The Distressed Assets Sector: Poised for Growth

The Indian distressed assets sector has seen sustained interest from investors due to several legal developments over the past few years. While the outcomes so far have been a mixed bag, a flexible approach and consistent regulatory focus on resolving distressed assets promises to unleash the potential in the sector.

Yogesh SinghPartner

Ankush GoyalPartner

Rohan KohliAssociate

In India, the market for Non-Performing Assets (NPAs) was marginal and relatively unknown to private investors until 2010. However, over the last decade, it has emerged as one of the major sectors in India, especially with the government taking note of record levels of NPAs in 2015 and introducing the Insolvency and Bankruptcy Code (IBC) in 2016 to stem this unchecked growth. IBC has been a contributing factor to India’s reputation as a business-friendly destination, most visible in its rise in the World Bank’s Ease of Doing Business rankings. Participation from domestic and foreign stakeholders alike has led to a vibrant insolvency ecosystem emerging in the country.

While several large and complex insolvency resolutions have been successfully completed so far, some key challenges remain which need to be addressed to better manage future resolutions. The government’s commitment to addressing these existing lacunae in the law and proposing structural reforms aimed at key institutional stakeholders in the insolvency ecosystem is likely to lead to the growth of the industry.

In this article, we explore some of the key developments which have played a major role in shaping this sector and a few broad emerging trends for the future.

  • Key Developments

    IBC: A game-changer with low effectiveness in terms of resolution but a radical change in the mindset of stakeholders

    Since its inception, the IBC has become the dominant choice for creditors to resolve bad loans. With the judiciary settling several key principles and timely legislative amendments, IBC continues to be the preferred choice as the law itself has evolved with market needs. In fact, the Reserve Bank of India’s (RBI) Report on the Trend and Progress in Banking in India (dated 29 December 2020), reported that 31.3% of all NPAs in FY 2019-20 were resolved through IBC from just 3.7% in FY 2017-18.

    An area for improvement is the extension of pre-pack insolvency process, which was recently introduced only for the MSME sector, to all corporates.

    The government and the RBI have also successfully used the IBC framework to intervene in situations where Non-Banking Financial Companies (NBFCs) faced major governance or risk management issues. The promulgation and implementation of the Insolvency and Bankruptcy (Insolvency and Liquidation Proceedings of Financial Service Providers and Application to Adjudicating Authority) Rules, 2019 (FSP Rules) is a testament to this. The FSP Rules aim to resolve insolvency and liquidation of financial service providers under the IBC, with the overall process being closely monitored by the RBI through an Administrator, who is vested with powers akin to a resolution professional in a regular corporate insolvency process (CIRP) under the IBC.

    While the market has responded well to the overall design and spirit of the IBC, not everything has been smooth sailing. To start with, the infrastructure to implement CIRP processes as per the IBC was lacking. One of the biggest challenges in resolving bankruptcies under IBC is the time required for a CIRP to be completed. CIRPs frequently stretch past the 330-day maximum period set out under the IBC and the process is often subject to frequent layers of litigation and appeals. In several cases, this has eroded the value for bidders and creditors alike, and sometimes pushed otherwise viable entities to liquidation.

    An area for improvement is the extension of pre-pack insolvency process, which was recently introduced only for the MSME sector, to all corporates. The creditor-in-control model, as originally conceived under the IBC, may not be the optimal process in all situations and the global success of pre-packs makes a strong argument for extending its ambit. Further, there have been improvements vis-à-vis borrower practices and lender sentiment as well as crucial learnings along the way for the market. Several banks and promoters are also actively looking to resolve situations upfront with more perceptible intent. All of this impacts the overall effectiveness of debt resolution under the IBC framework.

    Asset Reconstruction Companies: The next big thing?

    Asset reconstruction companies (ARCs) were originally set up under the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 as an institutional alternative for NPA resolution in India but their performance has been below expectations so far. There are several reasons for this– from legacy NPAs being sold off by lenders, fundraising constraints, to the lack of debt aggregation opportunities and liquidity in the secondary market for security receipts (SRs).

    The sectoral regulator, the RBI, being aware of these issues and realising the importance of ARCs in NPA resolution, set up a committee in April 2021 to review the working of ARCs (Committee). The Committee's report (dated 2 November 2021) reveals that since the introduction of the IBC, the sale of NPAs to ARCs makes up only between 25% to 35% of the total overall NPA resolution amounts each year. The Committee made several recommendations that promise to revitalise ARCs’ sluggish performance and overhaul their functioning. For example, the Committee’s recommendation to allow ARCs to participate as resolution applicants in CIRPs will provide some much-needed clarity, since there have been a few instances where ARCs have faced legal challenges while participating as resolution applicants in CIRPs. Similarly, the Committee’s recommendations to (i) relax the 15% skin-in-the-game requirement (i.e. the requirement for an ARC to hold a minimum 15% of SRs in each class and scheme on an ongoing basis), (ii) expand the investor base of SRs by including High Net Worth Individuals and corporates as qualified buyers, and (iii) allow ARCs to acquire stressed loans given by regulated overseas banks/ financial institutions to domestic borrowers, will provide great flexibility for their business model.

