India NBFCs: The next level

In the eyes of Gopal Jain, co-founder and managing partner at Gaja Capital, India's financial services sector is having its own "telecom moment." The term refers to the transformation of telecommunications over the past 20 years from a niche service, to which less than 10% of India's population had access, into a vital part of the economy connecting more than 90% of the country.

Key to this telecom transition was the liberalization of the sector in the late 1990s. It allowed private companies to compete with public sector monopolies to provide services – particularly to the rural population – that satisfied pent-up demand. Jain sees a similar dynamic developing in financial services.

"Just as telephony and telecom has become a ubiquitous feature and part of everyone's life, banking and credit will become ubiquitous as well," says Jain. "But the banking system in India, which is largely composed of public sector banks and heavily defended by the regulator in terms of entry barriers, is only partially positioned to deliver what is required to address this change."

Many players in the financial sector see non-banking finance companies (NBFCs) as the best way to bridge the gap between demand and supply, and the industry has attracted considerable interest from private equity firms in recent years. But the space is also still in flux, due to ongoing shifts both by larger banks and the country's financial regulators. Successful investment in the space will depend on the ability to predict the actions of these players and choosing the right NBFC to partner with.

Filling the gap

While non-banking finance is a factor in every market, in India the need for alternative financial solutions is particularly acute. The explosion of start-ups has created a new class of borrowers eager for access to credit, but existing financial institutions are largely uninterested in catering to a risky new market, and the strong regulatory framework installed by the Reserve Bank of India (RBI) means new players are unlikely to emerge.

"In a perfect world, as there is disruption in the financial markets and the needs of customers change, that unmet demand should be served by the banking sector," says Jain. "But in India it's impossibly difficult for new banks to get set up. That's something that hasn't changed in the last 20 years, which is why you see significantly more pronounced activity in India's NBFC sector."

This need has not gone unnoticed by the RBI, which has an obvious interest in helping the country's entrepreneurs grow their businesses and contribute to the development of the economy. The regulator is also interested in bringing rural and low-income Indians into the formal banking system, a policy hampered by the difficulty faced by banks trying to operate outside urban centers.

"The black pool of unorganized lending happening at usurious rates is what the RBI is really looking to tackle," says Dhanpal Jhaveri, managing partner for private equity at The Everstone Group. "Rather than going to a local moneylender who might charge 2-4% a month, sometimes as high as 10%, it's better to have an organized player making credit available to these customers. But for a bank to do that the cost structure is extremely high."

NBFCs have become the leading candidates to address this financial bottleneck. The companies can operate at a lower cost than banks and of necessity cater to customers neglected by the larger institutions. This means that rather than seeing NBFCs as competitors, banks look on the smaller institutions as valuable allies that can help them access borrowers that are otherwise unavailable to them.

This market exposure thesis is also key to PE interest in the NBFC space. GPs have taken a variety of routes to gain exposure to the institutions. Everstone, for example, founded its own NBFC, IndoStar, in 2011 to provide wholesale secured lending to corporate players. Others have focused on investing in existing NBFCs: Gaja, for example, led a $15 million funding round for Kinara Capital earlier this year.

Pressure points

GPs looking to enter the space need to keep a close eye on movements by the larger players. Since so many NBFCs have close ties to banks, the institutions are well-informed about which industries have proven successful targets for financing and could move in when they feel the market is mature. This would create significant competitors for the smaller institutions.

"Until 10 years ago housing was largely dominated by NBFCs in India. HDFC was the apex NBFC doing housing loans. Today banks take up the lion's share of housing loans," says Gaja's Jain. "This is how it will continue to happen: wherever interesting opportunities, asset classes, or categories of risk emerge, initially NBFCs will address that demand, sometimes in partnership with banks. Then as these niches become large enough to no longer be niches, banks take over."

As NBFCs take up a more significant role in the financing, regulation will also grow in significance. Some changes have created interesting opportunities for NBFCs. For instance, several PE-backed institutions have applied for a small finance bank license, created in 2015 to allow holders to perform banking services such as acceptance of deposits and lending. One recipient, Au Financiers, went public earlier this year, raising $296 million.

However, regulators are also mindful of the increasing importance of NBFCs to the financial system, and industry players expect the RBI to tighten the reins somewhat with a view to enforcing discipline on the new lenders. While the sector will remain strong, PE investors must be prepared to see lower levels of returns in the future.

"How they grow from here becomes a function of the regulatory oversight that applies to these NBFCs as they grow in size," says Kanchan Jain, head of India credit at Baring Private Equity Asia. "As regulatory burdens increase and NBFCs are brought under a similar regime to banks it's reasonable to expect that the valuation multiples will fall significantly."

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• Topics
• South Asia
• Financials
• Regulation
• India
• NBFCs
• Baring Private Equity Asia
• Gaja Capital Partners
• Everstone Capital