Rejuvenation of India’s stressed assets space

The Insolvency and Bankruptcy Code (IBC), while expeditiously resolving large amounts of non-performing assets, has opened up lucrative investment opportunities

December 28, 2018

In February, 2018, the Reserve Bank of India (“RBI”) had ordered all commercial banks to take immediate, time bound action against defaulting borrowers

For Asset Reconstruction Companies, the combination of financial scrutiny and a robust insolvency framework has made this an opportunity like no other

Behemoths such as KKR, Blackstone, CDPQ, JC Flowers, Lone Star, Bain Capital and the IFC have set up subsidiaries or form partnerships with Indian ARCs

As of August, 2018, creditors had recovered nearly US$7.2 billion from 32 different companies through the IBC, with an average recovery rate of 56.2 per cent

In February, 2018, the Reserve Bank of India (“RBI”) had ordered all commercial banks to take immediate, time bound action against defaulting borrowers. This came on the heels of the Insolvency and Bankruptcy Code that was introduced in 2016 and had revolutionized the debt recovery framework in the country. These actions were needed to curb a growing menace on the balance sheets of India Inc – the throbbing headache of stressed assets. While curbing the menace of non-performing assets, the measures have opened up opportunities in the whole of stressed assets sector.

For Asset Reconstruction Companies (“ARCs”), the key players in the stressed assets sector, the combination of greater financial scrutiny and a robust insolvency framework has made this an opportunity like no other. Estimates place the value of these stressed assets at US$235 billion.  There exists a tremendous supply of stressed assets and a favorable regulatory environment in which to operate.

Understandably, the interest in this sector by foreign investors has been unprecedented. In the last few months alone, the industry has witnessed behemoths siuch as KKR, Blackstone, CDPQ, JC Flowers, Lone Star, Bain Capital and the IFC set up subsidiaries or form strategic partnerships with domestic ARCs in India. This interest was cultivated by the interplay of three factors: the Insolvency and Bankruptcy Code (“IBC”), the RBI’s Stressed Assets Resolution Framework and a conducive investment environment for ARCs.

The Insolvency and Bankruptcy Code

The IBC was introduced in May, 2016. It replaced the earlier framework consisting of numerous distinct and, at times, contradictory legislations. It was a step towards a creditor friendly debt recovery process, administered by specialized Tribunals which provided for a conducive judicial ecosystem. Though recent in its origin, the IBC has made quick work of a number of insolvent companies already. Bhushan Steel was the first company to be resolved under the IBC. The company was sold to Tata Steel for a sum of US$5.1 billion. As of August, 2018, creditors had recovered nearly US$7.2 billion from 32 different companies through the IBC, with an average recovery rate of 56.2 per cent.

The IBC’s shift from a Debtor-in-Possession model to one of Creditors-in-Control is paradigm changing. Creditors can now initiate proceedings against a debtor when default thresholds are breached. If admitted, by the National Company Law Tribunal (“NCLT”), the promoters are ousted and control is vested with a Committee of Creditors (“CoC”). Meanwhile, the day-to-day management is overseen by an expert Resolution Professional appointed by the CoC. The Creditors are given a strict 180 day timeline to frame a strategy for reviving the debtor and any resolution plan must be approved by 75 per cent of the CoC. If no plan is approved within 180 days, the Debtor must undergo compulsory Liquidation. After this liquidation, the distribution waterfall, aside from costs, gives first priority to secured creditors.

The NCLT and National Company Law Appellate Tribunal, the specialized tribunals charged with administering the IBC, have also demonstrated commendable restraint and an unwillingness to entertain frivolous challenges designed to delay the resolution. This is particularly encouraging given that major grievance with the earlier framework centered around judicial delay and intervention.

In the last few months alone, the industry has witnessed behemoths siuch as KKR, Blackstone, CDPQ, JC Flowers, Lone Star, Bain Capital and the IFC set up subsidiaries or form strategic partnerships with domestic ARCs in India

RBI’s Stressed Assets Resolution Framework

The RBI’s ‘Revised Framework for the Resolution of Stressed Assets’ has supplanted previous directives put in place, to bring the regulator’s policy in conformity with the IBC. This framework requires banks to address NPAs in a systematic and time bound manner while abiding by rigorous reporting procedures.

Banks are required to notify the Central Repository of Information on Large Credits of any defaults on a weekly basis where the account exceeds US$720,000, apart from submitting monthly reports on its large accounts (US$288 million or more). To deal with defaults, every bank is required to put in place a resolution procedure, approved by the board, which details the bank’s resolution policy and the timelines applicable. However, the notification prescribes a maximum period of 180 days for loan accounts whose value is US$288 million or more. If an agreement is not reached within the stipulated time-frame, defaulters can be certain that they will be staring down the barrel of a resolution petition under the IBC.

This revised framework has accelerated the loan restructuring process which was largely promoter driven. With the threat of the IBC lurking nearby, lenders now have strong leverage against debtors.

Regulation of ARCs and Liberalized Investment

The Indian government has overhauled the regulations governing ARCs. Earlier, ARCs could acquire an asset with a 5:95 model, which meant only 5 per cent  of the cost had to be paid upfront while the rest could be paid with security receipts. Under this model, ARCs maintained a steady IRR merely on management fees without needing to restructure the assets themselves. Due to its ineffectiveness, a 15:85 model was introduced. This ensured that ARCs had more skin in the game and gave lenders more liquidity. The larger upfront payment made lenders more willing to take a haircut on the assets themselves, making it more profitable for the ARC to restructure assets. Therefore, while ARCs now require a larger capital base, it helped to align incentives in a manner conducive to the overall goal of restoring assets to profitability, efficiently. It also led to the consolidation of the market.

Another major stimulant was the liberalization of Foreign Direct Investment (“FDI”) norms for ARCs. In May 2016, the Government allowed 100 per cent FDI in ARCs under the automatic route, as opposed to the earlier limit of 49 per cent. This allowed foreign ARCs to set up operations in India directly as opposed to collaborating with domestic ventures, giving them more flexibility in operations and control. Nevertheless, a number of investors have chosen to join hands with established Indian ARCs while remaining bullish about the possibility of going independent in the future.

Improving strength in economy

The entry of foreign ARCs has brought in much needed patient capital. It exponentially increased the ability of ARCs to work with banks in acquiring stressed assets off their balance sheets. An estimate by Nomura pegged the total value of stressed assets in India at US$235 billion, of which, gross NPAs accounted for US$150 billion. On the other hand, CRISIL estimates that only US$14.4 billion of these NPAs are being managed by ARCs. This clearly illustrates the abundance of opportunities in India.

The combined effect of a favorable regulatory environment and stricter financial scrutiny has investors racing to set up operations in India. With that, it seems safe to conclude that this cocktail, of heavyweight ARCs and a strong IBC, is the aspirin needed to relieve India’s stressed assets headache.

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