ARCs may hunt MSME, retail assets as ground shifts
Asset reconstruction companies (ARCs) are expected to target stressed accounts in the micro, small, and medium-sized enterprise (MSME) and retail segments in the near-to-medium term, owing to the twin challenges of insufficient funding access and intensifying competition following the establishment of the proposed National ARC.
ARCs have faced headwinds over the last two fiscal years, with assets under management (AUM) – as measured by outstanding security receipts (SRs) – falling following a five-year run-up. Between 2015 and 2019, their AUM increased steadily as a result of supporting legislation implemented in fiscal 2014. However, that tendency reversed in fiscal 2020, with a 4% decline. CRISIL Ratings expects that AUM will shrink 1% to Rs 1.07 lakh crore in fiscal 2021.
While the slowdown is partly due to the overall macroeconomic environment, which has hampered deal completion and increased investor risk aversion, a few structural dynamics are also at work.
To begin, banks prefer to keep a small portion of SRs for assets sold due to the severe provisioning standards applicable to selling banks. On the other hand, ARCs typically retain no more than the regulator-mandated 15% of SRs. This creates a deficit that must be filled either by increasing the ARCs' holdings of SRs or by attracting external co-investors.
This represents a considerable departure from the past, when practically all SRs were subscribed to by either selling institutions or ARCs. External investors' proportion of total SRs issued climbed significantly to 12 percent as of March 31, 2019, from 3 percent on March 31, 2018, owing principally to the attraction of several substantial assets. However, the tendency has slowed, and co-investors have been picky. This contributes to the decreased growth of ARCs in fiscal years 2020 and 2021.
Second, in contrast to a few years ago, lenders currently have a variety of resolution and enforcement frameworks to choose from and are actively evaluating and using these frameworks. The Insolvency and Bankruptcy Code, 2016 (IBC), and its following amendments, have found widespread adoption. The RBI's June 2019 Prudential Framework for Stressed Asset Resolution enables lenders to settle stressed assets outside of the court system.
In light of this, CRISIL Ratings predicts the stressed asset industry would fragment, with participants focusing on distinct areas. Capital availability, debt aggregation capability, and operational infrastructure will all play a role in determining each player's positioning.
According to Krishnan Sitaraman, Senior Director and Deputy Chief Ratings Officer at CRISIL Ratings, "the National ARC is projected to dominate the major company market, given its stated mandate and access to money." Mid-corporate assets, where ARCs have a stronger track record of recovery, could be a play for both them and stressed asset funds. However, in the retail and MSME industries, ARCs have the potential to carve out niches. These segments require a highly operationally intensive structure that other investor classes are unlikely to create. Given the increased operating expenses, profitability will be critical, and ARCs that invest will need to keep a laser-like focus on this segment.”
To be sure, retail and MSME volumes are unlikely to surpass those recorded between fiscal years 2014 and 2019, when corporate assets drove expansion. Nonetheless, for those ARCs who do it correctly, it may be a lucrative company. Their ability to attract financing remains critical to their growth. Given that capital is expected to flow to the most effective platform, it will be vital for ARCs to demonstrate their differentiated recovery capabilities in order to maintain relevance with stakeholders.
The cumulative SR redemption ratio1 is one statistic used to assess recovery ability; it has increased in recent years and stands at 32% as of March 31, 2021, up from 17% three years earlier. This has been aided by the resolution of a few large-ticket assets through the IBC procedure, but overall recovery has remained lower than anticipated. Additionally, the time required for rehabilitation has been longer than anticipated. While recent originations have demonstrated improved performance, recovery has not yet reached acceptable levels.
According to Subha Sri Narayanan, Director at CRISIL Ratings, "ARCs have yet to establish their ability to revive on a major scale in the retail industry." However, one reason will assist their shift toward retail and MSME segments – it is the potential presented by incremental non-performing assets generated primarily by these two segments during the current cycle, with lenders, including non-banks, progressively selling these assets. Indeed, this transition is already obvious. Although the total volume of debt purchased in fiscal 2021 was lower, a CRISIL Ratings study found that non-corporate categories accounted for 44% of total debt obtained, a significant increase from 4% two years before.”
In general, if other segments face increased competition in terms of lender choices, increased participation in the retail market may be an unavoidable move. As previously said, the capacity to interact with other investors, attract capital in a variety of ways, and essentially demonstrate recovery capabilities will be critical for long-term growth and profitability.