Indian Micro Finance Industry Report

8/8/2019 Indian Micro Finance Industry Report

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February 25, 2009July 16, 2010

Indian Micro Finance Industry

Introduction

The microfinance sector in India has developed a sustainable business model that

has overcome challenges traditionally faced by the financial services sector in servicing

the low-income population. The Indian microfinance sector:

Generates a Return on Equity of 20 30 percent, driven by commercial bankfinancing, strong operating efficiency and high portfolio quality;

Is increasingly becoming a viable investment sector for commercial and socialinvestors given its growth and maturity;

Has equity valuations that are higher than the financial sector due to highgrowth expectations and substantial availability of debt;

Can expect growth in availability of debt to support expansion as more domesticbanks and alternative debt providers enter the market;

Can, over the short and medium term, see MFI shares trade at significantpremia to book value and cool down over the longer term as the industry

matures.

Finally, the Indian microfinance sector presents several exit opportunities including

secondary and trade sales as well as mergers and acquisitions. Larger MFIs may also

consider going public.


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Over the last two decades, social entrepreneurs, microfinance professionals,

government institutions and private initiatives in the country have nurtured the

growth of microfinance institutions (MFIs). If the Operation Flood' initiative was the

catalyst that linked village milk producers to milk consumers all over India, the

microfinance movement has channelled resources of the banking sector to theeconomically challenged in towns and villages.

Microfinance has gained in significance in the last few years. It is now on the

threshold of a boom. SKS Microfinance Ltd (SKS), the largest MFI in India, has placed

the sector on the equity market radar. SKS has 5.3 million members, a network of

about 1,630 branches, and a loan portfolio of Rs 3,200 crore as of September 2009.

Microfinance has indeed come a long way from village lanes to Dalal Street is no

mean achievement.

EVOLUTION OF MFIs (Micro Finance Institutions)

Globally, the Grameen Bank model of microfinance is well known and has been

replicated in many countries. A number of MFIs in India adopt the Grameen model

and other group models to reach out to their target clientele. India, in a way, is

unique.

It has a mix of the Grameen model, joint liability group model, franchisee model, andmore importantly, the self-help group (SHG) model. The SHG-bank linkage program

was initiated by the National Bank for Agriculture and Rural Development in 1992. It

is the dominant MFI model in India. The Small Industries Development Bank of India

launched its micro credit scheme in 1994 and formed the SIDBI Foundation for Micro

Credit in 1998.

Concerted efforts were made to link the sector with mainstream financial institutions.

Rating agencies have played an instrumental role in connecting the sector to lendinginstitutions and debt markets. With the proposed initial public offering of SKS, the

sector will establish its linkage with the equity markets as well.


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NEED FOR REGULATION

Regulation is essential for financial intermediation. The Reserve Bank of India (RBI)

provided the necessary boost to the growth of microfinance. In 2000, the RBI

announced that micro-credit loans given by banks directly to individuals or through

intermediaries would form part of priority sector loans. This provided an opportunity

for the MFIs to access bank borrowings. In 2002, the RBI constituted four informal

groups to examine the issues relating to the delivery of microfinance.

In 2004, the RBI expressed concern over MFIs raising deposits. This was because

MFIs operate under different legal structures and many of them do not come under

the purview of the RBI. In the context of regulation, the timely approval and passage of

the Micro Financial Sector (Development & Regulation) Bill would give more

recognition to the sector, and in turn, facilitate its orderly growth.

In the Indian context, the SHG-bank linkage programme continues to be dominant,

given the wide reach of the banks. As of March 2009, around 86 million poor

households through six million SHGs had placed their savings of about Rs 5,500 crore

with the public sector banks (PSBs).

A discerning trend has emerged over the last three years. MFIs have widened their

network and have absorbed a higher share of banks' disbursements. Similarly, bankshave regarded MFIs as a beneficial medium to scale up their volumes. In 2008-09,

MFIs channelled 23 per cent of bank lending towards microfinance against 15 per cent

in 2007. In all likelihood, the MFIs' share could have increased to nearly one-third in

2009-10. The PSBs disbursed Rs 3,700 crore to around 580 MFIs in 2008-09 and had

loans outstanding of Rs 5,000 crore to over 1,900 MFIs as of March 2009.

CHALLENGES AHEAD

The sector is at a critical juncture. The emphasis on financial inclusion, focus of

banks on the micro-finance sector and the vast, untapped segment in need of small

loans all these offer opportunities for the sector to scale up.


