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Vivriti Asset Management launches India’s First Securitization Fund with investment from IFC and M&G Catalyst, to Boost Financing for Small Businesses and Address Gender Gap

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New Delhi/Gandhinagar, India, May 23, 2023

 

Millions of low-income households and micro and small enterprises (MSEs), especially women-owned MSEs, will have improved access to finance, with investment from IFC and M&G Catalyst in India’s first securitization fund aiming to strengthen the securitization market and address gender gaps in formal finance, while expanding additional financing for MSEs in the country.

 

Vivriti India Retail Assets Fund (VIRAF) will be a first-of-a-kind asset-backed securitization (ABS) fund in India. IFC has invested US$30 million in VIRAF, managed by Vivriti Asset Management and backed by a capital commitment of $75 million from M&G Catalyst—a global private assets strategy within leading international investment manager M&G Investments. The fund will focus on scaling investment in securitized debt securities with MSE-backed assets—predominantly microloans to MSEs, which will constitute about 90 percent of the portfolio.

 

VIRAF has a fund term of 10 years with a target Assets under Management of $250 million and is domiciled in GIFT City, International Financial Services Centre. IFC’s and M&G Catalyst’s participation is also expected to attract other investors, mobilizing funds to channel to non-banking finance companies (NBFCs) that focus on supporting underserved MSEs in India.

 

India’s 63 million micro, small and medium enterprises (MSMEs) contribute up to 30 percent of GDP, generating over 40 percent of exports, and creating employment for over 100 million people. Yet, IFC study estimates the MSME finance gap in India is $342 billion, with MSEs accounting for 95 percent of that gap. IFC’s investment will help financial institutions offload existing MSME loans while unlocking capital to support MSME growth.

 

“VIRAF aims to deepen and develop India’s ABS markets, by intermediating large global capital pools to last-mile financing, thereby setting a prototype for more such vehicles. Our research indicates that Indian ABS have outperformed internationally better rated ABS, which makes Indian ABS a compelling opportunity for global investors. M&G and IFC’s participation serves as a validation of the huge and untapped potential of Indian ABS as an asset class, stability of the regulatory environment, and India’s positive macro-outlook,” said Vineet Sukumar, Founder and MD, VAM.

 

“Small and mid-sized NBFCs are at the forefront of India’s financial inclusion initiatives, allowing entrepreneurs to start and grow businesses, and low-income families to manage their finances. M&G Catalyst is a strategy which aims to deliver positive impact to society and the environment alongside financial returns, so we are particularly pleased that VIRAF is focusing on ESG assessment and engagement with IFC, helping them to become exemplary responsible and sustainable businesses,” said Matthew O’Sullivan, M&G’s Head of Origination APAC for Private Assets.

 

Further, the financing gap for Women-owned MSMEs is estimated at $158 billion, equivalent to about 49 percent of the total MSME finance gap in India. Addressing this challenge, the project is designed to cater to the needs of WMSEs with at least 45 percent of the Fund’s proceeds earmarked for them.

 

“Supporting IFC’s systematic approach, this investment will bolster India’s NBFCs and enable greater institutional funding to the sector, contributing to the financial sector’s resilience while also strengthening MSMEs post-pandemic,” said Allen Forlemu, IFC’s Regional Industry Director for Financial Institutions Group, Asia and the Pacific. “The fund will further showcase the attractiveness of securitization as a means to access capital markets, promoting similar innovative vehicles, expanding financial inclusion and fostering greater integration within the country’s capital markets.”

 

The Indian securitization market remains nascent and underdeveloped compared to other emerging economies, underscoring the need for a robust and efficient debt capital market that offers sustainable solutions to bridge the MSME finance gap. The fund supports this market’s growth, promoting greater participation from investors and originators, and channeling capital towards bolstering financial inclusion.

