Opportunity in financials in India

Introduction

Companies in the financial sector in India including banks and NBFIs have created tremendous amount of value over the years. There is a good reason for that. As I have discussed in one of the previous articles as well, it is rare to find businesses which have high returns on capital and at the same time have ample opportunities to reinvest the capital at the same high returns in the core business. If such businesses exist they can be the dream compounding machines. Financials is one space where companies with good business models can do exactly that. This has been addressed in an article I read by Saumil Zaveri – Searching for Compounding Machines Among Financials in India.

The article makes a case for investing in the financials space in India. The article outlines the solid growth prospects for credit in India. This has created a tremendous opportunity for providers of credit – including both public sector and private sector banks. However, public-sector banks have been dogged down by problems of their own including bureaucracy, inefficiency, stressed assets etc. As a result, a few private sector banks seized the opportunity and have been able to scale up and build superior franchises – such as HDFC Bank and Kotak Mahindra Bank. However, the runway for growth continues to be long for providers of credit even from here. Apart from private sector banks, some NBFIs have been able to build differentiated and sustainable businesses by focusing on certain niches. Bajaj Finance and Gruh Finance are two such NBFIs focused on consumer finance and affordable housing finance respectively.

In general, the NBFIs can be grouped into one or more of the following products categories.

  1. Consumer: further subdivided into – microfinance, home loans, auto loans (2W/4W), consumer durables, personal loans, loan against gold
  2. Micro, small and medium enterprises (MSME): further subdivided into – secured (loan against property) and unsecured
  3. Commercial Vehicles / Construction Equipment
  4. Commercial: further subdivided into – construction and real estate, capital markets, distressed and others

The demand for credit in India continues to soar and has a long runway ahead. In another article (Decoding India’s consumer lending opportunity), Bala Srinivasa puts the massive opportunity in the consumer credit space in India under the microscope. We get a sense of the current size of the opportunity and also its future prospects. Consumer credit is expected to increase at an astounding rate of 20% pa from US$287 billion in 2017 to US$1,230 billion in 2025. Further, what is even more interesting is the breakdown of the opportunity by customer segments. Customer segmentation has been done on the basis of income into the following five categories – Elite (annual household income > INR 20.6 lakhs), Affluent (between INR 10.0 – 20.6 lakhs), Aspirers (between INR 4.5 – 10.0 lakhs), Next Billion (between INR 1.4 – 4.5 lakhs) and Strugglers (less than INR 1.4 lakhs). The results of this exercise are quite illuminating:

  • Elite: consumer credit will increase by 2.8x from US$120 billion in 2017 to US$330 billion in 2025.
  • Affluent: expected increase by 3.0x from US$80 billion to US$245 billion.
  • Aspirers: expected increase by 4.2x from US$60 billion to US$250 billion.
  • Next billion: expected increase by 13.7x from US$25 billion to US$335 billion.
  • Strugglers: expected increase by 52.7x from US$1 billion to US$60 billion.

While Elite, Affluent and Aspirers will continue to grow at decent rates into the future. But there is going to be a boom in consumer credit for the Next Billion and Strugglers. One of the main reasons for this is the low bases from which they are starting.

There are still whitespaces both in terms of products and customer segments which remained largely underserved by the organized financial sector. As we can see from the article above the customer segments Next Billion and Strugglers are examples of such spaces. Another is the Medium, Small and Micro Enterprise (MSME) finance in India. Companies which operate in these white spaces are going to have a strong tailwind behind them in the years to come. However, these tailwinds are not only strong but equally they are rough as well. There have been many companies which have been caught up in the whirlwinds and have been destroyed. Hence companies will have to build systems which shield them from the destructive effects of the tailwinds while enjoying their advantages.

Additionally, these are incredibly hard but important social problems. The solutions to these issues, whether they be consumer financing for the Next Billion/ Strugglers or the MSME financing can be powerful source of poverty alleviation and job creation. Equally they will be enormous source of wealth creation for the companies which manage to solve them. But the problems do not have any easy solutions otherwise these would have been solved by the existing companies. Some companies have been operating in these white spaces with mixed results so far as we will see. Any solution to these problems will require developing a nuanced understanding of the customers. And this understanding cannot be developed quickly. It can only be acquired over years working with the customers and hence will require focus, persistence, patience and prudence. But the rewards for the companies which are able to break the code will be huge.

