Asset reconstruction business at crossroads

ARCs will come of age only when the legal process turns highly efficient


The 15:85 structure introduced by Reserve Bank of India (RBI) in August, raising asset reconstruction companies’ (ARC) minimum security receipts (SR) subscription to 15%, for acquisition of non-performing assets (NPAs) from banks, restored parity between NPA acquisition cost and the estimated recovery (see here). As expected, barring few tactical acquisitions by the ARCs for consolidation, the NPA acquisition by ARCs has come to a standstill. Why? The erstwhile 5:95 structure provided capital protection often exceeding 100% to the ARCs from the management fee. Hence, the ARCs could bid aggressively for asset acquisition and realise fair returns with back-ended recovery even when the total recovery fell substantially short of the acquisition cost. Though the resultant losses on SRs impacted the banks, the transactions suited them since those resulted in back-ended provisioning by the banks. Under 15:85 structure, the capital protection to ARCs is limited, and hence ARCs have to seek NPAs at a significant discount to the anticipated recovery, entailing upfront provisioning by the banks.

Overall recoveries from NPAs average around 25% of the secured loans outstanding.


Hence, for 20% return over a 5-year horizon under 15:85 structure, the ARCs tend to quote an average of less than 20% of outstanding loans for NPA acquisition. Based on RBI provisioning norms, such deals require provisioning in excess of normal if the asset has been non-performing for up to two years. This tends to deter the banks from selling early NPAs, and limits the transactions only to the loss assets. But is this happening?

Regulatory hurdle

According to RBI guidelines, the banks are required to sell the NPAs at a (reserve) price, which should not be generally lower than net asset value (NPV) of estimated net realisation from the account. This is not workable since this does not leave any margin for the ARC, barring exceptions. No wonder the banks have not been able to offer even loss assets at reasonable price to the ARCs under 15:85 structure.

Based on identical acquisition cost and 5-year back-ended recovery profile with 15:85 structure, reasonable returns to ARCs require high recovery ratios i.e. ratio of overall recovery to the acquisition cost. For 20% pre-tax internal rate of return (IRR), with management fee (1.5% pa) linked to SR value, the recovery ratio is 148% (see “A” in the figure). With management fee (1.5% pa) linked to recovery, the recovery ratio is 153% (see “B”). For all-cash acquisition, the recovery ratio is 182% (see “C”). It is evident that the 15:85 structure has resulted in fairly-efficient NPA price discovery, though the price discovery in all-cash acquisition is the most efficient. However, the acquisitions are not materializing owing to the regulatory constraint.

In the SR structure, the maximum recovery and hence the distribution is limited to the outstanding dues. Hence, if the stressed account turns around, a limited upside flows to the SR holders if in the portfolio, the recoveries leave surplus after paying for the expenses, management fee, SR redemption and yield if any. The ARCs are allowed to convert a part or whole of debt into, up to 26% of total equity. Such conversion can potentially provide significant upside to the ARC in case of all-cash acquisition. However, such upside tends to be nullified since the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 requires restoration of the management back to the defaulter after turnaround by the ARC.

Efficient legal process - A must for maximizing value

Owing to legislative loopholes, judicial pronouncements, and very tardy legal process, the DRTs, which adjudicate the Recovery of Debts Due to Banks & Financial Institutions (RDDBFI) Act 1993 and SARFAESI matters, take years to dispose of the cases. The recovery by ARCs, therefore, continues to be highly back-ended to which scenarios A to C relate. However, if the recovery is front-ended, ARCs’ returns increase substantially, and for 20% return, recovery ratio is just 122% (see “D”). Thus, banks can expect significantly higher valuations only with front-ended recovery. This, however, requires highly efficient legal process.


Way forward

RBI should withdraw the current NPA pricing methodology, which does not leave margin for the ARCs. The banks should sell the NPAs mandatorily to the highest bidder without reckoning the imprecise reserve price. Loss on sale to the ARCs should be allowed to be written off in three years, for the next five years. This will also catalyze all-cash transactions. ARCs should also be allowed 100% equity through conversion and exercise of pledge of shares if any.

