The distressed asset investment landscape in India has come of age and the time is ripe for discerning investors to step in and pick “value” assets. Over the last two years, there has been a remarkable change in the resolution process for non-performing loans (NPLs) on banks’ balance sheets. While India has had a fair share of stressed assets at regular intervals, investors have stayed away from the space in the absence of robust legal, regulatory and resolution frameworks. Lack of creditor-friendly laws have allowed promoters to exploit the system and banks have continued “evergreening” loans with lax oversight.
The Insolvency and Bankruptcy Code (IBC) 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 entities are waiting to see how the new frameworks play out, domestic ones have already started working actively in the space to acquire assets at discounted prices.
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, litigation or operations.
Unlike a blue-chip equity investment, distressed asset investments need considerable handholding after the initial financial assistance. It is important that the market begins to see value in the business, as the price you can command at exit would depend on this. Apart from capital restructuring, excess value can be created by changing the management, aligning incentives for stakeholders and restructuring operations.
To some investors, especially large corporate strategic ones, the current situation seems like a once-in-a-lifetime opportunity to expand capacity cost-effectively. A number of the resolution plans submitted to the NCLT involve big companies looking to strategically acquire large stressed capacities at discounted rates. The Reserve Bank of India (RBI) has come up with two lists that target a total of Rs4.06 trillion of the total Rs8.77 trillion of outstanding NPLs.
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.
We believe that there are six points to consider while investing in distressed assets:
1. Risk & reward: Pay-offs 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 good 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 stand-alone financial engineering opportunities, with low correlation with equity or debt markets. So they 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 greater clarity.
4. Partnering with experts: Considering the amount of effort that is 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 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 issues of regulation, labour unions, and legal matters 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 and potentially squander invested capital.
Although the space is seeing a flurry of activity, there are caveats that apply. There is money to be made, but risks related to legal, operational or valuation issues cannot be ignored.
Source: Livemint, May 13, 2018