India: Private Equity in microfinance sector will have pros and cons
India, June, 25 2008 -
Since 2007, there have been at least four PE investments in Indian MFIs totalling $43 million. Such investments are expected to accelerate.
The microfinance sector in India has been perceived by policymakers, particularly the Reserve Bank of India (RBI), as a useful channel for expanding access to various financial services for low-income persons and those in the informal sector.
India’s microfinance sector has an outreach of 36.8 million borrowers, about 50% of the estimated potentialaMFIs had close to 10 million customers and a cumulative outstanding portfolio of $769 million. The efficiency and profitability indicators of Indian MFIs are highly favourable compared to Asian benchmarks. Several leading MFIs have begun to operate on a national scale.
While MFIs focus on helping the poor access financial services at affordable costs, they attempt this in a financially sustainable manner so as to grow in both scale and scope of services offered.
Consistent with the blurring of distinctions between financial sector players and products, MFIs have been attracting considerable interest from financial institutions. For example, commercial banks have increased involvement in the sector as part of their corporate social responsibility and to meet 'priority sector’ lending needs. The sector’s business potential is also driving their interest.
There are several social venture capital funds in India like Aavishkaar-Goodwell that have been established with the explicit mandate to create both social and economic value. Some of their investments are in MFIs.
Private equity firms typically seek extraordinary returns and are seen as aggressive, non-transparent, difficult to regulate and uninterested in the broader social aspects of businesses they invest in. These firms have shown considerable interest in investing in India’s MFIs, particularly those registered as non-banking finance companies. PE firms typically invest in closely held companies in which they see possibilities of extraordinary returns that can be obtained through an exit strategy involving initial public offer (IPO) or takeover by large firms.
Since 2007, there have been at least four PE investments in Indian MFIs totalling $43 million. Such investments are expected to accelerate. There are two main reasons why PE firms are interested in the microfinance sector.
First, there is a perception that this sector is capable of providing extraordinary returns. Compartamos, a Mexican bank specialising in microfinance, made a successful IPO of 30% of its shares with a valuation at 12 times its book value, implying an internal rate of return of roughly 100% per year from the time it became a for-profit entity. Majority of the proceeds went to public service institutions, the main shareholders, but a third went to private shareholders. But the fact that these profits came from very high annual interest rates of around 100% charged to borrowers didn’t go unnoticed.
Second, studies indicate that returns from the sector are not sensitive to swings in global economic cycles. This makes such investments desirable for risk diversification.
The involvement of PE firms in India’s microfinance sector will have both advantages and disadvantages.
Access to PE opens up a new source of funding for the Indian microfinance sector, which has so far relied on commercial bank funding to drive operations. Excessive reliance on bank funding has resulted in high leverage (debt-to-equity) ratios for some of the leading Indian MFIs. Availability of PE could help MFIs increase their equity, resulting in more sound leverage levels.
The funding from PE could enable MFIs to build scale, reducing their average costs. With more funding, MFIs can invest in cost reducing technologies, which in turn may lower lending rates. Increased availability of funds may result in strategies based on lower effective lending rates, and may spur MFIs to offer new products to their customers.
In addition, PE investors could bring international expertise in finance and technology to the microfinance sector.
For all these positives, however, the entry of PE in this sector could have negative impacts. There is a fear that extraordinary returns sought by PE firms may result in MFIs losing their focus on social impact, causing 'mission drift'.
The availability of PE funds could well lead to aggressive lending by MFIs. Such a situation was witnessed in Andhra Pradesh in 2005, when there was a saturation of certain areas with too much micro credit, leading to over-indebtedness of borrowers and attendant problems. This suggests that excessive lending by the microfinance sector without considering the use of such credit and repayment capacity of the borrowers is counter productive.
Involvement of PE firms may lead to undue attention to peri-urban areas, as it is easier to attract skilled manpower and the transaction costs of lending are lower. Moreover, as bigger loan sizes tend to reduce transaction costs, lending policies may lead to targeting of more well-off segments of the population who can service bigger loans. These developments may negatively impact RBI’s financial inclusion goal. The time horizon of the PE investors may be an important factor in determining their impact. On a long-term basis, innovations that benefit the MFI customers are likely to yield positive returns, given the size of the Indian microfinance sector.
However, a short-term view with excessive emphasis on profits could result in undesirable lending practices. MFIs should, therefore, seek PE investments with a longer time horizon. The large MFIs have special responsibilities in ensuring that PE investments do not lead to mission drift, as the positive and negative impacts of such investments will be felt by the whole sector.
As more sophisticated financial institutions enter microfinance, India needs to develop an integrated regulatory structure from a fragmented one now. India should develop a diverse and robust, but well-regulated microfinance sector.