India NBFCs: Agreeable aftermath

When India’s Finnov received $70 million this week from NewQuest Capital Partners and Motilal Oswal Private Equity, it extended a Series C round that attracted the likes of Premji Invest, Mirae Asset Capital, and Alpine Capital last month. The round has now closed at $145 million, making it the largest Indian financial services investment so far this year, according to AVCJ Research.

But the year is still young, and Finnov is likely to be eclipsed, especially given recent momentum in the local financial technology space. Investment was said to have jumped as much as 60% during the pandemic, with some estimates suggesting more than $2 billion was put to work in the space last year. The country is now regularly cited as the largest and fastest growing fintech market in Asia.

More interestingly, the latest bets on Finnov were directed at its KreditBee platform, which hosts multiple non-banking financial companies (NBFCs). Nimbler and more accommodating than traditional banks, NBFCs exploded in popularity around 2018-2019 until cracks in the model began to show. Asset-liability mismatches resulted in a string of bankruptcies, and investment in the segment dropped 63% year-on-year in 2020.

The correction proved to be a return to proper form, however. AVCJ’s records reveal private equity investment in Indian NBFCs came to $1.1 billion across 29 disclosed deals in 2020, in line with 2015-2017 when an annual average of $1.3 billion was deployed and the number of disclosed transactions ranged from 16 to 29 per year. The boom has therefore come into focus as an anomalous overheating episode, peaking at $3.6 billion across 38 deals in 2018.

The most fundamental reason for NBFC resilience is sheer demand. The industry consensus is that if India is going to meet government targets to become a $5 trillion economy by 2024, growth must be fueled by credit, especial flexible credit. As Amit Gupta, a partner at NewQuest, put it following the KreditBee deal: “The requirements of the average value-seeking middle class Indian can only be met by a multitude of lending products. One size doesn’t fit all.”

NBFC 2.0

Still, confidence in NBFCs has been shaken on several fronts, which makes their permanence on the private equity menu an issue worthy of further investigation.

The bankruptcy of IL&FS in October 2018 is commonly cited as the clearest turning point in sentiment. The model of borrowing short and lending long had proven unsustainable; highly levered NBFCs were essentially competing in wholesale lending against the banks that supported them. The small and medium-sized enterprise (SME) and consumer lending markets that were a better fit for their versatility remained a niche concern. Post-IL&FS, those priorities have been correctly reversed.

The repositioning has been complicated more recently as pandemic-related economic pressures stoke concerns around a potential rise in nonperforming loans (NPLs) and rule changes proposed by the Reserve Bank of India (RBI) create uncertainty about the extent to which NBFCs will be regulated like traditional banks. Asanka Rodrigo, a partner at Actis, acknowledges industry nerves on these points but has seen little evidence of derailed operations or dented investor appetite.

Actis launched its own SME-focused NBFC, Profectus Capital, in 2018 and has continued to deploy capital in the business throughout these disruptions. Rodrigo, who also sits on the Profectus board, says macro challenges have caused only a smattering of delayed payments, rather than NPLs. Meanwhile, question marks around regulation have had surprisingly little impact on Profectus; the firm has only had to restructure one loan as a result.

“We’ve had more banking crises in the last 15 years than NBFC crises, so there’s nothing wrong with this sector per se. It’s had a lot thrown at it, but most of the better NBFCs have come out really well. Access to back debt for the NBFCs themselves has been the biggest difficulty in the past year, but even that has improved in the last 2-3 months,” says Rodrigo. “The sector has really been pressure-tested, and it’s quite robust. Where there have been problems, it’s been more governance related in my view.”

Indeed, new confidence around the governance of NBFCs is at the heart of their recent rebound in sourcing debt funding. In essence, the RBI’s proposed regulatory moves, mooted in the form of a discussion paper earlier this year, would approach NBFCs more as institutions than as simply promoter-led companies or entities under family groups.

The uncertainty has come with recognition that it will be challenging to apply regulation to clean up issues around gearing and asset-liability management without jeopardizing NBFC strengths such as speed and flexibility. Investors exposed to the NBFCs that failed in the IL&FS crisis notwithstanding, the market appears to be happy with the RBI’s balancing act so far.

Farewell wholesale

Under the new rules, oversight will be on a four-tier basis. The top tier would remain theoretically empty and reserved for organizations judged to be in extreme supervisory risk. The second highest tier would host the largest 25-30 NBFCs and harmonize their leveraging practices with traditional banks. The lowest two ranks would be populated by companies most closely adhering to a pure NBFC approach – small and agile but now effectively discouraged from playing in the wholesale space.

“We used to compete with NBFCs for a lot of deals in India when they were active in the wholesale space, but now that many of them have gone away, competition is much lower,” says Nitish Agarwal, CIO at Orion Capital Asia, a Singapore-based private credit manager with significant exposure to India.

“To that extent, the shift in the NBFCs’ business models has definitely helped private debt providers like us. In fact, it’s created a gap that we can fill. In hindsight, it’s always been a market that was more suited to private debt funds because we don’t have leverage at the back end to worry about. I’m glad that is finally coming out in the marketplace. It’s a sign of maturity.”