First let us get a quick overview of the major NBFIs in existence in India and their focus areas across the product and the customer segments. This is shown in Figure 1.

Figure 1

Figure 1

As we can see from figure 1, Capital First is focused on consumer and SME finance, with 27% and 60% AUM in these two segments respectively. In terms of customer segment they are focused on Aspirers and the Next Billion.

Shriram City Union Finance (SCUF) is also focused on consumer and SME with 41% and 53% AUM in these segments respectively. In terms of customer segment, they are focused on the Next Billion and to a lesser degree on Aspirers.

The next three companies – Chola, Shriram Transport and Mahindra Finance are focused on commercial vehicle finance. In terms of customer segment, Chola and Mahindra Finance are more focused on Aspirers while STF is more focused on the Next Billion.

Ujjivan and Equitas are focused on microfinance, although Equitas has diversified beyond microfinance into SME and CV financing as well. In terms of customer segments, they are the only company squarely focused on Strugglers and trying to move to next billion as well.

Muthoot and Manappuram are into gold loans within the broader consumer segment. In terms of customer segment, their focus in on Aspirers and Next Billion.

Edelweiss is the only company with a majority of AUMs in commercial segment while IIFL is much more diversified with focus on Consumer and MSME segments. In terms of customer focus, they are focused on the Aspirers.

The remaining companies are into housing finance within the consumer segment. While Gruh, Repco and DHFL are focused on Next Billion, the remaining companies target the Aspirers, Affluent and Elite customer segments.

Figure 2 below gives a quick snapshot of these companies in terms of financial metrics.

Figure 2: Financial snapshot

Screen Shot 2018-01-03 at 11.26.05 AM

Note: All the financial numbers are for FY17 (consolidated) except AUM and NPA (which are for the Quarter ended September 2017) and Mcap (as of 2nd January 2018).
1 Standalone basis
2, 3 The numbers only take into account the lending side of the business except the market cap which is for the entire business.

We will focus on the companies operating in white spaces. And the white spaces are:

  • Next Billion / Strugglers
    • Housing finance – DHFL, Gruh and Repco
    • Gold finance – Muthoot and Manappuram
    • Microfinance – Ujjivan and Equitas
  • MSME
    • MSME finance – SCUF, Capital First and Bajaj Finance

While housing finance is an excellent business which is widely recognized and followed, but the opinions about the others are quite mixed. Quoting from the first article, it has the following to say about some of the other product categories:

We have usually steered clear of segments like gold loans, microfinance, infrastructure, construction equipment, and commercial vehicles — from what we have learned some of these businesses are far more difficult to differentiate on and build superior operating cost structures or witness credit costs meaningfully lower than peers; others are more prone to excessive regulatory oversight or poor consumer credit discipline. Some of these segments have become more commoditized with more credit supply chasing stalling demand. Managements which have exited such segments have sometimes commented, “That was a mediocre business in good times and a terrible one in tough times.”

It is true that the performance of most of these businesses have been inconsistent in the past. It is also true that these businesses are not as robust as housing finance. However, given the long runway and the tailwinds for some of these businesses, especially microfinance and MSME finance, it might be worth exploring them in more detail to develop a more nuanced understanding. These businesses are in a nascent stage of their development. Not only are these businesses changing, but the competitive and regulatory landscape is also changing around them. As these companies evolve, some of them have the potential to transform themselves and emerge stronger with robust business models.

Housing Finance

Housing finance companies (HFCs), not surprisingly have performed the best amongst the all the NBFIs. The companies in housing finance have one of the lowest NPAs and the best return on assets (ROA) after gold finance companies. The excellent financial metrics for the companies in this sector reflect the strength of the business. Housing finance is amongst one of the lowest risk products since people are generally loath to default on their home loans. Additionally, it is a secured loan and even in case of defaults the financial institution can still recover their money. It is an ideal product on which many companies have built successful businesses. At the same time, these businesses continue to have long runways ahead of them. The multiples which these business command in most cases reflect the strength of the businesses and their excellent growth prospects.

