A recent article in the Harvard Business Review on new approaches to funding social enterprises cites IFMR Capital’s work in securitisation and structured finance of microfinance loan portfolios. The article explores how unbundling societal benefits and financial returns can dramatically increase investment.

The authors argue that financial engineering can be a powerful force for change. It can permit the mobilization of more capital for investment than would otherwise be available. It can generate rich opportunities to fund projects that fuel economic growth and improve people’s lives.  The article also mentions that the ability of social enterprises to provide their products and services rises or falls with the availability of capital and that the lack of funding opportunities is one of the major disadvantages social enterprises face. The article offers the insight that the funding of a social enterprise can be treated as a problem of financial structuring: the enterprise can offer different risks and returns to different kinds of investors instead of delivering a blended return that holds for all investors but is acceptable to very few.

This new approach to structuring can close the financial-social return gap.  The article goes on to discuss the various types of financing-innovation in practice such as loan-guarantees, quasi-equity debt, pooling and social-impact bonds. In the context of techniques that involve pooling and creating tranches, the article mentions IFMR Capital’s work in securitising microfinance loan portfolios in which an investment share is retained by IFMR Capital. The article also reviews the lessons the financial crisis has taught us, most importantly, the importance of standards and ratings and the need for transparency.

The authors conclude by stating that the challenges involved in creating fully functioning capital markets and legal frameworks to serve social enterprises cannot be underestimated and that some innovations may not be suitable for all organisations. However, with the right market infrastructure and legal framework in place, enormous amounts of private capital could be mobilised for social enterprises.

To read the complete article, click here.

Subsequent to our earlier posts detailing the three broad themes from the IFMR Financial Systems Design Conference 2011, Day 2 of the conference witnessed participants identify pathways to achieve the specific visions that were formulated across the sessions in Origination, Risk Transmission and Aggregation. These pathways have been segmented into the categories of Research, Regulation, Innovation and Public Infrastructure.

I. Research

1. Conceptually, what are the trade-offs, if any, between financial inclusion and systemic risk? Are there particular models of financial inclusion that fare better than others as viewed from this perspective?

2. Are there market based instruments (ex: listed subordinate debt) that provide additional information regarding the health of systemically important financial institutions? Can these effectively supplement supervision-based information?

3. How critical is priority sector regulation to the flow of credit to sectors such as agriculture and SME? Does priority sector regulation cause allocative inefficiencies in the economy? Are there less distortionary measures to direct resources to some sectors that have a high perceived social return?

4. Does structuring Government ownership in financial institutions differently reduce distortionary effects? For ex: holding company structure to channel all Government investments into financial institutions versus direct Government investments into specific financial institutions.

5. How must the performance of Chief Risk Officers in financial institutions be measured? How should their compensation be structured?

6. Financial advice as a function of originators. How is this best structured? What liability must the originator have for advice provided to clients? How must financial advisors be compensated? What is the corresponding regulatory and legal framework for customer protection in India?

7. How different are customer outcomes in an environment characterised by: (a) Financial product access alone and (b) Financial product access combined with financial advice?

8. Why is the take-up for risk transmission products (principally insurance) low at a household level? Is the selling process and agent incentives creating barriers to take-up?

9. In markets like India, what is the inter-play of hard information and soft information for credit origination? Do regionally focussed originators have better soft information? Why are non-bank institutions much more successful in some segments (ex: used commercial vehicles finance, microfinance) than banks?

II. Regulation

10. How should regulation of the financial system be structured given that the product level distinctions are blurring? Is there a need for distinct regulators for systemic risk and customer protection?

11. The conference highlighted that the roles of the regulator and the policy-maker are quite distinct? Is increasing financial access in an under-served market like India a policy objective or a regulatory objective? How should these be coordinated?

12. What are the inherent conflicts of interest in the way regulation is currently structured? How can they be addressed?

13. How should financial sector regulators be governed?

14. With increasing sophistication of markets and products, risk measurement capabilities of regulators will become important. What are the best ways to build regulator capacity?

