Will Private Equity’s love for NBFCs continue into the new decade?
Looking back at a sector that has been highly sought after in the past but is facing multiple headwinds and is under transition right now.
NBFCs or shadow banks as they are called globally have seen prolific private equity investment activity over the last 15 years or so. Few factors that made the sector extremely attractive included 1) sustained growth visibility driven by GDP/credit expansion in the economy 2) presence of niche areas that were neglected or under-served by commercial banks 3) high NIMs on account of attractive yields and fees at customer end 4) ability to raise non-equity capital thereby enhancing overall RoEs.
However, the sector is currently in a state of flux and has multiple issues to deal with including deteriorating asset quality, funding challenges and intense competition from both within as well as outside. Given the challenges, will NBFCs find love from private equity investors in the new decade or will it have to turn to alternate sources of capital?
Let’s start by looking at some macro level data for the sector. CRISIL recently came out with a report titled ‘NBFCs — Navigating the pandemic’ in Dec ‘20. It throws up some interesting trends and analysis on the sector’s historical growth and challenges that lie ahead.
NBFCs have grown over 12x through multiple cycles from FY 2000, but has been clearly facing headwinds way before IL&FS crisis hit the sector. Infact it had started slowing down from 2011, and growth went on a downward spiral from 2016 onward. In the past, the sector has shown resilience and come back strongly a couple of times - firstly starting in 2004 and then again post the GFC in 2009.
If one were to look at size and growth by sub-segment , then it clarifies few things upfront.
Some high growth segments like Unsecured Lending and RE/Structured Finance are now struggling to maintain the momentum. However, larger segments like HFCs and Vehicle Financing are still holding up fine.
Gold Loans seem to be on a tear driven by recent RBI relaxation in lending norms, albeit of a small base. LAP is also expected to be flattish while days of Infrastructure Finance clearly seem to be numbered in the country.
CRISIL report also notes that in Mar ‘14, there were only 2 NBFCs with greater than 50,000crs of AUM vs. 14 companies in Sept ‘20 that have achieved similar scale. This effectively means that that the top 20 odd NBFCs now have 50%+ of the overall market and hence clearly there is consolidation at the top.
Some of the challenges mentioned by CRISIL in their report include asset quality issues that started with economic slowdown in Jan-Feb ‘19 and further exacerbated by the pandemic last year, drying up of funding sources for smaller NBFCs including exposure of debt mutual funds which is at all time lows, renewed competition from commercial banks on attractive retail segments.
Now, let’s look at the other side — how has private equity’s interest in NBFCs changed over the years since early 2000s?
- 2000–2005: Select businesses like Indiabulls and Shriram got funded but overall investment activity remained sparse through this period.
- 2005–2008: High interest in Microfinance across a number of assets (SKS, Ujjivan, Spandana et. al.), select MSME Financing (Capital First), Gold Loans (Manappuram, Muthoot), early days of interest in HFCs (Repco, PNB HF).
- 2008–2012: In the post GFC world, Microfinance (Bandhan, MAS, Arohan, Bhartiya Samruddhi) and HFCs (Shubham, Aptus, HFFC) ruled the roost, albeit with a large deal in Shriram Group again. AU Finance first raised capital from private equity investors during this period.
- 2013–2015: High interest in Microfinance and HFCs continued, early days of MSME Financing (NeoGrowth, Kinara, Northern Arc, Vistaar, Five Star) and Education related NBFCs (Avanse, Varthana). Large deals in AU Finance, Bandhan, JM’s Credit arm.
- 2015–2018: Microfinance (along-with its adjacencies) and HFCs (driven by Government’s tax incentives for affordable housing) still hot favorite amongst investors. Sector sees rise of mid-market corporate NBFCs (Edelweiss, Piramal, KKR, Clix, Altico, Avendus, InCred, Indostar), digital-first lenders (LendingKart, OfBusiness, Capital Float) and some P2P platforms before the RBI clamped down on business processes. Fedbank, Varthana, Hero, IIFL Finance, DMI, Altico attract large amounts of capital and PE investors complete buyout deal of Aavas to facilitate AU’s conversion to a bank.
