Authored article by Rajiv Janjanam, Vice President and Portfolio Head, SME & Retail Lending, Capri Global Capital Ltd.

What financiers do when funding an SME, and what they can do better

The micro, small and medium enterprises (MSMEs) are the backbone of economic development in any country and more so in India as we have a huge population to be served. They are the incubators for talent, innovation and entrepreneurial spirit, which is key to a country's development.

The Indian small & medium enterprises (SMEs) sector is considered as the backbone of the economy, contributing 45 per cent of the industrial output, 40 per cent of the country's total exports, employing 60 million people, creating 1.3 million jobs every year and producing more than 8,000 quality products for the domestic and international markets.

With approximately 30 million SMEs in India, around 12 million people are expected to join the workforce in the next 3 years with the sector growing at a rate of 8 per cent a year. Efficiently organized and innovative, MSMEs often exercise frugal management skills and use local resources to create innovative products and services which cater to any country's growing needs. However, in order to continue scaling up, timely and adequate access to financial services is an imperative, and this has been traditionally one of the biggest hurdles.

Funding Gap in MSMEs

For SMEs, obtaining and securing the right source of finance is a major challenge. Lack of available funding for SMEs has been brought into sharper focus post-credit crunch.

The total gap in MSME funding is estimated to be around $126 billion. Out of this, the debt gap is approximately $84 billion and equity gap is about $42 billion, while the total equity supply is only around $526 million. Many growth businesses are started by entrepreneurs, often with little experience of how to raise finance to fund his/her growth.

The major reasons for creation of this gap are information asymmetry which exists in Indian SMEs, the family-owned nature of Indian businesses, and lack of information regarding tapping the right kind and source of finance.

Funding Structure

Traditionally, private funds from friends and family form the single largest source of finance to MSMEs in India. MSMEs in India also rely heavily on private money lenders and the unorganized financial sector for their requirements, where the terms of financing are unclear and interest rates are high.

Banks have been making steady strides in order to bridge this gap. However, the approach followed by banks to funding is very restrictive as the bank has to create value by controlling and managing risk.

In any loan application for a business, a bank has to necessarily evaluate the risks involved, gauge collateral support and the methods to mitigate those risks. Therefore, it is not always possible for an entrepreneur to satisfy all requirements and conditions which the bank might pose. The above methods of financing are majorly debt financing, and sources of equity funding remain elusive in India.

Government Initiatives in MSME Funding

The government has always been cognizant of the funding gap which plagues Indian SMEs. In the 2012-13 Budget, the government announced an India Opportunity Fund of $878 million to support Indian SMEs. This entire amount will be routed to SIDBI and is divided into specific targeted sectors, which include:

Domestic MSMEs >> Internationalization of SMEs >> Sector Specific Funds -ICE, Traditional Sectors, Defense, Infrastructure >> IPO on SME Exchanges

Such initiatives would go a long way in bridging the financing gap and ensuring that India gets a steady flow of entrepreneurs in various fields.

Some simple guidelines to funding SMEs

It is imperative for the financing company to understand the needs of the MSMEs and the capability of them to repay the loans they take.

>> Very rarely does the intention issue come up with the MSMEs. They are the first generation entrepreneurs from each of their families and do not leave any stone unturned to make their venture a success.

>> MSMEs do not have the wherewithal or the money to develop much needed finance team within their organization and end up hiring on a part time basis a small time chartered accountant to look into their accounts. While this suffices their need, however, when it comes to borrowing from large financial institutions, NBFCs or private equity investors fall short of creating the necessary documentation. For a financing company this can perhaps be overcome by watching the SME at work in their offices or unit, gauging if their operations are genuine and then helping them raise their financial reporting standards.

>> Asking key questions and judging the mentality/attitude of the MSMEs and the passion will tell more than looking for non-existent financial documents. A lifestyle of MSE promoter/partners/teams tells a lot about their future.

>> These micro and small enterprises serve much larger enterprises in their processes through job works / parts manufacturing, process outsourcing, supply chain etc. Strength of the principle plays a vital role. For example, a micro enterprise that manufacturers nuts and bolts for Maruti Suzuki largely draws its past, present and future performance from the performance of Maruti Suzuki as a company. During the boom phase, almost all of the suppliers/small time manufacturers of parts grew at a rapid pace and expanded. Some even ventured to cater to different industries rather than be defined by auto industry.

>> Another key aspect which almost every financier observes these days is their performance on loans/lines taken in the past. Key to this is Credit Information Bureau of India Ltd (CIBIL). A lot of information is derived out of the CIBIL report and plays a key role in assessing future performance on loans given to MSEs.

>> With specific mention to the micro enterprises, there exists one other key issue which is the way they operate. For example, businesses typically run by a family with father as the proprietor and children being inducted into business subsequently. Presence of business / legal existence proof also comes up as a hindrance. In some cases, simple rules like submitting your Know Your Customer (KYC) form requiring at least two proofs are not met as these customers fall short as they usually hold only IT returns. We do need to understand these aspects and help in generating another proof. A simple way could be assisting in installation of a landline at customer's office whose bill would suffice as a second proof.

It goes a long way in understanding these customers and the challenges they face to able to fund them with right products at the right time and help them grow. Be with them on the ground and see what they see, it is that very easy to assist them. After all they are the priority sector, and we carry the responsibility to bring in the financial inclusion.

(The author is Vice President and Portfolio Head, SME & Retail Lending, Capri Global Capital Ltd).