Within housing finance, there are companies focused on different customer segments. DHFL, Repco and Gruh are focused on the Next Billion segment. The average loan size for DHFL, Repco and Gruh are INR 14 lakhs, INR 13 lakhs and INR 9 lakhs respectively. The remaining are focused on the mass market including Aspirers, Affluent and Elite with average loan size of ~INR 20 lakhs. The Next Billion is arguably a difficult segment to operate in. For many of the households in this segment, formal income proofs and such documents are not easily available making it difficult to gauge the repayment capacity of the borrowers. But the difficulty of dealing with this segment is compensated by the growth prospects it offers. The story of Gruh is well known in the markets. Gruh has grown its assets and profit at a CAGR of ~22% and 26% respectively during FY2007-17. Its market valuation reflects this performance and is the best amongst all the companies on all three parameters – with price/ AUM of 1.3, P/ NII of 34.8 and P/E of 61.6. DHFL and Repco are available at more moderate valuations due to concerns around corporate governance for DHFL and performance reasons for Repco.

Gold Finance

While a lot of companies offer gold loans, the two major ones are Muthoot and Manappuram. Gold loan companies have been around for a long time in India because of our obsession with the yellow metal. India is the highest user of gold ornaments in the world. In earlier times, gold loan was given mostly by moneylenders or the landowners to the peasants. However, starting in the 1960s many banks started offering gold loans as well especially in Karnataka, Kerala and Tamil Nadu. Both Muthoot and Manappuram have their origins in the pawn broking business in the 1940s.

Gold loans are primarily accessed by customers who possess gold jewelry but who are unable to access formal credit from banks within a reasonable time. Hence, in general these customers belong to the Next Billion and Aspirers category. Also, the loans are usually small with average size of ~INR 40-50k and are given for a tenor of upto 12 months. Interest payments are usually back-ended due to the small size and tenor of the loans. The demand for the loans from these customers is quite inelastic with respect to the interest rate charged. This is due to various reasons. One, these customers are underserved by the existing financial sector and hence do not have too many options. Two, urgency of the loans as these loans are frequently required at short notice. Finally, due to the small size of the loans a few percentage increase in interest rate doesn’t make too much of a difference. This explains the high return on asset for gold loan companies, in fact the highest among all the NBFIs!

While the returns for gold loan companies is excellent, what about the risks. Gold loan is a secured loan due to the collateral. However, this doesn’t work if the price of the gold declines abruptly. This is exactly what happened in 2012. It will be instructive to analyze what happened during that period.

However, before that gold had a dream run in the first part of the decade. And so did the gold finance companies. The asset book of Muthoot and Manappuram increased at a CAGR of 57% and 85% during FY05-13. During this period, a lot of companies entered the gold loan business, attracted by the success of these two companies. However, all that changed when the price of gold started declining starting in 2012. Even Muthoot and Manappuram were badly hit during this period. Their asset book dipped sharply during FY 2014 (13% and 15% for Muthoot and Manappuram respectively) and even after growing steadily each year has barely managed to reach the levels of FY2013 even in FY2017. Their profitability also dipped during this period. The ROA of Muthoot and Manappuram declined from 3.4% and 4.9% in FY2013 to 3.0% and 1.6% in FY2014 respectively. The rapid growth and the subsequent slowdown of these two companies also made the regulators take notice. These companies had combined asset books of ~INR 43,000 cr at the end of FY2013 and any problems could have system wide implications. Hence the regulator stepped in. They brought down the loan to value ratio of the loans to 60% from 75% prevailing earlier. The regulator also put in place some other restrictions on gold loan companies as well such as tier 1 capital ratio of 12% as against 10% for banks. As a result, the profitability of the gold loans companies declined. Many companies which had been attracted by the lure of easy money exited the business during this period. Cholamandalam Finance, Mahindra Finance, Magma Fincorp and Capital First exited the business in FY2014/15 period.

