Recovery Rating for Asset Reconstruction Companies

METHODOLOGY - RECOVERY RATINGS FOR ASSET RECONSTUCTION COMPANIES

After acquisition of financial assets, SCs/ARCs, through a Trust managed by them, issue the instruments called Security Receipts (SRs) under the ‘The SARFAESI Act’. SRs are backed by impaired assets and can be issued only to Qualified Institutional Buyers (QIBs). Relevant guidelines have been issued by RBI for computation of Net Asset Value (NAV) of such SRs issued by SCs/ARCs. This ensures that QIBs value their investment in SRs in accordance with the applicable guidelines. Thus, rating serves as an objective tool for the computation of NAV.

SCs/ARCs are required to obtain rating for SRs from SEBI registered Rating Agencies.

As per regulations, the SRs must be rated within a period of six months from the date of their issuance. SRs have certain features similar to equity with one being the absence of any defined payment schedule. For rating purpose, the SC/RC needs to supply the necessary information to the rating agency. Infomerics, being a SEBI registered Rating Agency, undertakes ratings of SRs.

Commonality and conflict of interest if any, between the SC/RC and Infomerics are disclosed.

Recovery rating is based on the ‘recovery risk (probability of recovery)’ and not the ‘default risk (probability of default)’. Various risk parameters to assess the adequacy of future cash flows vis-à-vis debt obligations determine the Credit Rating whereas in case of Recovery Ratings, the value of security and the recoverability within the stipulated timeframe i.e. within the tenure of the SR under the most feasible resolution strategy are taken into consideration. The Recovery Rating reflects the present value of the anticipated recoverability of future cash flows vis-à-vis outstanding face value of the SR.

Rating of SRs would involve the following aspects:

Valuation of Collaterals

As regards valuation of collaterals, the approach of Infomerics would be as under:

Infomerics relies on valuation reports from independent valuers rather than internal valuations, if any, done by SC/ARC.
The valuation method used, should be based on assumptions which are reasonable as well as prudent. All the assumptions should have been clearly documented in the valuation report. The assumptions are evaluated, commented in RCN and may be modified by Infomerics, wherever required.
As the collaterals being valued are in respect of distressed debt obligations, Infomerics considers Forced Sale Value (FSV)/distressed sale value (DSV) and not the Fair Market Value (FMV) since the assets are not likely to fetch market value on account of legal issues.
Infomerics takes into consideration other factors like location, physical custody /control over the asset, legal enforceability, legal impediments, if any, marketability and potential fluctuations in the market value of the asset. Carrying costs of maintaining the repossessed asset before the same are disposed of would also be taken into consideration.
Infomerics also takes into consideration date of valuation report. Collaterals need to revalued on a regular basis, though the frequency may vary with the type of collateral involved and should not be older than 3 years.
If possible, accuracy and effectiveness of methodology for conducting valuations is also back tested by comparing the valuation with actual sale proceeds received on subsequent disposal of the assets. In case of major variations, Infomerics may request SC/ARC to obtain an independent second valuation from another valuer.

Haircuts:

Depending on the time of valuation and nature of underlying security, Infomerics may apply haircut on the valuation amount. In case of collaterals whose market value is highly volatile, Infomerics applies a higher haircut. In case adequate information like details of the assets, assumptions for valuations etc., is not available, Infomerics may take a more conservative approach by applying higher haircut.

Discounting of expected cash flows

SRs are valued on a present value basis from their expected cash flows, till maturity. An indicative yield is applied for discounting the expected cash flows of the SRs. It is based on the prevailing interest rate scenario and appropriate risk premium. The discounting rate generally applied by Infomerics is 500 bps above the average 5 year G-Sec yield. Discount rate is assumed 500 bsp above the immediate preceding 3 months average of 5 year G-Sec yield

The discount rate factors in the variability associated with the projected recovery. As such, Infomerics may decide to apply different discounting rate depending on the inherent risks associated with the anticipated future cash flows from the underlying impaired asset till the maturity of the SR. SRs have a five-year tenure, which can be extended up to eight years.

Holistic Approach

Infomerics takes a holistic approach in estimating the future recoveries and takes into consideration key factors like extent of debt acquired, composition of lenders, collaterals available, security and seniority of debt, individual lender vis-à-vis institutional lender, estimated cash flows, uncertainty in realising expected cash flows in initial period, management, business risk and financial risk.

