India NBFCs: Stemming the flow

When Indian Infrastructure Leasing & Financial Services (IL&FS) filed for bankruptcy last October, India’s non-banking financial companies (NBFCs) unexpectedly found themselves playing defense. Questions were swirling around the sustainability of their business models, and a number of the country’s financial institutions put a moratorium on lending to NBFCs, cutting them off from their main sources of capital.

Rapid intervention by the government and the Reserve Bank of India (RBI) helped stabilize the situation, and most observers say in hindsight the fate of the NBFC sector – which has seen significant investment from private equity firms in recent years – was never in significant danger. But liquidity remains tight and the institutions continue to struggle under a new cloud of suspicion.

Despite this temporary discomfort, investors see the liquidity squeeze as a positive development for the NBFC sector and financial services as a whole. Institutions have proven they can weather an unexpected challenge; regulators have demonstrated their willingness to respond quickly and defend a sector seen as vital to the national economy; and irresponsible behaviors among some institutions have been exposed before they could do more serious damage. The lessons learned from last year’s stumble are expected to put India’s NBFCs in a much stronger position over the long term.

“I am far more confident in the industry today than I was two or three months ago,” says KV Srinivasan, CEO of Actis Capital’s recently launched NBFC Profectus Capital. “The banks are seeing that the crisis has passed, and people have managed to pay their liabilities, and they are starting to lend again. The pace of buildup will be slow, and growth may be muted for the next six months, but following that, I think the industry will be more or less back to its previous pace.”

Attractive targets

Until last year, NBFCs seemed to occupy a charmed space in India’s financial services space. The explosive growth of the country’s start-up community and the government’s initiatives to bring more Indians into the formal financial system has created a growing class of borrowers looking for access to credit. However, traditional financial institutions are oriented around lending to large corporate players and have largely neglected this market.

NBFCs operate with less management overhead than banks and can enter remote markets more easily. This made them an attractive target for investors and they gained support from both regulators and the banks themselves. For the banks, the smaller NBFCs have been a convenient way to gain exposure to a new class of borrowers without risking their own assets.

“Retail finance in India continues to be underpenetrated, not just compared to some of the developed economies but also compared to some of the other developing economies,” says Gaurav Ahuja, a managing director at ChrysCapital. “If you compare penetration of retail finance in India versus China, Thailand, Malaysia, or other emerging markets, you will see that India’s penetration is still quite low. So clearly there’s a long way to go.”

Nevertheless, the sector’s rapid growth over the last two decades laid the seeds that threatened to turn last year’s liquidity crunch into a larger crisis. That resulted in overconfidence in the fastest-growing NBFCs, which in turn led their managers to take risks that left their institutions ill-prepared for even a small speed bump.

The first step toward the danger zone was the decision by NBFCs to expand their sources of liabilities beyond the big Indian banks. This was a reaction to the fact that banks were reaching the limit on lending to single borrowers, and managers felt they would need additional financing to continue their strong growth rates.

Some of the diversification has taken the form of corporate bond issuance: data from market research firm CRISIL indicates that NBFCs’ share of total Indian corporate bonds more than doubled between 2009 and 2018. Housing finance companies (HFCs), which follow similar business models to NBFCs but focus on mortgage loans, also doubled their share of corporate bonds over the same period.

The next step for some NBFCs was to grow their working capital with short-term commercial paper. This introduced an element of risk, but at the time, management teams saw little reason to worry, given their previous strong growth and the attractive prospects for the industry.

“We had seen the proportion of commercial paper in the resource mix of NBFCs move up from around 4-5% four years ago to about 16% by September, and in some of the entities their proportion was even higher,” says Krishnan Sitaraman, senior director at CRISIL. “The problem is that if you don’t get an automatic rollover, then you have to figure out how you’re going to repay, and that becomes difficult if you have a related longer-term asset.”

Growing problems

Some smaller NBFCs followed this same pattern, but with an eye to growing their valuations quickly and attract external investors. These institutions built up their loan books by attracting borrowers with low interest rates, but those loans were based on short-term capital that that the NBFCs planned to refinance with expected future equity investments before they came due. 

The IL&FS bankruptcy seemed unlikely at first to cause a broader disruption to the NBFC sector: while the company owned a small NBFC, its business was primarily focused on infrastructure loans with a much longer tenure than the three to four years typical of the institutions. But when a series of defaults by IL&FS led the government to step in and take over, the temporary reluctance by lenders to provide new financing to any companies seen as risky – including NBFCs and HFCs – raised the prospect of a sudden liquidity shortfall.

“A lot of the short-term borrowings from the capital market that were due for rollovers or redemption weren’t rolled over, and people started asking for repayments, which suddenly ballooned into a crisis,” says Pratik Jain, a director for Actis Capital based in Mumbai. “There was a period of two to three months where NBFCs essentially shifted their entire focus to managing their borrowing side, and they pretty much stopped lending for a while.”

The damage to the industry has been limited, but undeniable: listed NBFCs Au Small Finance Bank and IndoStar Capital Finance – both of which have private equity backers – saw their stock price plunge by more than INR200 in late September. While both have recovered steadily since then, neither has returned to its pre-crisis level. 

The impact would have been more extensive had regulators not stepped in, with the encouragement of the government, through a series of measures intended to boost confidence. The RBI orchestrated a mass buyout of NBFC lending portfolios by public sector banks, while the State Bank of India has indicated it would spend up to INR450 billion ($6.3 billion) in its own securitization program.

