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The Indian distressed asset investment landscape has come of age, and we think the time is ripe for discerning investors to step in and pick “value” assets. Over the span of the last two years, there has been a remarkable change in the resolution process for Non-performing loans (NPLs) on the balance sheet of banks. While India has had a fair share of stressed assets at regular intervals, investors have largely stayed away from the space, amid the absence of robust legal, regulatory and resolution frameworks. The lack of creditor-friendly laws allowed promoters to exploit the system, and banks continued ‘evergreening’ loans amid lax oversight.
The Insolvency and Bankruptcy Code (IBC), which was passed in 2016, changed the game. It has given stressed asset resolutions a legal structure, well-defined processes, responsibilities and timelines. The initial cases before the National Company Law Tribunal (NCLT) indicate that the authorities are being proactive in ironing out new challenges.
While global players are waiting to see how the new frameworks play out, domestic players have already started working actively in the space to acquire assets at discounted prices.
Can real money be made?
Distressed asset investments are exciting because of their inherent ‘buy low-sell high’ potential and ‘low correlation’ to other asset classes. The emphasis is on buying good underlying assets with potential for a turnaround, at reasonable valuations. As investors in a distressed asset, it is crucial to perform in-depth due diligence to avoid traps, whether related to pricing, litigations or operations.
Unlike a blue-chip equity investment, distressed asset investments need considerable handholding post the initial financial assistance. It is important that the market begins to see value in the business, as the price you can command at the exit would depend on this. Apart from the capital restructuring, the excess value can be created by activities such as changing the management, aligning incentives for stakeholders, restructuring operations and costs.
Deals in the market:
To some investors, especially large corporate strategic players, the current situation seems like a once-in-a-lifetime opportunity to expand capacity cost-effectively. A number of the resolution plans submitted so far to the NCLT involve big corporates looking to strategically acquire large stressed capacities at discounted rates.
RBI has come up with two lists which target a total of INR 4.06 Lakh Crore. of the total INR 8.77 Lakh Crore of outstanding NPLs:
- NCLT-1: 12 companies with gross NPL of INR 2.77 Lakh Crore, the average haircut of ~60%
- NCLT-2: 25 companies with gross NPL of INR 1.28 Lakh Crore, the average haircut of ~72%
Smaller and mid-market assets will make banks uncomfortable as investors may not see value in them. This may slow down the rate at which small businesses are put out for bids, perhaps inviting RBI or government intervention.
Navigating the space as an investor:
We believe that there are six points to consider while investing in distressed assets:
1. Risk & Reward:
Payoffs and mortality rate of distressed investments are similar to convertible debt, with better downsides than equity, as the underlying businesses have a fair past record and a cleaned-up balanced sheet. Pledged collateral also provides a floor for returns. Close involvement with the companies and impeccable execution of the resolution plan can drive stellar returns. However, these investments are inherently riskier; there can be valuation as well as illiquidity issues, and price discovery can be a challenge.
2. Low correlation with traditional asset classes:
Distressed investments are usually ‘standalone’ financial engineering opportunities, with low correlation with equity or debt markets. So, the asset class can be a great diversification strategy for investors.
3. Legal challenges:
Courts in India have historically been very accommodating towards promoter-led appeals. Adjudication timelines have been extremely long. While the IBC is expected to change things, it remains to be seen how it all plays out. There could be sudden changes in government policies, which could impact returns. Legal challenges and counter appeals will help set precedents and define case laws, eventually bringing in greater clarity.
4. Partnering with experts:
Considering the large amount of effort involved in scouting for and turning around distressed companies, partnering with industry professionals, private equity funds or special situation experts is recommended. Experts and their extensive networks help in sourcing opportunities, conducting reference checks and avoiding legal and valuation traps. Also, experts can help identify potential “value” assets even before they are officially classified as “distressed”, significantly mitigating legal uncertainties.
5. Promoter bonhomie:
Experts feel that it is difficult to run a company in India without the support of the promoters as they are usually a part of the management. Tiding over regulatory, labour unions, government and legal issues can become tenuous without promoter support. This is different from the global scenario, where professional managements run operations. Therefore, completely alienating promoters may not work in the Indian context.
6. Robust incentive framework:
Investors must set up a robust and fair incentive structure for each stakeholder in the turnaround story. Equity earn-outs for promoters have worked well in the past, according to experts. Misalignment of stakeholder interests can derail restructuring initiatives, potentially squandering away invested capital.
Although space is seeing a flurry of activity, there are caveats that apply. There is money to made, however, the risks, whether related to legal, operational or valuation issues, cannot be ignored.