Microscope on microfinance(2)

Microfinance has over the past couple of years become as frequent a component of private equity remits in India as infrastructure-related plays. 

And the reasons are just as obvious: 2010 Indian government figures put the percentage of the population living under the UN-designated poverty line of $1.25 a day at 37.2 percent – an increase of 10 percent or an extra 100 million people on the 2004 figure. Approximately a third of the world’s poorest people are estimated to live in India.

Such figures have provided ballast to a strategy which combines social incentive with guaranteed profits. Generalist GPs including Sequoia Capital, Matrix Partners, CLSA Capital Partners and Headland Capital have all made at least one investment in the sector. And, like infrastructure, microfinance has spawned a set of specialist private equity managers, such as Delhi-based Lok Capital, which in October last year held a first close on $52 million on its second microfinance-focused fund, and London-headquartered LeapFrog Investments, which last year closed a $137 million fund focused on microinsurance investments.

However, a series of events in the second half of last year have placed the sector under scrutiny, both public and political, and raised questions over the sector’s suitability for for-profit investment.

Dogged by controversy

First of the key events for India’s microfinance sector was the IPO on 3 August of Andhra Pradesh-based SKS Microfinance – the first and to-date only Indian microfinance institution (MFI) to go public.

The company, founded in 1998, had received at least four rounds of private equity financing prior to its listing on both the Bombay Stock Exchange and the National Stock Exchange of India, from investors including Sequoia Capital, Columbia Ventures, Sandstone Capital, Kismet Capital and SVB India Capital Partners. Its fourth funding round, in November 2008, raised $75 million – at the time the largest private equity commitment globally to an MFI.

However, the success of the IPO, which was almost 14x over-subscribed and raised $358 million from investors including billionaire George Soros, venture capitalist Vinod Khosla and Infosys Technologies founder N R Narayana Murthy, raised some awkward questions for the industry. Confronted with the company’s soaring stock price – and its implications in terms of shareholder returns – many people in India and beyond began to question the ethics of profiting (so greatly) from the so-called ‘bottom of the pyramid’ (BOP) segment of society. Concerns were also raised that the key focus of a public MFI would become its high-income shareholders, rather than its low-income clients. 

Debate was heightened when a spate of borrower suicides in the province of Andhra Pradesh hit the headlines in October and led to government intervention in the sector. The 75+ suicides were largely blamed on aggressive lending practices at several MFIs, which charge interest rates averaging over 26 percent (SKS for example charged 26.69 percent until it cut its rate back to 24.55 percent from January 11), and the clients’ subsequent inability to repay the debt. 

Andhra Pradesh province passed an ordinance in October, which then became law in mid-December, aiming to cap interest rates, mandate monthly rather than weekly debt collections, and prevent MFIs from using “coercive” action to speed these along. And at the central level, the Reserve Bank of India recently established a sub-committee, the Malegam Committee, to look into drafting potential countrywide regulations for the sector. A draft was due at press time.

Private Equity Reaction

Reaction to the scrutiny from the private equity community has been mixed. To the charges many of India’s MFIs have been guilty of aggressive lending and exploiting a financially illiterate client base, Mehta Vishal Mehta, co-founder and managing director at Lok Capital, points out that neither allegation is unique to India or the poor.

“This phenomenon happens in many countries – including the credit crisis in the US,” he says. There’s no doubt there was some very aggressive lending that happened in Indian microfinance. Were clients 100 percent sure about their repayment capacities and were they educated and was there a good financial literacy program running or not? The answer is no, but again none of this is unique to Indian micro-finance,” he says.

Though he is right, there is no getting away from the fact that the poverty of microfinance’s target client base brings heightened sensitivity to the issues raised. However, GPs and LPs alike stand by the right to profit from the sector.

“There is a misconception that microfinance means non-profit,” states Gary Ng, a Singapore-based director of private equity at CLSA Capital Partners, who led the firm’s $24 million investment into Chennai-based Equitas Micro Finance India last March.

“We believe that the microfinance industry can be like any for-profit business that services a specific segment of the population. For example, should a hospital or a Fast Moving Consumer Goods company that sell products or services to the low income customers not be able to make a profit from these customers?”

A “reasonable” for-profit model is “more efficient”, says Ng, instilling “more discipline amongst the customers”. Not only that, but external funds are necessary for the model to work and grow, he adds.

