By Satya Srinivasan, IFMR Blog Team

Recently, we flagged off our new blog series on financing options for non-bank originators with our first post that explored debt-funding options in some depth. We progress southward on the balance sheet this week to explore financing instruments that are quasi-equity by design – mezzanine finance. This is the second installment in a series of blog posts that explore financing options for non-bank originators.

Providers of debt often look to cushion their risk with equity. While the microfinance sector has seen a growth in private equity funding in the past decade, this infusion has been restricted to the larger organisations in the sector. There are several hundred organisations in the Indian microfinance sector that are unable to attract equity due to their legal structure. This either results in limited access to debt funding or a situation of over-leverage, which could threaten the sustainability of the business in times of a crisis. In a situation where the legal structure is not conducive to equity investments or early equity investment dilutes the promoter’s stake, one has to look at capital structures that provide similar levels of comfort to senior debt providers.

Mezzanine finance is a hybrid variety of capital that straddles the vast and unexplored space between senior debt and equity. Mezzanine instruments combine various characteristics of debt and equity. The risk classification of these instruments depends on whether they have predominantly debt or equity characteristics and can be classified accordingly within the mezzanine space. For instance, the instrument could be in the form of subordinated debt, which has predominantly debt characteristics due to a fixed repayment schedule. The other example of a mezzanine instrument is preference shares, where the mezzanine provider takes risk which is only slightly less than an equity provider since the holder of the shares get preference when dividend is paid out. In the event that the business does not make profits, a preference share holder does not get a return, while the subordinated debt provider would still get the fixed payout that was decided.

One has to look closely at mezzanine debt to understand what gives it a hybrid nature.

Mezzanine debt is subordinated to senior, unsubordinated debt capital but ranks ahead of equity in the capital structure. The subordination to senior debt happens in two ways – senior lenders are often times, secured and subordinate mezzanine debt is unsecured. Secondly, the tenure of subordinate mezzanine funds is longer, which provides a cushion to senior debt. This means that in case a business goes bankrupt, the senior lender recovers dues first, followed by the mezzanine provider and finally the promoter/equity provider gets his/her share. Obviously, since the risk is higher in mezzanine instruments, the cost of funds tends to be higher.

Mezzanine financing, while more expensive than senior debt, also poses certain advantages to non-bank originators (established as NBFCs) that balances the cost of raising capital -

1. Mezzanine funds, due to their innovative structure are classified under Tier II capital. Non-bank originators can leverage this capital with banks to raise additional funds. This effectively reduces the total cost of funds. For example, Tier II capital can be used to leverage bank finance up to 5 times. Hence for every 1 rupee of mezzanine debt raised, a maximum of Rs 5 can be raised as senior debt from a bank. If the interest rate for the mezzanine debt is 30% and the interest rate for the senior debt is 12%, the total interest paid would be 90 p on total debt of Rs 6. This is 15% of the loan amount and only 3% more than the cost of debt from banks.
2. Mezzanine funds can also help in adhering to capital adequacy norms. For instance if the total risk weighted assets of a non-bank originator is Rs 100 and its networth is Rs 10. The CRAR (Capital to Risk-weighted assets Ratio) is 10% which is below the prescribed norm of 15% (effective from April 2011). If the non-bank originator were to go for an alternate capital structure with Rs 10 equity and Rs 5 worth sub-debt then the CRAR would become 15%, which is the prescribed, minimum CRAR.

Non-bank originators cater to households with highly complicated financial lives and the slightest shift in the provision of continuous, flexible, reliable and convenient access to financial services can trigger a setback in the intricate financial lives of low-income households. It becomes imperative therefore for a rigorous and effective due diligence process to be in place before access to mezzanine debt is made available to non-bank originators. IFMR Mezzanine Finance Private Limited, whose objective is to provide deserving non-bank originators access to long term funds through mezzanine products, has a thorough and comprehensive due-diligence process. It scrutinises and defines standards for a range of parameters including leadership, financial performance, processes, products and strategy.

Saurabh, from IFMR Mezzanine who works for the due-diligence team, sums up the characteristics of the “ideal candidate” to receive mezzanine funding, as we put it to him – ‘good promoter background, sound governance, standard processes and robust systems, established lending relationship with a bank which will be crucial to their ability to leverage the mezzanine funds, sound audit and internal control systems and finally good risk management practices’, he says. A little surprised by the weightage to financial parameters in the exhaustive list, we ask him if an indicator like PAR (PAR or Portfolio at Risk is the outstanding amount that is overdue past a certain period of time and is measured by dividing the Outstanding amount on loans overdue past a given date by the Gross loan portfolio outstanding) does not have any influence on their assessment of how strong the non-bank originator is. ‘PAR is important for a short term lender. From a long term stability point of view, it is important to examine the volatility in PAR. A high volatility is an alarming indicator, while a consistent PAR, while high is still indicative of stable processes’, says Saurabh.

