About to Swoop

Kartick Maheshwari has been continually getting overseas calls for the past few days. Many of his US-based clients, including a number of private equity funds, have perked up following Finance Minister Arun Jaitley's Budget announcement allowing 100 per cent foreign direct investment in domestic asset reconstruction companies (ARCs). Jaitley also announced that global investors will now be permitted to acquire 100 per cent of the security receipts (SRs) of specific distressed companies issued by the ARCs. Until now, they could invest only 74 per cent in such SRs, with the rest being held by domestic investors. And since domestic investors were rarely in a position to risk such investments, these SRs hardly found buyers. The Budget has also cleared up any confusion about the taxation burden from any recoveries accruing from distressed assets. It has proposed allowing complete 'pass through' of income tax to securitisation trusts, including the trusts of ARCs. "By inviting external capital, it shows the government is concerned about distressed assets and is willing to go all out to clean them out of the financial system," says Maheshwari. "It amounts to creating a new asset class for those interested in such assets. It now becomes much easier for private equity funds to acquire distressed assets on their own."

Alarm bells over the expanding size of the distressed assets market - estimated at around Rs 8 lakh crore, including the Rs 4.5 lakh crore non-performing assets (NPAs) of banks - have been ringing for a while. Bank NPAs have risen around 50 per cent from Rs 3 lakh crore in 2015. Mounting NPAs have seen the Bankex (BSE Banking Index) lose nearly 28 per cent of its value, becoming one of the worst performing indices on the bourses, in the past 14 months. With banking and financial stocks accounting for over a quarter of the Sensex's weightage, the fall in banking stocks has also dragged down the Sensex by 16.5 per cent in the same period. With global commodity prices continuing their prolonged slump, most companies in the affected sectors continue to struggle. The Budget decision shows the government has realised domestic financial players are not in a position to infuse sufficient capital into the system, and is opening the door wider for external capital providers. Maheshwari maintains that even vulture funds such as Wilbur L. Ross and Lone Star Funds, which had quit India several years ago, are now contemplating a comeback.

Lukewarm Interest

Vulture funds - or funds specifically focused on distressed assets - aren't new to India, having been in the country since 2000/01, but the regulatory hurdle of not being permitted to repatriate funds saw many lose interest. "Vulture funds may not be new, but given the lack of a robust regulatory framework and bankruptcy laws, they are still waiting on the sidelines," says Siby Antony, CEO, Edelweiss ARC. In 2015, laws were amended to permit fund repatriation, but impediments remain. Most important of them is the law relating to distressed assets, the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, which gives banks and ARCs powers to act directly against defaulters and seize their assets without any court order to that effect, but does not extend the same rights to non-banking finance companies (NBFCs). In his Budget speech last year, Jaitley had announced to give SARFAESI powers to NBFCs, but the amend to the SARFAESI act to include NBFC has still not happened.

Another dampener for those interested in distressed assets is the absence of a modern bankruptcy law. Existing legislation, dating from pre-liberalisation days, aims primarily at reviving sick industries and includes many clauses which can be used to prolong the process of declaring them bankrupt. A new Bankruptcy Code was introduced last December, but still awaits the Parliament's nod. "There is no recourse as yet for bond holders," says Abizer Diwanji, Partner and National Leader Financial Services, EY. "Until bankruptcy laws are in place, we will see only indirect participation from funds." Still, the recent Budget suggests the government is extremely serious. "The message is already out that the bankruptcy law in India in its current form is a big deterrent for investors to put serious capital to work," says S. Sriniwasan, CEO, Kotak Investment Advisors. Kotak itself is said to be raising a special situation fund of $500 million to intervene in the distressed assets market. "There is a lot of buzz about vulture funds coming in. But serious capital has yet to enter the market," Sriniwasan adds.

The strategy vulture funds employ - that of buying distressed assets with the express purpose of profiting from liquidating them - has been missing in India, where the primary purpose of investing in troubled companies is to turn them around and profit from their success. Investors are only interested in those companies that have suffered due to changes in the business cycle or cash flow constraints and have some hope of being revived, and not in those which are beyond repair. Though the SARFAESI Act exists, banks rarely take recourse to it. The flip side is that companies that have suffered because of poor management practices find no buyers. "In India, in most cases, banks and funds which invest in a company are not hostile to the incumbent management," says Sriniwasan. "They work with the management. The SARFAESI Act acquires importance only when there is a difference of opinion between the two."

