The revised guidelines for asset reconstruction companies (ARCs) announced by the Reserve Bank of India (RBI) last Tuesday would structurally fortify the sector through improved governance norms, better disclosures, lower funding requirement for asset acquisition, and more robust balance sheets.

However, the guidelines also require ARCs to increase net owned funds¹ to Rs 300 crore from Rs 100 crore in a phased manner by end of March 2026, which could be challenging for some of the smaller ones.

The business profiles of ARCs will benefit from two crucial changes: one, lower funding requirement for acquisitions (see annexure for illustrations) and two, an option to participate as a resolution applicant under the Insolvency and Bankruptcy Code (IBC).

Investments by ARCs in security receipts (SRs) are envisaged at a minimum 15% of the investment of the transferor in the SRs, or 2.5% of the total SRs issued, whichever is higher, in each asset class under each scheme on an ongoing basis until the SRs are redeemed.

Earlier, ARCs had to invest at least 15% of the SRs issued in each class under each scheme even if there were other investors (other than the selling lenders) present.

Says Subha Sri Narayanan, Director, CRISIL Ratings, “The revision in the minimum investment in SRs is a significant benefit for ARCs. This will free up their funds and support growth over the medium term. For cash transactions², the saving could be as high as 80-85%. Even where the selling entity participates in the transaction, the funding requirement is somewhat lower than the earlier regime. The proportion of cash-based transactions in CRISIL-rated SRs has been increasing steadily and stood at 36% as of February 2022 compared with 4-5% as of February 2017. We expect this momentum to continue with lower requirement of funds for cash-based transactions.”

Allowing ARCs to become resolution applicants in the IBC process is also a step in the right direction. This will enhance business options available and potentially opens a new revenue stream. However, to be a resolution applicant, ARCs will need net owned funds of more than Rs 1,000 crore, which only a few of the 28³ may be able to garner.

Several measures to strengthen the governance framework of ARCs have also been introduced. With respect to Board processes, these include enhancing the Board’s independence, stipulation of tenures of Board members as well as a performance review process for them. The debt settlement process has also been made more rigorous.

The revised guidelines mandate enhanced disclosure norms pertaining to financial information, track record of returns generated and recovery ratings on SRs in offer documents. This is expected to bring in more transparency and ultimately boost investor interest.

Additionally, clear guidelines on charging management fees only from recovery of underlying assets should persuade ARCs to focus on faster resolution of assets. The RBI circular also requires ARCs to retain a rating from a credit rating agency (CRA) for at least three years.

Says Gautam Shahi, Director, CRISIL Ratings, “While the revised guidelines are clearly aimed at strengthening the sector, it could throw up a few challenges for ARCs. More than half of the ARCs have net-owned funds lower than the increased requirement of Rs 300 crore. A number of them may not be able to bring in additional capital. Further, the other governance measures are likely to increase compliance and operational costs, which could be challenging for some of the small-sized ARCs. Therefore, over time, these developments could lead to consolidation in the industry.”

¹ Net owned funds = share capital + share premium + reserve and surplus – accumulated losses
² Transactions involving no participation by selling entity
³ Excluding National Asset Reconstruction Company Ltd; less than 5 ARCs have net owned funds greater than Rs 1,000 cr as on March 31, 2022