Stress testing/Scenario Analysis

Infomerics also carries out stress-testing and scenario analysis in order to assess the impact in terms of variability in cash flows and consequently the impact on the recoveries and redemption of SRs under unusual market conditions.

Assignment of Recovery Rating

Once Infomerics arrives at an expected valuation, it assigns appropriate recovery rating. Recovery ratings are indicative of the expected recovery vis-à-vis face value of the SR. Each rating category in the recovery scale has an associate range of recovery, expressed in percentage terms with respect to the face value of the SR.

The absence of a defined repayment schedule imparts certain equity like features to SRs. The SR investor gets to keep the upside of his investment if the recovery from the NPA exceeds the face value of the SR. The NAV is assessed on the basis of recoveries being considered till the maturity of the concerned SRs. Thus, recoveries are defined as the net present value of all payments that the SR investor might expect over the life of the instrument.

Recovery rating is a function of two variables:

Collections from NPAs.
Recovery on SRs.

Collections from NPAs

Recovery ratings hinges on the assessment of recovery from the underlying debt exposure. An important point in the analysis is the resolution strategy: asset sale, restructuring/relief, change of management and so on. The likely outcome of the resolution strategy is analysed in detail based on the cash flow shared Needless to make a mention that NPAs are essentially distressed debt obligations which are in default for varied durations. The process of recovery has a high element of variability with respect to the financial health of the borrowers. This is apart from the willingness of the borrowers to repay its debt obligations. Thus, the quality of collaterals and the liquidity associated with the collaterals, apart from the business prospects of the issuer, are of prime importance in such cases.

Further, the type of resolution in these cases are also analysed in detail. There are mainly two types of resolution – liquidation approach and going concern approach. The two approaches for resolution are used in different circumstances. There can also be a combination of the two approaches, wherein a part of the business or assets of the company are sold to reduce the debt. Similarly, support from group/promoters may be made available to retire some debt and revive the business with a lower debt burden. The recovery assumption on a going concern basis is assumed to be higher than that in the liquidation approach. Under ‘going concern’ approach, Infomerics may draw various scenarios and the recovery assessment would be the probability-weighted average of recovery under these scenarios. Infomerics’ assessment also incorporates the resolution strategy as well as the capabilities and track record of the ARC concerned in devising and implementing these resolution strategies.

In case of small loans, SC/ARC may aggregate more than one debt exposures into a portfolio and issue SRs common to the entire portfolio. Extent of debt aggregation and cooperation from different lenders will have an impact on the likely recovery. Assessment of recovery prospects of such an aggregated portfolio is carried out by Infomerics on the basis of assessment of all or majority of the individual exposures in the portfolio.

Recovery on SRs

The assessment of recovery on specific SRs are further assessed based on the following factors:

Borrower’s capital structure and recovery for the Trust

There are various types of liabilities for any entity like statutory liabilities, secured creditors, trade creditors and other forms of unsecured creditors, subordinated debt, convertible bonds, and preference shares. The claim of each class on enterprise assets has been clearly laid down by law. The assessment includes a review of the entire capital structure of the borrowing entity, the key covenants of the loan facilities parked in the Trust issuing the SRs, and the terms of any arrangement arrived at between the borrower and the lenders, as may be applicable. This determines the likely recovery for the various loans parked in a particular Trust. Recovery could be constrained by the seniority/amount of the lender’s claim even if the recoverability from collateral or otherwise is higher.

Structure of the SR and cash flow waterfall

The payments to SR holders are effected only if monies are actually credited into the trust accounts and are available for distribution. SR holders receive the payments only if monies are actually received by the Trustee and are available for distribution. Interestingly, there exist no pre-set schedule of payment to the SR investors. The cash flow waterfall as defined in the transaction documents are taken into account while assigning the recovery rating. Resolution expenses and Trustee fees are generally considered senior to pay-outs to SR holders. Multiple SRs can be issued by a single trust, which may or may not be pari passu to each other. Accordingly, the recovery estimates for both series of SRs may be different. Infomerics’ Recovery Rating incorporates all payments expected to be made to the SR holders over a period commencing from the assignment of rating and ending with the expiry of the resolution time frame or the maturity date of the SRs, whichever is earlier.

Conclusion

Recovery Rating is based on `Recovery Risk’ as against `Default Risk’ which forms the basis in normal rating exercise like ratings of debt instruments and bank loans. i.e. ‘how much more can be recovered’ instead of ‘timely payment’ is taken into consideration while deciding the Recovery Rating.