But in an open, globally-linked economy, this cannot continue. "What we have seen in the past six to eight years with troubled companies is that they get into a debt trap," says Diwanji of EY. "In 40 to 50 per cent of cases, efforts at revival only lead to debt increasing as the interest piles up. This has to stop. If necessary, the bitter pill has to be swallowed." Once it is passed, the Bankruptcy Code is expected to fast-track the process of dealing with corporate loan default. No doubt its efficacy will be tested in court, but if it withstands the test, it will also be a deterrent for wilful defaulters and those irresponsible with company money. Though there have been political objections to the bill, Antony of Edelweiss ARC is hopeful. "In the current environment, it may even be possible for the government to pass it," he says.

Regulations apart, banks have also been reluctant to sell their bad debts so far - or at least sell at a price the ARCs and vulture funds consider reasonable. In the past 18 to 24 months, only around Rs 1 lakh crore of the total NPAs of Rs 4.5 lakh crore have been sold - another Rs 20,000 to 25,000 crore of NPAs are up for sale. Banks worry about how selling a loan at a small fraction of its value will look on their balance sheets, and what it will do to their capital adequacy ratios. This, in turn, inhibits funds from entering the stressed assets market. Yet, given the burgeoning NPAs, banks cannot hold on for much longer. "The process will be slow, but banks will ultimately have to give in," says Antony of Edelweiss ARC.

The SDR route

About eight to nine months ago, the Reserve Bank of India permitted banks to convert bad loans into equity, taking the strategic debt restructuring (SDR) route. So far, loans worth Rs 81,300 crore - or 1.23 per cent of the total loans of the banking sector - at 15 debt-ridden companies have undergone such restructuring (See Low-Hanging Fruit). Obviously, the banks will want to exit soon. "The banks cannot keep sitting on the equity," says Sriniwasan. "You can either go through chemotherapy or surgery. One of the two has to happen. Otherwise, technically speaking, if 51 per cent of a company is held by all the public sector banks put together, that company will become a public sector company." This is where vulture funds can step in and buy the assets.

More so because the shift from debt to equity does not make it any easier for the banks to divest the equity, nor does it bring about an immediate turnaround in the ailing company's fortunes. It is primarily a means of reducing the size of NPAs in the banks' account books. "It's a big myth that once debt is converted into equity, banks can easily sell their stake to recover their money," says Diwanji of EY. "In the current economic scenario, finding a buyer for these assets might be a problem." In some cases, especially engineering and EPC companies, the units are so over-leveraged, their loans are higher than the worth of their assets. "It has to be seen if the banks are willing to take a razor cut while offloading their stakes," says Antony of Edelweiss ARC. An estimate by Religare Research says that banks in the next one year will end up refinancing 30 to 40 accounts with which they have taken the SDR route, worth Rs 1.5 lakh crore - or 2.2 per cent of the total loan of the banking sector.

So far funds have been acquiring distressed assets indirectly by tying up with ARCs. "Funds have been making a backdoor entry into distressed assets through ARCs," adds Antony. The reason is not only the legal constraint - their direct investment in such assets, as in the case of Avantha Power and Infrastructure Ltd or Jyoti Power Corporation, has not worked too well. "Funds have burnt their fingers and hence prefer the indirect route," says a fund manager on condition of anonymity. "They have done structured credit financing in the past directly, but it has not worked well for them." Vulture funds are focused on providing this last mile financing. They have chosen to work with ARCs as they believe they have the ability to foreclose, which gives them the comfort of knowing that the money they are putting in will eventually be well secured. "If limited partners in a fund cannot get 20 to 22 per cent returns, they will not invest," says another fund manager who did not wish to be named.

Jaitley's Budget announcements are thus of crucial importance in tackling bad debt. They are all steps in the right direction. But they must be followed up with action on the ground - especially the passing of the new bankruptcy code and the amendments in the SARFAESI Act.