ARCs will come of age only when the legal process turns highly efficient. Hence, for speedy clearance of the backlog of about 45,000 cases in DRTs with defaults exceeding 1.45 lakh crore, the government of India should urgently increase the number of current 33 DRTs and appellate tribunals adequately, and introduce e-governance in all the DRTs and tribunals / courts. The system should be backed by adequate judicial manpower and amendments to RDDBFI and SARFAESI acts, including section 15 of SARFAESI act, to allow permanent management change. The recovery suits must be disposed of within the statutory timelines, and any laxity should invite strict penalty. Adjournments sought by the parties should attract prohibitively high fee so that the defaulters’ cannot adopt delay as a strategy.

The UK bankruptcy code is creditor-friendly, where over 50% of the distressed companies are sold as going concerns and over 40% of the companies are liquidated piecemeal. The liquidation process gets concluded in less than 1½ years and delivers to the lenders, recovery of about 75% with recovery cost of just 15% of the asset value. Overall, 75% of the distressed assets undergo bankruptcy and the balance is restructured, reflecting the lenders’ preference for restructuring viable businesses. Speedy resolutions under UK’s bankruptcy code show that the speed of judgments induces discipline among the borrowers. The government of India needs to appreciate merits of speedy adjudication and take immediate corrective action before it is too late.

(Rajendra M Ganatra is Managing Director & CEO of India SME Asset Reconstruction Co Ltd-ISARC. He had over 25 years of experience in project finance, asset reconstruction and financial restructuring. The views expressed in above article are personal)

Suresh Kumar Sinha
7 years ago
An excellent article by a financial services veteran on a very relevant topic of the Day --Suresh Kumar Sinha,Deputy General Manager(Retd.),Indian Bank.
7 years ago
Author has hit the nail on the head by commenting on the impediments in the legal system which have nullified the good intentions in introducing DRTs and SARFAESI and bringing ARC business to near naught. Legal process could be expedited, simplified and made more efficient by creating adequate infrastructure more so when it would be self financing in this case and boost economy.
7 years ago
arc companies makeing sale of assets without taking the future responsibility like provident fund , excise duty on machinery which also auctioned, service tax liability , vat/cst liability -- how buyer will get rif off these problems
Sunil Karunakaran
7 years ago
The sequel to the earlier articles on the subject by the writer is once again superbly analytical. Apart from highlighting the challenges confronting the ARC business post the recent regulatory changes, more importantly remedial measures have been suggested to retrieve the situation.
Somdutto Bose
7 years ago
Read your article. Very compact. However, in my opinion, the world we live in does not allow changes easily. The half baked socialist approach of India has resulted in a confused welfare state which is neither here nor there. Our banking is a closed system with a strong government presence. Therefore while change is constant and eventually many things will change, expecting the restrictions cramming your operation to go soon may be unrealistic. And here, it is not only the pseudo socialism but the genuine problem of corruption. Call me cynical but I feel that we really have not evolved or perhaps we evolved much earlier and are now in the degeneration part of the cycle. It can be said not without reason, that considering the level of corruption, that if the restrictions are unilaterally lifted we may misuse the same as has happened too many times in the past.

As for the legal system, now that is one sad case. You see we have simply continued with what the British left for us. Innovation is no longer there. We have made some minor changes here and there, otherwise its just another monolithic government machine, where there is no real checks and balances or performance yardstick which you have also mentioned. But due to our legacy issues, we are coming with some serious baggage. Yes, we desperately need to increase no. of court including DRT. But that would mean finding more Judges and POs. Where do you get them ? Or if you do, what about quality ? The disparity between small towns and big cities are known and is a major drawback here. The small town guys are the once primarily interested but as seen recently with UP, english is a serious issue with them. So, when the higher courts are english based and lower are vernacular, recruitment is an issue.

I think our country is too complex to have any major changes if realistically contemplated. Rather, it would have to be small changes. Yes, it would be slow and woefully inadequate but there is no other option. RDDB and SARFEASI has happened. Not quite what expected but its there. It would be like that only because of our social structure and strong regionalism which magnifies the problem.