15. What data and reporting standards aid transparency, particularly in the regulation of systemically important financial institutions?

16. Are there market based instruments (ex: listed subordinate debt) that provide additional information regarding the health of systemically important financial institutions? Can these effectively supplement supervision-based information?

17. Managing moral hazard is important while regulating credit risk transmission mechanisms. Conference emphasised the importance of adequate capital at risk for originators that participate in securitisation as an example of this.

III. Public Infrastructure

18. Payment system innovations crucial to better origination. There are several important developments in India in this regard, including the Interbank Mobile Payment Service (IMPS) and UID-linked electronic transfer of benefits. These need to be further strengthened. Cash dematerialisation infrastructure is also an important element of this.

19. Well-defined frameworks for bankruptcy/resolution are important to orderly development of markets.

20. Need to develop electronic records for collateral and collateral transfers. This includes land, house titles and vehicles.

21. Development of cyber security and privacy laws an important complement to financial sector development.

22. Expansion of broadband connectivity will have important implications for how originators are structured. Real-time data transfer has some off-set on originator-related risk.

IV. Innovation

23. Can transactional information/behaviour available with utilities and telcos provide originators information about credit risk and substitute for soft information/collateral? This might enable newer kinds of originators and under-writing processes in the near future.

24. Technological development is gradually eliminating economies of scale in origination. It may be possible to have smaller sized but efficient originators going forward. As a related point, the justification for mega-sized financial institutions that pose serious systemic risk may get diminished.

25. The Conference noted the need for much more product innovation, both for origination as well as risk transmission. Examples include commodity options, inflation indexed bonds and corporate bonds.

A summary of the overall Conference’s proceedings is available here for further reading.

On November 22nd and 23rd, IFMR Capital held its first partners meet, a two day meet with all its partners to re-envision access to finance for institutions that impact low income households. Industry participants and researchers came together to discuss a broader vision for the industry. While the two day event saw active participation and debate on issues that currently concern the sector, the emphasis of the meet was largely on the way forward. Held at a critical juncture, participants brainstormed and discussed strategies for reshaping the sector towards a shared vision.

The meet followed the appreciative inquiry format and drew out the best from the participants. The first part was designed to shift the focus of participants from being short-term reactive to long-term proactive. The second part focused on the positives of the industry and on what was valuable about the way the sector has functioned in the past. The participants broke into groups of two and interviewed each other. Each person described their high points and success stories, sharing instances of how and why being in this sector made them feel glad they belonged here.

The third part of the approach sought to use the output from the interviews to get a clear sense of what were the most important factors that contributed to the success in the sector. Later, organised in groups of six, participants worked on a vision of what the sector would be like in five years if the root causes of success were leveraged in specific areas of focus such as governance, customer focus, risk management, product development, etc. The end result was a shared vision that institutions in the sector could look up to.

Some important questions that emerged during the meet are listed below:

1. How should we position MFIs so that they become an indispensable part of the financial system?
2. How do we engage with the political groups more effectively?
3. What are the unique and additional responsibilities of MFI boards, given that they deal with a segment that is financially and otherwise excluded?
4. As a sector, what data do we need to collect and disseminate, internally and externally, to enable holistic risk management?
5. What investments in training will organizations and the industry make in:
• Moving from mono-line to a multi product model
• Ensuring common minimum values are shared across the sector
• Taking on the new role of a financial advisor
6. How do we use technology or other disruptive methods to dramatically improve operating efficiencies?
7. What is the regulatory framework which will allow MFIs to flourish and serve a wider range of financial needs?
8. How do we resolve short-term funding & liquidity issues for the sector?

In the last part of the meet, the groups focused on developing tactical strategies on four areas : brand management, product development, political engagement and ensuring common minimum values, areas that needed immediate action to take the industry from where it is today to where the group would like to see it in the future.

