Warren Buffett famously said, “You only find out who is swimming naked when the tide goes out”. The current global economic crisis has left many industries exposed to the falling tide; however, the Indian microfinance industry has proven to be buoyant and has emerged thriving, or “fully clothed”. This is quite appropriate in a country where people are fully clothed even when they swim in the waters on the ghats of Varanasi or elsewhere.
We believe the Indian microfinance sector presents an attractive investment opportunity. This view is apparently shared by investors such as Legatum, Sandstone, Sequoia, Silicon Valley Bank, Valiant, and others who have made recent investments. This industry catering to poor borrowers, which until five years ago was primarily sustained by aid money, has proven to be highly profitable.
The same borrowers, who are largely unaffected by the global economy, have now withstood the test of time, their creditworthiness demonstrated by the continuous strong repayments. The phenomenal growth of the Indian microfinance sector coupled with empirical evidence that it is relatively uncorrelated to the global economic situation, have driven significant investor interest.
Recession Proof Growth
The Indian microfinance sector has experienced massive growth, with both the number and sizes of microfinance institutions (MFIs) having exponentially multiplied in the last few years. Despite the economic crisis, the portfolio and client outreach of MFIs has grown by 97% and 60% respectively in the last financial year, implying a gross portfolio of more than Rs. 11,700 crore and 17.9 million active borrowers as on 31 March 2009.
This translates to an average loan outstanding of Rs. 6,500 and the numbers in aggregate reflect the fortune at the bottom of the pyramid. Most of the better performing MFIs have had triple digit portfolio growth rates.
This is just the tip of the iceberg though – MFIs have reached only 3.5% of the poor in India, signifying that there is an immense untapped terrain, yet to be explored. Growth has largely been skewed towards Southern India and microfinance is in its infancy in the North and the West. We describe below what has driven this strong, recession proof growth, as well as some of the sector’s challenges.
The phenomenal success of microfinance has been strongly facilitated by the Indian Government, including the RBI, by having furthered financial inclusion and nurtured the MFIs over the years.
The foremost initiative is the guideline on priority sector lending for all banks, which has incentivized debt funding to MFIs, even during the current crisis. Additionally, the dedicated and sustained efforts of state owned developmental financial institutions like SIDBI, NABARD and RMK have been indispensable to fostering Indian microfinance.
Going forward, the proposed creation of a national unique identification number will make feasible tracking of individual credit histories, exposures and developmental indicators. The Government will hopefully be even more helpful in the future by enacting legislation that allows the larger MFIs, which are NBFCs and have robust systems and processes, to mobilize savings deposits.
Specific legislation on microfinance is pending approval from the Parliament and is expected to provide a proactive and focused regulatory framework, standardized reporting and increased transparency.
The consistently robust repayment performance of the underlying clientele is the most impressive aspect of Indian MFIs. Overall default rates are much lower than most banks – often less than 1%. The reasons are manifold: (1) Non-payment would mean cutting off the poor borrower’s cheapest source of funding (2) India is still a highly community-centric society, which makes social collateral (peer pressure) very effective (3) The demand for micro-borrowers’ goods and services is typically stable and often comes from others in the same economic stratum and (4) For micro-borrowers, the return on investment is much higher than the cost of debt.
Increasing Funding Options
Indian MFIs have not yet been permitted to mobilize deposits. This had left MFIs with little choice but to largely mobilize term loans from banks and on-lend the funds on to the micro-borrowers.
Of late, there have been instances of select larger MFIs issuing listed debt instruments like commercial paper and non-convertible debentures – a recent media report stated that MFIs were looking to raise Rs. 1,000 crore this financial year through the issue of such instruments.
Such securities: (1) augment the investor universe by overcoming regulatory constraints and liquidity concerns, (2) reduce cost of funding as a direct consequence of this increased universe and (3) enhance the probability of funders taking exposure for longer tenures, which will help fund micro-housing and other products having longer terms. Securitizations are on the increase, banks are enhancing exposure to MFIs and the emergence of guarantee funds is facilitating debt funding to the smaller players.
Opportunities beyond Credit
An MFI is an incredibly powerful channel to reach rural masses and, as such, is a cardinal distribution channel to market products. SKS, India’s largest MFI, has teamed up with handset providers to supply its borrower base with low-cost mobile phones. Bajaj Allianz recently infused a strategic investment of Rs 50 crore into SKS as it agreed to provide the outreach needed to mass-distribute micro-insurance policies.
Through education, healthcare, energy-efficient devices and other products, there is an enormous potential to tap into the newly aggrandized disposable incomes of rural India, as well as create income sources for the poor. These opportunities will significantly contribute to increasing the fee-based incomes of MFIs, which will be independent of their loan portfolios.
Microfinance is a manpower-intensive business, which makes the cost of providing services at the doorsteps of customers quite high. Historical trends reflect that the operating expense ratios of most MFIs have been consistently diminishing, primarily because of the advent of information technology and the increase in staff productivity.
MFIs are increasingly becoming tech-savvy and automation of hitherto manual processes has enabled deep cuts in cost structures. Teledensity in India has been growing at breakneck speed, touching 37% (430 million subscribers) as on March 31, 2009. Mobile banking is expected to be the next revolution in Indian financial inclusion, especially considering the incredible success that countries like Kenya have had.
The biggest challenges of the sector are: (1) Lack of professional managerial expertise – this is rapidly changing and of late, a battery of professionals has entered the microfinance sector. Many distinguished bankers have promoted or are heading Indian MFIs, thus bringing in mainstream corporate expertise (2) Political Interference – isolated cases of interference by local administrative bodies exist but largely, the attitude has been that of laissez faire and there were no major incidents surrounding the recent national elections (3) General concern that the poor by definition must have a hard time making repayments – as discussed above, this has not proven to be the case in India or elsewhere overseas since the microfinance sector was formalized over thirty years ago.
The steep growth rate is expected to continue through the next decade before stabilizing, chiefly because of the immense unmet demand. The Deputy Governor of the RBI recently remarked that the RBI is urging the big information technology firms in the country to facilitate the mass implementation of devices like biometric cards, so as to bring down transaction costs in microfinance.
Exit mechanisms for investors have also become much more lucid – some secondary sales have taken place and reports of upcoming IPOs have been seen in the press. There is a market for all classes of equity investors in microfinance: infusions have varied from a couple of crore Rupees to more than Rs. 350 crore.
The median P/E at which private equity infusions into MFIs have taken place in the last year has been close to 10, despite growth rates of projected earnings often being above 100%.
Microfinance is all around us – from the massive shantytowns of Mumbai and the rural hamlets in the distant north-east to the maid in your kitchen. Microfinance came into the public eye after Dr. Muhammad Yunus and the Grameen Bank were awarded the Nobel Peace Prize in 2006 for the decades of developmental and economic alleviation in Bangladesh.
This was a testament to the double bottom line approach that emphasizes both profitability and social impact. Newsprint is replete with articles on this silent socioeconomic revolution. Investors are also increasingly realizing why this asset class is so attractive.
For those not invested in an Indian MFI yet, the words of Victor Hugo come to mind: “No one should resist an idea whose time has come”.
(Eric Savage is Managing Director at Unitus Capital and Abhishek Fogla is Associate at Unitus Capital).