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The MFIs are aware of the issues that need to be addressed. These include: imparting

counselling on savings-credit-protection', ensuring that lending rates are competitive

and operations are self-sufficient, bolstering capital and strengthening controls in line

with growing volumes.

The extent to which the MFIs resolve these issues would determine the future

prominence and profile of the sector.

MICRO FINANCE IN INDIA AT GLANCE

Microfinance is generally understood as the provision of financial services to low-

income households. Typically it involves supply of credit, savings, insurance,remittance and pension products/services in token sizes that are much smaller than

those prevailing in the mainstream commercial markets.

The Microfinance industry in India has borrowed largely from Grameen Bank in

Bangladesh, in terms of methodology, processes and systems. Most of the leading

Indian MFIs started out as NGOs during 1985-1999, adopting the Grameen Bank

model of group-based lending to women in rural areas.

Over the years, the MFIs have grown significantly and have transformed into for-profit

non banking finance companies (NBFCs), thus moving towards a more regulated legal

setup.

Between financial years 2004-05 and 2005-06, the combined loan portfolio of Share

Microfin Ltd, SKS Microfinance Pvt Ltd and Spandana Sphoorty Innovative Financial

Services Ltd, three of the largest NBFC MFIs in the country, showed a growth rate of

102%.


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Their combined outreach (number of active borrowers) showed a growth rate of 114%

over the same period. All the three MFIs mentioned above now have much more than a

million active borrowers each.

While there are around half a dozen large MFIs in the country, there are close to a

thousand other MFIs that can be categorized as tier-2, tier-3 and new-age MFIs; most

are in tier-3. This box below provides a description of the various categories of Indian

MFIs and their salient features.

Classification of MFIs in India as at the beginning of FY 2010

Tier 1 Tier 2 Tier 3 New-Age MFIs

Description

5-6 large NBFC

MFIs that have

been in

operation as

NBFC for 6-10

years and

previously as an

NGO for severalyears

10-15 mid-

sized MFIs

that have

recently

transformed

into NBFCs

500-800 NGO

MFIs that have

been growing

steadily and

face difficulty in

borrowing from

banks

5- 10 MFIs

promoted recently

by professionals

who are convinced

of the opportunity

at the bottom of

the pyramid. Most

of them are for-profit NBFCs.

Total

OutreachNearly 10 million 2-5 million < 1 million < 0.5 million

Typical

Portfolio> RS 100 crore

~= RS 50-100

crore

~= RS 30-50

crore< 30 crore

Source of Most have Have availed Dependent on Promoters equity


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equity availed of

commercial

equity capital

or are looking

for

commercial

equity capital

donated equity

and social

investors

and commercial

equity capital

Source of

debt funds

Institutional

loans + buyout

Institutional

loans +

buyout

Institutional

loans, soft

loans, grants

Institutional loans

+ buyout

Leverage Moderate Moderate High Low

Current Demand-Supply Mismatch

While the Indian Microfinance sector has grown rapidly, it is yet to satisfactorily meet

market demand.

With about 42% of the population living below $1.25 a day in the country according to

World Bank estimates, the total demand for micro credit in the country is Rs 700

billion at an average annual loan size of Rs 7500. However, even by 2011, when the

Indian Microfinance industry is expected to reach a size of about Rs 250 billion, onlyabout 50% of the market demand may be covered.

Past Performance

According to Crisil, the Microfinance sector in India is estimated to have outstanding

total loans of Rs 160 to Rs 175 billion as on March 31st, 2009. Also, the Microfinance

sector has grown rapidly over the past four years at an average compounded annualgrowth rate (CAGR) of 90%.


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The MFIs' asset quality as indicated by their PAR rates has improved and is healthier

than other asset classes. This is mainly because group pressure ('social collateral) for

timely repayment is at the heart of the Microfinance model adopted in India from

Grameen Bank. Established Indian MFIs also have efficient monitoring and collection

mechanisms.

Growth

Indian microfinance sector is expected to grow nearly ten times by 2011 to a size of

about Rs250 billion from the current market size of Rs27 billion, at a compounded

annual growth rate of 76%, according to a report released by Companies and

Markets.com. Microfinance in India started evolving in the early 1980s with theformation of informal Self Help Group (SHG) for providing access to financial services

to the needy people who are deprived of credit facilities. One of the fastest growing

sectors of India, microfinance is spearheading intense competition among the largest

players.

