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).