The Hindu Business Line : A performing value for NPLs

THE existing asset reconstruction company (ARC) framework envisages banks and financial institutions transferring their non-performing loans (NPLs) at "fair value", with lenders making upfront adjustments in their financial statements for difference between book and transfer values. "Fair value" is the value at which the buyer and seller may be expected to transact, while acting on an arm's length basis, with both having reasonable access to relevant information and neither being under any compulsion to act.

While NPL valuations would clearly depend on perception of both parties, ARCs/NPL investors paying cash are unlikely to acquire NPLs at prices higher than their assessment of net realisable value, considering the costs of maintaining and realising the asset value, together with a return on capital commensurate with the risk attached.

However, in view of lenders' unwillingness and inability to absorb upfront financial loss and often differing value perception between lenders and ARCs/NPL investors, NPL valuations have the potential to delay NPL transfers, impeding much needed consolidation of debt for speedy and focussed attention to resolution.

NPL valuations may be enhanced by certain measures, which would, therefore, encourage transfer of distressed debt and help the financials of the banks.

Strengthening of creditors' rights

International experience suggests that strong creditors' rights and insolvency laws are pre-requisites for successful and effective NPL resolution. Success of Danaharta, the Malaysian AMC, can be attributed to existence of strong and clear legal regulations.

On the other hand, in Thailand, the legal framework on creditors' rights lacked clarity and even the judiciary had difficulties in interpreting laws on creditors' rights, leading to long and costly legal disputes.

ARCs/NPL investors, with significant financial investments at stake, seek clarity on practical resolution options, likely timeline and possible impediments.

Any perceived uncertainty/impediment in implementing possible resolution options tends to get priced in, leading to lower valuations for the lenders. One such impediment is the automatic and indefinite stay against creditor actions, which follows from a BIFR filing. Enactment of the SARFAESI Act, 2002 that permits the secured lenders to enforce security interest without reference to court, was a critical step towards strengthening of creditors' rights.

Subsequent amendments have tried to address certain issues experienced or envisaged in implementation of the SARFAESI Act provisions. There is, however, still a need for strengthening of Debt Recovery Tribunals and practical measures for improving their functioning.

Rationalisation of transaction costs

High transaction costs involved in acquisition of financial assets is one of the biggest deterrents to asset reconstruction activities in India. Under the current legal regime, transfer of financial assets in some States could attract ad valorem stamp duty of up to 14 per cent of transaction value or market value of financial assets being assigned/transferred, thereby eroding the economics of the proposed transaction and impacting its pricing.

Stamp duty is a `State' subject and, therefore, the various stamp duty legislations need to be amended to reduce stamp duty payable on the assignment/conveyance of financial assets to an ARC. Further, as per existing laws, any income from an NPL resolution is likely to be taxed at the maximum marginal tax rate, with significant limitations on an investor's ability to set off loss incurred on some transactions against the gains made on others.

Given the economic desirability of reconstruction activity, need to clean up lenders' balance sheets, inherent risks involved in undertaking such activity and the need to attract NPL investors, there is merit in considering extension of "mutual fund type" tax exemption for ARCs and trusts set up by ARCs, recognising their pass-through nature, and either full exemption for the NPL investors or a simple tax regime based on low incidence, easy computation and allowing set off of losses.

The consequent lowering of tax incidence and uncertainty relating to asset reconstruction activity shall result in higher NPL valuations and the reduction in complexity shall itself be beneficial.

Large number of NPL investors

The introduction of NPL investors, both domestic and overseas, into the NPL resolution process has clearly been a key driver of success in other countries. They bring a combination of skills, experience, objectivity and commercialism to the resolution process. Importantly, they represent a significant source of capital that can be injected not just into the financial sector (through acquisition of NPLs), but also into the commercial/real sector via capital infusion into distressed businesses as part of a restructuring.

In the Indian context, involvement of independent NPL investors becomes even more important as existing ARC framework envisages little fiscal support from the Government, with funding for NPL acquisition and resolution coming from independent NPL investors and there is inadequate risk capital in the country. Discussions with various independent NPL investors suggest that Indian NPL opportunity is attractive provided there is a demonstrable deal flow and issues relating to investment structuring are addressed.

Involvement of such investors at a large scale should help generate competitive tension, thereby increasing NPL valuation from the lenders' perspective. Encouraging a wide array of institutional investors, without undue restrictions and with reasonable flexibility to structure deals commercially, is, therefore, desirable.

Aggregation of different lenders' stake

In India, NPL ownership is quite fragmented and debt aggregation is a key prerequisite for achieving successful NPL resolution. The existing ARC framework envisages ARCs/ NPL investors marketing themselves to various lenders and acquiring financial stakes held by them in a borrower.

While, on the one hand, this approach would have time/cost implications on the ARCs/NPL investors in co-ordinating with different lenders, on the other hand, ARCs/NPL investors are likely to provide for risk premium for possible difficulty in achieving debt aggregation.

ARCs/NPL investors would be willing to pay higher valuation for the aggregated NPLs as this would enable them to move ahead with their resolution strategy without waiting for debt aggregation to be achieved. Such a debt aggregation may be achieved through Government directions to banks for mandatory transfer of NPLs to ARCs in case any of the lenders decides to transfer its stake to an ARC or an NPL continues beyond a pre-determined time.

Professional management of the NPL process

Since uncertainty is the hallmark of NPLs and uncertainty erodes value, selling banks should consider various measures to mitigate this uncertainty and improve the potential buyers' ability to evaluate the assets as well as their confidence in the information provided. Professional advisors, specialising in NPL transactions, have developed their own expertise in this area, have access to a large number of investors and carry credibility built on track record. Collation and review of relevant information, validation of data and its professional presentation by such an advisor can make the task of potential buyers much easier and reduce the bidding cost, thus encouraging a larger number of potential buyers and increasing competition. The consequent improvement in value realisation makes the involvement of such advisors well worth their fees.

The above steps would not only go a long way in enabling lenders to get higher NPL valuations, these would also encourage development of the overall NPL resolution process and extracting higher value from them.

(The author is Executive Director PricewaterhouseCoopers Pvt. Ltd)

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