Future Prospectus

The Indian micro finance industry (MFI) would cross 11 crore borrowers and Rs

135,000 crore ($30 billion) in loan portfolio by 2014 and will require a huge capital

inflow both in debt and equity. The growth is expected to come from underserved

states that are witnessing a flurry of activity, and also from a range of new financial

and non-financial products that are being introduced in the sector.

Indian microfinance institutions have grown at a spectacular rate between 2004 and

2009, with an average size portfolio increasing 107 per cent on a year on year basis,

while number of clients increasing 91 per cent. As of 2009, the industry had a client

base of about two crore and gross loan portfolio of Rs 11,734 crore.


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Despite a sustained high growth rate in the industry, the full potential of microfinance

has not been fully explored in geographies such as Uttar Pradesh, Bihar and north-

eastern states. The microfinance penetration in India is merely 3.6 per cent, and 60

per cent of the portfolio is concentrated in the southern states of Andhra Pradesh,

Tamil Nadu and Karnataka. While access to capital remains a constraint for mostIndian MFIs, the market has matured in the past few years.

Hedge funds, high net worth individuals and blue chip private equity players have

entered the market amongst others, and public sector banks have increased their

exposure contributing a fourth of the debt capital needs of the sector.

MFIs wont lend over Rs 50k to single entity

Lenders will disclose details of interest rates, processing fees and insurance premium

they collect as part of the new policy. They said their collective lending to a single

borrower will not exceed Rs 50,000 to avoid default. The code spells out the

importance of cash flow analysis of borrowers and aims to avoid high-handed recovery

tactics. Lenders will also put a new mechanism in place to address borrower

grievances. Fierce criticism from RBI last month forced micro finance lenders to review

their business style. The central bank was concerned about operational irregularities

and governance issues.

Lenders have formed a self-regulatory body to draft the code and monitor practices

followed by members. Lenders like Bandhan, Basix, Equitas Micro Finance India, SKS

Microfinance and Ujjivan are members of the new organisation called the Microfinance

Institutions Network. Nevertheless, all 32 members of the new organisation have

agreed. Microfinance players, who have graduated to nonbanking finance companies,

are essentially members of the new self-regulatory group. The members have also

agreed to follow a practice whereby no company would hire all its employees from

other members. About 50% of the new recruits have to be from outside the sector.


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Worlds Largest Market

Most microfinance loans in India range from 5,000 rupees to 20,000 rupees, according

to an October 2009 report by Crisil Ratings, the local unit of Standard and Poors. The

country, where more than 600 million people live on less than $1.50 a day, is the

worlds largest microfinance market, according to a March report by CGAP and

JPMorgan Chase & Co.

Interest rates range from 18 percent to 33 percent, according to Vijay Mahajan,

chairman of Hyderabad-based Basix Group and president of the Microfinance

Institutions Network, an industry lobbying organization. Indian banks typically dont

lend directly to microfinance customers.

Sequoia Backing:

SKS, betting the potential for growth will attract investors, sought approval from

Indias capital markets regulator in March for an IPO and picked Kotak Mahindra

Capital Co., Citigroup Inc. and Credit Suisse Group AG to manage the offering.

Sequoia Capital, one of Google Inc.s and Yahoo! Inc.s early investors, began buying

shares in SKS in March 2007. It plans to sell less than a third of its holding in the

IPO, according to the filing SKS made in March. So even though microfinance has

been growing at stupendously high growth rates for the last four to five years sinceSequoia Capital first invested in the sector, it expect micro finance to continue to grow

at very high rates for the foreseeable future.

SKS, which mainly provides loans to poor women in rural areas, said its number of

borrowers climbed almost 20-fold to 3.95 million in the three years ended March 31,

2009. Loans outstanding increased more than 18 times in the period, to 14.2 billion

rupees, and profit jumped almost 49 times to about 802 million rupees.


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The outlook for microfinance investment 2010

After a challenging year, 2010 has begun on an optimistic note for microfinance

investors. Some fund managers have declared that the recovery has begun, albeit a

gradual one. We state that MFIs are recovering, despite some isolated incidents, with

an improving outlook for growth and profitability.

Echoing this sentiment, we expect the overall investment climate for microfinance to

improve in 2010.

