India’s credit recovery legislations have been unmitigated failures. Until 1985, for credit recovery from non-performing assets (NPAs), the courts of law would take eons to dispose the recovery petitions. The Sick Industrial Companies (Special Provisions) Act, 1985 (SICA), which was the first ever credit recovery legislation based on the revival of the NPAs in the industrial sector, soon became ineffective but was endured for 31 years until its repeal after 2016. The Recovery of Debts and Bankruptcy Act, 1993 (RDBA) worked satisfactorily for about two years. Thereafter, RDBA’s adjudicating authority, i.e., debt recovery tribunals (DRT) deteriorated constantly and currently as against a maximum period of 180 days mandated for credit recovery under RDBA, DRTs take on an average, almost 10 times this period.
Having sensed the failure of RDBA, the government of India enacted the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (SARFAESI), under which the lenders can seize the secured assets except agricultural land, etc, from the defaulters directly. The ineffective DRT, as the adjudicating authority for SARFAESI and the bad application of Section 14 and 17, have ensured that SARFAESI is, at best, a partial success.
As if SARFAESI was also doomed to fail, Section 2(za) of the SARFAESI Act provided for the setting up of asset reconstruction companies (ARCs) which, according to the Reserve Bank of India (RBI), constitute a supportive system for stressed asset resolution rather than the last resort to dispose NPAs by the banks. The banks are expected to sell the assets to ARCs at a stage when the assets have a good chance of revival and a fair amount of realisable value for rehabilitation and reconstruction. These expectations have not been met in over two decades of the ARCs’ existence.
ARC Structure
The term 'resolution' is not defined in the SARFAESI Act. However, given the expectation of a 'good chance of revival', resolution connotes debt and equity restructuring of NPAs and resultant credit recovery instead of asset seizure and sale. Hence, RBI has permitted up to a maximum period of eight years for resolution i.e., for full recovery of restructured debt. To maximise the NPA offtake, ARCs are allowed to acquire the NPAs with part cash and the rest by way of deferred debt in the form of security receipts (SRs). The SR-driven ARC structure allows NPA acquisition by the ARCs through a trust structure as under:
ARCs can buy the portfolio of a single or multiple NPAs in a revocable trust. If the NPA portfolio acquisition is based on the minimum permissible 15% cash and the remaining 85% of acquisition cost on a deferred basis from credit recovery, ARC receives 15% of SRs and the selling bank receives 15% cash and 85% SRs from the trust. The trust can continue to be managed by the ARC until the recovery can be achieved, even beyond the permitted resolution period of eight years. However, at the end of eight years, the outstanding SRs must be written off in the books of the SR holders, i.e., ARCs, banks and others.
ARCs charge the agreed management fee as a percentage of the entire portfolio acquisition cost consisting of the real component i.e., the cash and the speculative component, i.e., the bank’s outstanding SRs in the trust account. The SRs are speculative, since there is no certainty of full SR recovery, and ARCs face no recovery proceedings for failing to redeem SRs due to recovery shortfall. Such a management fee structure constitutes a regulatory reward which turns into a bonanza at a lower cash component, as can be seen from the table below.
With a management fee of 1.5% and a low cash component of the acquisition cost (i.e., the ARC’s SR holding), ARCs clock extremely high returns even when they grossly underperform and fail to redeem SRs because the return from the speculative part held by the banks as SRs is too high. Further, the longer the resolution period, the higher is the return to the ARCs. In such cases, ARC’s acquisition cost has no relation to the intrinsic value of the NPA. Thus, adverse selection is the bedrock of the SR structure, particularly with a very low cash component in the acquisition cost.
