Indian microfinance: Back from the brink

"There is no one way to help the poor. Poverty is like cancer - you need a cocktail of activities to fight it," says Vineet Rai of Aavishkaar Venture Management, India's first rural-focused venture capital firm.

In November 2010, though, it seemed as though that cocktail had lost one of its core ingredients. More than 70 recipients of microfinance loans committed suicide in the South Indian state of Andhra Pradesh, after being unable to repay what they'd borrowed. Debt collectors employed by microfinance institutions (MFIs) were accused of encouraging poor entrepreneurs to take their own lives, kidnapping family members and boarding up people's homes.

The state government reacted by introducing legislation intended to curb over-aggressive debt collecting tactics. What it actually did - in attempting to protect borrowers from harassment - was create hurdles for MFIs in recouping the money they had advanced to customers.

After the storm

The impact on the sector was devastating, and not just in Andhra Pradesh. Almost overnight, banks, including heavyweight lenders such as ICICI and HDFC, stopped providing financing to MFIs, freezing an estimated $133 million of credit. About 90% of borrowers in Andhra Pradesh halted their repayments, which resulted in some MFIs seeing their entire loan portfolios wiped out. And investors, who up until that point had looked at Indian microfinance as a sector with the potential to generate supernormal returns, got rather a sharp reality check.

Return expectations, which in some cases had exceeded 80% ROE at the height of the boom, were readjusted downwards to the range of 16-18%. This didn't result in a complete withdrawal by PE firms though - despite the skepticism, India still saw 19 deals worth a collective $88 million close in 2011, compared to 10 transactions valued at over $45 million the previous year.

A number of the deals that took place following the crisis succeeded International Finance Corp's (IFC) provision of $29.6 million for West Bengal-focused Bandhan Financial Services in September 2011. This was the biggest investment realized since October 2010, and though it had been agreed a year prior to its announcement, news of IFC's move sparked interest among observers keen to determine if capital would start to flow back into microfinance.

Returning confidence

That is precisely what appears to have happened. Despite continued reverberations from the Andhra Pradesh tragedy in the final months of last year - the founder and chairman of embattled micro-lender SKS Finance, which allegedly lent money to one of the suicide victims, resigned from his post last November - Indian MFI Ujjivan Financial Services successfully raised ($25.5 million) in February from seven investors. Wolfensohn Capital Partners and Dutch development finance company FMO committed INR400 million and INR326 million to the round, while existing backers Lok Capital, Sequoia Capital, Mauritius Unitus Corporation, Elevar Equity and Caspian Advisors also participated.

The company, which does not have a presence in Andhra Pradesh, went on to raise a further INR500 million from IFC in May, while Chennai-based Equitas Microfinance received INR1 billion, also from IFC.

Such was the renewed appetite for the sector that Mumbai-based Lok Capital managed to close its $65 million fund focused on microfinance and related companies - albeit six months later than expected - in January. Two months later IFC announced plans to roll out a $100m microfinance debt fund in India.

Regulatory clarity emerging from the long-awaited proposal of a national microfinance bill is partly responsible for the improved sentiment. The bill, which was drafted in July 2011, aims to make the Reserve Bank of India (RBI) the only regulator of the sector and cap the maximum annual interest rate MFIs can charge at 26%.

It has not been a smooth process - the late inclusion of a provision to increase in the loan credit ceiling for MFIs from INR50,000 to INR500,000 sent shockwaves through the industry last month - there is hope. Measures to facilitate the creation of microfinance development councils to advise governments on the sector, for example, will help in promoting the continued health of the MFIs still in operation.

"The clarity that was emerging on the regulatory front gave us comfort as to the sustainability and viability of the sector," says Sanjiv Kapur, managing director at Wolfensohn. "We were certain that with the RBI taking a very active role in the industry, adapting to the reality of the marketplace, there would only be a few players remaining in the industry in the next 2-4 years."

Indeed, consolidation has already begun to take place, and has a part to play too in the cautious optimism witnessed among PE firms. More than a quarter of the Indian microlending industry is concentrated in Andhra Pradesh, and given that the debt repayment rate in this state continues to be as low as 5%, virtually none of the MFIs are lending there, concentrating their efforts instead on recouping the cash from delinquent accounts.

"There used to be around 10-12 players, this has now shrunk to 4-5," estimates Venky Natarajan, managing partner at Lok Capital. In addition to Ujjivan, the firm's MFI portfolio features BASIX, which saw its assets fall from $326 million in September 2010 to $22 million today. "The liquidity is pretty much drying up beyond the top 4-5 institutions; they haven't received any refinancing, or very little over the last 12-18 months."

Investors into the top five MFIs, which include Equitas, Ujjivan and SKS, can feel secure in the knowledge therefore that their market is growing at the same time as the competition withers.

Another important factor which no doubt boosted last year's deal totals was a lowering in valuations among the MFIs that attracted capital. One reason for this has been the depreciation in the rupee since August 2011, while the distressed nature of a number of MFIs' portfolios, particularly those focused on Andhra Pradesh, will also have caused promoters to lower their fundraising expectations. The average Indian price-to-book value dropped from 2.0x in 2010 to 1.9x last year.

"On a risk-adjusted basis, there's absolutely been a fairly dramatic compression in valuations," says Wolfensohn's Kapur. "We did not look at the sector in the past because valuations were stratospheric and the nature of the business did not give us great comfort."

