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BW Businessworld

Tripped By The Domino

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In November 2011, the 11-member team of Lok Capital, convened in Delhi for an annual conference with its sponsors, also known as limited partners. After dispensing with routine business, discussions zeroed down to one topic: the country's troubled microfinance sector. The Gurgaon-based venture capital firm, which invests in companies that cater to the bottom-of-the-pyramid, has eight microfinance institutions (MFI) in its portfolio, which account for $18 million in investments.

Compared to the cumulative $731.6 million invested by venture capital and private equity investors in Indian MFIs so far, $18 million seems insignificant. But for Lok and its limited partners, it represents nearly 82 per cent of the firm's maiden fund, Lok Capital I. What makes it even worse is that the portfolio includes Bhartiya Samrudhi Finance, or Basix, and Spandana Sphoorty Financial, two MFIs currently struggling to stay afloat.

"On paper, the erosion in the valuation of our portfolio has been drastic," says Vishal Mehta, co-founder and partner at Lok Capital. Before misfortune visited the microfinance sector about 12-18 months ago, investors such as
Lok Capital were looking at gains of over 100 per cent from such investments. Now, over the next 3-5 years, Mehta expects returns to be a modest 10-15 per cent of his fund's original investment.

In Mumbai, Vineet Rai, founder and CEO of Aavishkaar Venture Management Services, which has invested over $18 million in MFIs from the Aavishkaar Goodwell India Microfinance Fund, echoes a similar sentiment. "It is quite clear now that 100 per cent returns are unrealistic. You have to settle for 18-22 per cent," he says.

Regional Domino?
The problem for these investors has a geographical core: the state of Andhra Pradesh (AP). Nearly one-third of the estimated Rs 30,000 crore MFI market in India was until recently concentrated in AP. In October 2010, the state government issued an ordinance (that later became law) to restrain the manner in which MFIs in the state functioned.

Among other restrictions, MFIs are now not allowed to collect repayments on loans on a weekly basis and new loans cannot be given to borrowers with pending loans. The state government's move followed allegations that borrowers in certain quarters had been driven to suicide by coercive loan collection methods used by MFIs. In a business model where the frequency of repayments is the lifeblood, it was a deathly blow.

Following the AP government's move, several large MFIs headquartered in the state suffered heavy losses. These included Hyderabad-based SKS Microfinance, the country's only listed MFI, and Basix. SKS reported a net loss of Rs 427 crore for the latest financial quarter ended December 2011.  Both companies have seen losses mount since October 2010.

A senior official from SKS says the company is cleaning up its books. "We are writing off losses," he says. "In the first two quarters of financial year we have booked close to Rs 600 crore in losses, and this will continue in the coming quarter. This is because over the last year, our recovery rate in AP has dropped from about 98 per cent to just about 10 per cent."

In the first half of fiscal year 2012 ended September 2011, SKS' loan book shrank to  Rs 2,635 crore, from Rs 4,148 crore in March 2011. Banks have stopped lending to MFIs, and that is a huge reason for the shrinkage, despite the enormous demand, estimated at Rs 5 lakh crore.

But the big shocker came in July 2011, when Basix, the country's oldest MFI, told a financial daily that the company was on the verge of shutting shop; it had accumulated bad loans of up to Rs 450 crore, the bulk of it in AP. The company needed fresh capital infusion of nearly Rs 1,500 crore (Rs 440 crore in equity and Rs 1,000 crore in bank loans) to enable it to lend in other states and balance its losses in AP.

"Investors who had large exposures to AP are looking at huge write-offs today," says Manoj Kumar Nambiar, head of IntelleCash, a Mumbai-based MFI incubator. "Only a handful are in the money," says another longtime veteran from the MFI business, "especially those that have no AP business." Most have lost about 70-80 per cent of their investments.