Muthoot and Manappuram have learned a few lessons from their mistakes in 2012. They have reduced the tenor of the loans from mostly one year loans earlier to now where majority of the loans are 3 or 6 months’ tenor. Although the risk of a major and sudden correction in gold price is still there, this measure would help in tackling the risk to a great extent. Additionally, they have also taken steps during the last few years to diversify beyond gold loans. As a result, for Muthoot and Manappuram the proportion of gold loans has come down to 96% and 78% at the end of September 2017 of the total loan book. Their profitability is also back to normal; in fact the gold loan business is the strongest in terms of profitability amongst all the NBFIs (Figure 2). Their return on assets for FY17 are 3.7% and 5.0% for Muthoot and Manappuram respectively. These companies also employ less leverage than their counterparts.

However, despite taking all these steps, in terms of market capitalization the gold loan companies still command the lowest multiples amongst all the other NBFIs. This is because of concerns around their growth. As already mentioned they hardly experienced any growth during FY2013-17. Even during the next two quarters after FY2017, when people expected them to start growing, they continued to stagnate in terms of their asset book. This was largely because of demonetization and GST, as their customers were the hardest hit especially from demonetization. But I think the growth concerns will prove to be temporary.

I think they have a solid business model. The risk is limited because they lend to individuals small amounts for small tenors, and that too collateralized by gold. Additionally, many other NBFIs have tried to replicate the business model but none has been able to scale up. As mentioned above, many companies which entered the business during the good times were forced to exit when the price depreciated post 2012. But the fact is that gold financing is a business which is still largely in the unorganized sector. Despite the entry of NBFIs and banks, the moneylenders and pawnbrokers still constitute 70-90% of the market, according to estimates. Hence there is still a huge untapped market for the taking by the organized players. The key to tapping into the market is being close to the customers. Most of these customers are located in semi urban or rural locations and hence the location of the branches is a strong competitive advantage in the business. This is where companies focused exclusively on gold loans score over the banks or other diversified NBFIs. Due to their focus on gold loans, they can open branches where it makes the most sense from gold loan perspective. While other banks and NBFIs take into consideration the demand for their entire product set including savings products as well as other assets other than gold loans when opening a branch. Once the turmoil in the economy due to the demonetization and GST is over, the demand for gold loans should come back. And when that does, gold loan companies will be in the best position to capitalize on the opportunity.

And finally, it is worth highlighting the resilient nature of gold loan business. One of my favorite investors – Allan Mecham likens such businesses to cockroach – “I constantly try and guard against investing in situations where the intrinsic value of the business is seriously impaired under adverse macro conditions. We prefer cockroach-like businesses — very hardy and almost impossible to kill!” I think gold loan is one such cockroach-like business. The acid test of any business is how it weathers a downturn. Muthoot and Manappuram weathered the crisis of 2012 well and have emerged from it stronger and with less competition. Although during the period of crisis, their profitability declined along with their growth rates. However, their profitability has returned to the levels of FY2013, although the growth still remains elusive. In my opinion going forward as well, any extended periods of slowdown or correction in the price of gold will only either kill or push out less serious players and will make the companies focused on gold loan stronger. On the other hand, during more benign times when gold prices are either stable or increasing, Gold loan focused businesses such as Muthoot and Manappuram will do disproportionately well. When gold price goes up, the demand for gold also goes up and so does the demand for gold loans. At the same time, the amount of loan for the same amount of gold also increases. I think the period of stagnation in gold price is coming to an end. Muthoot and Manappuram are solid franchises with excellent growth prospects.

Microfinance[4]

Microfinance has a long history in India. Microfinance originated to serve the people who were being left out of the financial system of the country. These were generally people belonging to the lowest income classes. The existing banks and other financial institutions were not able to serve them due to various reasons including high transaction costs and difficulty of reaching them in villages etc. Historically these poor people were being served by moneylenders who charge usurious interest rates. The moneylenders became especially prominent in India after 1830. At around this time, the British started demanding the tax from the farmers in cash instead of in kind which was the norm un until that time. Hence many of them had no option but to go to the moneylenders. Due to the fragile source of income of these people default rates were high and moneylenders accordingly charged high rates of interest to compensate for the same. This also led to cases of debt peonage in cases of default which is something quite common and has been observed since earliest times of recorded history. There were several recorded cases of revolt against the moneylenders as well during the 1800s.

During the 1860s, rural savings and credit cooperatives idea was originated in Germany by Friedrich Wilhelm Raiffeisen. The model proved to be very successful in providing banking services to the economically less fortunate. The idea was thought up and gradually refined over a period of time to save the rural farmers from loan sharks. The main tenets of the institution were its strong local and community presence. The capital was contributed by its members which included the wealthy as well as the farmers. The institution could make loans to the farmers and the profits were to be used for reinvestment in the institution and also for the welfare of the members. Reiffeisen founded the first rural credit union in 1864. The idea soon spread to other parts of Europe including France, Netherlands, Check Republic etc. In the Netherlands, Rabobank’s history finds roots in Raiffeisen’s ideas. In France, Crédit Mutuel and Crédit Agricole are direct descendants of Raiffeisen’s initiative. Indeed, many “Raiffeisenbanks” can be found across Central Europe.

In India, the idea of cooperative unions was tried but it never worked as well as in other countries. It was primarily because these were always credit unions and not savings unions. The government attempted to solve the problem of financial inclusion primarily through the banks. This process started with the formation of State Bank of India. Bank of Madras was merged into the other two “presidency banks” in British India, Bank of Calcutta and Bank of Bombay, to form the Imperial Bank of India, which in turn became the State Bank of India in 1955. State Bank of India, immediately after its formation was asked to open 400 branches outside of urban areas. After the green revolution, there was an imminent need to finance the agriculture sector for purchase of seeds and fertilizers. To have a more impactful financial inclusion agenda, the government brought banks under its own control. Hence, they nationalized 14 banks in 1969 and further 6 banks in 1980. In 1969, the government introduced the concept of priority sector loans. Under PSL guidelines, all banks were required to give 40% of their credit to agriculture and weaker sections of the society. Other methods were also tried by the government including Regional Rural Banks (RRB) in 1975 and Integrated Rural Development Program (IRDP) in 1980. However, most of these schemes were administered by the Public-Sector Banks (PSBs). None of these schemes were successful and the PSBs lost huge sums of money due to corruption and bureaucracy. After liberalization in 1991, the banks reduced their focus on the economically weaker section of the society because of the failure of most of the schemes up until this time. Between 1970 and 1991, the share of small loans by amount outstanding (upto INR 25,000) to total bank credit rose from 15% to 22%. By 1996 this dropped to 14.2% and by 2006 to 4.4%.

The next step to combat the rural savings and credit problem was formation of Self Help Groups (SHGs). SHG is a group of individuals who come together to pool their savings and borrow from the pool in times of need. The SHG model started in South India especially Andhra Pradesh, Karnataka and Tamil Nadu. Initially the SHG model was pioneered by mainly NGOs who obtained funding from NABARD etc. to lend to such SHGs. An NGO linked the first SHG with bank branch. The bank linkage program was started in 1992. By 2014, India had 7.43 million SHGs with about 104 million members and had banked savings of 9897cr. Of these SHGs, 4.2 million SHGs or about 40 million women had bank credit outstanding of INR 42,900cr. During early 2000s Andhra Pradesh (AP) accounted for 50% of the SHGs in India.

