Contact Your Financial Adviser Money Making MC
19
September 2016
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Loans (The Total Investment & Insurance
Solutions)
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 Total Investment &
Insurance Solutions
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ROE (The Total Investment & Insurance
Solutions)
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? The Total Investment &
Insurance Solutions
Sluggish business
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 Total Investment & Insurance
Solutions
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).
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SR subscription (The Total Investment & Insurance
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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) The
Total Investment & Insurance Solutions
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
Total Investment & Insurance Solutions
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.
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| Loan Outstanding (The Total Investment & Insurance Solutions) |
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.The Total Investment & Insurance
Solutions
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