ARCs: Will the new entrants fire up the market?
I mentioned in my previous piece that asset overstatement by the borrowers can only compound banks' valuation bias and impede non-performing asset (NPA) sales. 
 
The new guidelines by the Reserve Bank of India (RBI) have introduced "other banks, non-banking financial companies (NBFCs) and financial institutions (FIs) etc." also to bid for NPAs for “better price discovery”. There has been no bar on acquisition of bank debt by other banks and NBFCs, who must hold the securitized loans up to one year and meet minimum retention requirement of up to 10%. It is unclear whether these guidelines would apply to the banks or NBFCs acquiring non-performing assets (NPAs). Irrespective of this, migration to all-cash deals for NPA sale has put the ARCs to disadvantage due to significant regulatory constraints in raising equity and debt from the public, investment of surplus funds, the minimum stipulated security receipts (SRs) holdings, and the prior approvals for management and board changes. 
 
While the ARCs cannot meet non-fund working capital needs of the operating assets, they are unable to meet fund-based requirements due to high cost of funds. Hence, ARCs restructure only the accounts whose working capital requirements are insignificant, and which attain viability with substantially reduced debt, something that is possible only when the NPAs are acquired at reasonable cost. Such accounts are rare, and over 90% of the NPAs acquired by the ARCs are liquidated piecemeal or settled out of court. The new entrants, particularly the private sector banks, will have advantage over ARCs since they will be able to fund full working capital requirement. However, this will apply only to a small percentage, and ARCs will continue to hold edge for assets getting liquidated.  
 
The high level of NPAs and stressed assets of public sector banks’ aggregating 11.6% of gross advances as on March 2016 are not the result of market meltdown, but significant asset overstatement by the promoters and leniency of the banks. Sale of such assets at realistic prices to is a historical opportunity to spawn lean companies, which can be competitive and viable. It is not the dearth of capital, but lack of worthwhile acquisition opportunities that has stunted the market, and unless the regulation driven symptomic treatment gives way to transparent market driven price discovery for sale of NPAs, addition of new participants will not energise the market.
 
Consider the acquisition pricing of Asset reconstruction companies (ARC) under the 15:85 structure and all-cash over a resolution horizon of 1-5 years. They show wide variations (Graph-3). For a modest 20% pre-tax returns to ARCs, the bid price under 15:85 structure, varies from 69% to 93% of estimated recovery for resolution periods of 1-5 years (curve AB). 
 
As all-cash acquisition entails higher risk premium, for a modest 25% return, the figures vary from 47% to 86% (curve EF). If the average recovery of 25.6% as observed by the World Bank is taken, the all-cash acquisition price for 25% returns varies from 12% to 22% of the loan outstanding (curve GH), and is comparable with the actual average NPA acquisition cost of 17.2% to 20.8% of loans outstanding during FY-2010 to FY-2013 (Graph-2). This validates the robustness of the market driven process for price discovery.
 
 
Delays destroying value
It is self-evident that the pricing of NPAs is impacted by the resolution period. Graph-2 shows that ARC’s acquisition price of NPA for the 20% return based two-year resolution period would be 68% higher than that based on five-year period. This happens since over years, the unused and underused asset suffers impairment in value. In other words, an efficient legal system delivers substantial value through speedy disposal. This has been demonstrated in UK also where the liquidation process gets concluded in less than one and  a half years and delivers to the lenders, recovery of about 75% with recovery cost of 15% of the asset value. Speedy adjudication ensures productive use of the asset, apart from acting as disincentive for the defaulters.
 
 
In contrast, the average resolution period in India is five years. At present, there are over about 1.03 lakh cases pending in 33 DRTs under Recovery of Debts Due to Banks and Financial Institutions Act, 1993 (RDDBFI) and SARFAESI Acts involving outstanding debt of about Rs4 lakh crore. The surest way to enhance the bid prices is to ensure that the legal adjudication is hastened. The economic gains will ensure that the payback period for the cost of efficient legal administration is negligible. The government, therefore, needs to match legislative reforms with speedy adjudication on a war-footing. Same approach should be adopted in setting up and operationalizing National Company Law Tribunals (NCLTs) for migration to Insolvency and Bankruptcy Code, lest the history repeats itself to the detriment of the banks.
 
