RBI has replaced the 5:95 model with 15:85. Can something be done to retain the current cost structure for ARCs and mitigate the management-fee driven model? Here are the options
Stung by the aggressive management-fee based model adopted by Asset Reconstruction Companies (ARC), Reserve Bank of India (RBI), on August 5, 2014, has disbanded popular 5:95 model by enhancing ARC’s minimum Security Receipt (SR) subscription to 15%. In the 5:95 model, ARCs could fund their NPA acquisition by issuing Security Receipts (SRs) to the seller banks for up to 95% of NPA acquisition cost, with a minimum of 5% of the SRs being funded in cash by the ARCs. The management fee that was earlier linked to the outstanding SR value has now been linked with the lower end of the Net Asset Value (NAV) of SR based on the credit rating. What will be the impact of the new 15:85 model? See the graph below.
The 5:95 model with back-ended recovery profile gave attractive returns to the ARCs for different levels of recovery (30% to 110% of acquisition cost) from 21% (pre-tax Internal Rate of Return) to 32% over 5-year resolution horizon. For the same recovery range, the 15:85 model delivers poor returns, ranging from -11% to 10%. In order to match the 5:95 returns, the acquisition costs have to be substantially lower, ranging from 17% to 37% of the 5:95 acquisition cost. For a modest 20% return in the above range, the acquisition cost has to be 18-66% of the 5:95 acquisition cost. What do we infer from this?
First, correlation between acquisition cost and recovery has been restored. The ARCs will have to assess recovery prospects carefully. Even for a modest 15% return, with back-ended recovery profile, ARCs will have to clock total recovery of app. 135%. As we have seen earlier, for recovery beyond acquisition cost, front ended recovery is most beneficial to the ARCs. Hence for enhancing returns, ARCs will have to speed up the recovery process.
Second, in 15:85 structure, probability of SR write off and back-ended provisioning by the banks will tend to be zero. This will result from acquisitions by ARCs at realistic values, which would evidently entail immediate provisioning by the banks. The banks will now have to be bold to sell the portfolios notwithstanding immediate provisioning. The bank chiefs will no more be able to leave this unpleasant job to their successors.
Third, acquisition volumes will shrink. No wonder the RBI is considering licences for new entrants. Could something be done to retain the 5:95 structure and mitigate the management-fee driven model? Yes. There are options.
Lower management fee: In the above model, with 5:95 structure, same returns as with 15:85 models are achieved if the management fee is reduced from 1.5% pa (on outstanding SRs) to app. 0.50% pa. The banks are aware of the impact of management fee, and have been allowing 2% management fee to attract aggressive bidding for certain portfolios.
Link the management fee to recovery: Equitable cash distribution is possible, if the management fee is linked to the actual recovery. The graph below shows that the management fee of 0.75% of the cash recovery with a back-ended recovery profile results in positive IRR to the ARC beyond 60% recovery, and a modest 16% IRR at 110% recovery, with no SR write off and loss to the banks. Linking the fee to actual recovery poses income recognition problems which can be resolved.
The major challenge with the recovery model is the bid evaluation by banks. If the management fee is linked only to the recovery, what is the utility of the acquisition cost quoted by the ARCs? And how will the banks evaluate the bids? The conflict can be resolved easily by linking the recovery to the acquisition quote on the lines the private equity fund managers share the upsides. Even with 5:95 structure, the recovery based model can be designed sans the moral hazard with current 5:95 model. This model will do away with the need to determine NAV based on the subjective and often unrealistic credit rating needed in 15:85 structure, and will, therefore, be more scientific and cost efficient. It is expected that in due course, RBI will adopt this alternative recovery based fee model.
To sum up, the 15:85 structure is the right move but not final. ARCs will come into being only when the legal system is revamped as I mentioned earlier.
(Rajendra M Ganatra
is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)