Investing in distressed debt in India for foreign investors

Distressed debt trading in India has become an important investment opportunity for foreign investors in recent years. Apart from its sizeable market – the Reserve Bank of India (RBI) places the gross non-performing assets (NPAs) of public sector banks and private sector banks as of 30 September 2024 at INR3.15 trillion (USD38 billion) and INR1.34 trillion, respectively – market participants have easy access to acquire and trade in distressed debt and assets.

The growth of the India distressed assets market has been driven by a myriad of factors, including the introduction of the Insolvency and Bankruptcy Code, 2016 (IBC), the tightening of regulatory norms for NPAs and the liquidity crunch in the traditional banking sector.

While the vast potential of investing in distressed assets in India is evident to many, the primary challenge faced by foreign investors is navigating restrictive Indian exchange control laws to structure the optimal route of investment into India.

Investment in distressed assets

Gautam Narasimhan
Co-Managing Partner of ASEAN
and Managing Partner of Singapore
Singapore
Tel: +65 6671 6048
Email: gautam.narasimhan@aoshearman.com

As a starting point, foreign investment in India is regulated by the Foreign Exchange Management Act, 1999 (FEMA), and is usually routed through the foreign portfolio investment route.

A foreign fund can register as a “foreign portfolio investor” (FPI) with the Securities and Exchange Board of India (SEBI). FPIs are permitted to invest in specified securities such as non-convertible debentures, securitised debt instruments and debt instruments issued by banks. Although FPIs are not permitted to directly purchase loans, there are a few possible routes through which FPIs can participate in the distressed debt market in India, including the acquisition of security receipts issued by an onshore debt aggregation vehicle known as an asset reconstruction company (ARC), or subscribing to non-convertible debentures.

Foreign investors can also invest equity in non-banking financial companies (NBFCs) that aggregate loans or establish an alternative investment fund vehicle.

This article focuses on investing through security receipts issued by ARCs, as this route is publicly available and has arguably the lowest entry barriers for foreign investors to gain direct (rather than synthetic) exposures to distressed loans in India.

ARCs and security receipts

Rishi Hindocha
Partner, Singapore
Tel: +65 6671 6274
Email: rishi.hindocha@aoshearman.com

Asset reconstruction companies were established in India in 2003 under the Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act), a legislation introduced to facilitate securitisation, and to bring liquidity into India’s financial system. ARCs, which are regulated by the RBI, are specialised financial institutions akin to distress funds, and play a critical role in recycling liquidity in the market. Specifically, ARCs acquire the baggage of NPAs from banks and other financial institutions at discounted rates to free up liquidity, and seek to recover maximum value from the NPAs, whether through a workout, corporate insolvency resolution process (CIRP) or other enforcement action.

In addition to the private ARCs, it should also be noted that, in 2021, India’s first government-backed “bad bank”, the National Asset Reconstruction Company Limited (NARCL), was established to clean up the legacy stressed assets with large exposures in the Indian banking system. The NARCL can acquire NPAs through a mix of consideration – 15% of the consideration being paid in cash up front, and the remaining 85% being paid through the issuance of security receipts backed by a government guarantee up to a cap.

Benjamin Foo
Senior Associate, Singapore
Tel: +65 6671 6287
Email: benjamin.foo@aoshearman.com

One key peculiarity of ARCs in India is that they are allowed to tap into the public market to raise funds for the acquisition of NPAs through the issuance of security receipts pursuant to a scheme (which can be in the nature of a trust managed by the ARCs) to qualified institutional buyers (for example, a financial institution, insurance company, bank or other ARCs). The SEBI has also recently, via a gazette notification dated 28 February 2025, widened the list of qualified buyers to include NBFCs and housing finance companies.

Security receipts are instruments that represent an undivided interest in the distressed debt acquired by the ARCs from the original creditors of the distressed borrowers. They are backed by the expected recovery from the underlying assets and cannot be strictly characterised as debt instruments (since they combine the features of both equity and debt). However, they are recognised as securities under the Securities Contracts (Regulation) Act, 1956.

By holding security receipts, investors can indirectly participate in the recovery process of distressed assets through enforcement of security interest by the ARCs under the IBC, including through the CIRP. According to a CRISIL report, the cumulative redemption rate of security receipts is forecast to be about 69% to 71% in the fiscal year 2026.

