THE TIMES OF FINANCIAL DISTRESS

We inhabit a world, where the materialistic objectives are zealously pursued and in a Modern Society, they are fulfilled through legitimate  Economic structures. High Economic growth requires ample money supply. So in a modern society, a little expansive credit culture can not be wished away, even if we have to live with collateral effects of the same. Accordingly, the policies, procedures, systems of the Financial Intermediaries need to be geared up to meet the demands of such a high Economic growth oriented society.

All businesses go through financial stress, some cyclically, some intermittently. Since the Financial intermediaries  (FI) are in the business of Lending to businesses, FIs face the default Risk from its portfolio all the time. Dwelling upon a very diversified portfolio to minimize default Risk at a portfolio level is a Macro Balance sheet exercise. Even if a Bank’s portfolio is as diversified as the Market itself, it’s still left imbued with Market Risk. An important question to ask : Is the portfolio perfectly diversified? Is each of the Loan account a discreet variable having no interdependence with other Loan accounts in the portfolio? Answers to both questions are a resounding “No”.

So, we can not be complacent with our diversification theory and need to manage the Risk at each account level. Of course, how much effort can be put at each account level, depends on size of each account relative to portfolio size. From that perspective, a Corporate Loan portfolio asks for more Risk management at each account level than a retail Loan portfolio.

Corporates/ Business entities get born as a Project Entity. Some of them  1) perish early  2) some   survive in early period, grow and develop a Continuity/ Survival gene in them to cruise for a long period   3) some grow rapidly and never develop a continuity gene and die out after some time. 

When we Debt finance such entities at different stages for different tenors, Risk associated are so different and they emanate from myriads of sources that, we need to have different credit selection strategy, credit monitoring strategy and exit strategy calibrated carefully for each of them. 

Early stage Project Finance: A Bank Funding a Project with a D:E ratio of 70:30, literally owns 70% of Balance sheet of the Borrower’s entity; till the Net Profit is made. So, is n’t it an imperative that a Bank understands the Project at least as much as the Promoter understands, if not more than that? This understanding can not be only from Risk mitigation perspective, Risk mitigation being a reactive approach, never being a zero based approach. A Project Financier, as a part of Credit selection, need to understand Technology details, Industry dynamics, Regulatory/ Legal dynamics, Ground level realities, Political/ Environmental ramifications, as if, it is a Shadow Promoter. And all such analysis/ understanding need to be based on objective data collected through independent sources without relying only on the Promoter provided information, which may be used for corroboration. This being a very intensive exercise, requires highly specialized and skilled personnel working in a dedicated manner for each such account. 

Project Monitoring work can not be given a lip service, especially during Construction period. When the Promoter and its team works as the infantry  in implementing the whole Project, the Bank need to monitor the strategy and progress very closely. This is the period, when a lot of Fund diversion happens in procurement of Capital equipment and a lot of overspending happens through related parties. This leads to non optimization of Project cost during implementation, leading to cost over run sometimes; in any case, makes the Project viability hamstrung, going forward. Thorough Fund utilization checks and cross checks and monitoring all Project contracts can do away with such Financial injuries during Construction period.  Even after successful construction, the Debt Financier needs to stay alert to monitor the running Company’s operation and financial performance, till the end of tenor of their facility. 

Any Funding (Working Capital or Term Loan facilities)  for Corporates during running stage, though does not warrant the level of monitoring  that’s done during Project stage, yet needs an enumeration of elaborate system of various alarms (Industrial/ Market/ regulatory/ technology), which must be looked into, whenever raised. Any upcoming financial distress sends out a lot of non financial leading indicators, which needs to be decoded and an action plan to be devised including a possible exit strategy. For example, a decline in crude price now for a sustainable period shall lead to reduction in charter rates of the rig servicing equipment/ vessels in near future.

Bigger the tenor of facility, more exhaustive is the requirement of monitoring. Sufficient Asset cover  should not lull a Debt Financier into complacency, since the recovery / repayment of the facility of the Lender through Asset sale means can never be a first track option, its always a means of last resort. When the Asset sale does take place at a later point of time after complying with all legal regulatory procedure, Asset cover ratio would have thinned out to nothing almost. 