At the same time as the SHG model was flourishing, another breed of institutions started to emerge in the second half of the 1990s. These were called micro finance institutions (MFIs) and most of them modeled themselves on the Grameen Bank model of joint lending groups (JLGs). This means that the loans are given to a group of women with the loan guaranteed by each of them. There were differences in the two models. SHGs generally comprised of groups of 10-20 women. The majority of loans to SHGs were funded through their own savings. The sense of community was prevalent in the SHGs to a greater extent than the JLGs since the women discussed a variety of issues during their meetings. They discussed about their family issues, children’s education in addition to savings and loan etc. While the MFIs on the other hand embraced the JLG model. JLG comprised of group of 5-6 women. The focus in a JLG was more on loans and the feeling of community was lacking. Additionally, the most pressing problem for MFIs was the absence of savings to lend. They had to finance their loans through external sources of funds initially through donors as banks were not willing to lend to them. They were able to obtain some funding through SIDBI as SIDBI started supporting MFIs in a limited way.

However, this changed in 2000 when the RBI allowed indirect lending from the banks as well to be classified as priority sector lending. This opened the floodgates and MFIs grew rapidly during the first decade of the 2000 as banks started lending to them to meet their priority sector lending requirements. During the first part of the decade the MFIs operated as not-for-profit organizations. However, during the second part of the decade they gradually started converting to for-profit NBFIs as the flow of capital increased. The SHG movement had already prepared the ground for expansion of the MFIs. During the second part of the decade post their conversion into for-profit companies, private equity money also started coming in the MFIs. First such PE fund to invest was Legatum which invested in Share in 2007. Many private equity funds, led by Kismet Microfinance, Sandstone Capital, Westbridge Capital and others invested in the largest MFI at the time  (SKS) in 2008. SKS thereafter also decided to go for an IPO in 2010. From 2005-2010 the MFI industry increased at a CAGR of 88% in terms of loan portfolio. The funds which flowed into the industry paved the way for the excesses and the ensuing crisis in the MFI industry. The borrowers had never had it so good. They were being chased by the SHGs which were funded by NABARD as well as multiple MFIs, supported by SIDBI, commercial banks and PE funds. The crisis was not difficult to predict as we had a case of excess money chasing borrowers. Borrowers over-borrowed and when they couldn’t pay back, MFIs resorted to unethical collection practices in many cases. Within three months of SKS going public, the MFI sector faced its biggest crisis in Andhra Pradesh. The MFI industry almost died due to the AP crisis.

RBI put in place more severe regulations for the MFI industry in December 2011. The difference between the interest rate and the cost of funds was capped. Additionally, the number of MFIs lending to a particular borrower was capped; so was the total lending to a borrower. The MFI industry used the crisis and its lessons well. MFI industry outside Andhra Pradesh suffered only minor bruises from the crisis and continued to grow. The companies which were operating in Andhra Pradesh were on life support systems and took longer to recover, if at all. In most cases, companies outside Andhra resumed their growth trajectory within a couple of years. Ujjivan and Equitas are two such companies which quickly recovered from the crisis and continued to grow.

MFI industry has been focused on microfinance loans through group lending model. However, they have realized the fragility of their business model through multiple crises including Andhra Pradesh as well as demonetization. Hence, while they continue to focus on microfinance (JLG model), they are in the process of diversifying their product range as well as the customer segment. For example, Equitas has already brought down the microfinance loans as a proportion of their asset book to 36%. Ujjivan has projected their plans to bring down the microfinance loans to 50% over the next 5 years from 85% currently (FY17). Additionally, both Ujjivan and Equitas and a few other MFIs got the small finance bank license from the RBI in 2015 and are in the process of converting themselves to bank. With this they will be able to further diversify their product range by offering savings products to their customers as well. As mentioned above, one of the reasons cooperative credit unions were not successful in India unlike Europe is because they were prohibited from providing savings products. They could provide loans but were not allowed to provide savings account like a bank. The same regime was applicable to MFIs as well. With their conversion to bank, this very crucial impediment has been removed and the MFIs who have converted to banks will be able to provide full bouquet of services to their customers.

At the same time, with the savings products they will be able to move up the customer segment as well. So far while their focus has been on the Strugglers category only with average loan ticket size of ~INR 25,000. But now they are diversifying their loan book beyond microfinance to MSME and housing loans in case of Ujjivan and MSME, housing and CV loans for Equitas. For these loans the average ticket size is also higher at ~INR 6 lakhs for housing finance and ~INR 3 lakh for MSME loans. These companies are in the process of transitioning to be a complete service provider for the customer in the Next Billion and Strugglers category. These are the customer segments which have been ignored by the existing banks so far. Whether they are able to make the transition to a mass market bank for the underserved is a matter of conjecture, they certainly are in the best position in the history of India to do so.