All And Sundry
Apart from Lok Capital and Aavishkaar, other major investors in the sector include Hyderabad-based Caspian Advisors and Bangalore-based Elevar Equity. Caspian, via its Bellwether Microfinance Fund and India Financial Inclusion Fund has invested in 12 MFIs (as listed on its website), including Basix and Trident Microfin in AP. Caspian founder and managing director S Vishwanatha Prasad did not respond to emailed queries from BW. Elevar has investments in five MFIs, including SKS. In addition, it has also invested in four other companies on behalf of the US-based Unitus Equity Fund, whose investments it manages in India.

These investors have large exposures to the MFI sector because of their specialist focus on bottom-of-the-pyramid businesses. However, the sector has also attracted considerable funds from conventional investors as well. Sequoia Capital India, which is a sector-agnostic investor, has invested nearly $38 million in MFIs, according to private equity investments database VCCEdge. Similarly, Matrix Partners India has sunk nearly $35 million in the sector, says VCCEdge. Sequoia's and Matrix's big bets include SKS and Basix respectively.

In April 2011, five MFIs agreed with banks to undertake a corporate debt restructuring (CDR) program; their loans were given an exemption by the Reserve Bank of India(RBI) from having to declare the bad loans (that would be restructured) as non-performing assets, or NPAs. Basix and a couple of others did not participate then, choosing to depend on their bankers to fund them through difficult times. Now, for any new CDR plan, the RBI will not give banks the exemption from declaring the loans as NPAs.

"Basix will require capital, and the company has acknowledged the need to go in for a CDR," says N.K. Maini, executive director at SIDBI, which has a little over 6 per cent of Basix's equity. "Discussions between the bankers — HDFC Bank, Corporation Bank and Axis Bank — and the Basix board are currently underway."

Significantly lower returns and potential write-offs are not the only rude reality that investors in Indian MFIs face today. On December 2, 2011, the RBI issued the Non Banking Financial Company (NBFC) – Microfinance Institutions (Reserve Bank) Directions 2011. For MFIs that planned to become NBFCs, the barriers just got higher.

Net-owned funds, or equity capital is now Rs 5 crore at the minimum, with a capital adequacy ratio of 15 per cent; in other words, Non NBFC-MFIs must have Rs 15 in equity capital for every Rs 100 in loans. Interest rates have been capped at 26 per cent, and the gross margin at 12 per cent. Microfinance is a very high cost business, with collection and transaction costs at almost 10 per cent of the margin. To retain their NBFC-MFI status, MFIs cannot make automobile or gold loans if they want access to bank funding.

"That cuts growth," says Ramraj Pai, director at Crisil Ratings. "So MFIs cannot make the kind of superlative returns they made in the past." It also means that to stay reasonably profitable, the cost of funding for MFIs cannot exceed 14 per cent. In a high interest rate world, that's hard to manage.

"The RBI caps are okay for an organisation that has achieved a certain scale," says Nambiar. "For newer entrants, it means that instead of taking six months to break-even, it will now take a couple of years." MFIs that are in the game for the long term will need to have deep pockets. "In a way it will test the commitment of both the MFIs and their venture capital investors," Nambiar adds.

Future Strategy
The cue to how investors and their portfolio companies may have to navigate the future came when SKS Microfinance, the country's sole listed MFI, announced plans to diversify into non-MFI businesses. The Hyderabad-headquartered company will now deal in gold loans and insurance, among other financial products and services. SKS' diversification strategy, of course ,follows the recent exit of the company's founder and chairman Vikram Akula, who resigned last month to pursue other business interests. Akula's exit was preceded by a prolonged period of instability at the company, that began with its listing in August 2010.

Meanwhile SKS plans to change its business model for growth. About 10 per cent of its loan book is asset-backed lending, like for gold jewellery, for instance (the RBI's new rules stipulate that this cannot exceed 15 per cent of the loan book. From April 2012, the company plans to split the asset-backed lending business into a separate entity, a wholly owned subsidiary.

