India’s alternative lenders

This is when non-bank financial companies (NBFCs) step into the breach. These entities are largely excluded from retail banking - unable to offer current accounts or checking services, prohibited from engaging in foreign exchange. Their competitive edge is a willingness to accept innovative or higher-risk business models and a nuanced grasp of certain customer types and industries.

"The banks are not always in a position to jump at opportunities," says Saurabh Tripathi, a partner at Boston Consulting Group (BCG). "They are to a certain extent protected by regulation and so the opportunities are taken up by NBFCs."

Tripathi estimates that the NBFC share of financial services companies' market capitalization in India has risen from 14% to 25% in the last decade.

According the Reserve Bank of India (RBI), which is responsible for regulating NBFCs, their asset base soared even as the number of entities that take retail deposits dwindled. Excluding residuary NBFCs whose primary function is to receive deposits, non-banking finance companies accounted for INR6.6 trillion ($137.6 billion) in assets in 2009-10, up from INR348 billion in 1997-98. They are responsible for the equivalent of around 11% of total banking assets.

Private equity firms have inevitably been drawn to the sector. While there is certainly a gap in the market that they could fill, it is unclear how deep they will seek to penetrate areas such as mezzanine financing and what impact this might have on the traditional private equity business. One of the major driving forces, aside from commercial opportunities, is the ownership caps that exist on foreign investment in banks.

"There is so much wealth being created that financial services is going to be a big business. PE firms want to get into the sector," says Luis Miranda, former CEO of the private equity unit of Infrastructure Development Finance Corp. (IDFC), an NBFC that specializes in infrastructure project financing. "If you are a financial investor you can't take a stake of more than 5-10% in a bank but you can set up an NBFC and provide debt for companies."

Early movers

KKR was among the first to enter the sector as a full participant rather than as a financial investor. It set up KKR India Financial Services in 2009 with $50 million in proprietary funding and has done about $1 billion in deals over the last 12 months, with $500 million in 2011 alone.

Other foreign and domestic private equity firms have also entered the market or are preparing to do so. Earlier this year, Goldman Sachs, Everstone Capital and Ashmore Group formed an NBFC called Indostar Capital Finance. It is expected to focus on corporate lending, structured and mezzanine finance, promoter funding and debt for property and infrastructure projects.

In July, it was reported that private equity sources had invested $200 million in six NBFCs since the start of the year. Munish Dayal, a partner at Baring Private Equity Partners India, admitted that his firm is looking for investment opportunities in the space, noting that several NBFCs will require Series B funding in the next 2-3 years. Several days later, Apollo Global Management and ICICI Venture were said to be planning a joint venture NBFC.

As of March 31, there were 12,662 NBFCs in India, according to the RBI. These entities are engaged in everything from microfinance to mortgages to truck financing to the largely passive ownership of companies, but they are classified by liabilities, activity and size. Those that take public deposits, have large asset bases or are designated as systemically important - for example, because they play a major role in an area like mortgages or infrastructure financing - are subject to closer scrutiny.

Around 20% of NBFCs' funding needs are met by banks, with the rest coming from internal reserves, debentures, commercial paper and inter-corporate borrowing. Most are looking for additional investment following the RBI's move to increase capital adequacy ratio requirements in order to minimize lending risk: By March next year, NBFCs must hold INR15 in capital for every INR100 they lend out, up from INR12.

Several of the larger NBFCs, including Muthoot Finance, Mannapuram Finance and Shriram City Union Finance, have sold non-convertible debentures in the last few months. Muthoot has already raised INR9 billion through an IPO this year with Abu Dhabi Investment Authority, Matrix Partners, Kotak Private Equity and Baring India Private Equity taking a 7% stake as pre-IPO investors. Both Mannapuram Finance and Shriram City Union Finance have also received private equity backing; TPG Capital still owns a sizeable stake in the latter.

While there appears to be a clear desire for exposure on one side and a need for capital on the other, the motivations for greater private equity involvement in the non-bank finance space may also lie in the performance of private equity itself.

"PE as an asset class is not generating the returns that PE is expecting," says one Indian GP, who asked not to be named. "You have 1-2 winners in your portfolio that might generate 40-50% IRR and the rest is garbage. With the exception of a handful of houses, most funds are generating returns in the low 20s."

In this environment, the GP observes, it makes sense to diversify into debt products as they can deliver reasonably consistent returns comparable to those seen in private equity. Bank interest rates currently stand in the 12-14% area. NBFCs are able to charge 16-18% for short-term, loan-related facilities, and then factor in a few more percentage points through leveraging their own assets.

Deployment problems

Pockets of negative sentiment about PE returns notwithstanding, fundraising and investment by India-focused vehicles remains robust. Eight funds have raised $8.7 billion for the year to August 31, 28.8% of the regional total, according to AVCJ Research. In 2010, there was $2.4 billion in capital committed, which amounted to 6.6% of Asia's total. Investments are already at $5.8 billion for the year, compared to $8.7 billion for the whole of 2010, with the regional share floating around at 13-15%.

What the numbers don't fully reflect is the pressure some funds are under to deploy capital and the paucity of deals available, particularly in the $50-100 million space. It is generally agreed that that valuations in India remain high despite a recent weakening in the capital markets.

"We have been looking at a series of investments in healthcare and education and both are hot areas," says Mukund Krishnaswami, director, Lighthouse Capital Partners India. "These are green field projects without a single brick in place but they are asking for valuations of double-digit multiples for second- to fourth-year forward earnings."