Its for this I sometimes feel that there is some merit in the totalitarian form of government where things happen once it is decided upon. Whereas we have a mockery of democracy. I once asked a Chinese how they dealt with the mutli culture issue which must be there, the country being larger than India. He explained that once there was an emperor Qin (from which the word Chin has come). He decided that there would be one written and spoken language and simply wiped out all opposition. While it is debatable whether he was great or a monster in view of the age old argument of end justifying the means, it is better than what we have here, where I cannot understand what my next door neighbor is saying!!!
Rajendra M Ganatra
Replied to Somdutto Bose comment 7 years ago
While I applaud the incisive comments from a legal luminary like you, I am distressed at the abysmal and yet deteriorating state of affairs. Luckily solutions are available and if not implemented, the country will soon face not only economic, but also administrative crisis. It is time the government took governance seriously.
Rameshwar Singh
7 years ago
Congratulations for a very detailed analysis by Shri Rajendra Ganatra. However what I feel that at the outset why the loans are given where the proper feasibility is not done and what is the security obtained from the promoter. The promoter and sanctioning authority should be held responsible for the wrong projects. The rules should be so stringent that one has to think twice before doing anything wrong for misusing the public money.
The mention of UK bankruptcy act needs to be taken seriously and Govt of India under the leadership of Shri Narendra Modi should bring some changes to protect the public money from being misused.
us poojary
7 years ago
Well thought out article.My observation is that the latest guidelines by RBI may be to dissuade Banks from outright sale of non performing assets to ARCs as has been observed recently.
Your suggestions are apt for amending certain clauses in the SARFAESI act so that the defaulters do not take for granted the loop holes in the law to their advantage. Strict instructions should be given to the DRTs not to grant stay beyond a point and to deliver quick judgements. Otherwise there are cases in DRTs languishing for more than a decade. To accomplish this suitable measures such as increasing thfe presiding officers in good numbers in DRTS and adding more DRTs should be the immediate agenda for the Central Govt.
Once again congrats for a nice article.Please keep it up.
Rajendra M Ganatra
Replied to us poojary comment 7 years ago
I agree. Number of DRTs has to be thrice the current number. No. of DRATs has to grow manifold. The government can always create a new stream of quality POs through UPSC. There are feasible solutions whose execution will happen only when the government becomes serious about governance.
Rajendra M Ganatra
Replied to us poojary comment 7 years ago
I agree. Number of DRTs has to be thrice the current number. No. of DRATs has to grow manifold. The government can always create a new stream of quality POs through UPSC. There are feasible solutions whose execution will happen only when the government becomes serious about governance.
Ramesh Kubde
7 years ago
This is a well researched article, which gives insight into ARC's business. The banks are yet to realize full impact of RBI's new guidelines. Sooner the banks realize this, there would be a meeting point for banks and ARCs. The importance of expediting legal process is well known to everybody and it is expected that the new Govt. will take immediate steps to strengthen the legal system.
Rajendra M Ganatra
Replied to Ramesh Kubde comment 7 years ago
Yes the government has to take very urgent steps to impart efficiency in the legal system. It is already very late, and soon it will be too late, otherwise.
G Sampath Kumar
7 years ago
A brilliant article by the author elucidating an insight into the ARCs business after the implementation of 15:85 structure. The article exemplifies the capital protection enjoyed by ARCs, how the legal process has to rationalize and throws up the challenges ahead for a lucrative ARC business. Congratulations to the author.
Yerram Raju Behara
7 years ago
We do not have a Bankruptcy Law. The existing laws are either inefficient or hostile to recovery processes. The legal reforms presently under progress hopefully would adequately address this issue. Second, we have an archaic BIFR (Bureau of Industrial Funeral Rights, as I prefer to call) and we have DRTs not so well equipped to handle cases that knock their doors either speedily or efficiently. This DRT structure also needs to be looked into for adequate support systems and number of judges to handle the cases with speed.
ARCs is an extended arm. These ARCs as author suggests should be allowed the leeway to function on viable and efficient lines but with accountability to deliver results. From one window of NPA shifting to another window does not render the economy any good.
Rajendra M Ganatra
Replied to Yerram Raju Behara comment 7 years ago
I entirely agree. It is indeed a bad idea to shift NPA from one window to another without fixing the malady of PSU bank mismanagement. In my previous articles in Moneylife, I had mentioned that overseas, ARCs/AMCs were set up as special purpose vehicles to fix systemic meltdown. Only in India the ARCs are set up as perpetual entities.
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