Despite obvious disadvantages, the banks continued to sell NPAs under the 5:95 structure (with 5% cash and 95% SRs) with management fee of up to 2%, for catalysing higher bids from ARCs, only to defer the provisions. RBI rectified this anomaly in August 2014 when it enhanced the minimum cash component from 5% to 15% of the portfolio acquisition cost. This limited the regulatory reward to around 5% which is essentially the time value. However, since the NPA acquisitions by ARCs helped reduce provisioning, some banks enhanced the management fee and added recovery incentives to catalyse higher acquisition costs under the 15:85 structure for NPA sales. In terms of RBI guidelines, from FY17-18, the provisioning concession to banks for ARC sale was severely curtailed. This led to muted acquisitions of the NPAs by ARCs after FY14-15 as can be seen from the chart below.
With the regulatory reward down to a trickle in the 15:85 structure, ARCs faced a credit recovery risk that they could ill afford. So, a number of ARCs started acting as a platform for back-to-back deals to earn high returns without risk.
In a back-to-back deal, a party unrelated to the promoter of a defaulting company invests a quasi-equity of, say, RsX in a non-banking financial company (NBFC). Thereafter, the NBFC lends RsX to the ARC for the acquisition of the NPA specified by the unrelated party. The ARC uses its relationship with the bank and acquires the asset for an amount which is less than RsX, consistent with RBI guidelines. The ARC resolves the NPA with due process of law in which the assets of the defaulting company go to the unrelated party for RsX. This amount is enough to repay the NBFC loan with interest apart from the management fee. From the loan repaid by the ARC, the NBFC redeems the quasi-equity invested by the unrelated party. The deal involves the payment of an upfront fee of around 1% to ARC and meeting the documentation/ due diligence cost by the unrelated party. The mechanism results in the following cash-flow for the ARC:
Cash-flow to ARC (Acquisition cost: Rs100 crore, sale value: Rs120 crore) Rs crore
As the acquisition cost is generally at a discount to the unrelated party’s intended purchase value in such a deal, the ARC may enjoy an upside share. In the above example, net of interest on the NBFC advance paid by the ARC, the cash-flow results in an IRR of 17.3% to the ARC on its investment of Rs15 crore which itself comes from the unrelated acquiring party. Overall, the transaction involving the acquisition cost of Rs100 crore is costless and riskless for the ARC which earns Rs4.91 crore that is in the nature of an agreed platform fee. The NBFC, which is often controlled by the ARC group, also has a net gain in the deal. The NBFC loan can be replaced by the inter-corporate deposit by the unrelated party.
In short, in the back-to-back structure, ARC’s own investment in the transaction is effectively zero. Thus, ARC as a platform can be practically used for any number of such deals and can create the 'fastest growing ARCs' depending on the ARC’s soft skills. After the transaction, there is no bar on the unrelated party passing on the asset to the promoter or his proxy. Even if the resolution is done under the Insolvency and Bankruptcy Code, 2016, with the ARC sitting in the committee of creditors with a major vote share, the unrelated party can acquire the defaulting company as a proxy of the promoter.
The back-to-back deal, thus, involves carving out a value from the asset which is distributed among the platform-provider i.e., the ARC and others. The main issue is whether the earnings of the ARC in the back-to-back structure are drawn from the value added by it or nibbled from the existing value.
The value of the financially distressed entities can be maximised by the restructuring of debt, equity, asset or business apart from ensuring the required fund infusion and management revamp. ARCs hardly implement these requirements in the normal course, much less in back-to-back deals. So, clearly, ARCs are not adding value. RBI’s expert committee in its report of September 2021 decried ARCs’ performance as lacklustre, both in terms of ensuring recovery and revival of businesses. Chapter III of the financial stability report (FSR) of 2019 shows abysmal recovery by the ARCs as shown in the figure below.
The above chart has not been updated since June 2019. However, despite RBI’s governance prescriptions for ARCs released in the fair practices code for ARCs in July 2020 and a review of the regulatory framework in October 2022, there seems to be no qualitative change, since a flawed business model cannot be cured by regulatory prescriptions that can be followed perfunctorily, without attracting regulatory action.