Certainly, the news so far has been good, with major funds reporting positive results

for January and February, ending a trend of negative returns in Q4 2009. These funds

performed well in 2009, but the impact of the challenging economic conditions was

clear, with returns down significantly compared to previous years. For example, the

SMX 50, an index conducted by Symbiotics tracking the performance of major

Luxembourg-registered funds, shows returns for FY-2009 at 3.08%, down from 5.95%

in 2008 and 6.33% in 2007. This was in-line with the CGAP 2009 MIV Survey

estimates, which forecast returns to fall below 3.5% in 2009. Reasons identified by the

survey for reduced returns included high proportions of liquid assets in fund

portfolios, increased provisions against loan-losses and higher costs for currency

hedging due to volatility in Forex markets. Any discussion of the outlook for the

microfinance needs to consider these factors, how they impacted investment

performance in 2009, and what implications these have for the investment outlook

this year.


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Investment conditions will improve in 2010 by examining the underlying

fundamentals:

Liquidity

Liquid assets refer to the proportion of fund that is uninvested, that is the different

between the total assets and microfinance portfolio. Usually taking the form of cash

(although other non-microfinance assets may be included), a liquidity buffer is

desirable to guard against cash flow shortages. But as unproductive capital in the

sense it is not invested in loans to MFIs or equity, if liquidity positions become to large

they can place a drag on returns. For example, if a fund has 30% in liquid assets

compared to 10% a year ago, 20% less of a fund is being put to use (even if the

microfinance portfolio is the same size or even larger then it was). This situation can

result when fund growth, for example through new contribution, out-paces the rate of

investment. This is the situation which many microfinance funds are currently dealing

with.

Increased demand for funds will help ease excess liquidity, which by the end of 2008

were around 20% for Luxembourg-domiciled MIVs according to the CGAP 2009 MIV

Survey. Liquid assets such as cash as a percentage of total fund volume increased

significantly from 2008 to 2009 for two major Luxembourg funds responsAbility

Global Microfinance Fund (rAGMF) and Dexia Microcredit Fund (DMCF).

A similar trend can be seen in the percentage of non-microfinance portfolio funds

(MFPF) of Luxembourg funds as tracked by Symbiotics, which suggests a high level of

liquidity. While total assets of the SMX50 index leveled off in H2-2009, there has been

no indication that investor interest in microfinance has declined, as fund managers

are upbeat in their expectations for attracting new funds in 2010. The CGAP 2009 MIV

Benchmark Survey estimated that total assets would grow 26%, which would bring

total MIV assets to $8.5 billion. If total assets were to grow at a similar rate in 2010,

liquid assets could actually increase, putting further pressure on fund returns.


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Portfolio quality and loan-loss provisioning

Loan-loss provisioning is the expense that has to be set aside to cover losses from bad

loans, whether through defaults or renegotiation of terms, such as extension of

repayment period or interest rate concessions. Initially, financial performance

remained strong throughout most of 2008, maintaining confidence that MFIs were well

position to weather the downturn. According to the SYM50 an index by Symbiotics

tracking the performance of 50 large MFIs Portfolio at Risk (PAR) spiked

dramatically in December 2008, peaking at over 5% in October 2009. This in turn

directly affected financial performance, with Return on Equity (ROE) falling steeply at

the same time.

In response, MFIs generally slowed the growth of their loan portfolios to concentrate

on maintaining portfolio quality. However, weakening portfolio has forced some fund

managers to take provisions against troubled loans in H2-2009, as revealed by

publicly available monthly fund reports. Except for two cases, it was specified that

these provisions were made for loans to troubled MFIs in Nicaragua, and Bosnia and

Herzegovina. These countries have been affected by repayment crises which have

undermined the phenomenal growth that was key to making these countries

investment hotspots in the first place. A recently-released report from CGAP, Growth

Vulnerabilities in Microfinance, examines these and two other repayment crises in

Morocco and Pakistan.

However, microfinance has changed significantly since then. For example, investors,

rather then donors, are primary funders of the sector. As a young investment sector,

these repayment crises are the first to truly test the current microfinance investment

model. And despite a drop in performance, the sector has handled the challenging

conditions well, with no funds reporting any serious financial problems due to the

repayment crises. Regardless, it will probably prompt a review of risk management

strategies and encourage further portfolio diversification. Hopefully, this experience

will also enable investors to detect signs of stress earlier so that action can be taken to

help prevent future repayment crises from developing.


