Guest post | Opportunity in Crisis: Building an Indian NBFC

Ankit Singhal is the CFO at Singapore-based family office AJ Capital. The opinions expressed here are his own and do not represent those of DealStreetAsia.

After the exuberant times of the last decade, when NBFCs (Non-Banking Finance Companies) in India were the toast of investors and industry alike, the recent liquidity crunch has jolted many out of their euphoria. Investors are treading with extreme caution, banks are re-assessing lending to NBFCs, NBFC executives are selling loan books, scrambling to roll over funding, and CFOs and retail borrowers alike are questioning the viability of NBFCs as providers of capital. These challenges offer a golden opportunity for a new entrant to build a world-class team, acquire fairly priced assets, develop a thoughtful liability structure and compete with incumbents at scale.

The sheer size of the opportunity and improving competitive dynamics are key factors that guide our thinking. We would also keep a watchful eye on potential regulations from the RBI that favour longer-term borrowings, stricter asset quality and closer supervision in general.

Sector to benefit from structural tailwinds

Recent improvements notwithstanding, credit penetration in India remains low. Total credit to the private non-financial sector stands at 85% of GDP, vs. 206% in China and 150-170% in the UK and the US.

Banks have historically focused on corporates and government enterprises. Over time, while they have diversified into newer segments such as SMEs, MSMEs and retail, they have remained confined to urban and tier-1 cities offering a standardized suite of lending products. Banks continue to favour corporates over MSMEs and retail customers because of the accompanying higher yields, larger cheque sizes, lower cost of servicing/origination and higher customer retention.

NBFCs, on the other hand, evolved as a business model by focusing on underserved geographies and customer segments (not targeted by banks) with customizable products, reduced turnaround times and better service quality.

We believe banks remains behind the curve in addressing these underserved markets, and the competitive threat from banks to NBFCs continues to remain low.

Favourable competitive dynamics

The recent liquidity crisis has left many NBFCs in a weakened state. Over the past few months, costs of funding increased significantly and liquidity dried up, forcing NBFCs to sell down their loan books and adjust their near-term ambitions. Fresh disbursements fell drastically in the Sep-Dec’18 quarter given the shortage of funds. Profitability for most NBFCs suffered from stagnant or declining loan book levels, lower spreads (yields – borrowing cost) and elevated operating expenditure levels.

As the NBFC business model started to lose its sheen, consolidation was evident across the space. Many small/start-up NBFCs chose to exit or merge with larger players. The larger NBFCs re-evaluated their business models with a few realizing that a bank merger may be the best option (most recently Capital First and IDFC, Bandhan Bank and Gruh).

Sectoral focus

Though credit penetration is low, certain sectors such as housing, auto, gold loan, MSME and other retail financing segments have seen increased interest from existing NBFCs. However sectors such as logistics, warehousing, agriculture, education, healthcare etc. are still relatively untouched. New NBFCs should evaluate entering these segments to mitigate their cash burn (on account of competition) and reduce their ramp-up time.

Experienced management teams with the right culture

Many successful NBFCs (such as Bajaj Finance) have strong management teams with seasoned MD/CEOs who were instrumental in shepherding their firms through external shocks and maintaining a commitment to the long term vision. NBFCs that have chased short term wins (such as over-exposure to CPs) have paid the price as witnessed in the recent IL&FS crisis.

A new entrant would need a similarly robust management team that has a conservative mindset, long-term orientation to doing business and past experience of navigating credit cycles. The recent crisis has resulted in several strong and experienced industry professionals rethinking their current roles.

We are extremely confident that there is an opportunity to build a deep and capable core leadership. team.

Customer satisfaction and strong execution mindset

The current crisis also caused NBFCs to become inward looking due to which the end customers have suffered. As liquidity tightened, availability of loans reduced and the cost of new loans increased (given higher costs of funding for NBFCs). The current backdrop is ripe for a well-capitalized new entrant to disrupt and acquire customers.

By optimising its capital structure, focusing on operational efficiency and executional excellence, a new NBFC can ensure that the customer experience remains consistent and pleasant.

Borrowing profile

The ILFS debacle highlighted the pitfalls of excessive short term borrowing (especially rollover risk for commercial paper or “CPs”). The risk is due to significantly higher rollover pricing or unavailability of funds resulting in redemption pressure on NBFCs. Inability to manage short term repayments has a contagion effect (of risk aversion) for longer-term borrowings such as term loans and NCDs. This results in a complete liquidity shortage for both short and long term borrowings (as witnessed recently).

Our learnings suggest that a new NBFC should limit exposure to short term instruments to <10% of total borrowings. For new NBFCs where bank lines may be difficult to tap into, the recently liberalized ECB regime could serve an effective borrowing medium. ECB borrowings from long term foreign debt providers help diversify the investor base as well as reduce cost of borrowings.

Technology

Many startup/small NBFCs have highlighted technology as a differentiator for sourcing, underwriting and monitoring of loans. Closer evaluation suggests that the uniqueness quotient is low across the spectrum.

Many NBFCs have started to incorporate Machine learning and Artificial intelligence. We think this is still in a nascent stage and presents a great opportunity for investment to create true differentiation in underwriting/monitoring.

While technology has a role to play in effective credit delivery, we believe that human judgement is also important. Given the high growth witnessed across NBFCs in the last 3-5 years, we are conscious that future asset quality could be a question mark (as compared to liabilities which was the focus in the recent turmoil). We would caution against extreme use of automation/technology for underwriting and advocate thoughtful use of manual safeguards to secure against future NPAs.

Near term considerations

We believe there could be regulatory pain in the near to medium term given the NPA crisis (within large banks) and the ILFS saga that were recently witnessed.

There have been rumours on RBI proposing a) higher equity requirements for NBFCs by increasing the capital adequacy ratio, b) implementing an AQR (asset quality review) framework similar to that for banks, c) making short term borrowings more onerous by instituting adequate safeguards and restrictions, d) closer supervision and monitoring by RBI and e) detailed reporting requirements for NBFCs.

The above proposals could lower the incremental ROE trajectory than historically witnessed. The potential RoE impact is difficult to quantify. NBFCs with a flexible operating model that have prepared themselves to implement these and other prudent measures would still thrive and create significant value for their stakeholders.

We see a major opportunity in the current pessimism engulfing the sector and believe that the NBFC business model continues to remain extremely attractive.