Mezzanine funding is an innovatively engineered financing option, which seeks to offer non-bank originators much-needed capital. Due to its unique structure mezzanine funds can be employed to fuel growth, to seek standard funding and even to adhere to regulatory capital norms without any dilution in the promoter’s stake. Mezzanine financing, which was earlier only part of buy-outs and venture capital deals, can now fill the capital vacuum in the microfinance sector, provided, investments are backed by a rigorous due-diligence process that evaluates not only financial performance but also lays down benchmarks for corporate governance, best practices, systems, processes, risk-management and strategy.

With inputs from Jayshree Venkatesan, IFMR Mezzanine

By Jayanth Srinivasan, IFMR Mezzanine Finance

Last week witnessed the 4th edition of the annual College of Agricultural Banking – Centre for Microfinance conference on “Microfinance: Translating Research into Practice”, held in Pune. With the spectre of the crisis in Andhra Pradesh hovering in the background, the proceedings featured intense discussions over the future shape of the microfinance space in India involving over twenty thought-leaders – including researchers, practitioners and representatives from various commercial banks and the Reserve Bank of India.

While a detailed, session-by-session account of the discussions is featured here, two salient themes emerged from the two-day conference which deserve closer mention.

First, the regulatory morass affecting the space came in for sharp criticism. While many experts deliberated at length on the possible ways in which existing regulatory mechanisms could be expanded / fine-tuned / overhauled to meet the unique concerns of the microfinance sector, and while much lamenting took place regarding governmental failure to take cognizance of the work of past task-forces which had studied the issue in some depth, broad agreement was nevertheless forged on the principles to which any new post Andhra-crisis framework must fulfill:

(a) state-level legislation to be avoided: with the objective of preventing the mushrooming of a chaotic patchwork of diverging laws complicating operations of MFIs across India’s federal set-up, as well as nipping scope for any form of legal arbitrage in the bud

(b) customer protection to be strengthened: given that inherent political risk cannot be wished away, strengthening rights of micro-borrowers through appropriate administrative means would serve as the ideal safety valve

(c) growth of the sector itself and scope for innovation to be preserved and encouraged: with the government/regulatory bodies introducing clarity on the sector’s role in filling the gaps in the existing financial services infrastructure available in the country and at the same time making adequate provision for mitigating systemic risk

Secondly, the normative need for service providers in the sector to transform from being purveyors merely of micro-credit products to becoming financial services intermediaries offering a bouquet of products. Pointing out the deleterious aspects of the single-minded focus on pushing loan products with scant regard for the actual “wealth management” needs of the customers, several participants predicted that it was time for a change in the current delivery mechanisms. Possible transformations included regional institutions specializing in servicing local geographies a la the IFMR Trust’s “KGFS” model, and offering a range of products (such as micro-pensions, insurance, investment products et al) tailored to meet the actual needs of individual customers. Technology, in the form of “m-banking”, the interface with the UID eco-system and the like, would play a significant role in accelerating this shift.

While the repercussions of the Andhra crisis in terms of alerting stakeholders to the need for the sector to reinvent itself was clear for all to see, and though differences remained on the precise route to be taken going forward, it was nevertheless heartening to see all participants consciously strive to achieve common ground in conquering the challenge of meaningful and sustainable financial inclusion of underprivileged sections throughout the country.

- IFMR Blog Team

Puneet Gupta is restless and visibly excited. The last ten days have been the culmination of many days’ efforts in creating access to finance to deserving high quality Microfinance Institutions (MFIs). IFMR Mezzanine Finance Private Limited (IFMR Mezz), a part of the IFMR Trust eco-system, which is headed by Puneet, has just disbursed an amount of Rs. 10 million to Patna based Saija Finance Private Limited (“Saija”), an investment that had enough reasons to celebrate.

“We are thrilled!” says a beaming Jayshree Venkatesan, who heads the origination team at IFMR Mezz. What makes this investment special; we are tempted to ask her. “Well, a lot of things actually” she replies. “This investment marks our entry into the microfinance sector. We have been working hard for a while now on the structure and we have built one so unique that we are the first company to specialise in mezzanine financing for the microfinance structure anywhere in India.”

Quasi equity funds

What could be unique about an investment in an MFI? “The funds were infused in the form of unsecured, sub-ordinated debt over a period of 7.5 years, with quarterly interest payments and a bullet principal repayment at the very end. The subordinated debt will qualify as Tier II capital or quasi equity for Saija”, Puneet explains.

In the absence of easy access to debt capital, NBFC-MFIs have historically preferred equity investments by diluting their stake at an early stage. However, this is an option that is available only to a few large MFIs in the sector. Smaller MFIs, either due to their size, vintage or legal structure, are unable to attract equity investments, which severely impairs growth or results in over-leverage of their existing equity. IFMR Mezz aims to provide quasi equity that addresses this gap and allows for growth without dilution of equity stakes.

Rigorous Due Diligence

Of course, it was not a cake walk for Saija, which had to go through a rigorous due-diligence process. The investment was preceded by a multi-staged scrutiny process. IFMR Mezz has a pre-due diligence check list that had to be satisfactory before proceeding further. Saija’s documents were in order and the secondary data checks were positive. Next, IFMR Mezz dispatched a team to scrutinize the quality of operations on-site to remote districts of Patna and Arrah in Bihar. “We would follow the same stringent due-diligence process for all our future investments as well” says Suman Saurabh, who was part of the due-diligence team. “The investment committee of IFMR Mezz then bases its decision on the report that we prepare and if the committee finds it satisfactory, the funds are sanctioned.”