These steps are widely seen as having restored confidence in the sector. Bank lending and commercial paper rollovers for NBFCs have resumed – albeit at higher rates than before October – and NBFCs have also slowly begun to grow their loan books again.

With the worst of the crisis apparently over, market participants are expressing relief that the results turned out relatively mild. Moreover, many see the brief panic as a valuable reality check that arrived just in time to prevent wider problems in an overconfident sector.

“I think if a similar incident had happened two years down the line, or even within 18 months, it could have led to complete chaos, with a few NBFCs defaulting on their debt,” says Ravi Agarwal, president of RattanIndia Finance, an NBFC formed last year by Lone Star Funds and the RattanIndia Group. “And in financial services, if you default on even one dollar, it can lead to a crisis because everybody has borrowed against each other – if one big institution goes down it can take down 10 others.”

Key takeaways 

Industry observers see a number of lessons that investors can take from the NBFC markets’ recent challenges. The most obvious and immediate is recognizing the danger of using cheap short-term debt to finance longer-term loans. However, this observation has a number of deeper, long-term implications that investors hoping to make a play in the sector will need to keep in mind.

The first is that NBFCs are likely to be more conservative with lending in the future, since the easy capital flows to fund their previous aggressive practices are unlikely to return for some time. This means that they will be unable to build their loan books as quickly as before, which will keep industry growth sluggish. Even after financing returns to previous levels, the memory of the liquidity crunch is expected to keep ambitions in check.

Secondly, access to financing is expected to be affected by lenders’ perceptions of the NBFCs. Institutions that can boast the backing of a major corporate parent or partner will probably have an easier time accessing funds than those without such support, due to their perceived ability to make it through a future crisis.

“On the one hand, you have Bajaj Finance, which is under the Bajaj umbrella, and Hero Fincorp, which is part of the Hero group,” says ChrysCapital’s Ahuja. “And then you have the NBFCs which don’t have this brand above them. They don’t have the lineage, they don’t have parents that have multi-billion-dollar market caps, and lenders will be more reluctant to lend to them.”

PE firms may have an advantage here, as they can provide part or all of an NBFC’s working capital depending on the size of their investment. Actis, for example, has pledged to support Profectus’ working capital requirements for the company’s first three years of operations, while Lone Star and RattanIndia have similarly committed INR13 billion each to support RattanIndia Finance.

These developments are likely to fuel an evolution in the industry over the next few years, as NBFC managers reevaluate their business models in light of the new realities. Some of the fastest-growing NBFCs of 2018 are believed to be considering unwinding their operations or pursuing acquisition by a competitor due to the rising costs of capital making their previous operations unsustainable.

This is not to say that smaller NBFCs are inherently unsafe, Plenty of independent institutions are likely to remain in the market, and many will continue to attract investment from PE and VC investors. As long as there are populations that are underserved by traditional banks, NBFCs will exist to address their financial needs.

“You’re seeing a lot of interesting business models emerge in small and medium enterprise (SME) financing,” says Gaurav Malhotra, a director in the India office of UK-based development finance institution CDC. “There’s a lot of people out there who are doing secured lending, but there are many NBFCs approaching unsecured lending to SMEs with some interesting technology-oriented models. So that’s one segment that we would take a close look at.”

Fundamental viability

The importance of NBFCs to the Indian financial system, demonstrated dramatically by the government and regulators during the crisis, is another source of confidence for investors. Their willingness to step in and assist the sector shows that these stakeholders understand the impact that NBFCs have on the economy, and the RBI’s analysis of overall non-performing asset ratios and capital availability in the industry shows it shares the basic positive sentiment of most industry players.

“This being an election year, the last thing the government wants is bad news. So, they’ve given a clear direction to RBI to help the sector out, because underlying the sector you have many jobs, and the sector has funded many industries,” says RattanIndia Finance’s Agarwal. 

However, investors cannot expect the sector to return to its previous conditions. Even the smallest upheaval will have lasting impacts, and returning investors will likely never be as free with their capital as before. Lending terms will be more stringent and NBFCs will need to provide adequate proof of their ability to pay on time.

“The reliance on short-term borrowings, which had become a very significant part of the NBFCs’ liabilities over the last two years, has fundamentally changed,” says Actis’ Jain. “NBFCs are going back to the banks and borrowing long-term capital, and the asset-liability mismatch that we saw before is getting addressed.”

Regulation is likely to become stricter as well. Investors have long expected the RBI to impose discipline on NBFCs at some point, and the regulator will likely seek to apply the lessons learned in the past year to protect the Indian economy. While these impacts are likely to be delayed until after the election, industry participants expect regulators to raise capital adequacy requirements and restrict short-term borrowing among NBFCs in the future.

For the most part, however, investors are counting their blessings – first, that the crisis did not occur any later than it did, and second, that it has in many ways proven the fundamental viability of the NBFC model. Now that the danger has passed, the industry seems poised to return to its growth trajectory, with all involved much wiser for the close call.

“Over the last 15 years, we’d not seen any medium or large players in the NBFC sector defaulting before the recent developments,” says CRISIL’s Sitaraman. “So, the default of IL&FS did take investors and lenders by surprise, and their reaction was probably understandable. But nothing has changed about the underlying fundamentals – most of the other entities in the space were exhibiting good growth levels until September.”   

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• South Asia
• Financials
• Financing
• India
• NBFCs
• Actis Capital
• ChrysCapital Management
• Indostar Capital Finance
• Lone Star Funds
• CDC Group