Indian financial markets underwent two crucial reforms earlier this year. SEBI came out with a dedicated regulatory framework for Special Situation Funds (SSF). And the RBI has approved the new dual structure bad bank, NARCL-IDRCL. These two reforms aim to address India’s bad debt problem. While the bad bank is an improved version of the existing asset restructuring company (ARC) model, the SSF is a relatively new concept.
India suffers from a chronic bad debt problem. Higher bad debt requires higher provisioning, locking up more capital in the banking system. This reduces the supply of credit and hurts economic growth. To overcome this problem, banks and financial institutions were initially allowed to sell their distressed loans only to CRAs. Now they can also sell to SSFs. Shifting troubled loans to ARCs and SSFs would free up capital tied up in the banking system and help improve the supply of credit.
SEBI introduced SSFs as a separate sub-category of Class I Alternative Investment Funds (AIFs). AIFs manage private pooled funds raised from sophisticated investors with deep pockets. While hedge funds have traditionally played a prominent role in equity markets, their participation in distressed debt markets has been limited. Regulations did not allow OFIs to participate in the secondary market for corporate loans provided by banks and NBFCs. The new regulations now create a special subcategory of AIFs, namely SSFs, which are allowed to participate in the secondary market for loans granted to companies that have defaulted. This is a major reform that goes in the right direction.
This regulatory construct, however, raises a deeper political question: why not allow SSFs to participate in the secondary market for corporate debt even before the underlying company defaults on its debt securities? After all, default is a lagging indicator of financial stress. If lenders and bond investors could offload potentially stressed assets to SSFs before defaulting in the secondary market, they would benefit from a lower discount. SSFs would also benefit from sufficient time for debt aggregation before default, which would reduce collective action problems that may arise after default during an insolvency or restructuring.
On the other hand, it may be useful to recall how troubled US debt markets took off. There were two main factors – the enactment of the Bankruptcy Reform Act of 1978 and the rapid development of the high yield bond market in the 1980s.
The 1978 Act introduced a new Chapter 11. It removed the previous requirement that a debtor company had to demonstrate that it was insolvent (e.g. default in payment of interest) before it could benefit from debt protection. bankruptcy. As a result, companies could now voluntarily file for bankruptcy before default, much earlier in their financial crisis. Bond investors, inexperienced in insolvency and restructuring, would therefore no longer wait for the debtor company to default. Instead, at the first sign of impending financial stress, they would sell the bonds in the high yield market at a discount and exit the company.
Initially, these bonds attracted relatively small hedge funds looking for quick returns. Over time, funds specializing in distressed debt have appeared. They would identify opportunities to buy undervalued corporate bonds to influence the subsequent insolvency or restructuring process to maximize the value of the troubled company and exit with a profit. This ushered in the modern era of private equity participation in US troubled debt markets.
Admittedly, the institutional context of contemporary India is very different from that of America in the 1980s. However, to mitigate the risks of future insolvency or restructuring, Indian bond lenders or investors should have complete freedom to sell their loans or bonds on the secondary market at the best possible price, whether there is default or not. To achieve this, SSFs must have transparent access to the entire secondary investment market as well as to lower quality corporate debt (loans and bonds).
Allowing SSFs to purchase higher quality loans would also improve the liquidity of the secondary corporate loan market. Traditionally, banks issued loans and held them to maturity. Over time, loans moved from a single lender to multiple lenders through syndicated loans. As volumes in the primary syndication market grew, demand for secondary trading also grew to enable liquidity, risk and portfolio management.
Secondary loan trading is now institutionalized in international financial markets. These markets are liquid precisely because they are open to a wide variety of non-bank participants, including insurance companies, pension funds, hedge funds, and private equity funds. Allowing SSFs to enter the secondary market would therefore be consistent with international practice. The RBI Task Force on Secondary Business Lending Markets, chaired by TN Manoharan, made this suggestion in 2019.
Finally, the entry of SSFs into the secondary market should not jeopardize financial stability. SSFs may not borrow funds or engage in leverage, except for temporary funding needs. Therefore, risks associated with liquidity, credit or maturity transformation and asset-liability mismatches are unlikely to occur. Given their structure, SSFs are likely to become sufficiently indebted to a distressed business to acquire control of it or to influence its subsequent insolvency or restructuring process in order to maximize its value through turnaround or sale. of its activities. This would ultimately help generate decent returns for their investors over their limited life cycle.
Overall, the introduction of SSFs promises to usher in a modern era of distressed debt investing in India. To realize their true potential, SSFs must be allowed to participate fully in the entire secondary corporate debt market and not be limited to the post-default phase.
Datta is a Senior Researcher at Shardul Amarchand Mangaldas & Co., New Delhi. Views are personal