Doing good

What has provided comfort to some investors is the realization that their capital could end up furthering the alleviation of poverty. A form of financial inclusion, microfinance works by providing small loans to people who have no access to traditional means of credit.

As Lakshmi Venkatachalam, vice-president of private sector and co-financing operations at the Asian Development Bank, explains, "Financial inclusion is a very vital component of sustainable and inclusive growth, and has a significant impact on increasing general economic prosperity. Why? Because financial inclusion helps people to generate income, invest in opportunities, build assets and mitigate risks. It enables households and enterprises to manage cash flow to meet their capital and consumption needs and fosters productive activity at all levels of society."

As micro-enterprises rely mainly on family labor, use their homes as work places and have minimal legal costs as they operate in the informal economy, those borrowing $200-300 can ostensibly earn very high returns in India - beyond 50%, according to SKS. The question is: can private equity firms also earn strong returns from their investments in microfinance?

"MFIs, while socially very beneficial, can be a massive sham from an investment standpoint," an industry source tells AVCJ. "People only repay their loans because they know that when they pay back loan one they can get the same for loan two plus a bit extra. I would be surprised if there wasn't more investment, but a lot of PE firms don't know what they are doing in this area."

Plenty of other investors disagree with this perspective though, as Wolfensohn's backing of Ujjivan this year and CLSA Capital Partners' $24 million bet on Equitas in 2011 attest. Neither of these PE firms had any prior track record of investing in Indian microfinance, and yet each decided that now was the right time to look for opportunities among the players that had managed to keep afloat in a tough market.

Aavishkaar's Rai argues that returns around the 20% benchmark are easily achievable by the healthy MFIs; it is the PE firms that were seeking the inflated profits of the pre-crisis period that will come away from the sector disappointed. "Around 2008-2009, people thought that microfinance was going to give returns that were extraordinary, but the fact of the matter is, it cannot give those kinds of returns," he says. "If we look at the returns of most VC funds in India, microfinance firms can deliver reasonable returns from that perspective; 20% is the right return."

Hands-on approach

These positive - if modest - return expectations come with one caveat, however. In order to achieve them, PE and VC backers need to help the MFIs in their portfolios become more organized and transparent.

One way to do this is, advises Miranda Tang, managing director at CLSA Capital Partners, is by introducing a code of conduct stipulating the kind of credit and risk assessments that should be carried out on customers, loan collection practices, and transparency on interest rates and repayment schedules. A database that allows MFIs to pool their data could also be a useful resource for the sector.

"Korea has a comprehensive and shared database where it shows the credit history of any particular customer so a lender with have information to assess its own credit risk," says Tang. "When a similar platform is in place in India, it will help to provide detailed data points to MFIs in assessing their own credit risk."

GPs can also enhance their effectiveness in this sector by realizing the need for longer holding periods than previously forecasted. Whereas investors into MFIs in 2007 might have hoped to exit by 2010 or 2011, five- to six-year holding periods are going to be more the norm in today's environment. Trying to force an exit will have its repercussions. Hopefully, though, PE firms are now appreciate this is a different type of investment from that to which most of them are accustomed, and the fact that the end-users of these companies are the poor means they require a more tailored investment approach.

"Microfinance is not the silver bullet for dealing with poverty, though, and neither is social venture capital. We believe you need to be realistic," concludes Rai. "We are not really going to change the way the world operates just because you want to change the lives of the poor; these are long-term interventions and everybody - the economists, the government, investors - has to play a role."

SIDEBAR: Are microfinance interest rates too high?

A criticism often directed at Indian microfinance institutions (MFIs) is that the interest rates they charge to borrowers are too high. People barely living above the breadline are being exploited by having to pay rates of up to 26% is the argument. Muhammad Yunus, the Nobel peace prize winner credited with coming up with the concept of microfinance, has even proposed that MFIs charging more than 15% above their long-term operating costs should face penalties.

However, calculations made by Equitas Microfinance, a portfolio company of Aavishkaar Venture Management, CLSA Capital Partners and IFC, shows how - if they cap their rates at 26% - Indian MFIs only stand to be able to keep a fraction of the interest rate as profit.

As show in the table below, the interest rate is typically divided up as follows:

6.3% - salary and incentives for the staff (average field staff salary is INR8,500)
3.7% - overheads and other admin-related costs
13% - Cost of commercial bank financing
1% - Loan loss provisioning for hardship cases
2% - Profit

"It is costly for MFIs to reach out to their potential customers, to process the paperwork and to make collections," comments Miranda Tang, managing director at CLSA. "Only the most efficient MFIs can generate ROEs of 15-20% under these conditions, which is what private sector banks can earn. Other sources of money for this unbanked population are local money lenders which lend at much higher interest rates, touching 100% or more at times."

In 2010, the largest Indian MFIs with strong business models were providing 97% of loans to 86% of clients - and today their market share is surely even more prolific. By capping the rate at any lower than 26%, India's governments would have risked disenabling these firms from covering their costs, thereby choking off the supply of credit to those who need it most.

The MFIs that charge lower interest rates may make the lives of their customers somewhat easier, but their reach is far more limited.

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• Topics
• South Asia
• Financials
• Investments
• Regulation
• India
• Financial Services
• regulation
• CLSA Capital Partners
• IFC
• Wolfensohn India Advisors
• Asian Development Bank