Without question, the present scenario, in the wake of Friday’s circular, places a huge burden of responsibility on the Department of Non-Bank Supervision and the RBI and for the sake of real financial inclusion, we sincerely hope that the department lives up to its roles and responsibilities with diligence, aplomb and efficiency

On Friday (2 December 2011), the Reserve Bank of India (RBI) created a special category of non-banking finance companies (NBFCs)—NBFC–MFI. The RBI must be congratulated for creating this new category as it explicitly recognizes microfinance as an important facet of the larger financial sector.

While Moneylife will be providing a detailed analysis of this RBI circular and its implications through a series of articles next week, we continue the analysis of the growth of the commercial microfinance model with a focus on what led to the growth of the commercial NBFC MFI Model in India in the last few years along with the supervisory/regulatory lessons therein. This piece is especially for the Department of Non-Bank-Supervision (DNBS), RBI that will now have to play an even greater role—given that a new category of NBFCs called as NBFC–MFI have been created —in the overall regulatory architecture for micro-finance henceforth.

As outlined in recent Moneylife articles (Dissecting the mechanics of growth in Indian microfinance and Lessons from the commercial micro-finance model in India), the growth of NBFC MFIs was unbridled during the period (April 2008–March 2010). The key question that arises here is how was this growth possible in the first place, especially given that the Krishna microfinance crisis had occurred, just about a couple of years earlier (in 2005-06)?

In part, it must be noted that this growth was possible among other things, because of growing equity investments into Indian microfinance. Coming on the backdrop of the Krishna microfinance crisis of 2005-06, the so-called social equity investors (including some donors) provided the much needed relief to MFIs. They helped MFIs overcome the temporary liquidity problem by providing them with financial resources. Aided by such social equity (investment) pioneers, including donors, some MFIs started to grow again and grow fast. They were rewarded almost concurrently as they received significant equity from other so-called social as well as commercial investors, during the same period and thereafter.

However, I would like to first state a few caveats, which are in order. Actually, I had been trying very hard to unearth the level of equity investments in Indian microfinance but have been severely hampered by lack of reliable and valid data on the same. Several people, whom I approached, refused to share information citing confidentiality aspects. I was left wondering at this rather strange situation, where we have had almost Rs3,000 crore ($700 million) of equity coming into microfinance till up to July 2010 but there is still paucity of authentic, published data. Sometimes, I even get worried that we have no (real) idea of exactly the identity of those who are investing in a very sensitive sector like microfinance and much of my concern relates to the norms laid down by the financial services task force set up after 9/11. I do hope that regulators and other industry stakeholders share my legitimate concerns. They may be interested in looking at the June 2011 issue of India Today which states:

“There are also legitimate investments that come through proper channels. Sources at the Bombay Stock Exchange say funds from Dawood and his associates now come through the foreign institutional investor (FII) route. …The Securities and Exchange Board of India (SEBI) tried to track such investments. SEBI even tried checking dubious realtors. …In 2009, IB officials worked on a tip that terrorists had invested in Indian stock and commodities markets and that Dawood was instrumental in channelizing some investments because of his proximity with several business magnates in the oil-rich Gulf countries. Dawood’s clout with the sheikhs was evident after the fugitive was seen actively participating in buzzard-hunting expeditions near the Guddu and Sukku barrages across the Indus river in Pakistan.” (Source: Quoted from The House of Dawood, by India Today, 6 June 2011)

Anyway, after a lot of struggle, I was finally able to create a reasonably valid equity database, subject to caveats (of course). However, as I am still in the process of (re) validating the same, I would therefore like to caution you to view the following data and numbers accordingly. That said, it is also my belief that any further data updation will not significantly alter the trends—at best, some numbers for the respective years may increase or decrease but the trends should broadly remain the same. Having set out these cautionary aspects, let me now proceed to share what I have found.

Specifically, NBFC-MFIs (including the top 13 NBFC-MFIs from among the top 14 MFIs) received equity worth several million dollars (see Table 1 below) and this again should have been disclosed as per their statutory (quarterly) filings with the Department of Non-Bank Supervision, RBI.