Limitations, risks and challenges

Jia Min Lim
Associate, Singapore
Tel: +65 6671 6005
Email: jiamin.lim@aoshearman.com

The use of security receipts as a means of investing in distressed assets in India is an emerging trend that has caught the attention of major international funds. However, such transactions also entail various practical, legal and commercial limitations, risks and challenges, including:

(1) Capital constraints. There are fewer than 30 ARCs registered with the RBI, which is a small number relative to the market size. To ensure that ARCs have “skin in the game”, the RBI requires them to hold at least 15% of the investment of the transferor in security receipts, or 2.5% of the total security receipts issued, whichever is higher, in each asset class under each scheme on an ongoing basis until the security receipts are redeemed. This could limit the growth of the distressed debt market and the availability of attractive assets for foreign investors in this space. Investors should note that they will not be able to acquire 100% of the distressed assets through security receipts, as the ARCs will always retain a minimum stake.

(2) Limited purpose. An ARC is required under the SARFAESI Act to undertake only “securitisation and asset reconstruction” activities – therefore, if a foreign investor has a broader investment objective (for example, to on-lend more widely), this may not be the most appropriate investment structure, and investing through other vehicles such as an NBFC may be more viable.

(3) Regulatory uncertainty. Multiple authorities and laws are engaged in the legal and regulatory framework for distressed asset transactions in India, such as the RBI, the IBC, the SARFAESI Act and the FEMA Act. The interplays between the various regulations need to be carefully considered. In recent years, some ARCs have faced scrutiny from Indian regulators for using innovative ways to structure transactions to circumvent regulations, for example, by allowing themselves to be used as conduits for the evergreening of distressed assets (the practice of granting new credit to stressed borrowers defaulting to help them repay existing loans) instead of pursuing resolution through restructuring (which should be the aim of ARCs, as explained in (2) above).

In response to these trends, the RBI has urged the ARCs to adopt a “regulation-plus” approach, where the ARCs should comply not only with the letter of the regulation but also its spirit. Therefore, investors need to keep abreast of the latest developments and trends in the legal and regulatory framework and assess the impact of, and mitigate against, adverse regulatory actions or changes that may affect their transactions backed by security receipts issued by ARCs.

(4) Enforcement risk. The SARFAESI Act allows ARCs to enforce security or take certain other measures to protect their interests (including the right to change the management and to take over the secured assets) without any judicial intervention. While in theory this seems to be a desirable tool for lenders in an enforcement, these rights are subject to the overriding effect of the IBC. Once a CIRP is initiated, a moratorium will be imposed and all actions under the SARFAESI Act to foreclose, recover or enforce any security interest are prohibited. It is unlikely that any security can be realised under the SARFAESI Act ahead of the insolvency trigger under the IBC, as the underlying distressed company is almost inevitably likely to be insolvent by the time any creditor is able to complete any enforcement sales under the SARFAESI Act.

(5) Market risk and delayed monetisation. Security receipts do not guarantee recovery of the entire amount reflected there. While India’s insolvency landscape has been significantly transformed since the enactment of the IBC, which provides a time-bound, creditor-driven process for resolving insolvency cases, the actual recovery of distressed assets in India are still subject to various market factors, such as demand and supply, competition, sectoral performance, regulatory environment and macroeconomic conditions.

The RBI reports that recovery rates for banks via the IBC channel dropped to 28% in the fiscal year 2023 to 2024, down from 40% in the fiscal year 2022 to 2023. As of 31 December 2024, on average, the closure of CIRPs through resolution took 701 days (about two years). If the trend of declining recovery rates and prolonged periods for realisation of underlying assets acquired by the ARC continues, the Indian NPA market may become less attractive for investors.

Looking forward, there is a new RBI draft framework issued in April 2025, which proposes a market-based route for securitising stressed assets as an alternative to the current ARC model. If adopted in its current form and buttressed by clear operational guidance, the proposed new framework could potentially offer banks and NBFCs broader investor access and reduce reliance on ARCs for distressed debt resolution.

A&O Shearman does not practise Indian law. This note is for information only and does not constitute legal advice. Specific advice should be sought for individual matters.

A&O SHEARMAN
50 Collyer Quay, #09-01 OUE Bayfront
Singapore – 049321

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