With 29 ARCs in India being unable to absorb the NPAs, the government in July and September 2021, created a twin-ARC comprising the National Asset Reconstruction Company Limited (NARCL) for large NPA acquisition of Rs500 crore and above, and the India Debt Resolution Company Limited (IDRCL) for NPA resolution. NARCL’s NPA acquisition is under the 15:85 structure, with a major difference being that the 85% SRs carry the government of India guarantee for meeting the shortfall in SR redemption on resolution or liquidation within five years of the acquisition. The guarantee falls through thereafter. This puts NARCL as an acquirer at a major advantage compared to other ARCs where there is no such guarantee. Yet NARCL’s plan to acquire NPAs of Rs2 lakh crore in the first year of its operations met with about 50% of the target till FY23-24. This was not due to non-availability of NPAs but due to competition from some innovative ARCs.
The sale of a large NPA, of say ABC Power Limited (ABC Power) with about Rs4,000 crore debt through Swiss Challenge for bidding, garnered a maximum bid value of around Rs1.125 crore based on the 15:85 structure from NARCL and all-cash Rs1,240 crore from the bid-winner ARC. After about a year, the ABC’s promoter and the ARCs reached a full and final settlement of loans, and release corporate guarantee in lieu of transfer to ARC of ABC Power’s 100% equity held by the promoter. Thus, the ARC became the owner of ABC Power, and can exit through insolvency resolution under IBC in which a known party can emerge as a successful resolution applicant with a tacitly agreed allocation to the ARC and other creditors, and zero allocation to the equity-holder due to zero book value of the equity. Such a disposal would, thus, create a clean slate with no statutory blot on the company.
The valuation of an existing power plant is straightforward since the plant output, revenue and operating costs are easy to estimate. The ARC’s required return of, say, 20% and ABC Power’s resolution periods of one, two or three years entail the following realisations by the two bidders, viz., NARCL and the ARC.
It is inconceivable that an ARC with all-cash acquisition can take the risk of the required realisations as at serial numbers 4 to 6 above depending on the resolution period from an asset sale and invocation of the corporate guarantee, or a full and final settlement in a reasonable period. Such a deal in the risky power generation sector is doable only if a buyer is identified upfront under a back-to-back structure.
ARCs cannot compete with NARCL simply because the SRs of NARCL are backed by a five-year government guarantee. Hence, the possibility of a structured deal cannot be denied in such a case. No wonder, such structures have existed in the ARC ecosystem for a long time.
Many ARCs are still harvesting the regulatory bonanza of their remaining 5:95 portfolios. ARCs, which acquired 15:85 portfolios based on high management fees and recovery incentives, are also reaping benefits. However, the profitable and growing ARCs are the ones which structure back-to-back costless and riskless deals based on the use of the ARC as a platform for a fee.
In October 2022, RBI permitted the ARCs to invest in the SRs at a minimum of either 15% of the banks’ investment in the SRs or 2.5% of the total SRs issued, whichever is higher, for each class of SRs. This would effectively bring the ARCs’ minimum SR subscription to 12.75% and give more regulatory reward than under 15%, but will not stop the rent generation from structured deals.
ARCs, which cannot use the regulatory arbitrage, are facing headwinds from credit risks underlying 15:95 portfolios acquired with normal management and incentive fees and may not survive.
Recently it was reported that the redoubtable Aditya Birla Asset Reconstruction Company is exiting the ARC business due to the recent decline in NPAs and challenges from NARCL. It is incongruous that an ARC which was incorporated during the peaking NPA levels in March 2017 should exit the business citing a decline in gross NPAs which is still significant at 2.8%. More exits may follow due to the lack of the soft skills needed for ARC survival.
The recent statements of RBI confirm that it is fully aware of the practices in the ARC sector. The day RBI concludes that a flawed structure which catalyses adverse selection cannot be rectified by moral suasion, it will have no option but to disband the ARC structure.
(Dr Rajendra M Ganatra was managing director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He has over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in the above article are personal.)
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