If a mismatch in price expectations is indeed slowing down transaction volumes, private equity firms with NBFCs might find their ability to issue local currency debt a handy means of diversification. Rather than try and bargain down a very high valuation, a PE firm could offer a two-year debt funding package with a 5-6% coupon via its NBFC, using some of the target company's assets as collateral. Certain deals might also include an equity kicker, which would allow the PE firm to take an ownership stake after a certain period of time.

"Given that promoters' valuation expectations haven't slowed down, it's a lengthy process getting from the term sheet to closing a deal," says Akil Hirani, managing partner at Majmudar & Co. "Mezzanine that meets foreign exchange requirements could therefore be a big winner. A company's bank loans might have become overdrawn and it needs working capital."

Providing debt financing through a NBFC subsidiary also allows private equity firms to build business relationships with company management and entrepreneurs. If these are family owners who might be skeptical about selling equity to external parties, establishing a bond might make them more open to foreign investment later on.

"Indian people have a keen sense of equity and it is a big shift for a family company to bring in outsiders," says Shantanu Surpure, managing attorney at Sandhill Counsel. "If you want to be in the market you have to build relationships. While debt financing might not give you 3x returns, lend people money now and you will be the first guy they go to when equity is available."

An alternative solution

The approach is broadly comparable to that of KKR, which chose to create a balance sheet vehicle capable of providing rupee-denominated debt after consultations with customers indicated there was sufficient demand for such products. "We wanted to be a solution provider across the capital structure rather than just push a product," Sanjay Nayar, CEO of KKR India Advisors, tells AVCJ. "We didn't want to be just, ‘Here it is private equity - take it or leave it.' It's about providing an alternative solution."

Mezzanine products account for the bulk of KKR India Financial Services' offering. High yield debt rarely arises outside of distressed situations, or perhaps real estate and infrastructure, and the company is not focusing on these areas at present. At first, most of the customers had no ties to KKR but now portfolio-company financing accounts for close to half the NBFC's business.

The diversified approach very much fits in with KKR's global strategy: Globally, the company has divisions covering capital markets, asset management and fixed income as well as buyout funds, and it recently closed its first dedicated mezzanine vehicle. However, Nayar is cautious about overselling the significance of the NBFC, stressing that the essential motivation is to have the flexibility to offer local-currency credit, something which cannot be done through a US-dollar vehicle.

"A NBFC doesn't drive a PE strategy," he says. "It is part of a broader strategy to provide alternative solutions, but it doesn't change the strategy concerning private equity."

The issue of strategy points to wider concerns regarding private equity involvement in the non-bank financing sector. First, how does the NBFC fit into a PE firm's overall approach to India? Much of this comes down to whether NBFC ownership is seen as a purely financial investment and, consequently, whether there is any potential conflict of interest with traditional private equity operations. Second, does the PE firm have the requisite skills to operate the NBFC effectively?

KKR India Financial Services invests off its balance sheet alongside LPs from its funds, separate account holders and other third-parties who want exposure to India. It is then responsible for managing the investments. However, the remit might not be so clearly defined for all NBFCs. If a private equity firm is effectively using an NBFC as a balance sheet vehicle, LPs might ask the same corporate governance questions they ask of any GP balance sheet investments: Are your activities running contrary to the overall interests of the fund?

NBFCs are offering alternative financing products to equity-based deals that might ultimately complement the private equity business, but it could be argued that some debt solutions, though they might be most appropriate for the situation, represent PE investment opportunities foregone. "It's very difficult to truly cross-sell," says one India-based GP. "If you have equity subsidizing debt or debt subsidizing equity, then the likelihood is that someone isn't being treated fairly."

As to effective management, a private equity firm would hire qualified staff when setting up an NBFC or inherit and tap into existing expertise when investing in one. But it would still have oversight responsibility in unfamiliar area - one in which no single blockbuster deal can hide the failings of others. Stand-alone NBFCs that are unable to leverage wider interests to enforce payment might struggle; so too would operators who target certain areas such as long-term infrastructure project financing that is the specialty of IDFC.

Operational challenges

In an op-ed article published last month, BCG's Tripathi sought to contrast the typical bank branch manager who has to meet 60 or so different targets relating to the range of services offered with the singular focus of the NBFC. "Focus helps fine tune the business model and economics to suit the complex business opportunity," he wrote. "It ensures that either cost is controlled to the bare bone, or eyes are never taken off the risk, or remedial measures are swift, or all of these."

Tripathi's description also serves as reminder of the challenges non-specialists face in the specialist NBFC world.

Other industry participants add that receiving a license to set up an NBFC from the RBI and then bringing in the initial capital is a protracted process. Investing in an existing entity, meanwhile, can be costly - like many other Indian industries that are popular among private equity investors - and there is no guarantee that the two parties will be a good fit.

No one AVCJ spoke to would be surprised to see more private equity involvement in India's non-bank finance sector. But they are also united in the view that some of these PE-backed ventures might fail.

"Non-bank finance is a high growth area - meeting the need for credit that cannot be met by traditional banks," says Hirani of Majmudar & Co. "But who wins and who makes money is something that time will tell."

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• Topics
• South Asia
• Financials
• Mezzanine
• KKR
• IL&FS Investment Managers
• Baring Private Equity Partners India
• Goldman Sachs
• Everstone Capital
• Apollo Global Management
• ICICI Venture Funds Management Company