Thrissur in Kerala, Tiruchirappalli in Tamil Nadu and Haveri in Karnataka are unlikely towns investors will be herded into. But they recently entered India's venture capital map, thanks to the booming microfinance industry. On June 22, Thrissur-based ESAF Microfinance

and Investments (EMFIL) said it landed Rs 12 crore from Dia Vikas Capital, an arm of Opportunity International Australia, while Haveri's Navachetna Microfin Services Ltd received Rs 1.5 crore from a few high net worth individuals and IT professionals. A day later,  Tiruchirappalli-based Grama Vidiyal Micro Finance Ltd (GVMFL) said it raised Rs 20.4 crore from MicroVest, Unitus Equity Fund and venture capitalist Vinod Khosla. This is the second round for Grama, which had raised Rs 14.7 crore in 2008.

The dealflow in microfinance has only gotten stronger with investors looking at investing in Tier III towns like Thrissur and Haveri. MFI has seen the most active venture capital dealflow within the banking and financial sector since January 2008. Of about 50 private equity deals worth $1 billion in banking and finance in the last 18 months, MFIs alone accounted for 20 deals worth over $200 million of Rs 960 crore.

If this was not enough, last week SKS Microfinance, the largest MFI in India, announced a $10 million strategic investment from general and life insurance firm Bajaj Allianz Life Insurance. The two firms had earlier come together last year to launch the first micro-insurance product for the rural poor. The deal signals the significance of how the client network built by MFIs could serve as a distribution channel for products besides credit.

A large chunk of these deals are funded by microfinance funding institutions like Lok Capital, Aavishkaar Goodwell, Bellwether Microfinance and Unitus Equity Fund. They provide startup capital to MFIs, help them build capital and asset base, and make them ready for larger rounds with financial institutions and VC firms.

Since many MFIs are funded and have built scale, a whole new bunch of Silicon Valley venture firms and private equity funds are waiting to enter the industry. If Sequoia Capital India was the first traditional VC firm to invest in the space with a $11.5 million investment in Hyderabad based SKS Microfinance in 2007, the US based Sandstone Capital became the largest venture capital investor in an MFI by leading a $75 million round in SKS Microfinance in November last year.

That was the largest VC investment yet in any MFI in the world. SKS has total outstanding loans of $516 millon and 4.22 million clients at end of May, 2009.

Many other VC firms have already declared their keen interest in the space. They include Norwest Venture Partners, Mayfield Fund and Lightspeed Venture Partners, among others. Says Bejul Somaia, Managing Director, Lightspeed Venture Partners, “Our preference would be companies that have strong management and internal controls as well as reasonable traction on the portfolio side and the banking relationship side.”

Besides SKS, the firms like Equitas Microfinance, Bhartiya Samruddhi Investments and Consulting Services Ltd (Basix Group), Share Microfin, Bandhan Microfinance, and Ujjivan have acquired larger customer and capital bases. So the sector is bracing to see at least a couple of big ticket fundraisings in coming months. Share Microfin and Spandana Microfinance are in the

process of raising rounds between $50-60 million, according to sources in the industry.

There are several reasons for the huge investor appetite in this space. “There is a strong demand for organised forms of banking which cater to the bottom of the pyramid,” says Udaia Kumar, MD of Share Microfin. The credit requirement in India is huge and market penetration is still believed to be around 10% of the total requirement. In fact, 40% of India's population is unbanked, while MFIs have been able to reach only 114 million people with a loan portfolio of over $1 billion, leaving immense scope to grow.

Now many sector focused MFI investors are looking at areas where the MFI penetration is low. MFIs mostly have a presence in Andhra Pradesh, Karnataka, Orissa, West Bengal and Tamil Nadu. For instance, Aavishkaar, which usually is the first institutional investor in an MFI, is currently looking at deals in Uttar Pradesh, Gujarat and Bihar, which are under-penetrated markets. Aavishkaar Goodwell  invested in a Pune-based Suryoday Microfinance earlier this year.

Also the industry has grown by 100% year-on-year over the past few years, even when rest of the Indian economy had slowed down amid the global meltdown. So there is a decoupling factor attached to it.“Poor people are generally unconnected to the global economy and as a whole

the sector that has done extremely well during the difficult economic climate in past year,” says Eric Savage, Managing Director, Unitus Capital, an investment banking outfit that helps MFIs raise capital.

Soaring Valuations

With the rise in investor interest, the valuations of MFIs have also skyrocketed. For instance, valuation of SKS rose to more than Rs 2,000 crore ($416 million) in its recent round, and Spandana is expecting a valuation of over Rs 1,800 crore ($375 million) for its latest round.

Most of MFIs are raising funds now at approximately 10 times earnings while many are doubling earnings annually, says Savage of Unitus.

Niren Shah, Managing Director of Norwest Venture Partners, while positive of the MFIs, says that several companies were seeking to raise capital at 7-9 times their book value; where as there are publicly listed banks which are available at 0.6 - 1 times their book value. This is one of the reasons why many funds have stayed away from this field. “Even though we really like the sector, the reason we have not invested is that we find the valuations to be high relative to the risks we see and also relative to the valuations of other companies which serve the unbanked or credit deprived segment,” said Somaia.

Exits, M&A

MFI sector has only seen money coming in till now, and no money has got out. But we may not be too far away from a public listing in MFI space. Two of the largest players in the sector, SKS Microfinance and Share Microfin, plan to hit the capital markets in the next two years.

SKS has already made its first foray into the capital markets as it recently raised Rs 75 crore via a non- convertible debentures (NCDs) issue, which have been listed on the Bombay Stock Exchange. Other MFIs are also likely to follow suit.

Along with this, the sector is also likely to see consolidation in coming months. The M&A in the sector would be driven by need for large players, who mostly present in Andhra Pradesh, to expand to other geographies in the country. The large firms could look at buying smaller sized players with portfolio of around Rs 50-200 crore in other parts of India, says Aavishkaar’s Rai. The acquisitions would help big players get local talent, which, Rai believes, is more important than their loan books.

“You might see M&A in areas like North-East and East India, where MFIs working in a niche have created a regional stronghold,” adds Abhijit Maheswari, founder of Sloka Capital Advisory Services Pvt Ltd. Industry players say that talks between firms have already started. Smaller MFIs could also come together in a merger in order to take on the scale of larger players and attract funding from VCs. 

“Like-minded and medium size MFI could consolidate operations and books to achieve scale, attract capital and get access to alternative source of finance,” adds Maheswari.

The Growth Pangs

Though the sector paints a pretty picture, there are a number of challenges going ahead, players believe. Multiple borrowings by the same customer and hiring of staff to keep up with the growth have emerged as impediments. Rai of Aavishkaar says that there is a need for a credit bureau so that data can be shared to tackle multiple borrowing. Also a need for legal and regulatory framework is now being felt by the sector which has seen rapid growth.

Most of the large MFIs – even though registered as non-banking finance companies (NBFCs) - are not allowed to accept savings. The need for facilitating savings by poor is felt more than the need for credit. Besides, savings will take these institutions evolve to the next level, and would help them meet their funding requirements for future growth.

“In an environment where credit gets tight, a deposit base provides an additional source of funds, at a potentially lower cost than borrowing from financial institutions” says Somaia of Lightspeed. This option is present in other parts of the world.

Mexican MFI Banco Compartamos was allowed to take savings and became the first Latin American MFI to go for an IPO. Despite all of this, Indian MFI sector is growing at 100% year on year, a reason why the dealflow in the space will remain robust for sometime.

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