Sharks vs Builders: Winning in India’s Distressed Credit Space
By: Jim Zhou and Nameh Dhawan
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
In 2016, the Indian government passed The Insolvency and Bankruptcy Code, 2016 (IBC): a landmark legislation that overhauled the procedures for recovery or liquidation and consolidated past bankruptcy laws into a single framework. With new provisions, such as time limits on the bankruptcy process and the creation of specialized insolvency professionals, this new legal framework has greatly minimized the costs, time, and resources involved in the bankruptcy process. It increases the likelihood that businesses leave the bankruptcy process as active and functioning companies instead of being sold off for parts, similar to the differences between a Chapter 11 “reorganization” and Chapter 7 “liquidation” bankruptcy in the United States. As a result of these changes to the legal code, the overall viability of turnaround investing has increased.
Another previous hurdle for foreign investors with respect to India has been foreign direct investment (FDI) restrictions. India has taken steps to enable the entry of foreign investors who bring specialized skill sets in turnaround, as well as industry-specific knowledge. These provisions permit financial sponsors and foreign investors to own 100 per cent of a company, and, as a result, allow sophisticated investors to enter the market and benefit from their capital and operational skill sets.
These changes have piqued the interest of long-term private capital. Given the early stage of this asset class, the playbook for investment sourcing and execution is being developed on the fly and needs to be structured to leverage both the unique capabilities of foreign investors and the Indian bankruptcy environment.
Investor Risks
Years of poor governance and an unconstructive business environment have led to an inhospitable investment climate in India. As a result, investors have often worried about their ability to recoup investments. Historically, a patchwork of legal precedents and piecemeal laws such as the SARFAESI Act, 2002 were the primary means of creditor protection. These took a liquidation-first approach to recovery of debts owed.
The nature of litigation in India is even more concerning due to the backlog of judicial cases. It is estimated that a case with at least one appeal could take up to 10 years to effectively resolve. This is troubling as private equity (PE) investors often use the internal rate of return (IRR) as a metric to assess investment viability, and this variable is highly impacted by the time horizon of the investment. Here is where the IBC has made the largest strides, with mandated 180-day timeframes for case resolution that allow investors to better underwrite investments with an expectation of timely resolution.
Current Competitive Landscape
Asset Reconstruction Companies (ARCs) are in the business of buying non-performing assets (NPAs), which are loans that are unlikely to be paid, from financial institutions at a discount to book value. As the primary vehicle for NPA investments, ARCs serve the dual mandate of freeing up capital and management bandwidth for banks. The Reserve Bank of India (RBI) is responsible for approving ARC licenses. So far, distribution of these licenses has been limited, with only 24 ARCs as of November 30, 2017.
The five largest ARCs jointly account for an estimated 90 per cent of assets under management (AUM) in this space, demonstrating the concentration of capital in this space. Edelweiss ARC is the largest, managing around $6.4 billion as of June 2017 and controlling approximately 50 per cent of the industry’s AUM. Despite attractive returns of 20 to 25 per cent, ARC sponsors have traditionally consisted of only domestic institutions. However, with the recent promise of regulatory changes, major foreign investors, such as Bain Capital and Apollo Global Management, have begun to enter the space alongside local partners.
There exist significant capital requirements surrounding ARCs, including a 50-per-cent upfront cash requirement, which will be increased to 90 per cent by April 1, 2018. To buy assets, ARC sponsors require deep pockets because of the divergence from the historical ability to issue security receipts, debt-equity instruments issued by the ARC to raise money for acquisitions.
Additionally, NPAs are heavily concentrated in large corporations, with the 12 largest defaulters—collectively coined the “dirty dozen”—comprising an estimated 25 per cent of all NPAs. Similarly, banks expect a faster recovery, something only possible with industry expertise. Thus, foreign players who enter this space must be of significant size and retain expertise in relevant industries; this is achievable through a combination of attracting specialists from around the world and relying on local partners. These characteristics are typical of large global funds who would benefit the most from these recent changes.
Economic Analysis
Amongst Indian industries, the greatest concentration of NPAs can be found in the infrastructure and basic metal sectors, comprising 34.1 per cent and 14.4 per cent of total industry NPAs respectively.
Within the infrastructure industry, 19.6 per cent of outstanding loans are classified as NPAs. This is spread across a diverse array of sub-sectors including power, transport, and telecommunication. These NPAs pose the greatest risk to India’s financial system, with the RBI estimating that all banking sector profits achieved in the financial year 2016 to 2017 could hypothetically be wiped out if 10 to 15 per cent of loans and receivables become NPAs. The power sub-sector poses the greatest risk, accounting for 50 per cent of infrastructure sector credit.
The primary cause of NPAs amongst power companies is due to surplus capacity of coal-fired thermal plants, which comprise 67 per cent of all power capacity in India. Plants are operating at approximately 60- to 65-per-cent capacity, and loans to this sector have contracted by 10.4 per cent year over year following a lack of investment. This decline is compounded by increasing interest in renewable energy. New wind and solar energy technologies are now 20-per-cent cheaper than the coal-fired average and are gaining popularity. As a result, opportunities for recovery in Indian power credit appears bleak at best.