Here is a brief summary of the themes that emerged from the meet.

a) Customer centric approach: The MFI industry’s main strength is its ability to reach out to and serve a vast number of clients. Client engagement is continuous and services provided are valuable. There was a clear consensus that going forward this customer centric approach must continue to be of key importance.

b) Innovation: Every growing sector continuously evolves. Institutions must be able to respond to the changes in the sector. The need is for an innovative and flexible approach which ensures sustainability and works in the interest of its end customers. The idea of MFIs offering multi-products was discussed at length. This was the way forward and MFIs must invest time, effort and capital towards this. MFIs already possess large amounts of granular financial data pertaining to their clients. This could help them understand the needs and capacities of their clients better and in turn aid the design of relevant financial products.

c) Operating efficiencies: The cost to serve low income households can potentially be dramatically reduced by disruptive innovations. Key pieces of infrastructure such as the UID have the potential of making KYC a public good. Enormous strides in technology such as the use of biometric identification, automated payment systems, mobile technology with improved authentication through the UID can also ensure that local branch staff leverages technology to perform their most repetitive day-to-day tasks, freeing up their time to perform their core duty of understanding the needs of clients and recommending appropriate solutions. There was a clear consensus that business models need to evolve and leverage such innovations.

d) Importance of the mission: While sustainability of business was crucial, it was agreed that the commitment to social and economic well-being of the client was crucial to the sector. Given the profile of the average client, MFIs perform the important role of giving access to finance to the most excluded segment of society. Going forward, organizations must not lose sight of this fact. Further, it is necessary that there is an alignment of objectives and vision across the entire company.

e) Positioning of the industry: Concerns were raised about the response of the industry to the recent crisis and the lack of a unified voice. The role of the board was stressed in this respect, many felt that the board should play a role in ensuring customer metrics are tracked continuously and senior management is held accountable to performance as measured against the metrics. This would also ensure that MFIs are collecting enough information during good times as well as bad, so an accurate picture can be presented to the media, investors and regulators.

f) Holistic risk management: The current business model of organisations in the inclusive finance sector is strong on operations and therefore manages operations related risks very well. However, in order to evolve into universal financial service providers, organisations need to focus on risk in a more holistic manner, ie look at all aspects of risk such as operational risk, credit risk, interest rate risk, liquidity risk, political and regulatory risk. Capacities need to be built internally, for instance, risk departments need to be set up, people need to be hired and adequate training needs to be provided, investment needs to be made in risk management systems. However, it was agreed that senior management buy-in was critical to the implementation of “holistic risk management”.

To considerably expand access to capital for financially under-served households, IFMR Capital is organizing its first Partner’s meet on the 22nd and 23rd November. The meet will provide a platform to participants for reflection, dialogue and action.

Participants comprise a select group of expert practitioners in the field of access to inclusive finance for low income households. The participants’ will engage and will help answer key questions of critical importance:

• How do we design a financial system in which there are multiple and diverse originators providing integrated financial services to low income households and small businesses, evaluating and pricing risks appropriately, and ultimately taking responsibility for good financial outcomes for their customers?
• How do we work towards understanding the needs of our customers for financial services better and fulfilling them?
• How do we design business models that are based on deep local knowledge and relationships, while ensuring systemic stability?
• How do we ensure that inclusive finance originators have adequate risk management capability and supporting infrastructure to ensure sustainability?
• How would the organization have to evolve to obtain efficient and reliable sources of funding?

The spirit of this meet is to take a step back from the existing products, institutional frameworks, and regulatory architectures, and take a more fundamental view of what can be done to improve the ability of our financial system to ensure access to finance for every individual and every enterprise.Together, we will work on a shared vision for the industry and identify specific pathways to achieve that vision.

Conference Website: http://capital.ifmr.co.in/partnersmeet/

The International Growth Centre at the London School of Economics (LSE) is an institution that offers independent advice on economic growth to governments of developing countries. Bringing top policy-makers and researchers together, it endeavors to support policymaking with thorough research evidence as the foundation.

As a part of its growth initiative the IGC recently convened “Growth Week” between 19th to 21st September at LSE, a 3-day conference which brought together a diverse set of policy-makers and researchers from Africa & South Asia. Viral Acharya organized the session on Finance, Colin Mayer chaired the part on Macrofinance and Greg Fischer chaired the part on Mobile Banking. The focus of the session was on identifying areas of academic research on policy issues that practitioners and policymakers are seeking to address in relation to finance in developing countries and emerging markets.

