For any non-bank originator it is absolutely critical to raise large sums of risk capital on a continuing basis. While this need is primarily to meet capital adequacy requirements, there is usually a need of equity for growth, expansion, investments in infrastructure, or sometimes just to boost the balance sheet to help raise more debt.

Entities engaged in providing financial services in rural areas and to other excluded population have shown significantly high growth rates. Five year CAGR of some of the larger originators is as high as 80%.  This means that the equity base of such originators needs to almost double every year!

Our first blog post in this series, on debt examined ways in which loan funds can be raised by such originators and our second post on Mezzanine instruments started to address the issue of raising risk capital.

While Mezzanine Instruments can allow originators to most effectively leverage equity, there is a limit to how much mezzanine funds can be raised, both from a regulatory perspective and also from an efficient risk transfer perspective. This brings us to examine the various sources of equity capital (or Tier I capital). Broadly, the different sources of tier 1 capital are – (i) Accruals (ii) Additional investment by promoters (iii) Private Equity (PE)and (iv) A public equity offering.

For entities that are young, accruals may be extremely small and there may be a need to tap external sources of equity.

The two main sources are Private Equity and a Public Offer. Private Equity is not traded publicly on stock exchanges and is usually relevant when issuance size is smaller and there is limited public interest in dealing in the shares of the company. Private Equity can be raised from both retail and institutional investors.

A couple of considerations in taking equity public are the huge cost and time associated with an IPO. It is necessary for an originator to probe the viability of this expense. Another impediment to raising public equity is that there is every chance that the company may not be in the most appropriate stage for such financing.

According to Crisil’s India’s top 50 MFIs report, the 50^th largest MFI in India, has a loan outstanding of only INR 124 million, clearly demonstrating the very small scale of players in the industry today, making Private Equity the dominant source of risk capital for such originators.

Role of Private Equity

Private Equity investments are generally made by Private Equity firms, Venture Capitalists, Angel Investors (Angel Investors serve as the bridge between seed capital and Venture Capital) and other financial institutions established for this specific purpose and even by HNIs. While most of the Private Equity invested till date in India in originators has been to finance growth of existing businesses, in future there are possibilities of it being employed to finance Leveraged Buy-Outs (LBOs). Leveraged Buy-Outs involve raising a large volume of debt to fund a takeover, and are considered controversial because of the large amount of leverage involved in such transactions and the huge payoffs for partners in PE firms. Other well known uses are growth capital investments which are made in mid-size companies that seek capital infusion for funding growth, expansion or technology upgrades and Venture Capital investments which are made in early stage companies seeking seed funds. Venture Capitalists often play a significant role in shaping the company up and building strong balance sheets before they execute their exit strategy. Mezzanine investments are made to fund small or medium size, growth companies by providing funds subordinated to senior debt, either as subordinated debt capital or as preferred equity. Private Equity also plays a significant role in a mature environment where consolidation is imminent.

Types of Private Equity investors

There are two-types of Private Equity investors – (i) passive investors, who only provide capital support and depend on the management of the company to spearhead its growth and returns and (ii) active investors, who play a crucial role in bringing the company’s revenue model and growth up to shape. These investors provide more than just capital in that, they act as mentors to the investee company.

The environment for Private Equity and Private Equity investments in microfinance

China, Brazil and India still top the list of most attractive emerging markets for Private Equity investments. India’s FDI policy of 2005 allows up to 100% stake in ventures; however there are a set of sensitive sectors where caps on FDIs exist. FDIs in India surged for the first time in 2007, touching $11.19 billion. According to news reports, India received $18.35 billion in FDIs in the first 11 months of the financial year 2010-11 according to DIPP data.

In early 2010, before the Andhra Pradesh crisis, Private Equity companies and Venture Capitalists were upbeat about the microfinance sector. According to news reports, PE companies have invested INR 2,500 Crore in MFIs since 2006. PE investors found the sector’s immunity from the global economic crisis, low delinquency rates leading to assured returns and astounding growth, strong and highly positive investment parameters. The years 2009 and 2010 witnessed investments from big names like Oikocredit International that bought a 10% stake in Kerala based ESAF Microfinance and BlueOrchard PE which pumped INR 50 Crore in Asmitha Microfin Limited in addition to others like Avishkaar Goodwell and Unitus.  Very recently, Mumbai-based Svasti Microfinance raised its second round of funding from BlueOrchard PE Fund. 

Exit strategies

Returns to Private Equity is in the form of cash accumulation through cash flows from operation, repayment, increased earnings and other forms that constitute exit strategies. Exit strategies vary amongst investors, depending on their investment horizons and investment strategies. Exit strategies are generally in the form of -

1. Secondary sale - where the investors of the company sell their stake to a new investor
2. Company/Promoter Buyback – this is a theoretical exit option for most entities operating in origination. Given the continuous need for capital, it will usually be difficult for such entities to be able to buy back its own shares
3. Recapitalisation – where returns are distributed to the financial sponsor either from the cash flow generated by the company or by issuing debt and other securities for this purpose.
4. IPOs – the shares of the company are taken public, providing the investor with an immediate realisation. The PE investor can also choose to sell shares in the public market made available by this route at a later point in time
5. A merger or acquisition – through which the company is taken-over by another for cash, shares or both. This is a strategy employed by investors when their investments lie in companies belonging to industries where consolidation was imminent.

