Methodology for Resolution Plan Ratings

25th January 2024 (Version 4)

The introduction of radical measures such as IBC (Insolvency & Bankruptcy Code) is expected to gradually result in an improvement in the credit culture and act as a deterrent to wilful defaulters. While the intent of the regulation is to nudge the banks towards weeding out structurally unviable cases, it does allow the flexibility to the banks to resolve potentially viable cases in certain cases through resolution plans, wherever lenders expect that the revised debt servicing requirements (as per resolution plan) can be aligned to cash flows generated from the underlying assets.

Based on RBI’s " Prudential Framework for Resolution of Stressed Assets” dated June 7, 2019, Acuité has developed a framework for Resolution Plan (RP) ratings [also known as Independent Credit Evaluation (ICE)] to ensure a credible and consistent approach towards such cases.

It is pertinent to note that Acuité will be rating only the Sustainable Portion of the exposure. The RP rating will not be applicable to the Unsustainable portion of the exposure. However, the commitments under all categories of debt (sustainable as well as unsustainable) will be reckoned while arriving at the debt service coverage indicators.

Generally, the repayment of the unsustainable portion of debt (which could be in the debt instruments with equity like characteristics) is typically after the payment of sustainable debt. However, in certain cases, the payment of the unsustainable debt could also commence during the initial period of repayment. In such a case, the assumption is that the sustainable debt will have precedence over the unsustainable debt.

An independent Credit Evaluation is a one-time exercise for which assessment is carried out on a seven-point scale (RP 1 – RP 7). The deliverable is a report to be provided to the lender. There is no public dissemination of the outcome of the rating exercise.

Framework for evaluation of credit risk

In this case, Acuité shall primarily rely on the TEV report, Resolution Plan, and other related data furnished by the lender in this regard along with a need-based discussion with management and lender. Acuité may also call other documents such as Annual Report, Latest stock audit report, Forensic Audit Report, Monthly Operational data, to arrive at its rating.Acuite shall rely on its existing criteria for industry specific factors in conjunction with this methodology for arriving at the rating.

The brief parameters to be looked at are as follows:

1. Reason for past default and its mitigating factors in the proposed resolution plan

Acuite believes that it is important to understand the factors for past defaults by the entity. These could range from industry downturn, large capital expenditure, abrupt changes in incremental working capital requirements etc.

2. Quality of Management

Since the continuity of management is critical for the smooth revival of a company, the management succession is assessed. The nature of the ownership is also assessed. In certain cases, the lenders may decide to induct new promoters or a new investor may come in with a majority stake. In such cases, the competence and background of the new investors assumes relevance.

3. Assessment of Key Business Drivers and Scenario Assessment

Acuite evaluates the extent of cyclicality, the competitive landscape, regulatory environment, risks emanating from emergence of new technologies, threats from overseas suppliers, end user sector performance among others during the period of the resolution plan. The cyclicality of the industry particularly becomes extremely relevant, since the operating cash flows of the units in a cyclical sector may vary significantly depending on whether the unit is operating at a trough or peak of the cycle. Furthermore, the type of clientele, pricing power, threats from substitute and the degree of operating leverage is likely to determine the cashflow generation for servicing the debt obligations.

Acuite notes that while assessment of business drivers is critical to evaluate the sufficiency of cashflow, it is pertinent to identify logistical, commercial and other challenges that a company may witness which may result in complete stoppage of operations and therefore care must be taken to critically evaluate such issues.

Scenario Assessment undertaken by Acuite

Since most of the resolution plans pertain to stressed assets, the conventional measures of credit assessment will not be suitable for RP ratings. The key issue to be examined in such cases is of adequacy of cash flows to service the debt commitments. Hence, in RP resolution plans, the focus is on cash flows rather than profitability/gearing etc. The cash flow focus helps in understanding the cash flow buffers available keeping in mind the debt servicing commitments. Acuite shall seek financial projections from the lenders and evaluate the resolution plan considering the same as base case. Acuite shall also forecast for the financial performance by relying on the base case projections provided by the lenders and subsequently test the base case financial projections by applying suitable stress factors to observe resilience of the proposed resolution plan and various operating environments. This assumes importance as the robustness of the proposed plan is required to be tested to evaluate the cushion that may be available over the debt servicing requirements during the tenure of the resolution plan.

Tenure of the resolution plan: Since the resolution, plans are long tenure plans (in some cases beyond 20 years) and the cash flow visibility beyond the initial 3-5 years is difficult. Acuité believes that the likelihood of the variance from base estimates significantly increases with very long tenor plans (> 7 years); hence, sensitivity analysis becomes an essential part of such plans. Other factors such as the presence of DSRA (Debt Service Reserve Account) help in mitigating the impact of temporary inadequacy in cash flows. Hence, these factors also have a bearing on the overall assessment.

 

4. Resource raising capacity of Promoter: The Promoter’s ability to infuse additional funds (beyond the initial upfront contribution as required under restructuring guidelines) is assessed under this parameter. The promoter’s ability to raise funds through disposal of non-core assets and personal assets becomes relevant. The key factor is the importance attached by the promoter to the distressed entity and the promoter’s willingness to support the resolution plan.

Resolution Plan Rating

ICE SYMBOL	Definition
RP1	Debt facilities/instruments with this symbol are considered to have the highest degree of safety regarding timely servicing of financial obligations. Such debt facilities/instruments carry lowest credit risk.
RP2	Debt facilities/instruments with this symbol are considered to have high degree of safety regarding timely servicing of financial obligations. Such debt facilities/instruments carry very low credit risk.
RP3	Debt facilities/instruments with this symbol are considered to have adequate degree of safety regarding timely servicing of financial obligations. Such debt facilities/instruments carry low credit risk.
RP4	Debt facilities/instruments with this symbol are considered to have moderate degree of safety regarding timely servicing of financial obligations. Such debt facilities/instruments carry moderate credit risk.
RP5	Debt facilities/instruments with this symbol are considered to have moderate risk of default regarding timely servicing of financial obligations.
RP6	Debt facilities/instruments with this symbol are considered to have high risk of default regarding timely servicing of financial obligations.
RP7	Debt facilities/instruments with this symbol are considered to have very high risk of default regarding timely servicing of financial obligations.