Why special situation funds are necessary

News: Recently, Indian financial markets witnessed two crucial reforms. One was release of a dedicated regulatory framework for special situation funds (SSFs) by SEBI and, the other was approval of a new dual-structure for bad-bank (called NARCL-IDRCL) by RBI.

Why have such new reforms been undertaken?

India suffers from a bad loan problem which requires higher provisioning, and locking up more capital in the banking system. This reduces credit supply and hurts economic growth.

Special Situation Funds (SSFs) can buy bad loans (in addition to Asset Reconstruction Company (ARC) which can also do the same). This can release capital locked-up in the banking system and help improve credit supply.

Concept of Special Situation Fund (SSF)

SSFs is a sub-category of Category I Alternative Investment Funds (AIFs). AIFs manage privately pooled funds. The funds are raised from sophisticated investors with deep pockets.

Traditionally, AIFs could participate in the equity markets. But, could not participate in the distressed debt markets. It is because regulations did not allow AIFs to participate in the secondary market for corporate loans extended by banks and NBFCs.

Now, a special sub-category of AIFs, namely SSFs can participate in the secondary market for buying loans extended to companies that have defaulted on their debt obligations.

What more steps can be undertaken regarding SSFs?

SSFs must be allowed to have seamless access across the entire secondary market. It should be allowed to have access for investment as well as non-investment grade corporate debt (loans and bonds). It is an international practice. It was also suggested by the RBI task force (chaired by T N Manoharan) on secondary markets for corporate loans.

SSFs could also be allowed to participate in the secondary market for corporate debt even before the company defaults on its debt obligations. It has multiple advantages as given below:

• It will help lenders and bond investors to offload potentially stressed assets to SSFs before any default.
• SSFs would also get adequate time for debt aggregation before default. It reduces the collective action problems that may arise after default during insolvency or restructuring.

Indian lenders or bond investors should have full freedom to sell their loans or bonds in the secondary market at the best price possible, irrespective of whether default has happened or not.

Conclusion

Introduction of SSFs promises to usher in a modern era of distressed debt investing in India.

Source: The post is based on an article “Why special situation funds are necessary” published in the Indian Express on 16^th March 2022.