Security Receipts (SRs) are instruments issued by Asset Reconstruction Companies as consideration for their purchase of distressed assets from banks/ NBFCs. A SR reflects an interest in the underlying distressed asset/ pool of distressed assets.

Evolution of SRs

The enactment of SARFAESI (Securities & Reconstruction of Financial Assets and Enforcement of Security Interest), & RBI also allowed the functioning of Asset Reconstruction Companies ( ARCs) who would be authorised to buy stressed assets from banks for a consideration. 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. The scheme initially started with 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 gradually modified to 15 /85 scheme to nudge the ARC to have more ‘skin in the game’ by way of cash investment. RBI also linked the valuation of the SRs and consequently increased the ARC’s revenue linkages to the Recovery Ratings assigned by Rating Agencies on these SRs. RBI has also effected certain changes in the regulation pertaining to provisioning relief to the banks based on the SRs held by them in respect of an account.

The key methodology for assigning of RR rating hinges on following two factors:

1. Resolution methodology – Liquidation Approach or Restructuring Approach
2. Assessment of the Magnitude & Timing of Cash flows to arrive at the Present Value of Cash flows & Redemption of SRs.

Resolution Methodology

The approaches adopted by ARCs to resolve the distressed assets acquired by them can be broadly categorised as (a) Liquidation Approach & (b) Restructuring Approach

The Liquidation approach, usually, is adopted in cases of structural unviability of the business. Often the viability of businesses is threatened due to factors such as changes in regulation, emergence of new technologies, changes in customer preferences among others. In such a scenario, the lenders (including SR holders) will be left with limited options such as sale of assets. The value of industrial assets, (more particularly land), can support the recovery efforts of the lenders. The nature of the assets is important in this case. For instance, assets with customised applications will have limited marketability than assets with standardised applications. The regulatory restrictions on usage can also affect the marketability of the assets. For instance, the land and building of a distressed unit in an electronics zone can be sold mostly to units operating in similar segments or allied areas. In case of certain assets, the maintenance of the assets is another factor, as the lenders may have to ensure the timely maintenance to preserve their market value.

The appreciation in prices of land (especially in and around urban centres) has imparted a buoyancy to the recovery efforts of the lenders The valuation reports have to be obtained from bank empanelled valuers to get a fair estimate of the expected proceeds from sale of property. The timing and quantum of cash flows will be critical in this case. The IBC (Insolvency & Bankruptcy Code) has put in place a mechanism for timely resolution of assets. The mooting of the ICA (Inter Creditor Agreement) to bring all lenders under a common umbrella is also a progressive step in this direction. While such initiatives are expected to augur well for the ARCs, the operational impediments such as legal hurdles by existing managements (who do not want to be dislodged) or operational creditor’s issues will have to be ironed out.

Restructuring Approach

In most of the cases, the assets of the distressed entity have inherent economic potential. The entity in such cases could have faced distress because of transient setbacks such as cancellation of orders, build-up in receivables, labour strikes, raw material linkage issues, regulatory changes domestically or abroad among others. In such cases, the lenders pursuant to a techno-commercial viability study may decide to alter the terms of payment. The additional requirement of funds required for the smooth implementation of the scheme is also assessed while arriving at the restructuring scheme.

In such cases, the cash flows could be staggered over a period with payments to the lenders being made in a pro rata manner. The promoters of the distressed entity may also propose an OTS (One Time Settlement) with an upfront payment and balance, over a period, with some or all lenders. Acuité has observed that generally all the ARCs focus on consolidation of the debt in an entity by acquiring the stakes of various lenders. The ARCs ability to influence the resolution strategy is significantly enhanced by such aggregation of debt.

Acuite’s stance in restructuring cases will be to arrive at stress case scenarios in addition to base case scenarios, to gauge the extent of variability in cash flows and consequently the impact on the recoveries and redemption of SRs.

Discount Factors

Generally, Acuité applies a 9% discount factor while arriving at the present value of the cash flows. Acuite also considers the priority payments, if any, such as management fees before arriving at the distributable surplus.

Acuite’s Rating Scale and their respective interpretation is as under.