"We have been running the asset backed business as a pilot project since May 2011," says a senior company official. "Now, we can independently ramp-up that business." But 72-year old George Alexander Muthoot, managing director of Muthoot Finance is not so sure. "Many are planning to get into the gold loan business as demand is there on a sustained rise," he says. But it's not easy to make inroads and gain market share."

Given all its troubles, will the MFI business die out? No, say many; in fact, the worst, they say, may be over, as MFIs are booking losses, cleaning out balance sheets, and looking for growth outside AP.

"Think about it as a comma, not a full stop," says Crisil Ratings' Pai. Short-term funding is a problem for most of them just now, but MFIs will adapt quickly to the new RBI guidelines and develop new business models. "They will grow, but the unrealistic expectations will have to come down," Pai adds.

February 2012 will be an important milestone: the AP High Court will hear the SKS Microfinance case challenging the Andhra Pradesh Micro Finance Institutions Act 2011. The company is challenging dual regulation by the RBI's new NBFC-MFI guidelines on the one hand, and the AP government whose MFI Act treats MFIs as money lenders, on the other. It is also challenging one of the provisions of the AP MFI Act that requires every loan application made by self-help groups to be cleared by the local district rural development authority.

"Now, 100 per cent returns are unrealistic. You have to settle for 18-22 per cent," says VINEET RAI Founder & CEO, Aavishkaar Venture Management Services (Bloomberg)

Investors are also awaiting the draft Central Bill that may be introduced along with the Union Budget in early March that would regulate MFIs. Anything positive on both fronts will be good news for MFIs. For all the troubles, MFIs are still an attractive investment for most PE firms.

Take the Acumen Fund, which has been in existence for 10 years, and in November 2011, made their first ever investment in a MFI: Acumen invested $1 million in Tamil Nadu-based Gramalaya Urban and Rural Development Initiatives and Network, or Guardian. This investment transforms Guardian from a partially grant-funded Non Govermental Organisation to a fully self-sustaining MFI.

Volumes Rise
As far as investments in MFIs in India go, SKS has been among the most feted by venture capital and private equity investors. The company's dream run with such investors started in 2006 when Silicon Valley-based Indian-American venture capitalist Vinod Khosla led with a $2.5 million investment. Khosla was followed by Sequoia Capital India, which led the charge of other mainstream venture capital investors into the company with a $11.5 million investment in 2007, followed by a $37 million round in 2008. Investors such as Sandstone Capital, Elevar Equity and later Catamaran Ventures joined Sequoia.

The SKS deals opened the floodgates to venture capital investment in the then sunrise MFI sector. By December 2009, just a few months prior to the SKS listing, investments by venture capitalists had jumped to nearly $140 million from a mere $65 million just two years earlier. The number of deals had also climbed from seven in 2007 to 19.

And it was not just SKS Microfinance; the industry as a whole has benefited from PE investments. Even the latest policy blow (the AP MFI Act) has not dented PE enthusiasm. In 2011, the number of deals did fall to 8, compared to 24 in 2010. But in value terms it jumped over 50 per cent to $238.14 million ($158.67 million in 2010). (See Graph: The PE Landscape)

Over the longer term, the AP crisis and the  recent RBI measures may end up being a good thing for MFIs in India. It will help separate financial investors seeking only commercial gains within 2-3 years from those that look at ‘double bottom-line' returns, i.e., social and commercial gains. Investors such as Lok Capital and Aavishkaar, which are largely backed by development finance institutions like the International Finance Corporation and who have similar social objectives, fall in the latter category.

"Maybe we did not anticipate an AP kind of crisis but the risks were always pretty well known," says Aavishkar's Rai, who continues to invest in the sector. "This business requires very patient capital." He does acknowledge that most MFIs will now have to look at some degree of diversification to hedge their risks. Aavishkaar itself is now looking at early to mid-stage companies that define microfinance in a broader sense. Despite the losses in carry, PE firms are in no hurry to write the epitaphs of MFIs.


(This story was published in Businessworld Issue Dated 06-02-2012)