Guest Article by : Jayshree Venkatesan, CEO, IFMR Mezzanine and Vineet Sukumar, Head, Treasury and Origination, IFMR Capital
Background
The Indian microfinance sector has seen a series of rapid changes in the past decade. The sector grew rapidly in the period 2004-2009, with an average increase in number of clients year-on-year being 91%, while size of portfolio outstanding grew by almost 100% Y-o-Y[1]. During the same period, one also saw a number of Non-Banking Finance Companies (NBFCs) being established with a corresponding spike in interest from private equity investors. For instance, between 2007 and 2009 alone, the number of systemically important NBFCs, i.e., those with a balance sheet size greater than INR 100 crores (USD 20 mn)[2], grew from 7 to 25. Much of this growth can be attributed to increase in the number and quantum of equity investments during the same period. In FY 2009-10 alone, a total of 17 deals were closed, valued at INR 8.67 billion[3] (USD 173.4 million).
The other impact of the inflow of commercial capital to the sector was the expansion of MFIs beyond the southern states. For instance, in 2005, 48% of all clients were concentrated in the state of Andhra Pradesh. At the end of FY 2009-10, MFIs were present in 436 of the 621 districts in India, including 70% of the poorest districts[4]. Access to capital led MFIs, both existing players and new entrants to begin operations in the North and North-east, in some of the poorest districts of India. MFIs also began expanding to states like Orissa, Bihar and Uttar Pradesh. Utkarsh Microfinance operating in eastern Uttar Pradesh and parts of Bihar is one such example of this expansion.
The funding space today
In
the months succeeding the AP ordinance in October 2010, there has been a
steady decline in the number of equity investments made in the sector.
The equity deals at the close of FY 2010-11 were valued at about 41% of
the previous year i.e. about INR 3.55 billion (USD 71 million).
In December 2011, the Reserve Bank of India (RBI) issued a circular
that recognised the existence of entities called “NBFC-MFIs”, leading to
an increase in investor confidence in the sector. This was manifested
through the resumed equity investments to the sector. In the FY 2011-12,
eight MFIs received equity investments. While equity investments in
2010-2011 were lower than the previous year, it should be pointed out
that the sector has also seen investments from reputed foreign investors
such as IFC, DWM and Citi Ventures Capital. The recent Ujjivan deal is
significant because it saw the participation of Wolfensohn Capital
Partners, promoted by former World Bank president James D. Wolfensohn,
and a first time investor in the sector. The transactions in the post AP
ordinance period indicated that equity investors still believe that
select high quality institutions can do well. However, due to
significantly lower valuation multiples, cost of equity is much higher
for MFI promoters.
Debt funding has also seen a simultaneous drop. The top 25 MFIs
reported a growth rate of 43% for borrowers and 76% for portfolio in
2009-10. In comparison, the figures for 2010-11 are 7.5% for borrowers
and 7.2% for portfolio growth[5].
The estimated total size for micro-credit in India is about INR 3.3
trillion (USD 66 billion) and 650 million borrowers (~53% of the
population that does not access formal financial institutions of any
kind)[6].
MFIs currently meet about 6% of this demand. At the beginning of FY
2012-13, we are still at under 50 million borrowers and INR 200 billion
(~ USD 4 billion) of portfolio outstanding.
On comparing the pre AP ordinance period with the post AP ordinance
period, it is observed that the share of MFIs that had portfolio
outstanding greater than INR 10 billion has dropped to 58% from 67% (see chart 1 above)[7].
Even of this 58%, about one third is estimated in corporate debt
restructuring (CDR) proceedings. The direct implication of this
observation is that a much higher share of the future growth is likely
to be met by the Tier 2 and Tier 3 MFIs (defined respectively as MFIs
with a portfolio size of INR 5-10 billion and INR 1-5 billion), who have
continued to display high quality origination in the past year.
Potential for hybrid capital
With recent regulatory changes imposing a margin cap on MFIs,
promoters are re-examining their business models with the objective of
increasing customer reach, reducing operating costs and increasing
branch / staff efficiency. With the advent of credit bureaus, MFIs have
the benefit of external risk infrastructure but need to work harder at
finding new customers.
Under conservative growth scenarios, our estimates indicate a
cumulative equity requirement of over INR 5 billion (~USD 100 million)
over the next 2 years for the universe of Tier 2 and Tier 3 MFIs[8].
A quick analysis indicates that this entire requirement can be met
through Tier 2 capital instruments. This indicates an opportunity to
re-look at the capital structure of MFIs.
In order to attain their complete potential and transform their
businesses to retain competitiveness, MFIs today require access to
‘patient’ capital, i.e. capital infusion from a source that does not
impinge upon the organisation’s ability to take necessary business
decisions and retain focus on the long term. Hybrid capital would
address all the issues of being ‘patient’, providing the necessary
capital benefits while at the same time allowing the MFI promoter to
retain control on the business.
With banks resuming lending to the sector, albeit cautiously, a
well-capitalised entity is likely to attract bank borrowings.
Availability of long tenor hybrid capital would provide the necessary
impetus for high quality originators to improve their creditworthiness
and attract debt capital.
Conventional subordinated debt assumes immediate leveraging ability,
which MFIs lack at present. In the context of capped asset rates, MFIs
would require time to reduce operational ratios to a more comfortable
level during which it is necessary that cost of funds remain within
acceptable levels. Hybrid capital is a structural solution that provides
capital benefit without imposing an immediate high cost on the investee
company.
Further, MFIs require equity-like capital that could be leveraged for
further growth, without the dilution that accompanies equity infusion.
In the current context, with valuations at medium / low multiples,
equity infusion would imply rapid dilution. Our estimates indicate that
this dilution can be as high as 66%, given current valuations and demand
for growth capital. Delaying early dilution is important to build
robust organisations since it ensures that the promoters play an active
role in building the organisation. Too little ‘skin in the game’ could
potentially also lead to governance challenges as the promoter’s stake
and hence commitment towards the organisation might be insignificant.
Therefore, the need for the hour is well structured hybrid capital,
possessing equity-like characteristics while at the same time permitting
promoters to retain stake and providing MFIs time to adapt to the
current regulatory and funding environment without diluting the strength
of their origination process.
References
1. ‘Inverting the Pyramid’, Third Edition, Intellecap Publication
2. Assuming USD 1 = INR 50
3. Based on various press reports
4. Ibid
5. M-CRIL report dated November 2011
6. ‘Inverting the Pyramid’., op cit
7. Based on IFMR Capital estimates
8. This includes only NBFC-MFIs and does not take into account NGOs /
non-profits. Further, this analysis assumes a growth rate of 30% for
Tier 2 MFIs and 75% for Tier 3 MFIs over the next 2 years (which is
lower than the growth achieved in H2 2012)
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