[Editorial] The Need for a Special Situation Fund (SSF)

Quick revision mind map

Context

Two crucial reforms earlier this year

  • Indian financial markets witnessed two crucial reforms earlier this year.
  • Both these reforms are aimed at solving India’s bad debt problem.

SEBI

  • SEBI came out with a dedicated regulatory framework for special situation funds (SSFs).

RBI

  • The RBI approved the new dual-structure bad bank, NARCL-IDRCL.

While the bad bank is an upgraded version of the existing asset restructuring companies (ARCs) model, the SSF is a relatively novel concept.

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How bad debts hurt economic growth?

  • 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 credit supply and hurts economic growth.

A way to solve this problem

  • To overcome this problem, banks and financial institutions were initially allowed to sell their stressed loans only to ARCs.
  • Now they can sell to SSFs too.
  • Transfer of stressed loans to ARCs and SSFs would release capital locked-up in the banking system and help improve credit supply.

Special Situation Funds (SSFs): A major reform in the right direction

  • SEBI has introduced SSFs as a distinct sub-category of Category I Alternative Investment Funds (AIFs).
  • AIFs manage privately pooled funds raised from sophisticated investors with deep pockets.
  • While AIFs have traditionally played a prominent role in equity markets, their participation in distressed debt markets has been limited.
  • Regulations did not permit AIFs to participate in the secondary market for corporate loans extended by banks and NBFCs.
  • The new regulations now create a special sub-category of AIFs, namely SSFs, which are allowed to participate in the secondary market for loans extended to companies that have defaulted on their debt obligations.
  • This is a major reform in the right direction.

Why SSFs must be allowed to participate in the secondary market for corporate debt?

Benefit from a lesser haircut

  • A haircut is the lower-than-market-value placed on an asset when it is being used as collateral for a loan.
  • The size of the haircut is largely based on the risk of the underlying asset.
  • Riskier assets receive larger haircuts.
  • A haircut also refers to the sliver or haircut-like spreads market makers can create or have access to.
  • 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 lesser haircut.

Adequate time for debt aggregation

  • SSFs would also get adequate time for debt aggregation before default, reducing the collective action problems that may arise after default during insolvency or restructuring.

Improve the liquidity

  • Allowing SSFs to purchase investment-grade loans would also improve the liquidity in the secondary market for corporate loans.
  • Traditionally, banks originated loans and held them till maturity.
  • Over time, lending moved from involving a single lender to multiple lenders via syndicated lending.
  • As volumes in the primary syndication market increased, demand for secondary trading also developed to allow liquidity, risk and portfolio management.

Sync with international practice

  • Secondary trading of loans is now institutionalised 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 entry into the secondary market would therefore be in sync with international practice.
  • The RBI task force on secondary markets for corporate loans, chaired by T N Manoharan, made this suggestion in 2019.

Unlikely to jeopardize financial stability

  • SFs cannot borrow funds or engage in any leverage except for temporary funding requirements.
  • Consequently, risks associated with liquidity, credit or maturity transformation and asset-liability mismatches are unlikely to arise.
  • Given their structure, SSFs are likely to acquire sufficient debt in a distressed company to acquire control or to influence its subsequent insolvency or restructuring process to maximise its value through business turnaround or sale.

Way Forward

  • Overall, the introduction of SSFs promises to usher in a modern era of distressed debt investing in India.
  • To realise their true potential, SSFs must be allowed full participation across the entire spectrum of the secondary market for corporate debt and not just be confined to the post-default stage.

Practice Question for Mains

  1. Discuss how the introduction of Special Situation Funds (SSFs) in India promises to usher in a modern era of distressed debt investing. (250 Words,15 Marks)
Referred Sources

Indian Express

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