Many infrastructure loans are viable only at steep 50-70% haircuts. Banks are unwilling to take such a massive hit on profitability by selling down to ARCs, says a report. Hence, the budget provision of getting FDI into ARCs won’t work
In his third Budget, Finance Minister Arun Jaitley had announced 100% foreign direct investment (FDI) in asset reconstruction companies (ARCs) and similar foreign portfolio investment (FPI) in security receipts used in the transactions besides providing a better tax clarity. While these steps are long term positive for ARCs, it will not ease asset quality woes of banks sitting on a huge mountain of non-performing assets (NPAs), says a research note.
In the report, Religare Capital Markets Ltd, says, "We met three large ARCs operating in India to assess the impact of regulatory changes proposed in the Union Budget. ARCs are unwilling to buy large loans given the concentration risk and uncertainty with respect to timing and extent of recovery. Differential valuations are also hurting sell-downs."
The budget proposes that sponsors be allowed to own 100% in ARCs as against 50% earlier. This will improve the credit rating of ARCs, in turn bringing down their cost of funds and enabling higher leverage. Also, foreign investors (mainly debt) will be allowed to own security receipts (SR) of ARCs, helping the latter diversify fund sources. "In all, the proposed changes (see table at right) are expected to address ARCs’ capital needs, but we believe the impact will be seen over the longer term. Thus, medium-term pain on the NPA front will continue for banks," the report says.
However, Religare Capital Markets feel that the capital constraints of ARCs are unlikely to ease in a hurry. It says, two key changes like allowing the sponsor own 100% in ARCs and allowing FPIs to own SRs, will need amendments to the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act where the support of opposition parties is critical. "As per our meetings, the combined net worth of all ARCs is about Rs3,500 crore and assets managed around Rs40,000 crore. Many conservative ARCs are operating at low leverage and do not wish to increase this," it says.
"Sponsor capital will only flow after changes to the SARFAESI Act," the report pointed out, adding, "ARCs do not have the scale to buy out lenders in large companies in steel and infrastructure. They argue that buying small stakes from one or two lenders will not help, as recovery or implementation of the restructuring package becomes difficult with a minority stake."
According to Religare Capital Markets, India’s ARC model is best suited for retail, small and medium-sized enterprises (SME) and mid-size corporates where legal issues are more manageable and the recovery amount and timeline largely predictable. In contrast, large corporates have complex legal issues and the timing or extent of recovery is uncertain. Most large companies have cross guarantees for group entities and unfunded exposures that are difficult to assess. Working capital funding for revival is also a problem given the large amounts involved, even as finding a suitable buyer (bank) for the debt post-turnaround may be hard. For ARCs, a delay in recovery by even a year can materially impact return ratios, it says.
There is a wide valuation differential for infrastructure loans and so far, there have been very few ARC deals in the infrastructure space where asset quality stress is the highest. Many infrastructure loans are standard or restructured (provision cover of 5%) in the books of banks. As these loans are viable only at steep 50-70% haircuts, banks are unwilling to take such a massive hit on profitability by selling down to ARCs.
Religare Capital Markets feels that the transition to without-recourse model a distant dream in India. It says, "ARCs are of the view that under the existing 15:85 structure, they can generate an ROE of 18-20% if they are able to recover 25-30% of the debt over and above the actual amount paid by them to banks. Valuation is a contentious issue for without-recourse (all-cash) buyouts. ARCs are willing to pay half the price for a cash deal as compared to 15:85 structures, whereas banks are reluctant to sell assets at very low valuations."
While remain underweight on the sector, the reports states that corporate lenders are in its avoid list and it prefer playing the sector through private retail banks.