Asset reconstruction companies (ARCs) are expected to circle stressed accounts in the micro, small and medium enterprises (MSME) and retail segments in the near-to-medium term due to the twin challenges of inadequate funding access and intensifying competition from the proposed National ARC, says a research note.
In the report, ratings agency CRISIL says it believes the stressed assets space will see segmentation, with players having different focus areas and availability of capital, debt aggregation capability, and operational infrastructure will define the positioning of each player.
According to Krishnan Sitaraman, senior director and deputy chief ratings officer at CRISIL Ratings, the National ARC, given its stated mandate and access to capital, is expected to dominate the large corporate segment.
He says, “Mid-corporate assets, where ARCs have a relatively better recovery track record, could be a play for them as well as for stressed assets funds. In the retail and MSME segments, however, ARCs have the opportunity to create niches. These segments need an operationally intensive setup that other investor classes are unlikely to be interested in creating. Given the higher operational expenditure (opex) needed, the volume will be key to profitability, so ARCs that invest will need to maintain a sharp focus on this segment.”
ARCs have been facing headwinds in the past two fiscals, with assets under management (AUM) - as measured by security receipts (SRs) outstanding - contracting after a strong run-up in the previous five.
Between fiscals 2015 and 2019, their AUM had expanded steadily on supportive regulations introduced in fiscal 2014. But that trend then reversed in fiscal 2020 with about 4% contraction. In fiscal 2021, too, as per CRISIL Ratings estimates, AUM contracted around 1% to Rs1.07 lakh crore (see chart below).
While the slowdown is partly attributable to the general macro environment, which has hindered the consummation of deals and heightened risk aversion among investors, CRISIL sees a few structural trends also at play.
First, it says, banks prefer to retain only a limited share of SRs for assets sold due to the stringent provisioning norms for selling banks on holding these. On the other hand, ARCs in most cases keep only the regulator-mandated 15% of SRs. This results in a gap that has to be bridged either by the ARCs holding a larger proportion of SRs or by attracting external co-investors, it added.
CRISIL says, “This marks a significant shift from the past where till fiscal 2018, almost all the SRs were subscribed to by either the selling institutions or the ARCs. Post the revised provisioning norms, the share of external investors in cumulative SRs issued increased sharply to 12% as of 31 March 2019, from 3% as of 31 March 2018, primarily due to some large assets that attracted investors. However, the trend has not continued at a similar pace (see chart below) and co-investors have been selective. This is partly responsible for the lower growth of ARCs in fiscals 2020 and 2021.”
Secondly, the ratings agency says that in contrast to the situation a couple of years back, lenders now have multiple options for resolution and enforcement frameworks and are more actively evaluating and utilising these options.
The Insolvency and Bankruptcy Code, 2016 (IBC), with its subsequent modifications, has seen many takers. The Reserve Bank of India (RBI) ’s June 2019 Prudential Framework for Resolution of Stressed Assets gives lenders the option to resolve stressed assets outside the legal process.
To be sure, CRISIL says, volumes in the retail and MSME segments are unlikely to match those seen between fiscals 2014 and 2019, which was a period of growth led by corporate assets.
“Nevertheless, for ARCs that get it right, it can be a profitable business. Growth remains fundamentally dependent on its ability to attract capital. Given that capital is expected to flow towards the platform that is the most effective, it will be critical for ARCs to demonstrate their differentiated recovery ability to remain relevant to stakeholders,” the ratings agency added.
One metric to assess recovery ability is the cumulative SR redemption ratio, which has improved over the past few years and stood at 32% as of 31 March 2021, compared with 17% three years ago. This has been supported by the resolution of a few large-ticket assets under the IBC process, while overall recovery remains lower than expected.
Further, the time taken for recovery has been higher than envisaged. While recent originations have seen better performance, overall, recovery is yet to reach optimal levels, it added.
Subha Sri Narayanan, director of CRISIL Ratings says, “ARCs have yet to demonstrate their recovery capability in the retail segment at a material scale. However, one factor will support their shift towards retail and MSME segments — it is the opportunity in the form of incremental non-performing assets coming largely from these two segments in the current cycle, with lenders, including non-banks, increasingly putting these assets up for sale. In fact, this shift is visible already. Although the overall volume of debt acquired was lower in fiscal 2021, a CRISIL Ratings study shows non-corporate segments formed a 44% share, which is a stark increase from 4% two years back (see the graph below).”
Overall, CRISIL says, with other segments seeing greater competition in terms of alternatives for lenders, greater participation in the retail segment is perhaps an inevitable shift. As before, the ratings agency concludes that the ability to collaborate with other investors, bring in the capital in various forms, and fundamentally demonstrate recovery capability will be the key to long-term growth and profitability.