India microfinance: Acorns to oaks

Exactly 12 months ago India's microfinance sector had something of a watershed moment: VC-backed Bandhan Financial Services became the first microfinance institution (MFI) to secure a banking license from the Reserve Bank of India (RBI).

Set up in 2001, Bandhan provides services to impoverished women in rural India. Between 2009 and 2011 it received around $45 million from the Small Industries Development Bank of India (SIDBI), US microfinance accelerator Unitus Capital, and the International Finance Corporation (IFC). The latter returned to invest $258 million alongside Singapore's GIC Special Investments as recently as January. Bandhan is now looking to go public within three years.

Bandhan is a poster child for an industry that just four years ago was on its knees. A spate of suicides in Andhra Pradesh in late 2010 involving more than 70 impoverished microfinance borrowers were linked to allegedly overaggressive debt collection activities. The fallout from the scandal did irrevocable damage to the industry's reputation while a government crackdown that nearly wiped out microfinance assets in the state.

Fast forward to the present and many hold the view that microfinance has not only recovered, but also entered a new stage of rapid growth. As the industry evolves beyond its past, venture capital and private equity - which helped nurture microfinance in the pre-crisis era - are expected to continue to be an important part of that growth.

"Since 2012 the sector has really moved forward in positive sense," says Royston Braganza, CEO of Grameen Capital India. "In the last couple of years we have seen how Indian microfinance has returned to stability and regained confidence on a regulatory level, on a client level, and on an investor level. To summarize in three words: microfinance is back."

The type of growth and recovery seen by the industry since the Andhra Pradesh crisis is remarkable. According to a report by the Credit Rating Information Services of India (CRISIL), loan assets among the country's top 25 MFIs are set to reach INR350 billion this a month, a 40% increase from 12 months ago. Meanwhile, the two-year period ended March 2014 saw compound annual growth of 42%.

Back in fashion

AVCJ Research does not track the microfinance industry specifically, but records of individual deals show that many of the top 25 microfinance lenders identified in the CRISIL report above have been backed by venture capital. One the biggest investments to date took place this month, with Ujjivan Financial Services raising INR6 billion ($96.2 million) from a consortium including IFC, Elevar Equity, CX Partners, CDC Group, NewQuest Capital Partners and Bajaj Holdings.

Meanwhile, over the past 24 months there have been funding rounds for the likes of Satin Creditcare Network, Annapurna Microfinance, Janalakshmi Financial Services, Grameen Koota, Aye Finance, and Arohan Financial. The latter two took place in recent weeks. At the very least the steady flow of deals coming out of the industry suggests investor confidence is returning; much of this can be put down to the comfort brought about by regulatory changes.

"From a regulatory standpoint there has been enormous change with RBI coming in after the crisis," explains Samit Ghosh, founder and CEO of Ujjivan Financial Services. "The for-profit institutions - which account for around 80% of the MFIs in India - are now directly regulated by the RBI, a whole set of rules have come in, and that has brought a lot of discipline."

The RBI's first big move - in May 2012 - was to introduce a separate category of NBFCs (non-banking financial companies) that operate as MFIs (NBFC-MFIs). This came with a comprehensive set of guidelines which included stipulations such as a margin cap of 12% and a 26% interest rate cap.

Also directly after the crisis, the RBI introduced credit bureaus to record and monitor the credit worthiness of borrowers, with an emphasis on prior credit score checks and data sharing between MFIs. This allows MFIs to assess what kind of leverage prospective customers have, as well as their borrowing history.

Under the new systems MFIs submit data to the bureaus once a week, and every loan must be based on a credit report; it also means client are restricted to borrowing from a maximum of two MFIs. Additionally, the RBI created a new self-regulatory body - the Microfinance Institutions Network (MFIN) - to prescribe a code of conduct that provides operating guidelines for MFIs.

Another legacy of Andhra Pradesh is that the market is now far less fragmented. According to CRISIL, India's top 25 MFIs now account for 95% of the industry's loan portfolio - the largest of these players being Bandhan which now has a market share of over 20%, up from just 4% in 2009.

"What has happened since the crisis is that a handful of MFIs that were able to adapt quickly to the changing landscape," says Maria Largey, microfinance investment director at UK development finance institution CDC, an active investor in Indian MFIs.

"They changed their cost structures, reduced operating expense ratios (OEO), but also diversified their product bases in most cases. They were able to adapt and reduce the risk pretty quickly because of the way they had been structured."

This trend is only expected to accelerate as MFIs improve in areas such as branch efficiency - which means more average borrowers per branch. As the larger players grow at a faster pace than their smaller counterparts, some degree of consolidation is inevitable. Perhaps the start of this trend could be seen in IntelleCash Microfinance Network's INR520 million acquisition of a 56% stake in VC-backed Arohan in September last year.

Banking on growth

As MFIs have grown, so has the range of products they offer and the demand for larger loans. Ujjivan's Ghosh explains that there are typically two kinds of groups that MFIs lend to: self-help groups in rural India that borrow from MFIs, distribute the loans among themselves, and then repay together; and the joint liability system, whereby loans are extended to individuals who form smaller groups of around five, with the group having joint liability for each member's repayments.

Increasingly, however, customers are seeking individual loans of larger size. "The group loans are small, but as loan sizes are getting larger, people don't want to borrow in a group and be responsible for another group member's loan," says Ghosh. "They want to borrow on their own."

MFIs - which typically invest up to INR50,000 - cannot always meet the funding requirement of small entrepreneurs. As a result, the government plans to set up the Micro Units Development Refinance Agency (MUDRA) - a subsidiary of SIDBI that will have a corpus of INR200 billion and offer refinancing to MFIs looking to raise extra capital.

From a longer-term perspective, though, perhaps the key event of the past three years only occurred in the last few months: the RBI's decision to allow MFIs to operate as small finance banks.

"The ability to convert into a small finance bank is one of the biggest developments that have taken place in the industry and a number of us are aspiring to do so," says Ghosh, who adds that Ujjivan is one around 70 MFIs to apply for bank status at the beginning of the year. "The second biggest development is MUDRA, which will enable us to access refinancing."

His enthusiasm is mirrored by Grameen's Braganza, who says the new classification could fill the void that lies between transitioning from a NBFC-MFI to a commercial bank; a leap that - with the notable exception of Bandhan - has been all but impossible for MFIs. Converting to a small finance bank means being able to offer services like remittance facilities, savings, and transfers like any other banking institution. But more importantly it will provide them with new sources of capital.

"The MFIs that convert can reduce their borrowing costs down the road because they will be able to utilize deposits," says CDC's Largey. "But also from the client's perspective it is very exciting because these people now have more options in terms of products and they will be able to save their money."

However, the process is expected to be slow. Ghosh estimates that out of the 70 MFIs to apply for licenses, only 10-12 will be successful, and even it could take 18 months. Largey adds that this is also where venture capital, and even later private equity, could source future investment opportunities. She maintains that there will be a similar - if not a greater - level of capital needed as MFIs transform into banks.

"We have reviewed a handful a handful of banking license applications across the MFIs and they all have slightly different business plans but they all entail more capital - new branches, new staff to mobilize deposits." she says. "It is exciting time in this sector. The landscape is changing and it is changing quickly."

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