Recovery ratings indicate the present value of the expected recovery as a percentage of the face value of the SRs. In short, Recovery Rating is an estimate of how much the investor can realise over his investment in the SRs during a specified time frame.

The Recovery Rating Scale used by Infomerics is based on the present value of expected recovery as a percentage of face value of the SR. Each rating category in the recovery scale has an associate range of recovery, expressed in percentage terms. The final rating is arrived at on the basis of the range in which the present value of recovery percentage falls, which can be used by SC/ARC to compute Net Asset Value (NAV) of the SR. As per the guidelines of Reserve Bank of India, the SC/ARC, based on its recovery experience, needs to choose a particular percentage within the recovery range indicated by the Rating.

Surveillance and Dissemination

Review of Recovery Ratings

Recovery rating, once assigned, remains under regular surveillance throughout the tenure of the SRs. As per RBI Guidelines, rating reviews are generally undertaken twice a year i.e. as on June 30 and December 31 every year. However, the review on a continuous basis is also carried out to check if there is any further deterioration in the value of SRs and accordingly by way of appropriate rating action, the same is communicated immediately for the information of the investors and necessary adjustment in their valuation of the same.

Infomerics primarily relies on the information provided by SC/ARC about the progress made in respect of the resolution plans. SC/ARC is also expected to promptly inform Infomerics about the changes, if any, in the resolution strategy from time to time.

The indicative list of factors that may impact recovery ratings at the time of periodic review

/surveillance is given below:

Significant developments not foreseen during the last rating / surveillance exercise.
Substantial change in the valuation of collaterals.
Comparison between the assumptions made for the recovery process during the time of the last rating / surveillance exercise and the actual happenings.
Any differences in the realisation of recovery proceeds and the one envisaged earlier.
Part-redemption of the SRs.
Impact on the borrower’s business fundamentals and valuation of collateral security on account of changes in macro-economic factors.

Dissemination of rating actions

Infomerics Ratings shall be disseminating their accepted ratings and the related press release. Such dissemination is normally done through channels including website of Infomerics Ratings (www.infomerics.com).

INFOMERICS RECOVERY RATINGS SCALE

Rating Symbol	Rating Definition
IVR RR 1+	It indicates that the present value of expected recoveries is more than 150% of the face value of outstanding SRs
IVR RR 1	It indicates that the present value of expected recoveries is in the range of 100%- 150% of the face value of outstanding SRs
IVR RR 2	It indicates that the present value of expected recoveries is in the range of 75%- 100% of the face value of outstanding SRs
IVR RR 3	It indicates that the present value of expected recoveries is in the range of 50%- 75% of the face value of outstanding SRs
IVR RR 4	It indicates that the present value of expected recoveries is in the range of 25%- 50% of the face value of outstanding SRs
IVR RR 5	It indicates that the present value of expected recoveries is in the range of 0%- 25% of the face value of outstanding SRs

Archive

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act was enacted for facilitating banks to recover their non-performing assets without Court’s intervention. The Act provides three alternative methods for recovery of non-performing assets, namely securitisation, asset reconstruction and enforcement of security without the Court’s intervention. This act enables resolution of long-drawn legal matters in recovery cases and involves professional expertise of securitisation companies (SCs) / asset reconstruction companies (ARCs) in the recovery process. The instruments issued under the ‘The SARFAESI Act’ by SCs/ARCs after acquisition of assets to Qualified Institutional Buyers (QIBs) are named as Security Receipts (SRs). Relevant guidelines have been issued by RBI for computation of Net Asset Value(NAV) on these SRs issued by SCs/ARCs. This ensures that QIBs value their investment in SRs in accordance with the applicable guidelines. Thus, rating serves as an objective tool for the computation of NAV. Recovery rating is based on the ‘recovery risk (probability of recovery)’ and not the ‘default risk (probability of default)’. Value of underlying security and its recoverability are of prime importance in recovery rating; whereas, cash flow adequacy and future volatility in cash flows (including various other financial parameters hold significance in credit rating.

The assumptions made by the SC/ARC in arriving at valuation of SRs are evaluated and modified by Infomerics, wherever required. SRs are valued on a present value basis from their cash flows, till maturity. An indicative yield is imparted for discounting the cash flows of the SRs. Once Infomerics arrives at an expected valuation, it assigns appropriate recovery rating (the rating gives the range of recovery possible), which indicates the recovery expected from the underlying loan (and SRs), with respect to the face value of the SR, within a predefined band.

