Benefit from crucial changes. Revised guidelines for ARCs to fortify the sector: CRISIL Ratings

The revised guidelines for asset reconstruction companies (ARCs) announced by the Reserve Bank of India (RBI) last Tuesday would structurally fortify the sector through improved governance norms, better disclosures, lower funding requirement for asset acquisition, and more robust balance sheets, according to CRISIL Ratings.

However, the guidelines also require ARCs to increase net-owned funds to ₹300 crore from ₹100 crore in a phased manner by the end of March 2026, which could be challenging for some of the smaller ones, opined the agency.

The business profiles of ARCs will benefit from two crucial changes: one, lower funding requirement for acquisitions, and two, an option to participate as a resolution applicant under the Insolvency and Bankruptcy Code (IBC), CRISIL Ratings said in a note.

Revision details

Investments by ARCs in security receipts (SRs) are envisaged at a minimum of 15 per cent of the investment of the transferor in the SRs, or 2.5 per cent of the total SRs issued, whichever is higher, in each asset class under each scheme on an ongoing basis until the SRs are redeemed, per the revised guidelines.

Earlier, ARCs had to invest at least 15 per cent of the SRs issued in each class under each scheme even if other investors (other than the selling lenders) were present.

Subha Sri Narayanan, Director of CRISIL Ratings, said: “The revision in the minimum investment in SRs is a significant benefit for ARCs. This will free up their funds and support growth over the medium term. For cash transactions, the saving could be as high as 80-85 per cent.

“Even where the selling entity participates in the transaction, the funding requirement is somewhat lower than the earlier regime.”

The proportion of cash-based transactions in CRISIL-rated SRs has been increasing steadily and stood at 36 per cent as of February 2022 compared with 4-5 per cent as of February 2017.

“We expect this momentum to continue with lower requirement of funds for cash-based transactions,” she said.

Allowing ARCs to become resolution applicants in the IBC process is also a step in the right direction, the agency said.

This will enhance the business options available and potentially opens a new revenue stream.

However, to be a resolution applicant, ARCs will need net-owned funds of over ₹1,000 crore, which only a few of the 28 may be able to garner.

The agency noted that several measures to strengthen the governance framework of ARCs have also been introduced.

“With respect to Board processes, these include enhancing the Board’s independence, stipulation of tenures of Board members as well as a performance review process for them. The debt settlement process has also been made more rigorous,” per the note.

The agency observed that the revised guidelines mandate enhanced disclosure norms on financial information, track record of returns generated and recovery ratings on SRs in offer documents. This is expected to bring in more transparency and ultimately boost investor interest.

Additionally, clear guidelines on charging management fees only from the recovery of underlying assets should persuade ARCs to focus on faster resolution of assets.

The RBI circular also requires ARCs to retain a rating from a credit rating agency (CRA) for at least three years.

Gautam Shahi, Director of CRISIL Ratings, said: “While the revised guidelines are clearly aimed at strengthening the sector, it could throw up a few challenges for ARCs.

“More than half of the ARCs have net owned funds lower than the increased requirement of Rs 300 crore. A number of them may not be able to bring in additional capital.”

Further, the other governance measures are likely to increase compliance and operational costs, which could be challenging for some of the small-sized ARCs, he added.

Therefore, over time, these developments could lead to consolidation in the industry.

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