Also mindful of the bottom line is Hiti Singh, an investment manager at UK government-backed CDC Group (see boxed text), who says: “We have most definitely always viewed it from two angles: as important both in terms of the developmental returns and the financial returns.”

But Lok Capital’s Mehta points out that regardless of the investors’ stance on the ethics of profiting from microfinance, the opinion that might prove to be decisive is that of the Indian government.

“I think the biggest uncertainty in this sector has emerged to be the politicians claiming their territory and saying, ‘the BOP is my constituency, and anybody that wishes to provide a service to them will have to go by my rules’. ‘My rules’ in an Indian political context means ‘free service’, so you must do that under a non-profit orientation rather than a for-profit orientation,” he states.

What next? 

Mehta acknowledges that recent events in the microfinance industry have given Lok Capital –and its LPs – pause for thought.

“Our LPs are in a wait and watch mode – nobody’s in a hurry to get out. We haven’t really started investing from Fund II, so we do have that flexibility to wait and watch for a while,” he says, adding, Any investor, be it private equity or a social investor, who invests in companies which provide products or services to the the low income segment, will think twice now for sure.”

Not everyone has been so hesitant though. Mid-January saw the IFC, the investment arm of the World Bank, commit $35 million to Kolkata-headquartered MFI Bandhan Financial Services. 

And longer term, most are positive on the sector’s resilience, even saying that ultimately this great upset will enable the industry to emerge more streamlined and sustainable in the long term.

“Too much money has been raised for the MFI sector,” says CLSA’s Ng, who believes consolidation will be “beneficial for the better-managed companies”. 

Likewise, the increased scrutiny on the sector and blanket regulations expected to come out of the Reserve Bank of India’s Malegam Committee are being cautiously welcomed by many investors. 

“Recent events provide important learnings for the industry to assess progress and challenges to financial inclusion in India,” says Ayaan Adam, South Asia manager for financial markets at the IFC.

“Urgent steps are needed so that client relationships can be deepened to ensure quality financial services, consumer protection, and sustainable approaches to financial inclusion so those at the base of the pyramid are better off as a result of the financial offering,” he adds.

Regulation might be needed, but for Lok Capital’s Mehta the government’s game-changing intervention in the microfinance sector also serves to remind of “the political risk that comes with any business in India that looks to serve the BOP”.

And given the high percentage of India’s population – and therefore consumer base – sitting at the bottom of the pyramid, the political risk implied is pretty consequential.

Through bad times and good

Microfinance has to date been viewed as a valuable way for investors to achieve both financial and developmental returns. It has therefore been seen as a valid target sector for development finance institutions (DFIs) seeking to promote economic advancement in developing economies.

CDC Group, a London-based investor, is owned by the UK Government and pursues its development goals by backing private equity managers from a fund of funds worth around £2.5 billion (€3 billion; $4 billion). It made its first commitment to a microfinance-focused fund in 2003 and has now committed a total of $100 million to eight private equity funds investing in the sector, predominantly in Sub-Saharan Africa and South Asia. It has also backed a local-currency debt fund, which provides capital to the MFIs.

Hiti Singh, an investment manager at CDC and an expert on the microfinance industry, says that the incidents in Andhra Pradesh, where CDC has backed four MFIs, will hopefully bring about positive changes to the industry.

“The incidents in Andhra Pradesh bring some important issues to light: essentially that there is a lack of any sort of regulatory framework,” she says. “We are hoping that in the long run these incidents will have a positive effect as they lead to a more standardised, regulated approach to the sector.”

Singh highlights the fact that microfinance is still “very much at a nascent stage as an industry” and has experienced a period of incredibly rapid and “unsustainable” growth.

The suicides in Andhra Pradesh have not, says Singh, tempered CDC’s commitment to the sector, which the DFI still sees as “highly developmental by nature.” “It provides finance to the under-served and under-banked: people who can’t build up businesses or embark on micro-entrepreneurship. It also serves a lot of women.”

While CDC is monitoring developments in India closely – in particular the guidance which will emerge from Reserve Bank of India’s sub-committee on the matter – it has not ceased new commitments. It is currently carrying out due diligence on new microfinance funds in both India and Sub-Saharan Africa. “We are definitely very supportive of the sector and plan to continue committing to it,” she says, adding that any new regulations would be welcomed as “solidifying the sector within Indian financial services.”