Indian asset reconstruction companies (ARCs) present a bizarre mix of ageing and infancy. Fourteen out of 16 operating ARCs in the country have been in the business for over a decade. This period is sufficient for the industry to mature. However, the industry still displays infantile behaviour judging from an insignificant capital of Rs5,757 crore employed by the sector and assets under management of about Rs50,000 crore, relative to banking sector's non-performing assets (NPAs) of Rs3.10 lakh crore as March 2015, and low profitability vis-à-vis the underlying business risk (see Graph-1). The NPAs have galloped to Rs5.94 lakh crore as on March 2016, and this anomaly has only worsened.
The recent guidelines issued by the Reserve Bank of India (RBI) are set to change the ARC business forever. Recently, three new ARCs have been added, and more are about to follow. Can the ARC business, which has languished for over a decade look up now?
Indian ARCs are the by-product of tardy and inefficient legal system characterised by clogged and inefficient Debt Recovery Tribunals (DRTs), Debt Recovery Appellate Tribunals (DRATs) and higher courts, and public sector banks' high and growing NPAs. The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interests (SARFAESI) Act, 2002 introduced ARCs as intermediaries to buy NPAs from bank on payment of a part of acquisition cost in cash with the remaining cost being deferred. The NPA acquisition and management by ARC is done through a trust, which issues security receipts (SRs) to the ARCs for the cash payment and to the seller banks for the deferred part. The SRs are redeemed out of the recovery from NPAs, and the unredeemed SRs due to recovery shortfall are written off without recourse to the ARC. The management fee of ARCs as a fixed percentage of total SRs outstanding ensures high returns to ARCs in case of low SR investment even with significant SR write off. In the initial years, low SR subscription and issue of senior SRs to ARCs led to NPA acquisition at bloated book values and gave high returns to the ARCs despite significant SR write off in the later years, which impacted the seller banks adversely. Hence, in September 2006, RBI made at least 5% SR subscription by the ARCs mandatory (5:95 structure). Having suffered due to SR write offs, banks continued to insist on all-cash or major-cash NPA sales during 2007-2013, with the result that 5:95 sales during this period remained sporadic.
The banks returned with 5:95 sales in FY-2014. The 5:95 structure based on management fee of 1.5% per annum could deliver to ARCs around 18-20% return over a five-year horizon even with just one-third recovery ratio (total recovery as percentage of acquisition cost). This led to highly aggressive bidding for NPA acquisition by some ARCs, which led to introduction of 15:85 structure in August 2014, mandating a minimum of 15% SR subscription by ARCs. The management fee was also linked to the NAV of SRs. The 15:85 structure with the prevalent management fee of 1.5% pa contributed 10% to the ARCs' yearly return as against 30% in 5:95 structure. Thus, for say five-year horizon and 20% return under the 15:85 structure, the ARCs not only had to achieve full SR redemption, but also earn upside income from the surplus after full SR redemption. Hence, the 15:85 structure induced efficient NPA bid pricing, which was substantially lower than in 5:95 structure, and did not enhance ARC's cash commitment with 15% SR subscription (see table below).
The banks did not accept 15:85 bid prices, which were fraction of 5:95 bid prices, and the NPA sales dried up, barring exceptions for consolidation and strategic reasons. To generate higher bid prices, the banks permitted high management fee of up to 3% per annum, and recovery incentives. However, these could not mimic 5:95 bid prices and the NPA sales remained muted as expected. (Read: RBI restores sanity
RBI’s September 2016 Guidelines
Banks' major incentive for sale of NPAs to ARCs was the end of further provisioning since the SRs were treated as investment, and needed to be marked down only if the net asset value (NAV) of SRs dipped below the issue price. According to the new guidelines, from FY2018, the banks holding more than 50% SRs will have to make provisions on the SRs treating these as loans, or to the extent of NAV shortfall if it exceeds normal provisioning. From FY2019, this guideline will apply even where ARCs hold 10% SRs. The new provisioning is meant to achieve true sale presumably through all-cash sales of NPAs. The moot point is when sales under 15:85 structure nose-dived due to low pricing, will the lower all-cash pricing fire the NPA sales?
The new guidelines permit "other banks, non-banking financial companies (NBFCs) and financial institutions (FIs) etc." also to bid for NPAs for "better price discovery" and at the same time require two external valuations of NPAs with a bank's exposure of Rs50 crore and above. For valuation, the banks are required to adopt cost of equity or average cost of funds or opportunity cost or some other relevant rate, subject to a floor of the contracted interest rate and penalty, if any as discount rate for arriving at reasonable realizable value of the NPA. The valuation principles dictate that the discount rate should relate to the cost of capital of the target asset for acquisition. For a risk proven target NPA, the discount rate should capture the risk profile of the NPA, and this is best left to the competing acquirers. The bank's cost of capital as discount rate implicit in the guideline and the seller's valuation bias will continue to overstate the asset value and the reserve price which does not leave any margin for the intermediary buyers, and perpetuate the valuation mismatch which has stunted 15:85 sales.
RBI has prescribed number of schemes for restructuring of stressed assets, and the banks invariably adopt those for financially distressed accounts, and sell only the left overs to ARCs. Hence ARCs' bid prices are at a significant discount to the loans outstanding consistent with the asset risk profile. This has also emerged from RBI statistics according to which the ARCs acquired NPAs at prices varying from 17.2% to 20.8% of loans outstanding during FY2010 to FY2013, when the acquisitions were largely cash based (see Graph-2). These deals at low percentage of loans outstanding happened as they were purely market determined. Interestingly, acquisition at these prices has not enriched the ARCs as is evident in graph-1.
The World Bank and IFC's 2014 Doing Business Report states that, "in India, resolving insolvency takes 4.3 years on average and costs 9.0% of the debtor's estate, with the most likely outcome being that the company will be sold as piecemeal sale. The average recovery rate is 25.6 cents on the dollar" (page 206
). This is indicative of asset overstatement by the borrowers, which can only compound the banks' valuation bias and impede NPA sales. In the circumstances, will the new entrants fire up the market? We will examine that tomorrow.
(Rajendra M Ganatra, PhD is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 26 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal