Ensuring Debt Finance for All Professionally-run MSMEs.

For several years, a number of policy initiatives have been taken to address the financing gaps for MSMEs. Of course, we have improved over the years. However, a lot still needs to be done. Here is a set of views, that I have, on how to go about doing it. Some of it is about approach and some of it is about actual implementation. Of course, this is a complex problem and I am not denying that genuine efforts have been made in the past. My argument is that those efforts have fallen short and it may be a time for policy makers to do a few things differently (to the extent that some of the suggestions may seem impractical but I am taking the liberty to list them out here.)

Note: Unsecured, small ticket lending to MSMEs based on credit of the individual promoter is largely (on the How to aspect) a solved problem (in India) and has got/getting a lot of attention. (We are miles to go for universal access to finance for MSMEs even in the small ticket, individual credit led lending.) The focus of this write-up is on corporate SMEs with high growth aspirations, where the funding requirements is in crores (individual promoters credit is not a good alternative for company credit) and is generally not done by traditional lenders without mortgage collateral. For new age, asset light but professionally run businesses, it is a key gap, that remains unsolved at scale. Hence, the focus on that segment in this write-up.This write-up is addressed to those shaping policy and regulation. This write-up is specific to the Indian context.

Do NOT broad brush: The MSME segment includes not just the local tea shop, or the puffed rice making factory but also includes the SME corporate with turnover upto INR 250 Cr (as per the recommended Budget 2018 classification) with some of them having raised institutional venture capital. Hence, the funding requirement, credit evaluation process and lending model will not be the same. If we don’t separate out the sub-segments and find specific solutions for each segment based on loan size, security and nature of entity, we will not have a comprehensive solution.

It may make sense to break down MSMEs into categories based on legal structure i.e. individual, proprietorship, partnership and OPC or private limited and have priority sector or lending target setting done separately for them. Have caps on loan amounts for each type of legal structure. The reason why I say this is, I am not sure why a firm with several crores of rupees in turnover, borrowing from banks, etc in crores should have the legal structure of a partnership/proprietorship. It should be a private limited company. The regulators have to make it easier for people to set up companies and be compliant. This will enable access to additional sources of data which can be leverage to take lending decisions.

(A note for SMEs seeking larger loans: If you don’t have mortgage or collateral security AND you haven’t put in much of your money as equity because you don’t have much AND you don’t have reasonable size of operations AND you don’t want to be compliant with additional regulations or provide verifiable data on various aspects of your business AND you still expect funding in crores – time to get some coffee. The purpose of adding compliance and improving access to different sources of data from the SME is to deal with the lack of security. Please note that unlike equity investors, lenders do not get a share on your upside but they do get a share of your downside for sure and hence they need to ensure that downside is limited. )

Accept that only Banks will NOT be able to help us in ensuring complete access to finance for MSMEs: Banks hold public/retail deposits and it is natural that they will have less risk appetite than NBFCs or specialised funds who are typically funded by entities that have the ability to manage risk unlike the retail depositor of a bank. By design, NBFCs or specialised funds will take more risk through sectoral specialisations. Historically, banks have been treated as the favoured child by regulators. If there is genuine interest in enabling access to finance for all segments of MSMEs, it has to be recognised that banks, NBFCs, specialised funds will together be able to address the funding needs of MSMEs.

How about allowing specialised MSME lenders partial access to the payments and settlements system? This will allow them to set up basic escrow accounts and current accounts with zero or close to zero EOD balance and ability to receive funds ONLY from corporates. NO cheques, NO savings or other deposits. This will enable specialised MSME lenders/NBFCs to offer payments, set up escrows to do a cash flow traping arrangements to deduct repayments without having to depend upon banks who create severe roadblocks in letting specialised lenders access to these simple operations. Sounds, kind of, like payment banks but I am talking about larger value transactions. Say, those who offer loans in INR crores to corporate SMEs and need to transact in several lakhs and crores and not in thousands.

Use Govt backed DFIs as market developers: India needs to find a way to use Govt backed DFIs in a market development role and not in competitor role. Their role should be to find ways to encourage other commercial lenders/investors (Banks, NBFCs, specialised funds) to do the job of lending to MSMEs instead of competing with them by trying to reach the MSMEs directly. I understand that there was a time when DFIs had to “show the way” because the commercial lenders/investors were not interested. However, over the past 8-10 years, it has been shown that private entities have been trying to find different ways of reaching out to the lucrative MSME finance gap. Frankly, if all the banks and NBFCs together are not able to directly reach all MSMEs, it is good reason to introspect and accept that one or two DFIs with limited geographic presence can reach out to all MSMEs.

Policy makers should encourage the use DFI funds to act as market developers through guarantees/credit enhancements for institutional investors to invest into NBFCs/specialised funds that are trying to fund MSMEs in India. This opens up a much larger tap of borrowings for the NBFCs and specialised funds (beyond banks) and also enables them to raise funding at a cheaper cost (assuming credit enhancement by DFI will lead to better rating of the transaction.). Oddly enough, I have seen multiple instances where Indian DFIs offer funding to NBFCs/specialised funds at a cost that is signifcantly higher than what the commercial banks or offshore commercial and DFI lenders are ready to offer at.

Consider Bank, NBFCs and specialised funds as partners and not adversaries: Banks in India (DFIs included) do not like sharing of pari-passu or second charge with NBFCs or specialised funds, as a practice, when lending to SMEs. Even though nothing in the regulation or law disallows it. This is a version of caste system propagated within our financial services industry under the excuse of lack of sufficient assets. Interestingly, I have seen multiple cases of companies that are profitable for more than 3 years with INR 50 Cr+ revenues (and fixed and current assets worth atleast INR 15-20 Cr) having INR 2 Cr worth short term facilities from banks backed by 75% cash deposits and security over entire current and future assets of the company (and possibly even the kidney’s of the promoters) NOT willing to share pari-passu charge over receivables (not on cash, not on fixed assets, just receivables) for NBFCs willing to lend higher amount than the bank and under more flexible terms. Since, forced regulation and orders will not solve this “social” problem, a better way is to encourage banks i.e. say that for the MSME loan accounts that the bank has, if the banks are able to demonstrate another non-bank lender on-board, they will be awarded 1.5x the value of their loans as priority sector.

Over-leverage of SMEs has to be addressed differently: Initiatives like the central credit registry is necessary to give a clear idea about over-leverage.(This is already being done.) It should be made compulsory to have all types of financial lenders (not just banks) add the details of the loans on the platform.

Data, data, data: Enable electronic access to data for all types of statutory, regulatory and transaction compliance done by companies. Eg: Specialised lenders or even banks should have access to data on taxes, electricity payments, EPFO, ESI, salary, bank transactions, etc. Security and privacy concerns are paramount but given that they are solvable issues, we need to find ways in which access to all that data is made extremely convenient, if we were to expand access to finance for MSMEs.

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“World Domination”​ of the Agri Supply Chain

Historically misdirected/misutilised subsidies of the Govt made it very difficult for private players to operate in the agriculture supply chain. With the easing of regulations, we are seeing a large number of new private ventures (traditional and new age startups) entering agriculture. That is a good sign.

However, what worries me is that some of these companies (startups) and their VC investors are looking at the agri supply chain “domination” game with a similar approach like the Uber/Ola/Flipkart/Amazon model of “world domination” by burning huge volume of money to deliver market distorting “subsidies” to capture market share with the hope that the last startup standing will win it all. (Remember the days when drivers and riders were being paid to ferry you around? Or deep discounted sales prices for products?)

While Uber/Ola/Flipkart/Amazon is still to prove business viability, they are already shifting gears and causing significant distress to the affected. It may be argued that they have distorted local transportation markets for riders (costs have gone up significantly and availability is still a major problem) and have left several drivers with debt burdens they can’t service. We don’t know how this will end. (Anybody who knows, I am ready to buy you a coffee.)

If the startups and VCs replicate the same model of “world domination” in the agriculture supply chain (particularly when dealing directly with the farmer), they will most certainly leave the agri ecosystem with much more pain and damage than what the Govt did with misdirected subsidies.

VC Associates and Partners with no special expertise or knowledge of agri markets but with boatloads of cash will continue to wear Rolexes purchased with fund management fees whether or not their invested startup works. Startup entrepreneurs with “game changing” ideas but no capability to build a profitable business or achieve frugal growth, will buy mansions in Koramangala or Lutyens and select the next “Entrepreneur of the Year”, whether or not their startup works. But the farmer will be stuck between the devil (Govt) and the deep sea (startups) after enjoying a brief period of money induced trance and exuberance.

I know some will agree with all that I wrote. Good to know. Let’s get some coffee and discuss more. I also know that some will disagree with all that I have written and say that I can’t see the “big picture” and worse I am a “communist”. True, I can’t see the big picture but atleast, I am not blind or a communist. Let’s get some coffee and see if you can help me see the “big picture” and if I can get your eyesight back.

MUDRA Bank – How will it help?

First things first, a regulator cum re-financier (market player)  is bad design. Period. It leads to moral hazard where the regulator will shape policy to grow only its business. Yes, refinance is business.

But I hear that MUDRA Bank is expected to be a regulator and financier of microfinance institutions and micro-enterprises. Why?

The only other entity with such an entitlement, the National Housing Bank (which is a regulator and refinancier for Housing finance companies and bank housing loans) is expected to lose that status once the long pending NHB Bill is passed in its current form. The bill aims to move the regulatory powers of the NHB to the RBI and let NHB continue to operate as a sector focussed bank like NABARD and SIDBI. Obviously, the law makers realised that regulation and business do not go hand in hand.

That brings me to the second question, NABARD refinances MFIs, so does SIDBI. SIDBI refinances/ guarantees small/micro enterprise finance. So, basically, between the two they pretty much already do what the MUDRA Bank is supposed to do on the refinance side. So, why do we need a MUDRA Bank?  Yes, they don’t regulate. So, to regulate?

When the microfinance crisis broke out, there were discussions of NABARD being made a regulator for the MFI industry but that did not happen, primarily due to the fact that NABARD was actually a refinancier (a service provider) for MFIs and the significant majority wanted NABARD to continue as a service provider and not become a regulator in parts due to the lack of infrastructure and in parts to avoid the moral hazard issue. The only reason why NABARD was brought into the picture was microfinance institutions not only included the RBI regulated NBFC-MFIs but also societies and trusts not regulated by he RBI.  However, NABARD felt that they did not have some of the “missing links to operate in the sector” as a regulator.

What then, will the MUDRA Bank do differently? If the several decade old and experienced NABARD thinks they can’t handle the job, how will the MUDRA Bank manage?

Another interesting proposed change is that the FMC and SEBI are going to be merged, the logic seems to be that financial and commodity markets are, at the end of the day,markets and hence they should have a common regulator because this will streamline decision making and potentially trigger new products. Great!

And there comes my third question, why then are we trying to create multiple entities for microfinance and enterprise finance? Where is the coherence in “strategy”?

Instead of seeding new ideas, would it not be better to energise the NABARD and SIDBI to take the word “Development” in their names seriously for their respective sectors? To adopt innovation and  shake away  some of the bureaucracy that binds them down? To adopt proactive measures to tackle the problem of access to finance for small businesses?

And please, for the sake of humanity, why should a bank promoting entrepreneurship favour only the scheduled castes and tribes? Favour all enterpreneurs, if you can. Nobody does that in our country.

(Edited on 9th March, 2015 to add an article on the same topic by noted journalist/author Mr. Tamal Bandyopadhyay. He seems to point out similar concerns.)

Next…what?

 

Renewable Energy.

Water.

Medical Technologies. (Detection and treatment)

Agriculture.- Food production & Food preservation.

That is where breakthrough innovation is required. We will possibly see breakthrough innovations in these areas (in that order) in future. Something similar to what we have seen in case of communication technologies over the past decade.

While Renewable Energy and Medical Technologies have received venture investments, Agri-Tech and Water are still to see mainstream venture capital investments.

Reading List- 23rd Nov, 2013

1.)What if your memory is fake?