The first PE exit in Indian microfinance has already been executed successfully in SKS microfinance’s IPO. In late 2008, SKS raised INR 3.66 billion. The transaction led by Sandstone Capital represented the largest Private Equity investment in microfinance, globally, as of that date. Sandstone Capital was joined by existing SKS investors such as Sequoia Capital and Unitus.

Private Equity investments in an emerging market economy such as India’s help create more jobs by providing a fillip to growth, and also combine capital with expertise, making management more professional, thereby creating even more opportunities for investment and growth. Private Equity is a financing option that can work wonders for non-bank originators, in terms of fulfilling capital requirements, stabilising their balance sheets and in fuelling their growth and expansion plans. However, such capital comes along with an exit strategy – and non-bank originators will have to innovate in terms of business models, products and processes, and employ methods to reduce costs continuously to attract Private Equity investments and to sustain the interest of Private Equity players in their business.

- With inputs from Puneet Gupta and Jayshree Venkatesan, IFMR Mezzanine

By Kshama Fernandes, IFMR Capital

The goal of an investment professional is to maximise the risk-adjusted return on the overall portfolio through diversification within and across asset classes. High repayment rates, low volatility of returns and low correlation with other asset classes make microfinance an interesting asset class.What drives the high repayment rates and low volatility of returns? How can unsecured loans made to borrowers with no credit history be of higher credit quality than more established asset classes? To understand these questions, one has to look at the underlying model.

Social collateral

The joint liability group (JLG) system is an operationally intensive model with strong emphasis on adherence to simple, yet well-designed processes. The product is typically a one-year loan with equal weekly repayments. A group of borrowers get together and form the basic unit — the joint liability group. Coming from the same neighbourhood, they know each other well enough to understand the cash flows and requirements of households, and have insight into the ability and willingness of the members to repay.

The group members collectively guarantee the loan given to members in their group. If a member fails to pay an instalment, the others in the group pool together and pay.Very often, non-payment of an instalment is due to reasons of liquidity, not wilful default. Most low-income households have no collateral to provide. The model effectively replaces physical collateral with social collateral.

While this may appear simple, the implementation is complex. Borrowers, who have never availed loans in the past or experienced the discipline of repayments, need to be educated about the product, group formation process and the liability they take on being a member of the group.

Educating borrowers

MFIs spend a lot of time educating their borrowers through a well-defined CGT (Continuous Group Training) and GRT (Group Recognition Test) process before a loan is sanctioned and disbursed. While most MFIs insist on borrowers engaging in an income generation activity, often the loans are utilised to smoothen lumpy cash flows, typical of an agriculture-based economy.

Most rural households engage in multiple income-generating activities. They grow seasonal vegetables, rear livestock and work as daily wage labourers. Thus, repayments often come from within the existing household balance sheet, rather than from new business income.

The small weekly repayments match well with the high frequency cash inflows. The group guarantee, based on self-selection, repayment discipline with close group monitoring, and a financial product that matches the household’s cash flow patterns, results in high repayments.

The low correlation observed between returns on this asset class and mainstream asset classes, such as equities, bonds, commodities and bullion, is because in the short run, the small-scale activities and occupations engaged in by borrowers continue irrespective of the happenings in mainstream markets.

As markets for end products/services produced by clients are largely local, the micro economy continues to function irrespective of whether inflation skyrockets, stock index nosedives, interest rates strengthen or exchange rates collapse.

Distinctive features

The features distinguishing microfinance from other asset classes are:

Very high granularity resulting in portfolio diversification: Microfinance loans have small ticket sizes that average Rs 12,000. As explained earlier, these loans are used for income generation, to smoothen cash flows and repay high-cost debt. The granular nature of loans with diversified business activity underlying them makes for a well-diversified underlying loan portfolio;

Short-term assets: These are short tenor loans where the frequency of repayment is far higher than standard loans. The principal outstanding steadily reduces with every week of repayment. Hence the duration of a typical loan with a one-year maturity is around six months. From a risk-return perspective, this is an attractive feature; and

Superior credit quality due to underlying model: Except for instances triggered by political risk, losses in this sector have been in the range of 1.5-2.5 per cent. Pool performance has been consistently good for originators who have tapped capital markets through well-structured securitisation transactions; this enables investors to take an exposure to this asset.

Efficient geographical diversification can be achieved by pooling loans originated by multiple MFIs across States and districts. The collection efficiency of such transactions structured by IFMR Capital has been 99 per cent. These numbers are far superior to those exhibited by other retail asset classes.

Wider Investor Base

For an investor pursuing risk-adjusted returns, microfinance is certainly an asset class worth looking at. MFIs have been able to tap capital markets through securitisation transactions and non-convertible debentures (NCDs), attracting mainstream investors such as mutual funds, bank treasuries, and private wealth investors. As the investor base for microfinance diversifies, the sector is also likely to experience lower liquidity risk.

For instance, after the recent Andhra Pradesh crises, while banks reduced lending to the sector, NBFCs continued lending, preventing a liquidity crunch.

The professionalism and rigour of capital markets has resulted in increased transparency, operating efficiency and improved risk management practices in this sector. Market oversight and performance monitoring by investors and rating agencies will go a long way in establishing microfinance as a high-quality asset class.

 
This article first appeared in The Hindu Business Line.