The Risk-Reward Paradox in an Indian Distressed Debt Market

Credit Principle 1: High Rewards are associated with High Risk and vice versa. In other words, credit costs and rewards differ extensively across the capital structure to justify the risks involved at each layer of debt. Sounds simple, Isn’t it? Well, it is not as simple as it sounds. Definitely Not, if you are an investor or a lender in an Indian Distressed Debt market.

In an interesting recent turn of events, investors have begun to question the fundamentals of corporate credit, and whether it justifies having lower credit costs and high collateral's to securely position yourself as a lender in a liquidation scenario.

Which event I am referring to?

In a recent ruling by NCLAT on the Essar Steel case which media houses have reported to be “dangerous”, the rights of Secured Creditors have been jeopardized to ensure fair recovery for operational creditors. NCLAT has given a ruling stating that the creditors whose claims are backed by collateral will not get a preferential treatment.

“Instead of rejecting the resolution plan submitted by ArcelorMittal India Pvt. Ltd, we modify the plan to safeguard the rights of the operational creditors and other financial creditors,"

As a result of this ruling, the value of Essar secured paper has gone down to 60 points vs. 90 points earlier, and the secured creditors are in an utter state of disappointment. This implies, secured creditors who were earlier expecting a 90% recovery will have to get content with ~60% recovery currently. On the other hand, the unsecured creditors are delighted to be recovering something vs. zero recovery earlier. The case has now been referred to at Supreme Court.

Demarcating a clear line of difference between Operational and Financial Creditors

Let us first clearly understand the key differences between Operational and Financial Creditors. Financial Creditors are the lenders who take a higher risk than operational creditors and enable the firm to pursue long – gestation projects. Operational creditors are the suppliers of good and services who take limited risk and have a limited exposure to the firm.

Going with the Credit Principle 1, the Financial Creditors should ideally be entitled to more recovery, more so if they have security in place vs. operational creditors. However, this has not been the case as per the recent ruling.

It is extremely important to understand the implications; this ruling has on market sentiments. This article addresses how this kind of critical ruling can change the entire landscape of insolvency paradigm in India, where distressed debts are looming large.

 Below will be the key questions in the minds of market participants, post this event.

1.      Why should I settle for lower credit costs and take higher collateral's, when there will be no preferential treatment in liquidation?

As a Banker or a Lender, why should I settle for lower credit costs for secured lending, when the value of that security is contingent on the size and magnitude of operational creditors in the event of liquidation. Lenders will typically prefer being an unsecured lender and at least enjoying a higher credit costs in a going concern scenario.

2.      Why should I pay high costs for a secured paper, when a ruling can change the risk reward paradox completely?

Imagine a distressed debt investor, who purchases the Essar secured paper from few lenders, say at a price of 70 of par (assuming a recover of around 90% on the paper). With this ruling, the investors will be left with recovery at 60 of par, marking quantum of losses on their credit portfolio.

3.      Why should an investor do a rigorous credit analysis and study of capital structure, when the risk reward dynamics will change abruptly in a liquidation scenario?

A firm employing expert teams of credit analysts and lawyers doing rigorous due diligence on the transaction, finally ends up in trouble owing to a ruling, wherein rewards are not synchronized with risk.

Broader implications of the event on the Credit situation and distressed debt market in India:

• Credit costs can jump enormously, as lenders will charge significantly higher for long gestation projects and intrinsic collateral value will diminish
• Distressed debt investors will start factoring in an uncertainty premium while bidding for distressed assets, which reduces the scope for incremental IRR owing to compressed spreads
•  Foreign investors taking an active participation in distressed debt trading, will lose interest due to lack of trust issues in the implementation of IBC and the judicial proceedings

Disclaimer: Original court ruling has not been referred to, and references have been cited from publications in Indian Business dailies

References: https://www.livemint.com/companies/news/lenders-to-essar-steel-move-supreme-court-against-nclat-ruling-1563285565612.html