Asset reconstruction at crossroads

Illustration by Jayachandran/Mint

Live Mint  Ranjan Bakshi FEB 25 2014. 08 07 PM

Traditional asset reconstruction companies are facing stiff competition from vulture funds in an open market

It’s been a long time coming, but the Reserve Bank of India’s (RBI’s) latest pronouncements in the Framework for Revitalizing Distressed Assets in the Economy, issued in January, is finally beginning to set the asset reconstruction companies (ARCs) conundrum in perspective. The central bank has moved decisively on mechanisms for early detection and redressal of stress in the financial system, but ARCs have been neglected for a long time. RBI has finally woken up to this struggling infant, but in trying to make amends, has it inadvertently penned its requiem?

Over the years, watchful regulators across the world have struggled to mop the party floor after nights of excessive credit binges. Developed economies such as the US and UK have developed a well honed legislative and regulatory regime seamlessly operating with its financial system and creating a healthy market for high yields. ARCs in India were set up at the turn of the century against the backdrop of the Asian meltdown and the dotcom bust. Recalcitrant borrowers reneged with impunity as banks whistled for their money. Gross non-performing assets (NPAs) of public sector banks hovered at an alarming 16%. The long overdue Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (Sarfaesi) Act heralded seminal changes by providing much needed succour to banks reeling under an unresponsive and overburdened legal system. However, not content with handing the banks a stick to beat defaulters with, RBI decided to go the extra yard. It, very sensibly, handed out seven ARC licences.

The recorded tale of ARCs has since been a litany of woes. The deputy governor of RBI, in his address to BANCON in July 2013, lamented the reluctance of the banks to part with their NPAs and noted that divestments were down from Rs.13,000 crore in 2008 to Rs.6,000 crore in 2012. Gentle prodding is now beginning to take on ominous overtones as RBI is clearly not amused. NPA pricing has become a perpetual bone of contention between the banks and ARCs. Against global averages of between 10-20 cents, current Indian auctions clear well over 40 cents. Barring Asset Reconstruction Company (India) Ltd (Arcil), which has big boys as sponsors, most ARCs continue to be fledglings, grateful for whatever crumbs come their way. Universal application of Sarfaesi Act provisions to all banks was a long overdue necessity. However, imagine for a moment if the Sarfaesi Act were restricted to ARCs alone. Suddenly they would’ve taken on a whole new meaning with clear differentiation between where banks left off and ARCs stepped in. Creating specialized agencies without exclusive powers and instead placing them on par with banks wasn’t quite designed to secure their niche. Unfortunately that is all in the realm of conjecture now and banks today cannot be faulted for questioning the value added by ARCs to the resolution process. In short, what can ARCs do that the banks cannot; more so, if resolution skills are seen to be restricted to mere asset stripping? Viewed in this light, the bank’s reluctance to part with assets to ARCs at deep discounts becomes apparent.

Unlike developed markets, where term financing has primarily been via public issuance of bonds and debentures, term debt in India has historically been the sole preserve of banks and financial institutions. Asset accretion driven balance sheet building inhibits secondary trading of debt. This, in turn, inhibits transparent price discovery. A host of operational issues continued to dog the industry’s faltering steps. Tackling wilful defaulters without the power to change managements or take board room control was akin to entering a mortal combat with one arm firmly tied behind your back. Raising equity and funding was severely constrained by caps on foreign institutional investor participation. This left out the larger international fund managers with the requisite know-how and appetite to contribute effectively to the resolution effort. The passage of the Enforcement of Security Interest and Recovery of Debts Laws (Amendment) Bill, 2011, has attempted to plug these loopholes. While allowing ARCs to convert debt to equity, it not only established the primacy of ARCs but additionally provided meaningful exit options to beleaguered investors in distressed assets. Ability to acquire underlying securities insured ARCs against distress sales and reduction of consent of lenders to 60% of total borrowings has provided some relief against the merry-go-round called aggregation.

But RBI has now gone a step further. In its press release of 30 January, the central bank seems to suggest now that the playing field has been levelled; it is time to open up the market. In slow measured steps it has now permitted private equity funds/non-banking finance companies to participate in auctions by banks. Sarfaesi protection will, ipso facto, be made available to these entities for resolving the auctioned cases and also for resolving their own NPAs.

ARCs are now up against a far more formidable challenge than an apathetic regulatory regime. These distressed asset/vulture funds are not licensed ARCs with a limited mandate to negotiate purchases from banks. They are free birds with choice of assets, diversified revenue streams, deep expertise and large pools of funding. This is as it should have been from the outset—Sarfaesi applicable to all and NPA resolution open to anyone with the requisite resources. So, whither ARCs? Will they, like an appendix, be reduced to footnotes or will they reinvent themselves to stay relevant and morph into the very funds they now feel threatened by.

Ranjan Bakshi is a risk specialist in private equity and was earlier managing director of hedge fund Strategic Value Partners and Deutsche Bank’s distressed assets business in Europe.