    Other legal and regulatory developments

    Along with the broad regulatory push to the IBC and ARC framework, several other legal developments have complemented the government’s efforts of supporting debt resolution.

    The Securities and Exchange Board of India (SEBI) introduced an operational framework in June 2020 aimed at ensuring liquidity for mutual funds to offload their debt exposures faster and return money to investors. This framework permits transactions in defaulted debt securities after the maturity date/redemption date. Subsequently, in February 2021, the RBI also exempted FPI investments in such defaulted bonds from concentration norms, short-term investment limits and minimum residual maturity requirements. Together, these developments will help deepen the market for defaulted securities in India.

    In September 2021, the RBI released its Master Directions on Transfer of Loan Exposures (Directions) which consolidate the legal and regulatory regime on the transfer of stressed assets by financial institutions. These Directions expand the list of permitted transferees of stressed loan exposures beyond banks, NBFCs and ARCs to include companies registered under the Companies Act, 2013 – this will significantly expand the distressed assets industry. The recommendations around mandatory auctions through Swiss Challenge method and requirement to obtain two external valuation reports for loan transfers above INR 100 crore are aimed at improving price discovery and addressing risk governance issues in the industry.

    Further, SEBI has recently approved the introduction of 'Special Situation Funds' (SSFs) as a sub-category under Category – I Alternate Investment Funds (AIFs). The proposed SSFs can invest in (a) stressed loans available for acquisition in terms of the Directions or available for acquisition as part of a resolution plan approved under the IBC; (b) security receipts issued by ARCs; and (c) securities of companies in distress. To incentivise investors towards such SSFs, SEBI has proposed several relaxations for SSFs such as: (i) exemption from investment concentration norms in one investee company, and (ii) removal of restrictions on investment split between unlisted and listed securities of investee companies – which are otherwise applicable to Category – I AIFs. These proposals are expected to attract a new set of investors and expand the overall market for stressed assets in India.

  • From long-time marquee investors and focused funds, to bulge bracket investors making headway into distressed asset investing, the investor profile in this sector has diversified considerably over the years.

  • Emerging Industry Trends

    Today, India has a vibrant ecosystem around distressed assets, with bespoke structures including one-time settlements, bridge financing and pre-insolvency resolutions being increasingly preferred. From long-time marquee investors and focused funds, to bulge bracket investors making headway into distressed asset investing, the investor profile in this sector has diversified considerably over the years.

    Several foreign investors have also partnered with public and private sector banks and financial firms to launch India-focused special situation funds for investing in distressed assets. A new crop of insolvency professionals which are regulated by the Insolvency and Bankruptcy Board of India has also grown to cater to this influx of capital.

    The IL&FS default and the resultant macroeconomic and liquidity crisis resulted in several banking and non-banking lenders turning cautious, which temporarily slowed the capital flow in markets. However, the successful resolution of Dewan Housing Finance Corporation Limited as one of the largest corporate insolvency in India and the first one under the FSP Rules is quite a success for the IBC ecosystem. This deal is likely to set the tone for regulators and the industry for the coming years.

  • Green Shoots

    The legal and regulatory developments discussed above come on the heels of the government setting up National Asset Reconstruction Company Ltd. (NARCL) and India Debt Resolution Company Ltd. (IDRCL) specifically aimed at the resolution of high-value distressed assets. The unique part-government owned structure, with a government guarantee on the SRs issued by NARCL is an assurance of its financial strength and demonstrates the government’s seriousness towards the venture. The entry of these entities in the ARC industry will invariably increase competition in the sector and will spur resolution of a greater pool of assets.

    RBI’s recent actions in taking SREI Infrastructure Finance, SREI Equipment Finance and Reliance Capital to insolvency proceedings under the FSP Rules further demonstrate its confidence in the IBC process. However, the IBC process should not be seen as a one-stop solution to resolve stress in financial institutions. The successful resolution of Altico Capital is one example where RBI favoured debt resolution through private investors outside the IBC process. Going forward, we expect the RBI to keep a close watch on the sector and continue to strike a balance between favouring bespoke private solutions versus superseding boards of financial institutions and preferring the IBC process.

    Market reports have indicated that the government plans to table another amendment to the IBC to introduce cross-border insolvency within the IBC process. We expect this to be largely based on the UNCITRAL Model Law, with foreign creditors and bankruptcy professionals being permitted to participate in the CIRP. The cross-border framework is also expected to provide for coordination between foreign and Indian courts for enforcement actions and addressing issues around simultaneous proceedings in multiple fora. Overall, we expect the distressed asset industry continuing to be vibrant and a key focus area for the government over the next few years.

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