The article argues for the greater role to Asset Reconstruction Companies by allowing them to invest in the equity [shares] of the distressed companies.

Context

• In a recently released paper “Indian Banks: A time to reform” Viral Acharya and Raghuram Rajan argued for a greater role for Asset Reconstruction Companies.
• They argue that when there are fewer bids in a bankruptcy auction, the value on loans is better realised if read an asset reconstruction company takes over the borrower and places the firm under new management.

Current limits on the role of ARC

• The RBI limited the role of  ARC to participation in resolutions under the Insolvency and Bankruptcy Code, 2016 (IBC) only by partnering with an equity investor, which is the resolution applicant.
• If the application succeeds, the equity investor would acquire the shares, while the ARC trust would acquire the debt.

Background of the ARCs

•  Some stakeholders are asking for extending the role of ARCs by allowing direct invest in the equity of distressed companies through IBC resolution just like private equity funds.
• The RBI doesn’t appear to favour such an extended role for ARCs.
• This is due to the uninspiring performance of the Asset Reconstruction Companies in the past.
• At the time of the Asian Financial Crisis,  India’s non-performing assets stood at a whopping 14.4 per cent.
•  It was in this context that the Narasimham Committee (1998) recommended setting up an ARC specifically for purchasing NPAs from banks and financial institutions.
• Subsequently, the SARFAESI Act, 2002 created the legal framework for establishing multiple private ARCs.
• This policy achieved only modest success.
• The maximum average recovery by ARCs as a percentage of total bank claims stood at 21.5 per cent in 2010.
• Since then, it has steadily declined and reached 2.3 per cent in 2018.
• This low recovery could be the result of collateral disposal rather than genuine business turnarounds [i.e. operating the business and turning it profitable].

Need for extending the role of ARCs

• In 2002, India lacked an effective bankruptcy system.
• There was no market for corporate control of distressed firms.
• ARCs were originally designed for this peculiar institutional ecosystem.
• They were required to hand over the distressed business back to the original promoter once they had generated enough value to repay the debt.
• Consequently, ARCs had little incentive to turn around distressed businesses.
• This situation completely changed in 2016 as the IBC seeks to maximise the value of distressed businesses through a market for corporate control.
• ARCs should be able to fully participate in this market and attempt successful turnarounds by acquiring strategic control over distressed businesses.
• In a solvent company, shareholders have stronger incentives than creditors to maximise enterprise value.
• This is because an increase in enterprise value automatically increases the value of its equity.
• In contrast, creditors do not benefit from increases in enterprise value beyond their individual claims.
• If ARCs could hold more equity instead of debt in the resolved company, they would also have a stronger incentive to take strategic control to ensure successful turnaround.

Way forward

• The law should enable ARCs to invest in a distressed company’s equity, whether by infusing fresh capital or by converting debt into equity.
• Effectively, an ARC should act more like a private equity fund, as Acharya and Rajan suggested.
• This in turn would make the market for corporate control under IBC deeper and more liquid, improving ex-ante recovery rates for banks.

Consider the question “What are Asset Reconstruction Companies? How allowing the ARCs to invest in equity of distressed companies under IBC help successful turnaround of the distressed business?”

Conclusion

•  If only ARCs are allowed to directly participate in IBC resolutions by infusing equity, they could emerge as the most efficient vehicle for turning around distressed Indian businesses.

Back2Basics: Difference between debt and equity

• Debt market and equity market are two broad categories of investment available in the general investment milieu.
• Equity markets trade in shares or stocks of the company listed on the stock exchanges.
• A stock in a company indicates a unit in the ownership of the company.
• As shareholders, you become part owners of the company.
• The largest shareholder, with 50% or more shares, becomes the owner of the company.
• Equity markets are riskier than debt markets.
• Debt is a form of borrowed capital.
• The central or state governments raise money from the market by issuing government securities or bonds.
• In effect, the government is borrowing money from you and will pay interest to you at regular intervals.
• The principal amount is returned on maturity.
• In the same way, a company raises money from the market by selling debt market securities such as corporate bonds.
• The debt market is made up of bonds issued by government authorities and companies.

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