Securitisation and India

Securitisation is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling said consolidated debt as bonds, pass-through securities, or collateralized mortgage obligation (CMOs), to various investors. The principal and interest on the debt, underlying the security, is paid back to the various investors regularly. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

In India, securitisation has been for while now, the route to achieving the mandatory priority sector targets for banks both domestic and multinational. Securitisation as a market itself has evolved from being mere sale of portfolio from one organization to another to becoming complex structures in itself. This market has been in existence since the early 1990s, though has matured significantly only post-2000 with an established narrow band of investor community and regular issuers. In the early 1990s, securitisation was essentially a device of bilateral acquisitions of portfolios of finance companies. There were quasi-securitisations for sometime, where creation of any form of security was rare and the portfolios simply got transferred from the balance sheet of the originator to that of another entity. In recent years, loan sales have become common through the direct assignment route, which is structured using the true sale concept. Europe and United States has one of the most complex and developed securitisation market. India is still a small market where securitisation grew 15% over previous year in value terms. The number of transactions was also 32% higher in FY2012 than in the previous fiscal. The number and volume of retail loan securitisation (both ABS – Asset Backed Securitisation and RMBS – Residential Mortgage Backed Securitisation together), was the highest in FY2012 compared to previous fiscals, while the LSO (Securitisation of individual corporate loans or loan sell-off) issuance was the lowest ever. This in reality is an increase in volume—following a continuous decline for three years and was on account of a 26% rise in securitisation of retail loans.

In India, issuers have typically been private sector banks, foreign banks and non-banking financial companies (NBFCs) with their underlying assets being mostly retail and corporate loans.

The key objectives for Indian banks include:

·       Liquidity: Securitisation is an easy route than raising deposits that are subject to reserve requirements

·       Regulatory issues: Constrains arising out of Provisions, priority sector norms, etc.

·       Capital Relief: Major investors are mostly mutual funds (money market/liquid schemes), close-ended debt schemes and banks. Long term investors like insurance companies and provident funds are currently not active due to regulatory constraints. Foreign institutional investors are also missing due to regulatory ambiguity. As per guidelines, mutual funds are required to declare their NAV’s on a daily basis due to which they prefer the structure/asset classes which involve low pre-payment rates. The lack of domestic non-traditional hedge fund style investors to participate in equity and mezzanine tranches has led to originators holding them.

Some examples of securitisation in the Indian context are:

·       First securitisation deal in India between Citibank and GIC Mutual Fund in 1991 for Rs 160 mn

·       India’s first securitisation of personal loan by Citibank in 1999 for Rs 2,841 mn.

·       India’s largest securitisation deal by ICICI bank of Rs 19,299 mn in 2007. The underlying asset pool was auto loan receivables.

·       India’s first mortgage backed securities issue (MBS) of Rs 597 mn by NHB and HDFC in 2001.

·       Securitisation of aircraft receivables by Jet Airways for Rs 16,000 mn in 2001 through offshore SPV.

·       India’s first floating rate securitisation issuance by Citigroup of Rs 2,810 mn in 2003. The fixed rate auto loan receivables of Citibank and Citicorp Finance India included in the securitisation

·       India’s first securitisation of sovereign lease receivables by Indian Railway Finance Corporation (IRFC) of Rs 1,960 mn in 2005. The receivables consist of lease amounts payable by the ministry of railways to IRFC

·       L&T raised Rs 4,090 mn through the securitisation of future lease rentals to raise capital for its power plant in 1999.

An important change negating lot of banks from lending to NBFCs was what we observed in the ‘Master Circular by the RBI for Lending to Priority Sector’ released in July 2011, where loans by banks to NBFCs no longer qualify as Priority Sector Lending (PSL). With this change in regulation there was only one major way in which banks could meet their shortfall in priority sector lending targets, viz., acquisition of compliant portfolios from NBFCs. For the Originators’ (or NBFCs) motive in entering into these transactions was a pricing, capital relief and tenure-matched funding, apart from having an alternate fund-raising channel. This saw a neat rise in transactions involving bilateral assignment of retail loan pools of mainly including loans to Small and Medium Enterprises (SMEs) or Small Road Transport Operators (SRTOs) and micro credit.

These Bilateral assignments which account for around 75% of ABS and RMBS volume in India—continued to be the preferred route relative to conventional securitisation, given that these transactions were not covered by RBI’s guidelines of Feb 2006 on securitisation, thus making them less restrictive for originators.

That no longer is the case according to our internal estimates given that the RBI Guidelines on Securitisation issued in May 2012 that prohibit stipulation of credit enhancement for assignment transactions, thus exposing the purchasing banks to the entire credit risk on the assigned portfolio.

Priority Sector Lending targets however continue to exist and continue to get stricter and larger (MNCs with greater than 20 branches now are treated similar to domestic banks with 40% of their lending portfolio to be to the Priority Sector. And these could going forward be met at-least partly through the securitisation route, wherein credit enhancement is permitted.

Securitisation too is has its own deterrents which are high capital charge for Originators and impact of mark-to-market for the Investing Banks. Another key constraint presently is the ambiguity on the taxation of PTCs (or Pass Through Certificates), a matter which is presently sub-judice. Pending clarity on the issue, Mutual Funds—as well as several banks—are staying away from making fresh investments in PTC instruments. The microfinance industry saw 13% rise in deals involving sale of portfolio through securitisation and other bilateral transactions last financial year.

Last year, sailing through rough waters, the MFI industry managed to strike deals worth Rs 3700 crore (securitisation and direct assignments). This year, the industry is expected to have sold portfolios worth Rs 4,200 crore to banks and other financial institutions, according to data from MFIN (microfinance institutions network).

Additionally, RBI’s expected adoption of the proposals of the Nair committee on Priority Sector Lending (report submitted in February 2012) would be a key regulatory guideline which could further affect the securitization market in India.

We await further guidelines this year from the regulator – this will in addition to the changes in Priority Sector Norms affect the market in totality.