Article: Fake memory

Those people who seem to have a photographic memory might just be having a fake memory!

2.) A brilliant innovation gets you fit for the Olympics!

Video: Subway tickets

3.) The story of Mike Tyson. Told again.

Article: Mike Tyson

4.) How Amazon became an everything store

Article: Amazon

5.) Why does airline food suck?

Article: Airline food

Boredom and Low humidity are two key reasons along with constraints in preparing food in the air. We lose sense of taste/flavour due to a blocked sinus and low humidity. This makes us less perceptive of the taste. Interestingly, Indian food is less affected by these conditions due to the fact that naturally permits humid sauces in its preparation.

Pricing: Loan against property v/s home loan

Simplified Definitions

Mortgage Loan/Loan Against Property (LAP):A mortgage loan is given for an open end use and is given against the lien of a property.

Home Loan: is given for a restricted purpose of buying/ constructing a house to stay.

Typically a mortgage loan is often the most common way of raising funds for growing the business. Banks typically get comfort from the availability of fixed collateral to be able to recover from in case of loan default.

The rate of interest charged on a Loan Against Property is higher (much higher) than a Home Loan.

Historically, default rates of LAP (for business purposes) have been high justifying a high rate of interest.

Why?

Question 1: Is the assessment of loan eligibility for LAP done assuming that cash flows from the business will grow due to utilisation of the funded amount for capex/WC use? If that is not the case, why would the default happen?

Question 1 a.) why can’t we give the loan based on existing cash flows?

People say that the loan size would be too small and not meet the requirement for the capex. My comment on that response would be “Oh common! let’s grow step by step. Give me some other reason”.

Question 2: Why doesn’t the “emotional attachment” story that works in case of home loan doesn’t work for LAP?

Question 2. a.) Does the person seeking a LAP have multiple properties and so property offered on mortgage has lesser “Emotional attachment”?

Guess so.

(Also, the question is how enforceable is the mortgage? In a lot of cases, especially developing countries, legal recourse may just be too cumbersome/ inefficient. So, isn’t the collateral acting more as a deterrent. I guess it is.)

Question 3: Would a LAP given based on existing cash flows AND after taking the owners current residential home as collateral completely change the loan performance?

That is what a number of financial institutions are now trying out with the lower income/informal sector entrepreneurs. Assess loan eligibility based on current cash flows and take the residential property of the entrepreneur as collateral. However, the interest rates continue to be higher going with the notion that LAP has generally resulted in high defaults. Interestingly, last 3 year’s history in these kind of loans show very low (between 0.5- 1 % delinquency in the 90 days past due bucket). Off course, three years is not enough time but these 3 years have been the roughest phase for business in India in general as well. The other key reason for good portfolio performance could be that this type of lending is new and the good quality selection could be due to the initial “start-up precautions” taken by the financial institutions starting this product.

Assuming loan performance does show improvement in this kind of loans, is there a reason to suggest lower interest rates and hence greater affordability?

At last but very important, one oft stated reason for low home loan interest rates is that the purchase of home does not generate additional revenue but LAP for small business does and hence the borrower can pay a premium. For all practical purposes, this reasoning silences all the discussion and the confusion around the pricing by simply stating that the lender wants his pound of flesh! That’s all!

What do you think?

How much equity and when?

When you judge a promoter on his interest in the business in terms of equity contribution brought into the business, what would you consider more sensible?

A. bringing in equity capital in phases

All start-ups are prone to initial setbacks but some of them can recover if further capital is pumped in to the changed business model (pivot). If the promoter spends all his money in the first attempt/business model, he would never have money to implement the pivot.

B. Bringing in equity capital in one go right at the beginning

If the promoter has brought in all his money into the business right at the beginning, it shows his dedication and indicates that come what may, he will make his business work.

From an investor perspective:

  • How do you determine which level of capital brought in is enough to prove seriousness of the promoter in the business?
  • Would the amount of personal equity brought in, indicating dedication to the business, vary from industry to industry? (My sense is yes. Tell me if I am wrong)

How would the assessment vary between the first equity investor and the first debt “investor”?