MSME Finance

Micro, Small and Medium Enterprise (MSME) financing is a huge opportunity in India and it is largely untapped until now. Just like in the case of consumer financing the focus of the existing banks is on the medium part of the MSME sector. There are more than 51 million MSMEs in India employing more than 117 million people. These MSMEs together account for 45% of the Industrial output 40% of total exports from India. Out of these MSMEs, 95.1% are micro enterprises, 4.7% are small enterprises and 0.2% are medium enterprises. Most of these micro enterprises are either proprietorships or partnerships, while small enterprises are also co-operatives in certain cases. Medium enterprises are public or private limited companies. Bulk of these MSMEs are unregistered, with registered enterprises comprising only 5.9% of the total MSME units. Out of the registered MSMEs ~88% have no formal financing available while the same number for non-registered MSMEs is 93%.[5]

These MSMEs are enterprises which are engaged in retail trade, restaurant business, general merchants, builders, manufacturers, tour operators, or other such small-scale businesses. Most of them do not have proper documentation including registration documents, valid bills, proper accounting systems, and lack of known buyers. In addition, they also do not have any security to offer in the form of property/ security deposit. No wonder the existing banks and financial institutions find it difficult to lend to this segment. Lending to this segment of borrowers requires excellent localized knowledge of the area as well as businesses within that area. In the absence of accounting systems, financial information including revenue, working capital etc. needs to be ascertained independently by the financial institution. As we can see, there are no formulas for lending to this segment which can be applied universally. For example, microfinance sector was able to scale rapidly because they followed joint lending model to women which is a proven model. In absence of such a model, and because of the highly-localized nature of MSME financing; the transaction costs in financing them are very high. Despite these difficulties a few NBFIs are taking baby steps in providing financing to this segment.

From Figure 1, we can see the following companies focusing on the MSME sector – Capital First has 60% of their AUM in MSME finance, Shriram City Union Finance (SCUF) 53%, Bajaj Finance 31%, Equitas 30%, Chola and IIFL 27% each, DHFL 21% and Repco 20%. However, most of these companies are doing secured lending in the sector – also known as Loan Against Property (LAP). We will focus on the companies which are developing their credentials and building expertise in non-LAP lending in the MSME sector. If we remove LAP, the top three companies in this sector are – SCUF, Bajaj Finance and Capital First with MSME portfolio size of INR 14,000cr, INR 6,200cr and INR 4,100cr respectively.

Bajaj Finance’s focus is on affluent SMEs with average annual sales of INR 10-12 cr. with established financials and demonstrated track records. Their loan book in the SME sector is ~INR 6,229cr and average ticket size is INR 9-14 lakhs. They started this business and initially started by lending to small component vendors of their group company Bajaj Auto. As they became comfortable with these customers they gradually moved to other customers. Today, along with their consumer durable business, this is one product which they offer very widely from most of their branches. They use this product to gradually transition these customers to higher ticket loans like LAP. Their customers are typically companies who already have multiple banking lines in place. The unsecured loans are typically working capital loans with tenor of upto one year.

Capital First’s loan book is ~INR 4,100cr and the average ticket size of the loans is ~INR 20 lakhs. Similar to Bajaj Finance, Capital First also offers these loans as short tenor working capital loans to MSME businesses. They claim that they use a proprietary algorithm to check the creditworthiness of the borrowers and make lending decisions accordingly. Given the localized nature of the business, I am very skeptical of a universal algorithmic solution to MSME lending. Only time will tell if they have indeed cracked the code of MSME lending, but I have my doubts.

