Model efficiency will lead to better price discovery and value maximization
The 2020 Nobel Prize in Economics has been awarded to Paul Milgrom and Robert Wilson for their pioneering work in auction theory. Milgrom developed bidding strategies in which bidders could know each other’s expected value, resulting in higher revenue for the seller. Wilson’s work showed how rational bidders place their bid below their estimate to avoid what is known as the winner’s curse.
In India, almost every day, we come across financial news or advertisements regarding the solicitation of offers for the purchase of Non-Performing Loans (NPLs) under the Swiss Challenge Method (SCM) with reference to an offer of anchor received. The terminology first gained traction after being part of the Reserve Bank of India’s (RBI) Stressed Asset Sale Directive in 2016. The SCM methodology was later further developed in a transfer circular of loan exposure published by RBI in 2021. Subsequently, the Insolvency and Bankruptcy Board of India (IBBI) also considered using the methodology for the sale of assets in liquidation. Now, SCM is the most widely used method for conducting NPL auction transactions in the amount of hundreds of thousands of rupees are consumed through the Swiss Challenge route.
As defined in Wikipedia, “A Swiss Challenge is a form of public procurement operated in certain jurisdictions, which requires a public authority (usually a government agency) that has received an unsolicited bid for a public project (such as a port, road or rail), or for services to be provided to the government, to advertise the offer and invite others to match or exceed it. even the unsolicited offer to match or better the best offer that comes out of the Swiss challenge process.In the Indian context, for NPA Sales, the original bidder providing the basic offer has the right to match or better the challenger’s offer and has the first right of refusal.
Now, the Swiss Challenge method is mandated to be used in NPL sales with an outstanding amount above Rs. 100 crore by all banks/financial institutions. Let’s analyze the issues around its implementation and its conceptual limits.
• In NPL, it is the bank that wants to sell an asset and is soliciting or is in the process of soliciting an offer. The unsolicited offer, the basic starting point of Swiss Challenge, is a misnomer in NPL sales.
• Banks have an internal reserve price for the sale of an asset. It is expected that bids that only exceed the reserve price are likely to go further in initiating a Swiss Challenge process. However, as it stands, the reserve price is often much higher than its value that a bidder would place in cash on the table.
• NPLs are mainly sold to Asset Reconstruction Companies (ARCs), which make payments through a unique instrument called Security Receipts (SR) – a kind of IOU or promissory note payable from the proceeds realization of the underlying assets.
• The problem is compounded when SRs issued by a government-led ARC are guaranteed by the Indian government. Any counter-offer received, in dispute, from any other CRA or eligible entity, will have no government guarantee and, therefore, offers and counter-offers are unequal. This disparity will make the evaluation of bids discretionary and distort the rules of the game.
• There is no symmetry in the tender time given to challenger bidders to prepare counter-proposals versus the time taken by the offeror for preparation. This is especially true when it comes to very large wallets made up of multiple high-value accounts. The base bidder makes a bid after spending considerable time evaluating the bids and has made/is making a bid. However, a similar time frame may not be available for the challenger. The original bidder has first-mover advantage.
• Transaction tension drives value maximization. Once the main bidder has the right of first refusal, the tension is readjusted and the challengers stop at what they perceive as far as the original bidder can afford to match.
• Most importantly, and as a substantial part of the payout is in the SRs, the qualitative aspects of the ARC resolution skill set play a vital role in realizing value. His record on SR redemption is a key factor, which doesn’t get the weighting it deserves.
• With a limited number of buyers and limited capital/resources, the market is illiquid, reducing competition and maximizing the value of NPA sales.
NPL auctions under the Swiss Challenge, as they stand today, are constrained by the factors described above in driving towards the optimal factors representing the Swiss or Challenge attributes. Swiss stands for neutrality, but in this format it is biased in favor of the author, who has the first right of refusal. This does not pose an adequate challenge due to the asymmetry in time to perform due diligence and the illiquid market with a limited set of players. In its current format, the SCM is at best an insurance to limit the erosion of value, because the initial bidder has a firm offer that can only be improved. Thus, the achievements cannot go any lower.
An effective auction model facilitates price discovery and value maximization. The existing auction model can possibly be re-evaluated, based on empirical data and study of behavioral aspects of seller and buyer, to lead to a more effective price discovery mechanism in the Indian market of distressed debt.
Mishra is a former banker.