Why NBFCs may face liquidity crunch..

Wed, 9 Apr Pre-Open

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In order to safeguard interest of debenture holders, the new companies act has carved out a new set of regulations to minimize the risk of default. The biggest concern for debenture holders is the risk of non-repayment of principal and interest. And as highlighted in Live Mint, the new act addresses this concern by asking companies to create a debenture redemption reserve (DRR). A DRR is a reserve created out of profits to redeem debentures. This money cannot be used for any other purpose other than redeeming debentures. As such, creation of DRR assures repayment and reduces the risk of default.

As per the new companies act, any company raising money via debentures has to create a DRR of at least 50% of the amount raised. For instance, if the company plans to raise Rs 100 bn via debentures it has to create a reserve of Rs 50 bn from its profits. Also, there is another norm that requires companies to invest at least 15% of the value of its debentures maturing in any particular year. As an example let's assume Rs 100 bn worth of debentures are about to mature for company X next year. In that case, company X has to invest Rs 15 bn at the start of the year and ensure that this amount is used only for repayment. The investment could be made in deposits or government bonds.

Both these norms are likely to hit NBFCs the most as they actively raise money via debentures. For one, the creation DRR will affect the re-investment rate of NBFCs. The profit, instead of being churned into the business, will be used to create reserve. As such, profits shall get locked. Secondly, 15% investment rule will reduce the money available to do business. For every Rs 100 raised via debentures only Rs 85 will be used for business purposes as the balance has to be invested. This shall create liquidity issues and raise the cost of funding.

Effectively the new law will choke any company of liquidity and raise its cost of funds. This shall kill the debt market when it is already in nascent stages. Hence, the company law should look at an alternative way to address repayment concerns or dilute the new code. For instance, instead of creating a DRR of 50% of the amount raised it could be reduced to say 20-25%. Also, most long term debentures are secured against the company's fixed assets. Hence, the risk of default is minimal.

All in all, we believe that new laws are stringent in nature and unnecessarily suck out liquidity from companies. Diluting them a bit shall help companies who plan to tap the bond markets via this instrument.