Given that the basic metals industry contains the next largest amount of NPAs and the opportunity for debt recovery given improving industry tailwinds, it is recommended that global PE investors consider investments in basic metals, specifically steel. The four largest distressed debtors are Essar Steel, Bhushan Steel, Monnet Ispat, and Electrosteel Steels, who collectively owe more than $26 billion. As many as 40 firms are under pressure from their creditors to sell assets under India’s new bankruptcy code. This temporary financial distress coincides with surging demand for liquidation of collateral assets. Indian producers added leverage to fund expansion plans when the economy was growing at a much faster rate. However, a large portion of debt turned sour due to a slowdown in the Indian economy and a decrease in steel prices following over-supply from China. With steel prices rebounding from a 2015 low, demand beginning to pick up, and the Indian government being more supportive from a regulatory standpoint, it is reasonable to believe in bright prospects for the Indian steel sector.
Moving forward, this oversupply will cease to be an issue. The Chinese government’s crackdown on wintertime particulate pollution in 2017 was extended to the nation’s steel industry, forcing mills nationwide to shut down or curtail operations. These restrictions are estimated to have cut China’s steel output by 10 per cent over the past five months and will extend to affect one-quarter of the nation’s total steel-making capacity. On the domestic demand side, there are multiple drivers for long-term growth in domestic consumption. Prime Minister Narendra Modi’s infrastructure plan is expected to be a core driver of consumption. In the near-term, spending on housing, educational institutes, hospitals, and government offices will gather pace leading up to the 2019 elections. Long-term projects, such as the Housing for All by 2022 movement, provides millions of slum residents with affordable housing, and the Bharatmala project, which includes the construction of 34,800 kilometres of roads in the first phase alone, will continue to drive sustained demand.
From a political perspective, Indian steel manufacturers will also be the beneficiaries of their government’s increasingly protectionist stance on the steel industry. On May 3, 2017, the newly outlined National Steel Policy chartered a roadmap to increase the country’s annual steel production to 300 million tonnes by 2030, a significant increase over 2017’s figure of 101 million tonnes. A similar proposal enacted the same day approved a policy for providing preference to domestic steel for government infrastructure projects.
By targeting companies operating in the steel industry, investors will be able to take advantage of NPAs with a higher probability of converting to performing assets. Coupled with a strong interest from various parties for steel operational assets, credit investors will likely recuperate a significant portion of their debt holdings.
Past Case Studies
While the state and private banks of India are actively involved as creditors in the largest bankruptcy proceedings in front of the National Company Law Tribunal (NCLT), small defaults are more work than they are worth for these institutions. Due to the complexity of multiple banks participating in deals, ARCs are optimally placed to aggregate debt and reduce how many parties have a say in the final resolution to increase NCLT proceeding efficiency. As banks hesitate to deal with debts that they believe will provide immaterial returns through liquidation, ARCs can acquire the rights to this debt at a favorable price and achieve attractive returns through the reconstruction of the company’s assets.
In the case of Kamineni Steel & Power, the Hyderabad NCLT established that the IBC’s overarching aim is resolution of corporate debt rather than forcing the sale of assets in a liquidation. Thus, any good-faith resolution plan can be passed with less than the 75-per-cent creditor vote requirement even if certain creditors are holding up the process. Other NCLT benches have stated that the 75-per-cent requirement is not flexible. In the case of Synergies-Dooray, a related party that held debt of the parent entity, the company assigned its debt to a creditor to push their collective vote above the 75 per cent.
Given the large set of assets—nearly $150 billion—that form this asset class and limited deployed capital at approximately $9 billion, investors can afford to be extremely selective and pass resolution plans favorable to the parent entity. Tactically, investors should mind these legal precedents and consider the precedents of the particular NCLT bench where the resolution plan is filed, identifying if it falls into the 75-per-cent camp or the positive-resolution camp. In the first, investors must seek to acquire sufficient debt to form 75 per cent of the creditor committee and force a resolution plan through. Alternatively, they must acquire a simple majority and demonstrate willingness to reconstruct the asset and not simply sell it off for parts. To limit downside risk—particularly given the greyness of this market—investors must avoid investing in firms with significant related-party transactions or relationships. The uncertainty around ownership rights could lead to the approval of a resolution plan to the detriment of the investors’ returns.
Conclusion
This selectivity enables investors to increase their expected value of return and to begin pursuing the significant opportunities present in India’s steel sector. Expected price increases and need for expanded capacity present an attractive end-industry for foreign credit investors. The positive prospects as well as large size of investable assets enables large investors to identify potentially high-quality assets amongst the large pool of overall assets.
If investors are skilled in distressed debt investing, aware of the legal structures surrounding Indian bankruptcy law, and are ready to commit capital, there are outsized returns awaiting the steely-eyed.