has allowed ARCs to be a Resolution Applicant (RA) which, under section 5(25) of the IBC, refers to a person or entity that submits a resolution plan to the resolution professional. However, there are preconditions: the ARC must have a NoF of Rs 1,000 crore; a board-approved policy relating to its role as an RA; a committee composed of a majority of independent directors will take decisions on submission of resolution plans under the IBC; and the ARC is required to explore the possibility of preparing a panel of sector-specific management firms and individuals.
“This (RA aspect) would work particularly well in cases where the corporate debtor belongs to an industry which would require some time to revive and warehousing such assets could substantially enhance the value of resolution like, say, thermal power plants,” notes Bansal.