Kshama Fernandes represented IFMR Trust and participated on the panel on “Ideas for growth: Macro Finance” along with Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India & Ms. Shyamala Gopinath, former Deputy Governor, Reserve Bank of India.

Talking about the past, present and future role of commercial banks in India, Dr. Gokarn spoke of the efficiencies and inefficiencies of the system and the challenges they pose in the present context. While suggesting that there was a need to build on the existing penetration of banks, banks would continue to remain the principal channel of intermediation as far as lending is concerned.  However other financial intermediaries could have a significant role to play in the financial inclusion space by developing business models that were designed to address the specific needs of their customers.

In her presentation, Ms. Gopinath pointed out that while financial innovation definitely does have an impact on growth, it needs a precise framework to function in the desired manner. The basic framework required was:

• Reasonable sophistication of participants (Financial literacy)
• Sound legal framework for dispute resolution
• Robust market infrastructure
• Reasonably liquid and deep cash market
• Financial Stability

Kshama Fernandes presented the Financial Systems Design framework based on a bottom-up approach with high quality origination, orderly risk transmission and robust risk aggregation as the three pillars of a well-functioning financial system.

The presentation below describes the key issues, the enabling infrastructure and some research questions that were discussed during the session.

The panel was attended by a large number of academics, researchers and some practitioners and generated a lot of discussion and interest on potential areas for future research. The broad areas that came up for research included: Finance and Growth (investment, bank lending, venture capital); Financial Systems and Stability (asset markets, securitization, financial regulation); and Financial Inclusion and Access by the Poor to Financial Services (savings, borrowing, payments).

As a follow-up to the Growth Week and an effort to advance these research areas, there will be a meeting of all academics associated with the Finance Programme of IGC on Tuesday November 15 at the LSE in London.

The IFMR Financial Systems Design Conference 2011 was organised into three main sessions for discussions – Origination, Risk Transmission and Risk Aggregation. Our earlier post summarised the deliberations that took place on Origination. This post summarises the deliberations on the theme of Risk Aggregation.

In a financial system, risk can be mitigated either through diversification or transfer. The former involves a portfolio-based strategy designed to reduce overall risk by combining a variety of assets which are highly unlikely to behave in an identical manner. The latter involves the movement of risk to external counterparties that are better positioned to hold those risks, on account of being well capitalised and well diversified entities.

Entities ultimately bearing such risks may be termed “aggregators”. Any well-functioning financial system should have robust risk aggregation capacity with a range of institutions, such as commercial banks, insurance companies and mutual funds, having the appetite and the ability to play the role of aggregators.

Characterising the present state of risk aggregation in India

In discussing the current risk aggregation landscape in India, following features stand out:

• The size of the Indian financial system is not adequate to meet the needs of the real economy.
• The landscape is dominated by government owned institutions or directly by the government.
• There exist multiple regulators governing the field with absence of effective mechanisms for inter-regulatory exchange of information. Different substantive rules lead to a skewed playing field for different types of risk aggregators.
• Senior management compensation structures dominated by stocks and options are potentially faulty as they do not incentivise risk management.
• Mechanisms for dispute resolution are not sufficiently well developed.
• Positive regulatory developments are underway, including the setting up of the Financial Stability and Development Council to prevent inter-regulatory conflict, RBI guidelines permitting credit derivatives for corporate bonds, SEBI guidelines allowing exchanges to list securitised paper, and the setting up of a Financial Sector Legislative Reforms Commission to comprehensively rewrite the existing set of laws pertaining to the financial sector.

Watch video of Dr. Ajah Shah‘s keynote address on Risk Aggregation.

Key Themes

Ideas that emerged on aggregation from participant discussions at the Financial Systems Design Conference may be organised along the following themes:

Role of the government as a large risk aggregator

The first line of thinking advocated a neutral role for the government in this space, with it playing the role of an arbiter who sets the ground rules and not being involved in the capacities of owner, provider or interested party. The contrarian view took the stance that activities that have a “public character” can be achieved only if the government has ownership.

