What is bad for banks is good for ARCs

Track record for asset resolution critical for long-term sustainability Pawan Agrawal Subha Sri Narayanan Senior Director – CRISIL Ratings Team Le...
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Track record for asset resolution critical for long-term sustainability

Pawan Agrawal

Subha Sri Narayanan

Senior Director – CRISIL Ratings

Team Leader – CRISIL Ratings

Nitesh Jain Associate Director – CRISIL Ratings

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What is bad for banks is good for ARCs

August 7, 2014

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Key messages







Growth will settle at a lower level for ARC industry –

AUM reached Rs.42,000 crore by June 2014, a 4 times increase in a year



Growth to moderate to 30 per cent in the current year, given the recent regulations

Capital and earnings will emerge as challenges –

Recent regulatory changes significantly increase the capital requirements of ARCs



ARCs that can raise capital in a timely manner will be better positioned

Track record of asset resolution critical for long term sustainability of ARCs –

ARCs have successfully reconstructed several large accounts



However, experience shows that the recovery till date has not been up to potential



Cumulative redemption ratio* till June 2013 stood at 53 per cent

Better recovery prospects ahead –



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Lower vintage and quicker debt aggregation to be the key drivers

Recent regulations structurally positive for the sector

* Redemption ratio = SRs redeemed / SRs issued; Source: RBI

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Growth will settle at a lower level for ARC industry Trend in Assets Under Management (AUM; SRs outstanding) 60,000

55,000

50,000 42,000

30,000 20,000 8,800

10,000 Jun-08



Jun-10

Jun-11

Jun-12

Jun-13

Jun-14 E

Jun-15 P

Regulatory support coupled with high level of NPAs fuelled recent growth – –



Jun-09

Shortfall on sale of assets permitted to be booked over 2 years for banks Upfront booking of profit on sale of assets to ARCs permitted for banks

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Rs. Crore

40,000

Industry will need to adjust to the minimum 15 per cent requirement now – –

Aligning pricing strategy with expectation of selling banks will be challenging in the near term Proportion of cash deals is likely to go up

Source: RBI, CRISIL estimates

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Given the nature of assets, ARC business has traditionally been equityfunded



Aggregate net worth is modest at ~Rs.2,500 crore as on June 30, 2014







Gearing has increased to 1x as on June 2014 from 0.1x as on June 2013



Gearing philosophy varies significantly among ARCs

Capital raising will emerge as a significant challenge –

Earnings will come under pressure due to revision in management fees norms



Regulatory restrictions on sponsor shareholding and listing can act as a constraint…



…may be partly offset by higher regulatory limit for FDI and FII investment in ARCs



Could result in lower growth or higher gearing

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Capital and earnings will emerge as challenges

Ability to raise capital in a timely manner will become a differentiator

Source: CRISIL estimates

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ARCs have successfully reconstructed several large accounts Reconstruction has been used as preferred strategy for large accounts* –



Reconstruction includes restructuring and sale of business strategies

Several success stories over the past decade –

A thermal power plant (redemption ratio of 85%)



An integrated textile co (80-90%)



A large steel co (90-100%)



A railway supplier (90-100%)



A large petchem and fertilizer co (60-70%) What has worked well?

Sale of assets/ Settlement 23%

Re-construction 77%

What has not worked?

 Timely debt aggregation by ARCs

 Delay/inability in aggregating debt

 Unprecedented increase in land prices – promoters have more skin in the game

 High vintage of NPAs

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 Prolonged litigations

* Large accounts = principal debt of over Rs.100 crores

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Sale of assets drive recoveries from small accounts Sale of assets has been used as preferred strategy for small accounts* –



Includes settlement with promoters as well

Re-construction 21%

Redemption ratio is better at ~63% Sale of assets/ Settlement 79%

What has worked well?

What has not worked?

