AT THE HEIGHT OF global financial crisis in 2010, a meeting between Leon Black, head of U.S.-based private equity (PE) firm Apollo Global Management, and K.V. Kamath, till recently chairman of ICICI Bank, went largely unnoticed. It was strange since both Black and Kamath have larger-than-life reputations. Kamath had built India’s largest private bank from what was a development finance institution. Black had founded Apollo in 1990, and his funds have returned an average 39% since inception.
What should have been a pointer, at least in the financial services sector, is that from 2008, Black had been buying up loan portfolios of troubled U.S. banks; he’s known in the industry as a leveraged buyouts man. In India, ICICI Bank had been piling up bad loans that were a direct outcome of its aggression in dolingout corporate loans during the boom years (till 2008). Was Black in India seeking ICICI’s bad loans?

A couple of years later, the purpose behind Black’s meeting with Kamath emerged. He wanted the distressed assets of other Indian firms. Apollo Global had signed a deal with ICICI Bank to create Aion Capital Partners, an India-focussed fund that seeks opportunities in companies facing special situations, including corporate spinoffs, corporate restructuring, recapitalisation, financial restructuring, privatisation, or financial distress such as bankruptcy or non-performing assets. The fund opened in early September, and has already raised over $300 million (Rs 1,614 crore); It is expected to keep fund-raising open for 12 months to create a corpus of $750 million. Both Apollo and ICICI refuse to talk about Aion, citing regulatory compulsions.

Globally, there are funds that invest in distressed assets, looking for high returns at bargain prices. If there’s a turnaround in the fortunes of the company, the investor profits; if the company goes under, the investor gets a share of any real assets. These funds are disparagingly called vulture funds, because they prey on weak and dying companies. At first look, funds such as Aion could be considered vulture funds, but there’s a significant difference: they don’t look for weak companies. Rather, they look for fundamentally strong companies going through cash-flow problems, which will recover once sufficient funds have been injected.

This is not the first time that such special situations funds have tried to capitalise on India Inc.’s financial distress. After the Lehman Brothers’ collapse in 2008 and the subsequent fall of the Indian market, firms such as U.S.-based W.L. Ross and Citadel, big players in the distressed assets market, swooped down on India. Ross picked up a stake in loss-making airlines SpiceJet, which he later sold profitably, while Citadel bought into offshore drilling contractor Aban Lloyd, which was weighed down by debt it raised for an overseas acquisition. In 2009, another U.S.-based hedge fund, QVT, bought 42% of the foreign currency convertible bonds of pharma firm Wockhardt when the company defaulted on the bonds after it had piled up Rs 2,700 crore in debt from acquiring foreign companies and run up losses from complex currency derivative transactions. QVT bought the bonds from foreign investors when the stock was beaten down to a low of Rs 70.

Shyam Maheshwari, partner, SSG Capital Management.
Shyam Maheshwari, partner, SSG Capital Management.

Such investments, however, were one-off, made from funds already raised for the Asian region or the emerging markets. This time round there’s been a spurt in the number of India-specific funds. Apart from Aion, there’s Arun Mehra’s VEC Investment, which will focus on companies with a substantial portion of their businesses in India and going through the process of restructuring or are in financial distress. Mehra, who managed Fidelity’s India funds, some $4 billion at their peak, floated VEC Investment last December. Then there’s Arth Capital, set up by Anish Modi, who is credited with one of the earliest distress deals in the late 1990s, buying bonds of the debt-laden Chennai-based India Cements. Modi was earlier partner and India head of ADM Capital, a firm set up in 1998 during the Asian crisis to buy distressed assets. ADM manages assets worth $1.7 billion, and has invested $2.7 billion in 99 private transactions since inception; 64 have been fully exited. According to Preqin, a London-headquartered data intelligence firm which tracks the alternative assets industry, 18 distressed PE funds that are India-specific or include India in their geography raised over $13.3 billion between 2005 and September 2012.

The appearance of such special situations funds signals a greater maturing of the Indian financial markets. Now both borrowers and lenders have recourse if things come unstuck. It also creates a framework which, while not actively encouraging risk taking, will not discourage it either. In some ways asset reconstruction companies were supposed to play this role, but their impact has been limited.

THREE YEARS AFTER BLACK and Kamath began talks, banks in India are facing the largest number of requests from companies to restructure loans, as they find them hard to repay; a record $40.5 billion worth of corporate debt from 370 companies is being evaluated. Most of these companies are over-leveraged for two reasons—the dizzying opportunities that entrepreneurs saw around them in the past few years, and their inclination to borrow to finance their growth rather than dilute shareholding. In FY12, banks restructured $16 billion worth of loans; this year, that’s expected to go up 25%. Before this, banks restructured loans averaging $5 billion every year.

Companies ask for loans to be restructured when they are unable to repay on time; restructuring involves giving the borrower more time to pay. The underlying premise is that the loan is inherently sound because the business is, but the borrower is facing temporary cash-flow problems.