Regulation and management of systemically important risk aggregators

Participants stressed the need for effective regulation and management to ensure that risk aggregators are able to deal with plausible stress events, especially for “systemically important” entities. The need for norms stressing levels of capital adequacy was particularly emphasised.

Risk management capability within the financial system

In this context participants discussed effective risk management mechanisms. The participants debated outsourcing risk management to third party experts like rating agencies versus building internal risk management capabilities.

Vision statement

Following the discussions along these key themes, participants formulated the following vision statement for Aggregation:

“Our vision for risk aggregation in the Indian financial system is one where aggregators are numerous enough, large enough, and have the risk management capabilities to evaluate, price, hold and manage the diversity of risk originated from the real economy.”

A more detailed summary of the deliberations on Aggregation is available here.

The first IFMR Conference on Financial Systems Design was held at our office in Chennai on Aug 5-6, 2011. The objective of the conference was to engage in an in-depth conversation on the future of the Indian financial system and some of the underlying design challenges being faced in various markets.

In order to retain a functional perspective, the conference was organised into three main sessions for discussion — Origination, Transmission and Aggregation — as three broad buckets of questions and concerns – one involving customers and customer protection issues, the other involving markets and derivatives and the third involving large, nationally important financial institutions and systemic risk concerns.

In the introductory session, Nachiket shared some of his thoughts on the Indian financial system.

The format of the conference allowed for collaborative work and visioning by the participants. Following a lead presentation for each of the main sessions that identified key themes, each table came up with vision statements for that theme which were then shared across the room and discussed. Following the visioning, there was an exercise to identify the pathways for us to get to the desired end-state. These pathways were categorised into Research, Regulation, Innovation and Public Infrastructure.

The conference yielded very rich discussions and the participants identified several interesting issues and priorities for the Indian financial system. In the following weeks, we will share the summary of discussions and identified pathways for each of the three sessions.

In a conversation with Nachiket Mor and Bindu Ananth, Dr. Viral Acharya, Professor of Finance at the New York University Stern School of Business, speaks on issues centring around aggregation of risks in a financial system, with an emphasis on those particularly relevant to the Indian financial system.

Dr Viral Acharya in conversation with Bindu Ananth

In particular, Dr. Acharya fleshes out three salient, and against-the-grain-of-current-thinking, points.

One, while scale does play an important role in allowing aggregators (Banks, Insurance companies, Monolines, other Government Sponsored Enterprises) to efficiently discharge their primary function as warehouses of risk, financial system designers must guard against the possibility that that systemic nature per se does not become a source of value creation (ie. through them consequently knowing that they have become “too big to fail” and therefore beginning to take on higher risk). To guard against this, financial system designers must thus encourage a diverse set of institutions to come up to play the role of aggregators. Thinking through resolution mechanisms for aggregators upfront and setting those rules of the game are extremely crucial. While corporate bankruptcy has become clearer post-SARFESI, individual and aggregator resolution mechanisms remain unspecified in India.

Two, while ensuring capital adequacy for aggregators is vital, Basel-type static capital requirements may not be adequate. He speaks at length about the formula proposed by him and others at the Stern school regarding setting capital adequacy in a manner that ensures aggregators remain well-capitalised in “plausible but sufficiently severe stress scenarios”. But where worst-case outcomes do materialise, two options are open: (a) allowing some aggregators to fail; and (b) using taxpayer’s money (ex-post, not ex-ante) to inject public capital into the system as the last resort.

