Asset reconstruction companies (ARCs) are expected to circle stressed accounts in the micro, small and medium enterprises (MSME) and retail segments in the near-to-medium term, given the twin challenges of inadequate funding access and intensifying competition once the proposed National ARC materialises.

ARCs have been facing headwinds in the past two fiscals, with assets under management (AUM) – as measured by security receipts (SRs) outstanding – contracting after a strong run-up in the previous five. Between fiscals 2015 and 2019, their AUM had expanded steadily on supportive regulations introduced in fiscal 2014. But that trend then reversed in fiscal 2020 with ~4% contraction. In fiscal 2021, too, as per Crisil Ratings estimates, AUM contracted ~1% to Rs 1.07 lakh crore (refer to annexure 1).

While the slowdown is partly attributable to the general macro environment, which has hindered consummation of deals and heightened risk aversion among investors, a few structural trends are also at play.

First, banks prefer to retain only a limited share of SRs for assets sold due to the stringent provisioning norms for selling banks on holding these. On the other hand, ARCs in most cases hold only the regulator-mandated 15% of SRs. This results in a gap that has to be bridged either by the ARCs holding a larger proportion of SRs or by attracting external co-investors.

This marks a significant shift from the past where till fiscal 2018, almost all the SRs were subscribed to by either the selling institutions or the ARCs. Post the revised provisioning norms, the share of external investors in cumulative SRs issued increased sharply to 12% as on March 31, 2019, from 3% as on March 31, 2018, primarily due to some large assets that attracted investors. However, the trend has not continued at a similar pace (refer to annexure 2) and co-investors have been selective. This is partly responsible for the lower growth of ARCs in fiscals 2020 and 2021.

Second, in contrast to the situation a couple of years back, lenders now have multiple options for resolution and enforcement frameworks, and are also more actively evaluating and utilising these options. The Insolvency and Bankruptcy Code, 2016 (IBC), with its subsequent modifications, has seen many takers. The RBI’s June 2019 Prudential Framework for Resolution of Stressed Assets gives lenders the option to resolve stressed assets outside the legal process.

Against this backdrop, Crisil Ratings believes the stressed assets space will see segmentation, with players having different focus areas. Availability of capital, debt aggregation capability and operational infrastructure will define the positioning of each player.

Says Krishnan Sitaraman, Senior Director and Deputy Chief Ratings Officer, Crisil Ratings, “The National ARC, given its stated mandate and access to capital, is expected to dominate the large corporate segment. Mid-corporate assets, where ARCs have a relatively better recovery track record, could be a play for them as well as for stressed assets funds. In the retail and MSME segments, however, ARCs have the opportunity to create niches. These segments need an operationally intensive set-up that other investor classes are unlikely to be interested in creating. Given the higher opex needed, volume will be key to profitability, so ARCs that invest will need to maintain sharp focus on this segment.”

To be sure, volumes in the retail and MSME segments are unlikely to match those seen between fiscals 2014 and 2019, which was a period of growth led by corporate assets. Nevertheless, for ARCs that get it right, it can be a profitable business. Growth remains fundamentally dependent on their ability to attract capital. Given that capital is expected to really flow towards the platform that is the most effective, it will be critical for ARCs to demonstrate their differentiated recovery ability in order to remain relevant to stakeholders.

One metric to assess recovery ability is the cumulative SR redemption ratio¹, which has improved over the past few years and stood at 32% as on March 31, 2021, compared with 17% three years ago. This has been supported by resolution of a few large-ticket assets under the IBC process, while overall recovery remains lower than expected. Further, time taken for recovery has been higher than envisaged. While recent originations have seen better performance, overall, recovery is yet to reach optimal levels.

Says Subha Sri Narayanan, Director, Crisil Ratings, “ARCs have yet to demonstrate their recovery capability in the retail segment at a material scale. However, one factor will support their shift towards retail and MSME segments — it is the opportunity in the form of incremental non-performing assets coming largely from these two segments in the current cycle, with lenders, including non-banks, increasingly putting these assets up for sale. In fact, this shift is visible already. Although overall volume of debt acquired was lower in fiscal 2021, a Crisil Ratings study shows non-corporate segments formed a 44% share, which is a stark increase from 4% two years back (refer to annexure 3).”

Overall, with other segments seeing greater competition in terms of alternatives for lenders, greater participation in the retail segment is perhaps an inevitable shift. As before, the ability to collaborate with other investors, bring in capital in various forms, and fundamentally demonstrate recovery capability will be the key to long-term growth and profitability.

¹ Calculated as cumulative SRs redeemed as of a particular date / cumulative SRs issued as of the same date.