The largest NBFCs will continue to deal in wholesale, albeit as a small part of a more diversified book. This will be achieved through vehicles separated from the NBFC structure, especially alternative investment funds (AIFs), which cannot borrow from banks.

KKR India Financial Services (KIFS) is set to be among them. KKR set up KIFS in 2009 and pumped $150 million into the company as recently as January 2020. The NBFC, which has deployed more than $5 billion since inception, is a balance sheet business, so it hasn’t suffered the industry’s widespread trials around asset-liability mismanagement.

Nevertheless, underperformance has made KIFS a poster child for the market’s woes in recent years and spurred a tie-up with InCred, an NBFC backed by several PE firms. InCred is widely expected to manage the KIFS book going forward, winding it down as part of a shift to a retail-focused strategy. Some wholesale activity does appear to be on the cards, however.

“When we think about the future of wholesale lending in India – and when we talk to the likes of Edelweiss and Piramal – I think it’s better to do that in a fund format than as a balance sheet lender. Otherwise, you find it hard to get the right liability duration,” says a source close to the situation. “AIFs make perfect sense. I wouldn’t be surprised if, after this merger, the combined business was looking to do something similar.”

Wholesale loan books – including large corporate, property development, and construction financing – could attract special situations investors and credit funds in the years to come, but there will be substantial impediments to meaningful deal flow. These portfolios are considered relatively easy to replicate independently, which generally snuffs any appetite to pay a price-to-book multiple in excess of 1.5x. At the same time, resolving liquidity issues with a range of lenders is seen as an offputtingly complex process with little precedent for success.

Altico breakthrough

Ares SSG, recently formed by the merger of Ares Management and special situations investor SSG Capital, made traction on this front in March with the acquisition of all the underlying assets of Altico Capital for about $380 million. More than 50% of these assets were NPLs (a healthy figure is usually less than 5%). The deal has been called the first resolution of a stressed NBFC outside of India’s insolvency and bankruptcy process and a signal that similar transactions could follow suit.

Ares SSG initially intended to acquire the entire Altico entity, having been satisfied with its corporate governance as a development project of private equity firm Clearwater Capital Partners. Familiarity with the company and its backers also provided comfort. Indeed Manish Jain, CEO at SSG Advisors and an advisor to Ares SSG, helped build out Altico’s real estate-focused strategy in the early 2010s as a senior vice president at Clearwater.

The transaction took more than a year to close – the original bid was made pre-COVID – and eventually the decision was made to acquire only the portfolio. Much of the delay can be attributed to the uncommon complexity of the lender group, which included NBFCs, private banks, mutual funds, foreign banks, development finance institutions, and foreign bond holders. Customized plans had to be offered to each lender, 100% of which were accepted in the end.

“It may seem like an easy decision looking back, but in April, when the world seemed to be falling apart, it was a really tough call,” Jain says. “This was Ares SSG’s single largest commitment ever, and to put that kind of money in a real estate portfolio when the market seemed to be going down the dumps was difficult. But Ares SSG stuck to the bid because they have a long-term commitment and view on the market. I think the whole lender community appreciates that. Nothing motivates people like precedent, so this creates a big opening for other resolutions on similar lines.”

Jain has watched the retrenchment of the NBFC market in the past two years from a front row seat but sees no existential threat to the business model. He notes that the shift away from wholesale and toward retail is filling massive financing gaps in consumer and SME spheres. This is broadly seen as an irreversible and sweeping trend in Indian credit in general. But it raises the question: Is the NBFC industry setting itself up for another overheating disaster on the retail side of the spectrum?

Quiet confidence

For now, even with the dust of COVID-19 yet to settle, investors remain confident. Credit cards and unsecured loans are still considered relatively high-risk areas, but gold finance and home loans remain prospective. In terms of SME targeting, retail and hospitality are logically on watch, but the overall local economy is considered big enough for investors to safely shop around.

“We’re always dynamically changing allocations between subsectors, but we haven’t had to make any significant tweaks,” says Actis’ Rodrigo. “We’ve reviewed the data and the strategy and it’s still valid. The state banks are still not able to play in this space, so it’s still a very good opportunity for the private sector.”

In December, Fitch Ratings noted that NBFCs with SME exposure in India could face a challenging 2021 as borrower relief programs taper off. This was projected to lead to uneven portfolio quality and hence uneven funding conditions. Any new wave of COVID-19 infections could only pile on the pressure.

The current counterargument here is that the opportunity is just too large to ignore and the options for workable entries too plentiful. SME portfolios in India tend to be inherently well diversified since the loans are relatively small and it is often necessary to spread exposure across different subregions. The challenge has always been in navigating governance issues and understanding the underlying companies, which will put specialists at an advantage. Otherwise, the broader Indian growth story is expected to carry NBFCs with it.

“You can take a broad brush and say the entire SME sector has been pretty badly hit by COVID, but the market is large enough and there will always be a limited amount of capital at play here compared to demand,” Jain says. “Sometimes it’s difficult to extrapolate from the macro-level numbers, but if you look hard, you will find a lot of SME clients that are worth financing. This segment will be huge in the next few years.”

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• Topics
• South Asia
• Financials
• Financing
• India
• Actis Capital
• Orion Credit Capital Asia
• Ares Management
• SSG Capital Partners
• NewQuest Capital Partners
• NBFCs