Given the continuous rise of stressed assets in the banking system, accompanied with a low volume of sale of such assets by banks to asset reconstructions companies (ARCs) / non-banking financial companies (NBFCs) / financial institutions (FIs), the Reserve Bank of India on 1 September 2016 has announced new guidelines regulating sale of stressed assets, with the intent of incentivising more proactive sales (Guidelines). This has a significant impact on the manner in which banks as sellers and ARCs / NBFCs / FIs as buyers will now transact in this asset class and will require them to recalibrate their approach towards selling and acquiring interests in distressed portfolios. Some key changes announced under the Guidelines are explained in this Ergo Newsflash.
As will become apparent from the below, for the time being, distress investors may move into a wait & watch mode in assessing whether the new policy will simply disrupt the nascent investment model in India or force banks to aggressively offload their stressed portfolios at realistic values.
What does the policy portend for banks?
Onus on bank management to get assets to market; process designed to reduce double jeopardy on state owned banks
Banks will now have to put in place detailed internal policies for disposal of stressed assets and (at the very least) on an annual basis, identify and prepare a board approved list of stressed loans which need to be sold in the relevant financial year. Banks also need to lay down the norms for sale and most importantly, delegate powers to managers to consummate such sale. In relation to assets held by banks under the doubtful category, the board (or committee) of such bank would be required to document its views on exit or retention, on a periodic basis.
On the face of it, each of these changes could result in banks, mainly the public sector banks (the largest holder of non-performing loans in the Indian banking eco-system), to become nimbler and more empowered in asset sales, thereby spurring transactions.
In particular, the banks must:
- endorse the discount factor to be applied in an enabling policy; and
- obtain at least 2 valuation reports to justify the discount factor (at their own cost).
Both of the above are expected to result in deal certainty for buyers when transacting with public sector banks and provide an upfront sense of the maximum discount which banks may be willing to absorb. That said, the discount factor is a function of market forces and pricing, and there is an outside risk that the enabling policy will strait-jacket banks, instead of giving them a free hand (contrary to the policy intent). As such, one hopes that banks will use this new opportunity to have in place a carefully structured policy on asset disposal, which will not only serve as an effective shield for managers, but will also grant autonomy to conclude transactions in line with market reality.
The Guidelines require banks to put in place a board approved policy for auction of the stressed loans through the Swiss Challenge method. In short, banks can widely publicise the auction process through which the stressed loans are proposed to be sold following identification of stressed assets. Any interested bidder can submit its bid after carrying out the due diligence and if the bid is higher than the floor price as determined by the bank as per its policy, the bank would be required to publicly call for counter bids. In such bidding process, certain ARCs (depending on their existing exposure) would be given a right of first refusal to match the highest bid. In case of refusal by the relevant ARC, the asset can be offered to the first bidder followed by the highest bidder (in each case at the highest bid price).
If banks put up a portfolio for sale, but abandon the sale process after receiving bids, they will be forced to apply provisioning, which is the higher of: (i) the discount on book value quoted by the highest bidder; or (ii) as per applicable asset classification / provisioning norms.
As such, banks will not be able to simply test waters by putting assets on sale, and it is likely that any process / negotiations they now conduct will be with seriousness of intent. As a seller, they will now have serious impairment consequences for walking away if they perceive the bid price to carry a higher discount than they originally anticipated.
Move towards true sale will result in more insistence on cash settlement and potentially a move towards buyer bonds issued by ARCs
To the extent a bank has more than 50% of the security receipts issued in connection with an underlying loan portfolio sold by it, from 1 April 2017, such bank will need to undertake higher, and almost mark to market, provisioning for stressed loans (with one of the components for provisioning linked to the net asset value of the relevant loan, as declared by ARCs). From 1 April 2018, this 50% threshold will reduce to 10%.
The higher provisioning will deter banks in accepting security receipts, especially as the 10% threshold is not a case of "kicking the can down the road", and is the clear and present percentage threshold for banks to consider.
Given limitations on ARC balance sheets and the disincentives imposed on the participation of AIFs / NBFCs in stressed loan acquisitions, the ability of market participants to offer cash to banks (in lieu of security receipts) may not be always viable and subject to tax and other considerations, potentially encourage use of buyer bonds and other debt instruments issued by ARCs to banks. Accordingly, for the time being, in the absence of ARCs considerably bolstering their own balance sheet strength, this rule change could significantly constrain their ability to proactively acquire stressed loan portfolios from banks.
What does the policy portend for distressed investors?
Limitation on the ability to conduct bilateral deals
There is now a regulatory preference to move to an electronic auction process for stressed loans, over bilateral sales to distress investors. While auctions have been a growing trend in the market, this could potentially hamper the ability of distress investors to opportunistically "cherry-pick" portfolios ahead of time and privately negotiate acquisitions with banks.
Further, even where transactions are agreed on a bilateral basis, banks will look to invoke the Swiss Challenge rule and test waters from other bidders in a counter bidding process. Apart from increasing deal timelines and the attendant risks for investors, the process in our view appears to be avoidable in a situation where the bank has already obtained expert valuation reports, and is able to demonstrate that the asset is not being sold for less than fair value.
Cash is king
ARCs with strong sponsor support and well capitalized balance sheets will clearly be in pole position, as they will be better placed to offer a cash / debt instrument payment solution to the banks. That said, to solve for bank provisioning, the requirement for upfront cash payment (in case of issuance of security receipts) is not desirable for the larger distressed asset investing community – which is still coming to terms with the [mandated] 85:15 minimum split between security receipts and cash. In particular, financial modelling / bid pricing will now need to be stress tested to ensure that the return of equity on the higher cash component remains protected.
Having said that, it will also not be surprising to see the market innovating to provide more debt instruments (as consideration to the banks) as also structuring the payment waterfall of ARC trusts so that, at the time of the sale of the stressed loan, (i) the provisioning requirements for the banks may not be triggered, and (ii) investors are able to reduce their initial cash outflow. That said, these are early days and any such structures will have to be carefully examined for potential leakages.
Might is right, and bigger the better
The right of first refusal granted to ARCs with existing large positions (25-30%) in the underlying asset is however highly positive, as it will allow an ARC to mitigate the risk of a vulture fund or other minority debt investors aggregating debt and then creating a "hold-out" concern for it. It could also allow the ARC to quickly build itself to a 60% position in the borrower's loans with more certainty – thereby being in the driver's seat for all SARFAESI related enforcement actions. This would be in addition to the "blocking rights" which will become available to it (as a majority lender) in any bankruptcy code related resolution process in the future.
Banks will now be subject to a higher disclosure of their legacy exposure to security receipts (e.g. separate disclosure of the book value of security receipts backed by non-performing loans sold by the bank itself, and the provision against it) and will need to categorise this disclosure by vintage. This level of disclosure was hitherto not a line item, and may prompt banks to jettison them off their balance sheet. This could perhaps create a silver lining for acquisition of security receipts by investors from banks. For sake of completeness, on first glance it also appears that the acquisition of legacy security receipts may not trigger a counterbidding process, and the same can be effectively acquired on a bilateral basis.
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