SCUF’s unsecured loan book is ~INR 14,000cr and the average ticket size of the loans is ~INR 5 lakhs. They are different from Capital First and Bajaj Finance in that the quantum of the loan is comparatively less and they offer tenors of upto 3 years as compared to one year for Bajaj Finance and Capital First. Additionally, they have been in the business longer than the others since 2006. SCUF customers in the space comprise replacement equipment manufacturers, traders, grain merchants, small hoteliers and caterers and similar such non-corporate businesses in semi-urban India. Like Bajaj Finance, who started the business targeting the vendors of Bajaj Auto. Similarly, SCUF started the business by focusing on customers of their Group company – Shriram Chits. Although they have now moved to serving customers beyond the Shriram Chits ecosystem, still 75-80% of their customers are from the chits ecosystem. They have experience of dealing with such customers for a long time in their Group company. SCUF does not offer MSME loans in the new branches. They start by offering less risky products such as gold loans and 2W loans. Once they get to know the customers, if the same customers also need a business loan they will consider them. They have managed to build an ecosystem where secured loans such as gold loans are not purely transactional in nature. These loans are used as a step to understand the customer. Over a period of time such customers can move to MSME loans if possible. They progress from small loans 2-5 lakhs which are fully secured. For repeat customer loans can go up 10 lakh even if not fully secured but only for those who have good credit history with SCUF.

SCUF has followed a process which focuses on close engagement with the customers. The due diligence consists of several rounds of interactions with the borrowers collecting certain data. The data is then corroborating by comparing it with the industry data available in the local market and talking to their vendors, suppliers, and their peers in the industry. They spend time with the customers and their family to understand their expenses. They also help them prepare the cash flow and thereby assess the loan and credit limits. For SCUF, this is largely a relationship lending, a process which they have developed over decades.

I don’t think there is a one size fits all approach to lending to the MSME segment. These customers are widely different from each other, engaged in different businesses, and as a result have varying risk profiles. Hence, there cannot be a risk model which is universally applicable. More than anything it requires experience of having worked with the customer segment and spent time in developing a nuanced understanding of this segment and the inherent risks in lending to them. In this regard, I think SCUF has the best chance amongst the existing players to really scale up the model. Shriram Group has been working with the people who are left out of the financial system for a long time. They have spent decades working in these communities and understanding their customers. During this time, they have experimented with various products such as gold loans, 2-wheeler loans, vehicle loans and of course MSME loans. But they have always been laser focused on their customer segment most of which belong to the Next Billion category. SCUF was born out of the need of their chit fund customers for business loans. I think it would be fair to say that Shriram Group has been working with these customers for the longest time and understands their risk profile better than anyone else in the country. The journey of Shriram Group started with the chit funds in which they managed the savings of these customers. Chit funds proved to be very effective in helping and encouraging people to save more. From these beginnings, they moved to the lending businesses in Shriram Transport Finance and SCUF. However, in each of STF and SCUF they are currently only offering loans. A still deeper engagement with the customers can only be possible if they are able to offer savings products as well thus completing the product suite. That is the natural progression of this business in my view, which will go a long way in making their customer relationships much more sticky. I think SCUF will at some stage convert themselves into a bank when the regulatory regime is in their favor.

The battle for cracking the code of banking to the underbanked/ unbanked is on. In my opinion the ultimate winners in this battle will be players who have spent time working with these customers at the grassroots level. If I have to, I would put my money on MFIs such as Ujjivan in consumer financing and SCUF in MSME financing. These companies have been at it for years working with the same customer segment in the same communities. They recruit most of their employees from the same communities as well. They have been helping these communities by job creation as well as by providing financing for consumer and business requirements. At this stage, it appears to me that they are best positioned to take advantage of this massive opportunity.

[4] Bandhan: The Making of a Bank, Tamal Bandopadhyay

[5] 4th Census of MSME, Ministry of Micro, Small and Medium Enterprises

Value investor

2 Comments

  • Prasun bhansali

    your analysis is amazing, with such simplicity- a way of telling story- you have explained, one of the complicated industry. In whole analysis Figure 1 is like meat of whole analysis and you have depicted it beautifully.
    Also the way you have connected the dots of industry is awesome..hats off..

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