Market goes through Economic cycles; Industry goes through its own cycles, each cycle having its different time period. Each cycle takes its toll in the industry; which is a sort of natural purging exercise of Market Economy , which punishes inefficiency and under productivity heavily. Lenders need to identify such Assets early through the above discussed signalling system and exit. If they can not exit, they need to take a conscious call on Company’s ability to weather the rough period and come out unscathed and thereby decide whether to support through more Funds or pull the plug. This intervening period is also the right time to scout for possible merger/ acquisition. If everything fails, then the Company can be sent for Insolvency proceedings as a matter of last resort. 

Many Companies having a strong dedicated Management with set systems and procedures, do develop a continuity gene in them. Its an imperative and a duty on the part of Lenders to recognize the same and support them through Funding during negative cycle times. An appraisal method, which is designed for analysing a Project during a positive half cycle period shall surely fail the test during a negative half cycle period. For example, during a negative cycle period of shipping industry, Asset prices shall be the lowest leading to low Asset cover (FACR); yet that can be the right time to lend into the Asset, since future charter rates is expected to be higher than the  current charter rates. On the other hand, when an Asset is Funded during Asset peak time, you see the Asset value withering away and earning cash flows vanishing, as the cycle comes down. So, while as human beings, we are very much weighed down by present parameters in our appraisal process, we can not lose sight of the fact that repayments are in the medium to long term future and hence give due weightage to future parameters. Bigger the tenor of Loan, bigger the hazard of forecasting. And its very much human to err more, as we ty to forecast for longer term; no matter how much of mechanized data analysis tools we may use including Artificial intelligence. So, what we can not do by sound and full proof  forecasting, we can do by rigorous monitoring. In short, an appraiser need not have all honky dory view of a Project proposal during good euphoric times and in the same breath, he/she need not be a doomsday sayer during gloomy times. So support to such good entities can come through both  infusion of more Debt Fund and restructuring of existing financial liabilities. Any such restructuring, which is  done in expectation of full recovery (where NPV of existing structure and proposed structure are same), need not attract NPA provisioning clause, Yes, it may be recognized as an impaired account and some provisioning may be done for a short time frame till, the Borrower looks like coming out of Financial difficulty.

Any Loan Asset sale / assignment by a Bank to ARC/ Fund at a lower value during Borrower’s financial distress times shall add enormous value, only when the ARC takes proactive steps to work with the Borrower and supporting him trough Funds and a deeper restructuring of existing liabilities. Any Loan sale by the Bank to ARC is a Risk arbitraging exercise. ARC can create Capital out of its activity, when it can actually contribute to turning around the Asset by Reengineering the Company’s strategy and Operation and not by focusing only on Financial Re Engineering. Only buying out the Loans and sitting on it in expectation of good times, is like sitting with a fishing chord on a river bank as opposed to going deep sea fishing.

The path of last resort, the Insolvency proceedings may be used only where the Company does not seem to have developed a continuity gene. Lack of continuity gene can be recognized by the fact of Fund diversion by Promoters, low level of equity infusion by Promoters, lack of a Professional Management, dishonoring of commitment to Financial and Operation stake holders and a host of such factors. Our country, having adopted the Insolvency & Bankruptcy Code into Law in year 2017, is still going through a lot learnings and changes in accordance with the typical characteristics of Market place in this country. 

“The Marketing & Financing of Stressed Assets” are yet in infancy stage in the country. It is always difficult to grade the Risk associated with the stressed Assets and hence, they sell for high discounted values in the Market, like junk bonds did in USA. While domestic Debt Market Funding of stressed Assets is still some years away, there is enough Risk Capital in the world to buy out such Assets. But such Capital needs to be associated with the Turn around  Professional Management Teams or the other proved Promoters in the same industry. In absence of a Turn around strategy and its implementation, the Risk Capital shall see itself being written off with time. A mere compliance with IBC Code in the Insolvency Resolution process shall not serve the greater purpose of  the Law, which is the “Reorganisation of Asset”. We have seen the Lenders recovering a mere 8% to 20% of Loan  in many of good to marquee Assets. It can be attributed to lack of proper Investor Marketing. Also with vexatious litigation in the process, Asset value itself is getting impaired hugely, leading to sale of Assets in parts during liquidation stage.  

The process of reorganization of such Assets in steel, shipping, infrastructure sectors etc. requires deep cross functional team expertise spanning over commercial, technological, financial. Till such an ecosphere is developed in our country, a lot of industrial Assets of the country shall continue to get junked thereby depriving the country of its much needed Capital formation.