 

About VAM

Vivriti Asset Management (VAM) is a performing-credit focused asset manager, investing in debt issued by mid-sized enterprises. With commitments of c.US$400 million across 8 funds, VAM manages sector-agnostic funds that have invested across infrastructure, energy, logistics, financials, Saas and services businesses.

Vivriti Asset Management Private Limited (IFSC branch) is registered with International Financial Services Centres Authority (IFSCA) as a Registered FME (Non-Retail) and the Investment Manager for Vivriti Fixed Income Fund – Series 3 IFSC LLP (trade name of Vivriti India Retail Assets Fund). VIRAF is a restricted scheme (non-retail) under the IFSCA (Fund Management) Regulations, 2022.

 

About IFC

IFC—a member of the World Bank Group—is the largest global development institution focused on the private sector in emerging markets. We work in more than 100 countries, using our capital, expertise, and influence to create markets and opportunities in developing countries. In fiscal year 2022, IFC committed a record $32.8 billion to private companies and financial institutions in developing countries, leveraging the power of the private sector to end extreme poverty and boost shared prosperity as economies grapple with the impacts of global compounding crises. For more information, visit www.ifc.org

 

About M&G Investments

M&G’s Catalyst investment strategy sits within the Private & Alternative Assets division at M&G. With over two decades of experience in private asset investment, M&G already manages over £77 billion in private credit, private equity and real estate on behalf of Prudential policyholders and external clients. Drawing on this expertise and track record in private assets, Catalyst is a global, flexible strategy investing in private companies with innovative solutions to some of the world’s biggest environmental and social challenges. M&G Investments is part of M&G plc, a London Stock Exchange-listed savings and investment business with over €400 billion of assets under management (as at 31 December 2022). M&G plc has customers in the UK, Europe, the Americas and Asia, including individual savers and investors, life insurance policy holders and pension scheme members.

 

For more information, visit www.vivritiamc.com

What to expect from the upcoming Union Budget as an AIF Asset Manager

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The journey of the Alternative Investment Funds (AIFs) industry in India since the Securities and Exchange Board of India (SEBI) came up with the regulatory framework in 2012 is nothing less than extraordinary. It opened a whole new door to sophisticated investors looking to invest in products other than traditional asset classes and in varied sectors. When it comes to products in the private debt space, the ability of AIFs to go much deeper in the market has attracted a lot of investors’ attention, resulting in deeper segmentation of risk and return in the balance sheets of institutional investors, family offices, and HNIs.

The above factors led the total number of AIF schemes in the country to more than quadruple from 250 in FY18 to over 1,000 in the present financial year. The commitments raised, which denotes the amount clients are willing to invest in AIFs, clocked a 5-year CAGR of ~50% to ~INR 7 lakh crores as of Jun 2022.

Despite the regulatory leeway, more is expected from the governing bodies in the upcoming Union Budget to sustain the interest in AIFs and hasten the pace of its growth. Some clarifications are needed with respect to AIFs set up both domestically and in International Financial Services Centre (IFSC), a specialized designated area in a Special Economic Zone (SEZ) located in GIFT City, Gujarat.

AIFs set up in India are registered under SEBI (AIF) regulations, 2012 and are classified as Category I, II, and III AIFs depending on the investment objective and strategy. These AIFs are considered Indian resident investment vehicles from both exchange control and taxation perspectives. From an Income tax perspective, Category I and II AIFs are accorded a tax pass-through status, whereas Category III AIFs pay tax at the fund level at the maximum marginal rate.

On the other hand, AIFs set up in IFSC are regulated by a unified regulator, International Financial Services Centres Authority (IFSCA) under IFSCA (Fund Management) Regulations, 2022. The Investment Manager in IFSC (called a ‘Fund Management Entity or FME’) is required to obtain an FME license, which is a key distinction between IFSCA and SEBI regulations. Interestingly, AIFs in IFSC are considered non-resident from the standpoint of exchange control, though they continue to be treated as residents from the standpoint of Income tax. These AIFs are also registered as Category I, II, and III AIFs and are intended to be taxed in the same manner as SEBI-regulated AIFs.