Sample this to understand the intensity of the due-diligence – over fifteen MFIs were considered for a subordinate loan, of which only one-third qualified for an on-site inspection by IFMR Mezz. Saija was the fourth MFI to be visited by IFMR Mezz and yet is the first investment to be completed.

Net cost of funds

The intense scrutiny of the processes is not for nothing as the MFI has a lot to gain for once the investment is made. Mezzanine financing ensures that the growth of the MFI is not affected due to lack of funds and that too without diluting the stakes of the promoter. It also ensures that the net cost of funds raised through this route is lower than from equity sources. For instance, if Saija is able to leverage IFMR Mezzanine’s infusion of funds up to 5 times, the effective cost of funds for the transaction increases by merely 150 basis points over cost of debt.

“What this means to us is that it not only shows that our systems are strong but also that we can now be more confident about the future when we raise more funds” says an upbeat Mr. Sinha, the promoter of Saija. “This takes away a lot of pressure and allows me to focus on the growth of the company. Now that this is taken care of, come April next year, I will completely focus on delivering new products like insurance and other products to our clients” he adds.

With the microfinance sector recently running into turbulent times, complaints of an unjustified liquidity tightening in the system have been doing the rounds. But IFMR Mezz chose this very circumstance to reinforce its commitment to the microfinance sector. A new partner in growth has arrived indeed.

To know more about mezzanine finance, visit mezzanine.ifmr.co.in

- By Balajee GE, IFMR Blog Team

“In 5 years, our village would have metal roads, hospitals and old-age homes to take care of the poor, the poor women who work for others now would become employers, giving employment opportunities to many other under-privileged people. We would become a model-village on self-sustenance.”

No, this is not a page out of an election manifesto nor is it a speech by a politician or a government official. This was a vision of a young MFI employee who unleashed his dreams during an Appreciative Inquiry process that we facilitated last week in a small MFI. A remote municipality in rural Andhra Pradesh, Yemmiganur, an hour’s drive from Kurnool (so remote that there was only this one MFI operating in this geography) was where I realised the power of dreams and the potential that lies untapped in rural India.

A big thanks to IFMR Mezzanine team (especially to Jayshree, Irfan and Jayanth) that was willing to experiment in what was otherwise a routine due-diligence process. I was privileged to accompany them and facilitate this AI process for the ten employees of the MFI. We were riding high on the success of our AI summit and wanted to see it applied over a smaller organisation.

Just before lunch, the Mezzanine team concluded the two-day due-diligence process (which in itself was a fascinating experience and a topic worthy enough to qualify as a separate blog post). Ushering all the employees into one room, we split the crowd into three groups. We could sense the participants (including the CEO) were a bit hesitant, as they had not gone through anything like this before, especially amongst their own colleagues. Sitting cross-legged on the floor, they started the AI process by interviewing each other and discussed their high-points in their life and in the job and what made it possible.

Before the session started, one of the participants had asked me what time it would all end, clearly he wanted to see this through and get on with his daily work. But later, when we went around asking them to close their interviews and get ready for the presentation, almost all of them were asking for more time. They were still getting to know their colleagues better and they were enjoying it!

While they were presenting the positive core of strengths of the MFI, there was an evident sense of pride in, not just what they had done but also, what their colleagues had done. They were genuinely appreciative of everything they had discussed.

The next exercise was something that turned out to be quite a revelation to all of us, including the CEO of the MFI. We asked them to dream ahead and come up with a vision for 2015. One hour and lots of drawings and paintings later, the teams went up to share their dreams. We were expecting the groups to share what the MFI would like in 5 years, but the groups had other plans.

Their dreams went way beyond the MFI’s growth. They presented plans to make their villages ‘model villages’. In their dreams there was better infrastructure, better facilities in the villages, better pension plans, and better schools. In 5 years, employees would become self-dependent employers, giving employment opportunities to others. And they tied all this neatly back to their MFI saying they would become an integral part of every household in the state, so much so, that even if the children didn’t take care of their parents, the MFI would!

Clearly, the MFI employees were on a high after dreaming ahead and visioning what the future would look like. It was evident from their repeated words of appreciation to us for having taken them through this process.

The employees had a clear picture of the future in their mind

One of them confessed that, usually when there was an investor visit, they would hope there was no feedback from them and would just wait for the investor to leave. But here, they began to see us as potential partners and not just as investors. They asked for feedback and were keen on learning from the inputs the Mezzanine team had for them post due-diligence.

The AI process had somewhere struck a chord with the MFI employees. It seemed to make the due-diligence process a more welcome exercise and most important of all, it unleashed some ideas from the employees that were powerful not just in scheme but in terms of scale as well. By the end of the process, the spirit of the organisation came out and the fact that they were there for the greater good of the society clearly stood out.

The most striking aspect of the day was the reinforcement of our belief based on which IFMR operates. That the rural folks are very clear in what they could do, given the resources. All they need is access to finance. The rest, they can take care of themselves.