Three, a fine balance needs to be struck between rigidity and flexibility in credit enforcement proceedings (be they at the ultimate firm / individual level or at any other level in the chain of transmission of risk). Too rigid an approach would defeat the purpose of the entire enterprise (namely, the orderly transfer of risk at market-determined prices to those who are most willing to hold it); too flexible an approach may lead to laxity in honouring of commitments. At the same time, he strongly emphasises that in an end-game situation where there is a “big blow-out”, the ultimate bearer of the risk has to be the aggregator – in other words, the present blame game in the American context on the “originate and distribute” model being flawed is invalid as the better option is to ensure that the design encourages aggregators to price in the cost of their being the ultimate risk-holder and thus impose arms-length discipline on originators (who are themselves of course ensured to be adequately capitalised, and who do provide credit enhancement in their risk-transfer transactions with aggregators to ensure their local information is appropriately factored in).

Dr. Acharya signs off making a few further points of importance to the regulatory structure of India: (a) that there might be a need for a separate regulator of systemic risks/systemically important institutions (in the way Dodd-Frank legislation has done for the US) – over and above prudential regulators and consumer protection regulators; and (b) states in India’s federal set-up should be subject to a minimum, non-negotiable standard in matters such as consumer protection to prevent a race-to-the-bottom situation where they end up competing to dilute regulation (c) the lack of a level playing field between private and public sector financial institutions will need to be addressed.

The entire chat transcript is available here. Prof. Acharya has recently co-authored a book “Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance” that looks at the US experience with GSEs in detail.

- G E Balajee, IFMR Blog Team

The recent securitisation transaction completed by IFMR Capital was a landmark deal in the microfinance sector. It was a Rs. 108 Mn rated securitisation transaction backed by microloans originated by Grama Vidiyal Micro Finance Limited. This is not the first time that a transaction such as this has been executed by IFMR Capital. What makes this transaction special is that, this is the first time private wealth investors have invested in microfinance. In other words, this is one of the best examples of the wealth of the richest being directed towards the poorest in the country.

IFMR Capital already has some innovations in the area of securitisation to its credit. Its Multi-Originator (MOSEC) structures have focused on smaller but high quality microfinance institutions (MFIs) that deserved capital market exposure. It has also arranged the first mutual fund investment in microfinance. “We have always been on the lookout for new investor classes for our clients”, says Vineet Sukumar, who heads Origination and Treasury at IFMR Capital.

Though a lot of private investors would have liked to invest in the sector, lack of publicly available information about the MFIs has been an important reason that has kept them away. “Efforts by IFMR Capital in collecting granular data, success in transaction placement, and engagement with a strong private wealth advisor like Avendus has ensured that a good start has been made”, explains Meenal Madhukar who heads Investor Relations at IFMR Capital.

While a commercial institutional investor has the resources to verify information about a company before investing, a private wealth investor relies on, and is very sensitive to, public opinion and information released in the press. Ever since SKS IPO filed its draft red herring prospectus, the sector has been beset with negative press coverage. It is well known that bank funding to MFIs had dried up after the Andhra Pradesh (AP) ordinance. If traditional sources were apprehensive of the future of the sector, private investors were even more wary of investing in the sector.

“This investment, coming in the backdrop of the AP Ordinance and liquidity shortfall in the sector, conveys a strong message that the sector is able to diversify fund sources even at such tough times. Further, funds from such non-traditional sources are being availed at commercial rates that are well comparable with other fund sources. Separately, IFMR Capital’s success in inculcating a new investor class into the sector at this time underscores the success of our business model and strategy”, says Vineet.

So what does this do to the microfinance sector? The earlier securitisation transactions arranged by IFMR Capital have consistently helped smoothen out the seasonality of the funding pattern that is prevalent in the MFI sector, or for that matter, even in the priority sector as a whole.

“This opens up a vast opportunity for microfinance. In general, private wealth investors have higher risk-taking ability and able to invest in times when mainstream investors take a back seat. So this deal not only opens a large investor base, but also a diversification opportunity to raise funding in tougher times”, explains Meenal.

This investment by private wealth investor is expected to form the base for more High Networth Individuals (HNI) and family offices to evaluate this sector. Family offices are substantial sources of funds in today’s market. While microfinance presents a good opportunity for social investing with commercial returns, the disclosures, monitoring and transparency associated with a structure of this nature makes the transaction attractive.

Here’s hoping that this transaction helps scale up private wealth investment into microfinance.

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