The data suggest the following basic facts:

•  Basically, NBFC-MFIs can be categorized into two groups, on the basis of the equity investment they received. As a group, the six equity leaders comprise of the top five AP headquartered NBFC-MFIs and one other state NBFC-MFI. And these five NBFC-MFIs, who received a large inflow of equity, were among the top five AP headquartered NBFC-MFIs and they were also part of the 13 NBFC-MFIs in the top 13 NBFC-MFIs mentioned in previous Moneylife articles.
• In numerical terms, the five equity leaders NBFC-MFIs, who were AP headquartered, are said to have received equity infusion of over $400 million after the Krishna crisis (from April 2007 until March 2010).
• Further, after the Krishna crisis (from April 2007 onwards), these five AP headquartered equity leader MFIs added nearly 12.02 million clients. Of this, nearly 9.59 million clients were added during the period April 2008–March 2010. In other words, almost 80% of the total clients added after the Krishna crisis (from April 2007) were done so during the period, April 2008 to March 2010—which also corresponds with the highest equity inflow into these five AP head quartered NBFC-MFIs (around $300 million) 
•  Likewise, the gross loan portfolio added (after the Krishna crisis) by top five equity leader Andhra Pradesh headquartered NBFC-MFIs stood at nearly $2.549 billion. Of this, over $2 billion were added during the period April 2008–March 2010. In other words, over 80% of the total GLP added after the Krishna crisis (from April 2007) were done so during the period, April 2008 to March 2010—which again corresponds with the highest equity inflow into these five AP head quartered NBFC-MFIs (around $300 million) 
• And what is interesting and taken up in subsequent article is the fact that the five equity leader MFIs were able to leverage their infused equity several times in terms of debt received (from SIDBI/banks) and thereby place over 85% of their total assets as loan portfolio. The result of this perfect storm, as the mix market (www.mixmarket.org) calls it, is now history… and it certainly made front page news in India and elsewhere!

That said, given the above, the key question that arises here is: whether or not, this unprecedented and sudden inflow of equity, into select NBFC-MFIs, raised any alarm bells for the concerned departments (DNBS and other departments) at the RBI, especially in terms of the following:

• Why has there been a sudden inflow of equity into microfinance and, that too, at a scale not seen before at all?
• What is the motivation for these people/institutions to invest in microfinance, especially given the fallout of the global economic crisis? As Naina Lal Kidwai is said to have argued at the Sa-Dhan March 2010 National Microfinance Conference and similarly, as N Srinivasan wrote in the State of the Sector Report (2010), we surely need to understand what made microfinance so attractive to equity investors, especially, during a period of serious global economic crisis? This is a critical question indeed. Whether the department of non-bank supervision felt alarmed by this is an aspect that needs attention from the RBI. 
• What kind of MFIs are receiving this equity inflow, at what valuations and why?
•  Who is investing in these MFIs and what are their expectations in terms of returns etc? What returns, if any, did the investors actually get?
•  Where is this equity money coming in from, in terms of countries? This is especially critical given the fears about not–so–legal money (from people like Dawood Ibrahim - Please refer India Today, 6 June 2011) coming into the stock market via foreign institutional investment.
•   Is there anything abnormal with the operations of these MFIs in terms of growth or profits or earnings per share or promoter and management compensation etc?

OK, there is some very interesting data—on the last point with regard to these five Andhra Pradesh headquartered MFIs—in an excellent Intellecap report. As the Intellecap report (www.intellecap.com/assets/81/Inverting_the_Pyramid_3rd_Edition-Print.pdf) notes,

“Indian MFIs are receiving the highest valuations in the world. A recent report by the Consultative Group to Assist the Poor (CGAP) and JP Morgan (CGAP, JP Morgan, occasional Paper: Microfinance Global Valuation Survey 2010, March 2010) shows that the median price to book value (P/BV) multiple is 5.9 in India, thrice that of global multiples. Some have been quick to call this “irrational exuberance” on the part of investors.