- 2018–2020: IL&FS crisis hit towards the end of 2018 and funding from various sources (including Debt Mutual Funds, market CPs) dried up completely for most of the NBFCs. Large buyout deals in Aadhar, Avanse, Indostar due to parent-related/direct stress and confidence capital raise from ECL Finance were notable. In addition post the pandemic, there have been few bridge rounds in many NBFCs to shore up their capital base.
So what are the implications for the NBFC sector and related investment activity in the next few years?
Products: In my view, the low hanging fruit in the space has already been plucked for most of the sub-segments. The investment focus will shift on more mature, late-stage businesses in the traditional sub-segments. Scheduled commercial banks will provide tough competition in most of the retail segments of HFC, Gold Loans and Vehicle Financing. Segments like Infrastructure Finance and Structured/Mezzanine Debt are going through an identity crisis and do not seem to be coming back quickly for sure. Most of the larger MFIs have either got listed on the stock exchanges or are in the process of listing and have converted to SFBs. However in a large country like India, some interesting product niches will continue to emerge and will attract funding, including digital-first businesses.
Access to Sources of Funding: With shallow debt market in India, NBFCs have relied heavily on banks, debt MFs, market CPs for their funding. With the funding become more scarce for most of the players, the leverage levels have been going down. This will in turn mean that RoEs will compress, thereby making the sector less attractive for private equity investors. Post Covid related support measures from the RBI and Government should buttress growth in the near term. For the longer term, NBFCs will have to innovate and find new sources of capital to maintain an optimal capital structure.
Business Processes: NBFCs will need to sharpen their focus on sales & distribution with loan origination becoming harder especially on the retail/MSME end of the market. We have seen a number of tie-up announcements between NBFCs and commercial banks for co-origination and co-lending in the last 18–24 months. Many of the NBFCs have also learnt that collection is perhaps the most important part of the business and they need to significantly tighten collection processes and also innovate with availability of novel payment mechanisms. While underwriting has always been tough in a cash economy like India, it has changed in the last few years with formalization reforms. Hence credit underwriting will need to evolve and adapt continuously to the new ways of doing business.
Consolidation: We will some interesting consolidation in mature, traditional sub-segments. This could be in the form of NBFCs merging with each other or even commercial banks stepping in to buy some NBFCs for specific product/market related access (Indusind Bank/BFI). At the same time, bulk of the fresh credit growth will be captured by the larger players and we may not be left with a long tail of players in 10 years time.
Digital-first Lenders: There will be a metamorphosis amongst digital lenders as a lot of companies from adjacent spaces who have found it difficult to make money in their core business have expanded to lending to make money. It reminds me of question by Kunal Shah of CRED — Is lending a product or a feature? However, many of them have realized that it is very easy to lend but 100x more difficult to underwrite properly and collect efficiently. Recently, RBI has also come down heavily on aggressive collection practices followed by some digital and mainstream lenders.
Opening up of the Banking Sector: RBI has recently floated a discussion paper on opening up of the banking sector and giving out more licenses to corporates. This like many other things has evoked strong reactions from both the camps who support or oppose the move, including many arm chair economists like me. But one things for sure, RBI will definitely move ahead on gradually opening up the sector and this will mean more challenges for the smaller NBFCs who will not have access to this option. More consolidation will result from this move as well.
To conclude, the NBFCs serve about 18% of the total credit demand in India right now (significantly up from 12% in 2008). After their harrowing experience in corporate NPA mess, smart commercial banks are now coming back strongly in the retail market and will give tough time to NBFCs in capturing credit growth. I would not be surprised if we see that the 18% number has not moved up significantly in the next 5 years. The next few years will definitely see separation of the men from the boys in the NBFC sector and we may not see a flurry of investment activity in the mid-market space for sure.