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The business models of ARCs are built around their expertise in acquiring distressed assets (NPAs) from banks and financial institutions and successfully resolving these assets. Since the capital base of these ARCs was modest, RBI allowed the ARCs to pay a part of their consideration in the form of SRs. Security Receipts (SRs) are instruments issued by Asset Reconstruction Companies as consideration for their purchase of distressed assets from banks/NBFCs. An SR reflects an interest in the underlying distressed asset or pool of distressed assets. The consideration for acquiring these assets is generally a combination of Security Receipts & upfront cash. SRs are issued by separate trusts which are formed by the ARC to represent a distressed asset or a combination of distressed assets.
RBI’s initial guidelines envisaged a 5/95 configuration (i.e. 5% of the purchase consideration to be paid in cash and balance 95% by way of issue of SRs). The scheme was subsequently modified to 15/85 scheme to nudge the ARCs to have more "skin in the game’’ by way of a minimum 15% cash investment. The proportion of the cash/SRs currently is largely a function of the negotiation between the buyer of the asset (ARC) & Seller of the Asset (Lender). Pursuant to regulatory changes, the lenders have been showing a distinct preference for more cash deals which have resulted in increased capital requirements for the ARCs. The investments in SRs are also currently permitted for QIBs, which has increased the flexibility of the ARCs in acquiring more assets. The regulator has been mulling avenues to improve liquidity in SRs through options like listing.
Factors considered while assessing the performance of an ARC
1. Promoter support:
Acuite will evaluate the extent of available promoter/s support, the financial strength of promoter and the interlinkages in the form of capital, managerial and/or operational support. Regular capital support from the promoters will ensure that company has resources for scaling up the business, while managerial support will aid in framing various risk management policies, resolution strategies, etc. This is a key parameter and more so in the event of nascent stage of operations of an ARC where the track record of operations is yet to be established.
Many ARCs, however, have a distributed shareholding from financial institutions and mostly banks. The promoter support in such a case may be assessed either from the largest shareholders (if they hold a material stake, say over 30%) or on a collective basis if there is a track record of collective support. Further, in case of a distributed shareholding of public sector banks, the indirect consolidated government holding is also assessed and the extent of support from the government, if of a material nature, is evaluated.
2. Company management and expertise:
Acuite will understand the background of the management in terms of their experience, expertise, their ability to add value to the overall resolution process and the resource raising ability. The overall organisational profile, decision making philosophy regarding acquiring new assets, valuation, recovery mode etc. will be assessed under this parameter. The ability to attract marquee investors and QIBs is also an important aspect to be examined under this parameter.
3. Capital Structure:
The capital structure/gearing is also an important factor in determining the credit quality of the ARCs. Typically ARCs have been modestly leveraged up to 2-3 times since a large portion of their acquisitions have been through issuances of SRs. The nature of the assets to be offered as collateral has also been a challenge in raising funds, especially from the conventional banks. Nevertheless, besides banks, the ARCs have raised funds through sources like debentures, ECBs etc. The higher the dependence on external debt, the more the susceptibility of the credit to any external shocks.
4. Acquisition/ risk management policies:
Acuite will understand the asset acquisition policy of the ARC in terms of the preferred size of the acquisition, sectoral preferences etc. This will help in understanding the diversity and granularity of the AUM. The more granular & sectorally diverse the AUM, the more resilient is the credit profile & earnings profile across business cycles. Besides the diversity across sectors, sizes, top exposures etc. Acuite will also examine the approach to consolidation/aggregation of debt. This is because aggregation confers certain advantages to an ARC in terms of speed of decision making and influence on the approach to resolution.
5. AUM Analysis:
The AUM profile is understood in terms of their sectoral diversity and their recovery rating diversity. As regards recovery ratings, more the proportion of high rated Security Receipts, higher is the possibility of future earnings improvement through recoveries/redemption of SRs along with the timely realisation of management fees. Since the trusts are usually established for 5 years (extendable to 8 years) the vintage of the assets acquired is also considered important here. The higher the vintage beyond 5 years, more likely is the possibility of certain write-downs over the near future. Acuite seeks granular data on the top 5/10 exposures, rating wise/ seasoning/ industry wise bifurcation of AUM in order to understand the resolution of the top exposures and AUM construct.
6. Track Record of Resolutions:
An improving trend of cumulative redemptions of SRs to cumulative issuances is indicative of positive developments in area of recoveries/ resolutions. A consistent track record of resolutions suggests healthy operational efficiency. In certain cases, resolution of a few large ticket cases can also influence the results for a given period. Acuite also examines the resolution across the portfolio by way of the ratio of cumulative recovery/total SR’s, Recovery % of AUM or ATA, Yearly recoveries and Turnaround time.
7. Operating Efficiency:
The ratio of Operating Expenses to the Average Assets Under Management & Operating Income is also examined to identify any trends of strengths and weaknesses. Typically, the ratio will be high in the initial stages and will stabilise once the AUM acquisition reaches an optimal level.
8. Earnings Quality:
Acuite will evaluate the strength of earnings by way of trend and consistency of management fees. Typically, an ARC derives its revenues from three sources, i.e. management fees, redemption of the SRs held by it in the various distressed assets & upside fees. The Management fees are the relatively steady portion of the revenue streams. The other two revenue streams are generally lumpy and depend to a large extent on the resolution of the assets. As a result, the consistency of a portion of fee component lends some cushion to earnings profile. Trends in composition of fee income in the total revenues, profit on the redemption of security receipts, PAT as % of average total assets are evaluated.
ARC with limited or no track record
In the event that an ARC is a newly formed one with limited or no track record of operations, the following parameters will assume significant importance:
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