Change or perish
Barring exceptions, ARCs worldwide (called asset management companies -AMCs) are special purpose vehicles, which are wound up after resolving NPAs emerging from economic meltdown. Perpetual ARCs are few, and constitute part of financial conglomerates such as Woori F&I and UAMCO in South Korea. Numerous stand-alone ARCs as in India cannot be sustained perpetually since no country can survive churning out high level of NPAs permanently. Thus, an evolutionary change in India’s ARC landscape was expected in course of time. The new RBI guidelines will hasten the change.
 
The SR structure used by ARCs is a risk-reward sharing structure in which ARC’s risk is 15% and seller bank’s risk is 85% of the value. While the ARC’s reward is entirely financial, the bank’s reward is less financial since it is happy with just SR redemption, and is not concerned with returns thereon as long as it can avoid further provisioning, and this has changed now. With migration to all-cash deals, the banks would be replaced by other investors as risk-reward sharing participants who would seek returns comparable with those of ARCs. This would become possible if the assets are bought at reasonable prices and returns are derived from value addition. Even if the new participants cannot adopt SR structure, they will be able to adopt tax transparent pass-through structures under the existing laws. 
 
It is a matter of time before the NPA acquisition based on market driven pricing assume primacy since the economy cannot afford loss due to delay. ARCs have expertise in NPA management, and to survive and prosper, they will have to focus on restoring NPAs and deriving gains from value addition instead of acting as recovery specialists as hitherto. Efficient implementation of Insolvency and Bankruptcy code will hold key to the qualitative change in the landscape.
 
This is concluding part of a two part series. 
 
 
(Rajendra M Ganatra, PhD is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 26 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)
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    COMMENTS

    Ramesh Kubde

    3 years ago

    Thanks to author for an articulate article on status of ARCs in India and the road map ahead. The Banks normally blame ARCs for not bidding aggressively ,but the average return on net worth of 5% to 6% for ARCs is indicative of their poor performance and also the reason for not so aggressive bidding. It is only the Bank's valuation bias which is impending the NPA sales. He has, therefore, rightfully emphasized on the market driven pricing of assets, which can only drive the sale of NPAs.

    Jyoti Sharma

    3 years ago

    It is a well researched article highlighting the constraints due to which Banks are not able to sell off NPAs to ARCs. Besides, due to funds constraints, ARCs are not able to go for all cash deals. Change in the legal environment and development of secondary market for SRs will help in a long way for NPA management system in the country.

    Natarajan V. Subramanian

    3 years ago

    Well thought out write up. The structure of ARC's are flawed and needs a review. Its role is vital in a country like India and should be strengthened at all cost and not destroyed.
    Arlington, Va,22204, USA.

    SRINIVAS SHENOY

    3 years ago

    I feel that there should be stricter vigilance, while granting fresh credit followed up by inspection of the assets and continuous follow up is a must, in any case. Agree that our laws were not in favour of the lenders, but relentless follow up usually personal does get the desired results. Hopefully implementation of Insolvency and Bankruptcy code will hold key to the qualitative change in the landscape as is rightly said if properly and strictly implemented.

    Sunil Dhawan

    3 years ago

    I must thank you for your sharing with so much clarity
    banks need to revisit reserve price and respect cash deals by understanding time value for money
    Risk Capital is plenty but only at a minimum return of 24%

    REPLY

    Rajendra Ganatra

    In Reply to Sunil Dhawan 3 years ago

    That's the crux of the matter. And that means a very competitive acquisition cost. The day it happens, the market will zoom.

    Rajesh Gupta

    3 years ago

    Excellent insight on the development and functioning of ARCs in India

    IOC investment plan not to affect its credit profile: Fitch
    International rating agency Fitch Ratings on Monday said Indian Oil Corporation's (IOC) financial profile would "remain stable" even though the state-run oil marketing company (OMC) planned to invest Rs 1,700-Rs 1,800 billion over the next six years.
     
    The OMC on Thursday announced that it would invest Rs 1,700-1,800 billion over the next six years, including around Rs 150 billion in the current fiscal and around Rs 250 billion each in FY18 and FY19.
     
    "Fitch has already factored in most of the capex over the next three years, and we see no significant change to our current expectations as a result of this announcement. We continue to expect IOC's free cash flow to remain negative over the medium term, due to the high capex," the rating agency said, adding that it expected "IOC's financial profile to remain stable due to strong volume growth and relatively robust refining margins".
     
    According to the rating agency, the oil marketing company's credit metrics is likely to weaken marginally but to remain within levels commensurate with its standalone profile over the medium term.
     
    Fitch equalises IOC's ratings with that of its largest shareholder, the Indian state (BBB-/Stable) due to their strong operational and strategic linkages.
     
