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Outlook on India's financial institutions' ability to recover from stressed assets

We are now about two months short of completing a full year of working from home. One hadn’t imagined in March 2020 that the impact of COVID-19 would be so severe and influence the way we work. It has curtailed economic growth and has led to the shutdown of companies and large-scale labor displacement. The economic downturn has put further stress on India’s banking sector, which has been reeling under non-performing loans (NPLs) for many years. The recent forecast from the Reserve Bank of India projects a base case scenario of NPLs at 13%. With meaningful credit growth unlikely in the near future and weak capital adequacy ratios, banks, especially public sector banks, are heavily dependent on their ability to recover from stressed assets. However, it’s easier said than done, and they face many impediments under the current operating environment.

Suspension of IBC

A part of the moratorium announced by the finance minister was to suspend the Insolvency and Bankruptcy Code (IBC)—initially for six months, which has now been extended till March 31, 2021. One can understand the government’s thought process—COVID-19 was an unexpected event and companies could not have planned for such distress. To keep with the entrepreneurial spirit, the government didn’t want a procedural law to result in companies being dragged towards insolvency and bankruptcy. When the initial relaxation to the IBC was announced on May 17, 2020, we had highlighted concerns around it and its implications for both IBC as a concept and banks and their efforts to recover. The IBC recently completed five years, and overall, the IBC should be considered a success because it changed the way promoters operated and shifted the pendulum in favor of the creditors. However, the suspension of the IBC does devalue its relevance. Creating an artificial gap in the process will allow companies with a window to find options to give IBC a complete miss. Further, international investors will also view this as an intervention and their confidence in investing in and funding turnarounds could be dented. Lastly, banks have lost access to one critical mode of resolution, which had benefited them in the last five years.

Greater Supply of Distressed Assets Leading to Cherry-picking

COVID-19 has resulted in more companies needing distressed funding. Accordingly, the supply of distressed assets available across the sector has gone up multifold creating a problem of plenty. Previously, investors had to choose from companies that had good assets but a weak capital structure or fraud-related issues, with group of shareholders having misused company’s funds for personal benefit. But, at present, there are companies with strong balance sheets and robust business potential facing distress due to liquidity issues. These businesses are more attractive as the resolution/recovery time is faster. There has been greater investor interest for such assets, especially from special situation funds. It is estimated that PE funds infused close to USD 2 billion into distressed assets in 2020, much more than their commitment in 2019. We expect this trend of investors cherry-picking companies with short-term issues to continue and believe that many companies that would have otherwise found takers, especially under the IBC, could now head toward liquidation.

Corporates Conserving Capital

Large corporates with strong balance sheets and fundraising ability were expected to participate actively in the distressed asset space. However, the impact of COVID-19 has been so severe that it has forced most of these companies to conserve cash and create a liquidity backup for the next 12-24 months. These large companies, while having aspirations to grow, are hesitant to commit or lock their capital on new opportunities given the uncertain business environment.

Valuation Mismatch

Despite large-scale economic disruption caused by COVID-19 world over, the equity markets are at an all time high. While the fundamentals have been weak, excess liquidity in the system has meant that funds have moved into equity markets. This has caused wide disparity with promoters of distressed companies expecting higher valuations while benchmarking themselves with the equity markets. Investors, on the other hand, are unwilling to offer such a premium as they expect asset prices to decline sharply once the liquidity has been sucked out.

With COVID-19 likely to stay in 2021, the distressed market is expected to see more opportunities. However, with looming uncertainty, investors will be more selective, cautious and careful in allocating funds towards the asset class. All this means “stressful times” lie ahead for the distressed market.

This article was first published on Business Standard.

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