 Relatively higher asset coverage offers better cushion

 Poor availability of documentation related to security creation

 Quicker implementation of resolution strategies being sole lender

 High vintage of NPA

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 Promoters’ ability to bring in funds also played an important role # Principal debt of below Rs.100 crore

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Overall recovery has not been up to the potential Recovery Ratio – 5 yr plus vintage

Trend in Industry Redemption Ratio 60% 53%

Rs. Crore

50%

8,000

40%

32%

6,000

30%

4,000

20%

9% 2,000

10%

-

Redemption Ratio (%)

10,000

Actual recovery till Dec 2013 (A)

4,800

Principal debt acquired till Dec 2008 (B)

13,200

Recovery Ratio (C=A/B*100)

36%

0% Jun-05 Jun-08 Jun-09 Jun-10 Jun-11 Jun-12 Jun-13

Aggregate SRs issued till Dec 2008 Aggregate Redemption (LHS) Source: RBI

Redemption Ratio (RHS) Source: CRISIL estimates based on experience in rating SRs



Cumulative redemption ratio till June 2013 stood at 53 per cent



The recovery ratio is even lower at ~36 per cent –

Recovery ratio defined as recovery as a percentage of principal debt acquired



Recovery ratio better reflects effectiveness of ARCs from bank’s perspective



The analysis covers SRs of 5 years or older

7,700

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12,000

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Outlook: Better recovery prospects ahead







Recent regulatory changes will improve quality of debt acquired… –

Early formation of, and participation at, Joint Lenders’ Forum is a significant positive step



Lower threshold (60%) for consent to enforce SARFAESI to speed up debt aggregation

…due to vintage of NPAs coming down –

The vintage has come down to < 2 years for recent sales, from ~5 years earlier



Recent sale of NPAs of a shipyard and a hotel company are testimony

…and quicker debt aggregation –

A key enabler for faster resolution



The average time taken for debt aggregation was ~2 years in the past

ARCs are arranging additional funding for revival; expedites resolution –

Examples: A textile company and a mid sized Bangalore based residential developer



Implementation of learnings from past experience to help ARCs



Regulatory attention should now be focused towards quicker legal process –

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Will need to address the challenge of prolonged litigation

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Recent regulations structurally positive for the sector Impact

 Will lead to higher capital requirement for ARCs  Will significantly impact growth Increase in minimum investment requirement in SRs to 15%, from 5%  ARCs to have more skin in the game – will drive better recovery in the long term  Will lead to efficient price discovery in long term Management fees to be calculated on NAV rather than acquisition value

 Will have negative impact on earnings  Will incentivise ARCs to recover more

ARCs to be member of JLFs

 Will quicken the process of NPA sale  Good for NPA resolution in long term

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Regulations

More time for due diligence to ARCs  Will enhance robustness of due diligence process Requirement of rating in six months

 Quicker fair value assessment for banks

Greater disclosures

 Will increase transparency

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10

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Primer on ARCs and CRISIL’s experience in the sector

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CRISIL’s wide coverage provides a 360° view of the ARC industry Rated ~50 banks

Rated SRs ~Rs.12,000 cr

Recovery risk rating of SRs issued by ARCs

Recovery

Loans

Ratings of bank loans

Rated more than 13,000 firms

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Redemption proceeds

Ratings of banks

NPAs Ratings of ARCs

Rated 5 ARCs

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Specialised institutions to deal with NPAs in India; regulated by RBI



Play an important role of putting back the assets for productive use



Industry is in nascent stage even with more than 10 year history



Arcil was set up as first ARC in 2002; currently 14 ARCs operational in India –

Arcil, Edelweiss ARC and JM Financial ARC are the Top-3 players



ARCs set up a trust which issues Security Receipts (SRs)



Key industry statistics (as on June 30, 2014*) –

Principal debt acquired: ~Rs.90,000 crore



SRs issued: ~Rs.54,600 crore



SRs redeemed: ~Rs.12,600 crore



SRs outstanding (Assets Under Management; AUM): ~Rs.42,000 crore

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What are Asset Reconstruction Companies?

* Source: CRISIL estimates

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ARC model in India

Payment for NPA sale

CRISIL

Rating of SR issuances

Recovery

Investor

NPA Sale

Investment in SRs

Issuance/ Redemption of SRs

ARC

Resolution strategy

Distressed Asset/NPA



ARCs acquire NPAs from banks/Fis through trust



Trust issues Security Receipts



SRs are issued in senior-subordinate structure, as well, called as Class A and Class B SRs, respectively



Selling banks are primary investors in SRs

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Bank/FI

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CRISIL’s recovery risk rating scale Range

R1+

Indicates 150% and above recovery of outstanding face value of SRs

R1

Indicates 100% to < 150% recovery of outstanding face value of SRs

R2

Indicates 75% to < 100% recovery of outstanding face value of SRs

R3

Indicates 50% to < 75% recovery of outstanding face value of SRs

R4

Indicates 25% to < 50% recovery of outstanding face value of SRs

R5

Indicates less than 25% recovery of outstanding face value of SRs

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