    The agency has not factored in its investment along with the other state-owned oil-marketing companies -- Bharat Petroleum Corporation Limited and Hindustan Petroleum Corporation Limited -- in the proposed refinery project in coastal Maharashtra.
     
    Disclaimer: Information, facts or opinions expressed in this news article are presented as sourced from IANS and do not reflect views of Moneylife and hence Moneylife is not responsible or liable for the same. As a source and news provider, IANS is responsible for accuracy, completeness, suitability and validity of any information in this article.
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    Where does RCom-Aircel stand post the merger?
    The merger of the wireless business of Reliance Communications (RCom) with Aircel Limited (Aircel), is a key milestone in the ongoing consolidation in the telecom sector, says India Ratings and Research (Ind-Ra). The combined entity RCom-Aircel will now be the third largest telecom entity in India by subscriber base, thus moving ahead of Idea Cellular Ltd (Idea). 
     
    "The merged entity will offer strong competition to both Vodafone India Ltd (Vodafone) and Idea, which are weaker placed, as far as 4G operations are concerned. The sector will now have five meaningful players namely, Bharti Airtel Ltd (Bharti), Vodafone, RJio, Idea and the merged RCom-Aircel-Sistema (with a new brand) as the industry moves towards data driven revenues," the ratings agency said in a report.
     
     
    Ind-Ra says it believes that the merger will enable the new entity RCom-Aircel to give strong competition to its peers in the backdrop of the disruption that the launch of operations by Reliance Jio Infocomm (RJio) has caused. This development coupled with RJio's penetration strategy will spur competition and in turn push tariffs lower.
     
    The top five circles of Aircel are Assam, Jammu & Kashmir, Uttar Pradesh (East), Bihar and Gujarat, while those of RCom are Bihar, Tamil Nadu and Chennai, Delhi, and Mumbai. 
     
    The merged entity will be positioned as the second largest in the Bihar circle, after Bharti, and overtaking Vodafone and Idea, which were number two and number three respectively. In the Tamil Nadu and Chennai circle, the merged entity will vie for the second spot with Vodafone, which is ranked the second largest after Bharti. 
     
    RCom has a wireless active subscriber base of 9.2 crore as on March 2016 (market share 9.8%), whereas Aircel has 6.3 crore subscribers (market share 6.8%), leading to a combined subscriber market share of 16.1% with 15.6 crore subscribers; which will rank forth after Idea with 19.6% subscriber share and Vodafone with 20.4%  subscriber market share as of March 2016. "The merged entity could potentially have a revenue market share of 14%, given RCom's existing revenue market share at around 11% in FY16 and Aircel's 3% revenue market share," Ind-Ra says.
     
    According to the ratings agency, the spectrum acquisition strategy, particularly around 4G, is an important driver for the consolidation in the telecom sector. "This deal provides RCom access to the superior 800MHz band in eight circles with extended validity till 2033, as its own spectrum is scheduled to expire in 2021-2022. The merged entity will have 448MHz spectrum, which is about 17% of the total spectrum held, is the third largest spectrum holding, following 770MHz of Bharti and 596MHz of RJio," it added.
     
    Aircel reported revenues of Rs5,500 crore, with EBIDTA of Rs806 crore, and an EBIDTA margin of 14.5%, and net loss of Rs1,450 crore and cash loss of Rs600 crore in FY15. Aircel had a total debt of Rs20,900 crore in FY15. RCOM reported consolidated revenue of Rs22,100 crore, EBITDA of Rs7,400 crore and EBITDA margin of 33.6% in FY16 and debt of Rs4,100 crore. The combined entity's revenues are estimated at around Rs25,000 crore (for full year of operations), with EBITDA of around Rs6,500-Rs7,000 crore.
     
    However, Ind-Ra says both RCom and Aircel have significant debt and their average revenue per user (ARPU)'s are below industry average, as evident from their low standalone revenue market share and Aircel's presence in low ARPU generating circles. "Aircel on a standalone basis is a highly leveraged entity (FY15 debt to EBIDTA 26 times), whereas RCom had net leverage of 5.6 times in FY16. Therefore, we believe the merged entity will continue to depend upon the parents' support for fund infusion for growth capex. Post the deal the merged entity will hold Rs28,000 crore of debt from its parents to start with," it added.
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    COMMENTS

    Kamal Garg

    3 years ago

    Most probably the combined entity will be sold sooner than later. There are many indicators of this in the proposed entity including the fact that there are no promoters on the merged entity's board.

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