RECOVERY RATING IS A FUNCTION OF TWO VARIABLES:

Collections from NPAs.
Recovery on SRs.

COLLECTIONS FROM NPAS

Recovery ratings hinges on the assessment of recovery from the underlying debt exposure. An important point in the analysis is the resolution strategy: asset sale, restructuring/relief, change of management and so on. The likely outcome of the resolution strategy is analysed in detail. Needless to make a mention that NPAs are essentially distressed debt obligations which are in default for varied durations. The process of recovery has a high element of variability with respect to the financial health of the borrowers. This is apart from the willingness of the borrowers to repay its debt obligations. Thus, the quality of collaterals and the liquidity associated with the collaterals, apart from the business prospects of the issuer, are of prime importance in such cases.

Further, the type of resolution in these cases are also analysed in detail. There are mainly two types of resolution – liquidation approach and going concern approach. The two approaches for resolution are used in different circumstances. There can also be a combination of the two approaches, wherein a part of the business or assets of the company are sold to reduce the debt. Similarly, support from group/promoters may be made available to retire some debt and revive the business with a lower debt burden. The recovery assumption on a going concern basis is assumed to be higher than that in the liquidation approach. Under going concern approach, Infomerics may draw various scenarios and the recovery assessment would be the probability-weighted average of recovery under these scenarios.Infomerics’ assessment also incorporates the resolution strategy as well as the capabilities and track record of the ARC concerned in devising and implementing these resolution strategies.

RECOVERY ON SRS

The assessment of recovery on specific SRs are further assessed based on the following factors

Borrower’s capital structure and recovery for the Trust

Structure of the SR and cash flow waterfall

The payments to SR holders are effected only if monies are actually credited into the trust accounts and are available for distribution. SR holders receive the payments only if monies are actually received by the Trustee and are available for distribution. Interestingly, there exist no pre-set schedule of payment to the SR investors. The cash flow waterfall as defined in the transaction documents are taken into account while assigning the recovery rating. Resolution expenses and Trustee fees are generally considered senior to pay-outs to SR holders. Multiple SRs can be issued by a single trust, which may or may not be paripassu to each other. Accordingly, the recovery estimates for both series of SRs may be different. Infomerics’ Recovery Rating incorporates all payments expected to be made to the SR holders over a period commencing from the assignment of rating and ending with the expiry of the resolution time frame or the maturity date of the SRs, whichever is earlier.

CONCLUSION

Recovery ratings indicate the present value of the expected recovery divided by the face value of the SRs. It is an estimate of how much the investor can realise over his investment in the SRs during a specified time frame. The final rating depends upon the different range of recovery.

SURVEILLANCE AND DISSEMINATION OF RESULTS

Review of ratings

Recovery rating, once assigned, remains under regular surveillance throughout the tenor of the SRs. Rating reviews are generally undertaken twice a year. In case of special situation, rating reviews can be more frequent.

The factors that may impact recovery ratings at the time of surveillance are including:

Significant developments not forecasted during the last rating / surveillance exercise.
Comparison between the assumptions made for the recovery process during the time of the last rating / surveillance exercise and the actual happenings.
Any differences in the realisation of recovery proceeds and the one envisaged earlier.
Part-redemption of the SRs.
Impact on the borrower’s business fundamentals and valuation of collateral security on account of changes in macro-economic factors.

DISSEMINATION OF RATING ACTIONS

INFOMERICS RECOVERY RATINGS SCALE

Rating Symbol	Rating Definition
IVR RR 1+	It indicates that the present value of expected recoveries is more than 150% of the face value of outstanding SRs
IVR RR 1	It indicates that the present value of expected recoveries is in the range of 100%- 150% of the face value of outstanding SRs
IVR RR 2	It indicates that the present value of expected recoveries is in the range of 75%- 100% of the face value of outstanding SRs
IVR RR 3	It indicates that the present value of expected recoveries is in the range of 50%- 75% of the face value of outstanding SRs
IVR RR 4	It indicates that the present value of expected recoveries is in the range of 25%- 50% of the face value of outstanding SRs
IVR RR 5	It indicates that the present value of expected recoveries is in the range of 0%- 25% of the face value of outstanding SRs