The real estate sector, still stressed due to the double impact of demonetisation and GST (much like the mythological Scylla and Charybdis), is yet to absorb the impact fully when faced with the Covid situation. With home buyers' concerns prioritised by the government and the judiciary, there may be a growing sense of despair amongst the majority of developers, with no specific reforms for the sector other than some in the affordable housing space. On the other hand, the housing finance companies (HFCs), while keeping a close eye on the recoverability of their retail and wholesale books amidst the moratorium imposed by the RBI, are preparing for a change of guard as the regulatory baton transitions from National Housing Bank (NHB) to the central bank.
The RBI has on 17 June 2020 issued draft guidelines for the HFCs seeking comments from stakeholders. Whilst the guidelines are still at the drawing board stage and may well undergo some modifications, it does reveal the direction of the RBI's intent with respect to the HFCs. The underlying narrative expressed by the RBI through these draft guidelines is to increase the exposure to retail individual borrowers.
A mechanism of mandating a minimum exposure of 37.5% of its total assets (less cash, bank balance and money market instruments) in retail housing finance to individuals is proposed, which would consequently and systemically reduce the exposure of the HFCs in developers. Credit for developers, primarily for construction finance, was funded largely by the HFCs. They saw a business opportunity to grant construction finance to developers to garner a favourable position for retail lending in the same project. Further, with respect to group companies of the HFCs in real estate business, it is proposed to prevent double financing in a manner that the HFC may only have an exposure in the project either through financial assistance to its group company engaged in real estate or the retail home buyers, but not to both.
With the Insolvency and Bankruptcy Code already in suspended animation for at least six months, it is imperative that alternative channels for rehabilitation and restructuring are made available for this sector. With the sector reeling under severe stress, distressed funds would be looking at opportunities to deploy capital in this space. However, an important factor for any distressed capital to fund stressed assets is the ability to have a flexible capital structure. The agility to fund and consequently control, either or both the equity structure and the debt stack of a company, is precisely what a distressed fund requires. The current regulatory framework, however, does not afford this flexibility.
There are primarily two private pooling vehicles through which the equity or the debt capital of a stressed company can be acquired. Alternative investment fund (AIF), a private capital pooling vehicle regulated by the SEBI, can only acquire equity (and debt securities) but not loans. The other is an asset reconstruction company (ARC), which is regulated by the RBI and is also a capital pooling vehicle, but for identified qualified institutional buyers investing in the acquisition of non-performing loans.
An ARC can only acquire debt. The equity acquisition for an ARC is limited to the conversion of debt into equity pursuant to the covenants of a loan agreement pertaining to the underlying loan acquired by the ARC. Thus, our regulatory framework does not offer the flexibility to a distressed fund to route all its investment, irrespective of the proposed capital structure of the investee company, through a single pooled vehicle regulated by a single regulator.
Albeit this sounds completely perplexing, the reason may be historical and lost in the milieu of semantics. Ostensibly, the SEBI is the regulator for securities market and protects investors interest in securities, and the RBI is the regulator for the banking system and consequently responsible for the regulation of the stressed assets in the banking system. Other than this optical construct, there is no constitutional impediment for the SEBI to allow AIFs to acquire loans or for ARCs to acquire shares. Whilst in the case of the SEBI, the AIF Regulations need an enabling clause, for ARCs it would require an amendment to the SARFAESI Act, the governing statute for ARCs. If the same is allowed, the institutional investors would be able to have flexibility on the capital structure of the target company once the vehicle is chosen. Of course, an investor must be mindful, inter alia, that ARCs can only acquire NPAs or SMA2 (where the default is more than 60 days) or that AIFs may not have the benefit of enforcement under SARFAESI.
Although the IBC has been suspended, it may not have been the perfect prescription for large real estate projects, especially due to the sheer volume of stakeholders being represented in the COC. A more consensual approach is required for resolving large residential real estate projects. A regulatory framework that is flexible for the investor as regards the nature of capital outlay with respect to the investee company must be seriously explored by the regulators.
This paper has been written by Krishnava Dutt (Managing Partner) and published by The New Indian Express on June 30, 2020.
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