Analysis shows that while the leading large MFIs have been able to command very high premiums, valuations vary across the sector based on investor type, MFI class and stage of investment. The vast market potential, demonstrated growth of the sector and positive macro-economic outlook contribute to relatively higher valuations in India.

In addition, the number of investors (see below) chasing deals with the few large, high growth MFIs has driven up their valuations considerably. These MFIs are able to command valuations upwards of 10 times their projected profit after tax (PAT). Early stage MFIs are, on the other hand, typically valued lower, at between one and three times the book value (Analysis by Intellecap in the report -www.intellecap.com/assets/81/Inverting_the_Pyramid_3rd_Edition-Print.pdf). Across the sector, the drivers of value are primarily growth and returns, both demonstrated and potential. Thus, to put Indian MFI valuations in perspective, it is instructive to compare the return on equity (RoE) and PAT growth of the leading MFIs with other financial service business, banks and NBFCs. As shown in Table 2, leading MFIs outperformed Banks and NBFCs on both counts. On average, MFI Roe is 32.1%, a full 12 percentage points higher than that of Banks and NBFCs. MFI profits grew over three times that of the sample banks’, and five times that of the sample NBFCs’ between 2006 and 2009. The closest comparable, in this sample, to MFIs in terms of business model is Mannapuram General Finance (a listed NBFC that provides gold and vehicle loans, amongst other services), as their clientele is similar to that of MFIs and loan sizes are relatively low (Rs20,000), although their loans are backed with collateral. Despite the company’s RoE and PAT growth being lower than those of MFIs, its P/BV is at 8.4, higher than average for leading MFIs. Thus, given the enormous market potential, the ambition of leading Indian MFIs, and their demonstrated high growth, prudent cost management and thus high returns, the current valuation levels are not surprising.” (www.intellecap.com/assets/81/Inverting_the_Pyramid_3rd_Edition-Print.pdf)

The above makes it reasonably clear that one of the major reasons for MFIs to grow, in the manner they did, was to attract capital at higher valuations, generate unusual profits and the like…

Again, the key question here is whether the department of non-bank supervision (DNBS) at RBI spotted this?

That said, going forward, especially after Friday’s RBI circular, there are several important questions that the department of non-bank supervision should keep in mind while monitoring equity investments into Indian micro-finance:

• Which MFIs have received equity during the quarter? How much of equity have they received? What has been the net result of the equity infusion in terms of shareholding pattern and ownership?
•  Who are these equity investors (people/institutions etc)? Where are they located? National (within India)? International and which regions? What is known about them, their institutions (if applicable), governance etc? What is the motivation of these investors for making such equity investments? What is their track record in terms of (genuine) past support to the micro-finance sector/social enterprises?
• On an individual basis, which MFIs received the largest equity investments and why? Are these equity investments first time or repeat investments? What has been their growth rate in terms of active clients and gross loan portfolio over the last 3-5 years? Is there a relationship between equity investments (made) and client/portfolio growth for the MFIs concerned?
•  What can be said about governance for the MFIs that received (the largest or repeat) equity investments? Who are the board members and what is their motivation for being a part of the board? Do the financial statements/reports filed with the department of non-bank supervision, suggest any connected lending to founders, managing directors (MDs) directors etc.? Have promoters and others been given an unusual amount of shares/ESOPs/ESPS etc and at throw away prices?
•  Do financial statements reflect any frauds/ghost clients? If growth has been extraordinary rapid, is there came to believe tweaking of performance results as is said to have happened at Sahayata? (Award winning Sahayata Microfinance is the latest to go astray) 
•  In short, what are the quarterly trends with regard to equity investments, client growth, portfolio growth and MFI performance for the quarter concerned? What implications do they have for regulation and supervision of NBFC MFIs – the new category of NBFCs?

Without question, the present scenario, in the wake of Friday’s circular, places a huge burden of responsibility on the Department of Non-Bank Supervision, RBI and for the sake of real financial inclusion, I do sincerely hope that the department lives up to its roles and responsibilities with diligence, aplomb and efficiency. Well, time alone will provide the answers…