Under Reserve Bank of India (RBI) rules, a restructured loan is not treated as a non-performing asset—so the provisioning requirements are just a little higher than for good loans. There is a far higher provisioning requirement (10%) for non-performing assets, which affect a bank’s bottom line. That explains why banks have been willing to restructure loans without much persuasion. This has worried the central bank. It fears that arbitrarily restructured loans will turn into non-performing assets, leaving banks at a loss since their provisioning will not be enough. In its Financial Stability Report in June, the RBI warned that 15% of restructured loans can become non-performing assets. Later, in August, RBI deputy governor K.C. Chakrabarty told a conference that, “Restructuring is neither being permitted in a transparent and objective manner by banks nor is it being resorted to in a non-discriminatory manner.” Restructured loan amounts at public sector banks have grown at 47.86% between 2009 and 2012, while the corresponding growth in credit has been 19.6%.

The RBI has set up a working group to study this issue and come up with recommendations on loan restructuring. The group, headed by executive director B. Mahapatra, has recommended a higher provisioning requirement for restructured loans—from the existing 2% to 5% in a phased manner over two years. If accepted, this could put pressure on banks and act as a disincentive to widespread restructuring. Higher provisioning will hurt capital adequacy ratios, especially once the Basel III norms come into effect (starting 2013). Basel III involves far higher capital requirements—an attempt to prevent future financial crises—and comes into effect at a time when raising capital is getting tougher. Add higher provisioning (12.5 times more) for restructured loans, and banks are in an unenviable position. Draft guidelines based on the Mahapatra recommendations are likely to be issued in January. In the interim, RBI has increased the provision for restructured loans from the existing 2% to 2.75%.

Meanwhile, there is the Sarfaesi Act (Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002), which allows lenders to sell the property of defaulters to get their money back. Vikram Chachra, managing partner and chief operations officer, Eight Capital, a Mumbai-based outfit that deals in distressed assets, says the turning point came in 2004, when the Supreme Court ruled against Mardia Chemicals, saying that banks were free to sell its properties hypothecated to them. So companies struggling to manage finances in a poor economic environment aren’t immune to their assets being sold off, however extreme that is.

With loan restructuring no longer as viable (for borrowers and lenders), enter special situations funds. A special situations fund is typically a five-to-seven-year locked-in fund, unlike a seven-to-ten-year growth fund where the partners can choose to redeem investments. The fund is open to limited partners (investors in PE funds), including sovereign wealth funds, pension funds, and high net worth investors. “The limited partners expect to multiply their initial outlay, which is their return, in the form of illiquidity premium,” says Shyam Maheshwari, partner at Hong Kong-based SSG Capital Management, a special situations fund. The illiquidity premium is for the locked-in investment which carries a higher risk because it is invested in companies which have stress on their balance sheets.

Here’s how they work: They repay the bank (lender) on behalf of the company (borrower) and, if required, lend more money to the company, of course at rates far higher than what banks charge because of the risks involved. The money is structured as a debenture, with an option to convert it into equity later. They then nurse the company back to health and, at some point, exit the investment. “We need not be an equity holder to have a say in the company,” says Maheshwari. The covenants in the loan documents spell out the investor’s rights, say, around leverage and use of funds. “They act as our safeguards,” says Maheshwari.

Given the kind of interest both classes of funds take in their investments, special situations funds such as Eight Capital are mistaken for growth PE funds. The difference is that growth funds handhold promoters to move the company to the next phase, and look for strong companies with potential for growth. Special situations funds, however, look for companies that have been beaten down, and seek to turn them around from near breakdown. But it’s equally true that after they’ve turned a company around, special situations funds function like growth funds in spirit.

Aditya Rao, executive director of Pennar Industries, an engineering firm, calls these funds “true partners in growth”. He should know. Some years ago, two special situations funds—Eight Capital and Spinnaker Capital—bailed Pennar out of a rough patch. The 2002 recession, coupled with the steel sector’s downturn, which began in 1998, had hit Pennar hard. Its top line had crashed to Rs 76 crore in 2001-02 from Rs 320 crore in 1997-98, and the company had to go to the Board for Industrial and Financial Restructuring. The government set up the board to identify sick firms and help revive them or shut them down. Pennar’s debt was over Rs 224 crore, and even two rounds of debt restructuring did not help. It looked like there was no hope, when Eight Capital and Spinnaker stepped in. “They gave us money and support to make intelligent decisions,” says Rao, referring to how Eight Capital helped Pennar make its operations more efficient and took an active interest in roping in a technical collaborator. Today, Pennar’s revenue is at Rs 1,024 crore (for FY12) and operating profit margin at 10.95%.

Chachra offers a pointer to newcomers in the special situations funds space. “We have to take a growth approach in India and cannot take a liquidation one,” he says. No promoter will approach an investor known to slice and dice companies. Also, any such liquidation will be long drawn out, with stringent labour laws governing large-scale layoffs. “[Such] litigation against even a few will lead to tarnishing the image of all lenders,” says an official at a public sector bank on condition of anonymity.

Clearly, special situations funds have a larger role to play, that of betting on laggards who can win. That’s an eagle’s play. Not a vulture’s.