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capital, which VCCEdge estimates to be around US$80 million, representing 40% of all

private equity deals in India.

This influx of capital will probably increase this year in anticipation of the much

vaunted IPO from SKS Microfinance Indias largest MFI. This may be not only from

investors seeking to profit from not just this IPO but also from subsequent IPOs that

are expected to follow, and is likely drive up valuations further, reinforcing a bubble

mentality. At the same time it may encourage investors to look further afield to less

competitive microfinance markets in northern India where markets are less penetrated

and valuations may be lower. Certainly, this will be a situation that will need close

monitoring, as 2010 looks set to be both a landmark year and critical turning point for

the microfinance equity market in India.

Regional Outlook: An uneven recovery in 2010

BlueOrchards observation on the current state of the microfinance sector echoes that

of the economic outlook. In the DMCFs January report, the fund manager stated that

although most regions were coming out of recession, some regions remain under

significant pressure especially Eastern Europe and Central America. Christian

Speckhardt from responsAbility, supports this view also, stating that although there is

a noticeable improvement in credit quality overall, risk metrics in Eastern Europe and

Central America are likely to continue rising slightly.

According to Mr. Speckhardt, loans in local currencies will become more common in

2010, which will open up more opportunities in Sub-Saharan Africa. Armand

Vardanyan, Fund Manager of the Vision Microfinance Dual Return Fund, also foresees

increased opportunities in Africa and Asia throughout the year.

Asia and Sub-Saharan Africa (SSA), despite having several fast growing microfinance

markets occupy still occupy a small share of fund portfolios compared to EasternEurope and Central Asia (ECA) and Latin American and the Caribbean (LAC) (Table 3).

South Asia share has been growing consistently since 2006, and is expected to have


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had a record year of growth due in large part to the rapidly expanding Indian market.

With a large unserved market, particularly in the north, India is expected to continue

to be one of the fastest growing markets in 2010. However at present, most investment

is concentrated in MFIs based in the south, fueling concerns that this inflow of capital

could encourage the development of a debt bubble in the southern states.

Regardless, EAP will continue to be an important region for investment in Asia, with

the region boosting two large, well established microfinance sectors the Philippines

and Indonesia. However, the main draw for investors has been the much smaller but

booming market in Cambodia. According to the IFC, lending from MFIs has increased

55% annually between 2006-2008, with total outstanding loans of US$440 million YE-

2008. In 2009 the sector continued to grow, with data from the Cambodian

Microfinance Association showing that outstanding loans of member MFIs grew by

13% between Q4 2008/09, from US$437 million to US$ 493 million.

2010 A year of consolidation

For the sector 2009 represented a turning point for microfinance with conditions

which tested strength of the microfinance model. On the whole the sector has done

well, but it has also brought to the surface underlying issues the industry needs to

address as it matures adequate risk management and balancing of growth with

operational sustainability. With growth expected to slow in 2010, this will the sector a

chance to consolidate the gains made in recent years by focusing on addressing these

issues.

Likewise, microfinance investors will also adjust to this new climate. While MFI

demand for debt is expected to recover in 2010, it is likely to remain lower then pre-

crisis levels. This may mean that if fundraising remains strong, funds may find it

difficult to lower fund liquidity, which may in turn maintain pressure on fund returns.

Equity investments will continue to growth in importance during 2010, centered

around the high growth market in India. While 2010 is likely to another standout year


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for equity investment in India, with signs of a valuation bubble developing the

situation will have to be monitored closely.

In 2010 investment in Asia and Sub-Sahara is likely to increase as investors seek to

further increase fund diversification and take advantage of growing opportunities in

these regions. Investment in the more established regions, Europe and Central Asia

and Latin America and Caribbean, may grow more slowly and possibly decline as a

percentage of microfinance portfolio allocations.

_________________________________________________________________

Disclaimer:

This document prepared by our research analysts does not constitute an offer or solicitation for the

purchase or sale of any financial instrument or as an official confirmation of any transaction. The

information contained herein is from publicly available data or other sources believed to be reliable but

we do not represent that it is accurate or complete and it should not be relied on as such. Firstcall India

Equity Advisors Pvt.Ltd. or any of its affiliates shall not be in any way responsible for any loss or damage

that may arise to any person from any inadvertent error in the information contained in this report. This

document is provided for assistance only and is not intended to be and must not alone be taken as the

basis for an investment decision.


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Documents

Indian Micro Finance Industry Report