Criticality for India’s financial inclusion

India is a country where debt capital markets have not succeeded in replacing banks for critical areas such as project and infrastructure finance, or in developing the mid-market space. Today, the share of sub-AA ratings accounts for sub-5% of bond markets. To correct this, it is essential for the AIF industry to develop as pooled investment products that are the safest and best way to direct household savings to debt capital markets.

Therefore, there is a critical need for the Government and regulators to support and promote AIFs as a path toward financial inclusion and the development of capital markets. Below we discuss suggestions to achieve the same.

Domestic funds under SEBI

  • Regulation of the Asset Manager: Globally, fund managers are regulated by the securities regulator, with requirements of minimum capitalisation, compliance, disclosures as well as corporate governance. This provides more comfort to investors as well as ensures a certain level of quality amongst the players in the market. Given the growing size of the AIF industry, it is about time that asset managers are regulated.
  • Increasing investor participation – Harmonising ticket size of investment: India provides various opportunities for investors to partake in debt or debt-like opportunities. However, the ticket sizes of investments vary. For direct bond investments, the minimum ticket size has been lowered by SEBI to INR 1 lakh recently. For ReITs and InvITs, the minimum ticket sizes stand at INR 50,000 and INR 1 lakh, respectively. For PMS, the same is INR 50 lakhs. However, for AIFs, the minimum ticket size stands at INR 1 crore and INR 25 lakh for an accredited investor. It would be useful to have parity between these options on the basis of risk and return. Pooled investment opportunities with professional managers offer diversification and essentially lower risk – hence, it would stand to reason that the ticket size should be lower than for direct bonds.
  • Accreditation can be transformational: Accreditation of investors has been introduced by SEBI as a way to determine investor maturity and therefore reduce investment ticket size. With the increase in private wealth and the growth of HNIs, it is necessary to provide a significant policy push to this initiative. If accreditation becomes “digital” and hence instantaneously verifiable, the impact on deepening AIF penetration could be transformational.
  • Provide Asset Managers the option to self-select and structure: The Cat I/II/III framework was useful in setting an initial framework for creating the AIF industry. However, the utility has run its course. There is now a need to permit Asset Managers to self-select (one time at the time of fund creation) the fund structure on:
    • Pass through taxation versus fund-level taxation. For fund-level taxation, the tax rate should be in line with that for companies at 25%
    • Leveraging the fund versus not, in line with risk guidelines – e.g., higher leverage allowed for lower risk strategies
    • Open-ended versus close-ended structure
  • Management fee and fund expenses: Management fee and fund expenses are expenses of an AIF incurred exclusively for the purpose of making investments and generating returns for the investors – such as paying the Asset Manager, Auditors, Rating Agencies, etc. Currently, there is a need to clarify that such expenses are tax-deductible when income earned by AIFs is in the nature of investment income (i.e., capital gains or other sources). In the case of Category I and II AIFs, although the management fee is paid out of income earned by investors, it is however not considered tax-deductible by the investment managers for TDS purposes. It will be useful to get clarity in this budget on this matter.
  • GST on Carried interest: The SEBI (AIF) Regulations require an investment manager or their affiliates to act as a ‘sponsor’ and provide a minimum sponsor commitment to ensure a certain ‘skin-in-game.’ Further, an investment manager may be required to contribute alongside the investors as part of commercial arrangements with investors. This results in the locking up of funds for the sponsor as well as carrying risk attached to the investments. To adequately incentivise a sponsor, a carried interest is paid out of the additional returns generated by the investors over and above a certain pre-agreed hurdle rate/ minimum expected return. Carried interest is therefore a return on investment (ROI) allocated to the sponsor and is independent of the fact whether such contribution is made by the fund manager or not. However, following a ruling in 2021 involving various venture capital funds, carried interest was considered neither interest nor ROI but consideration retained by funds/ trusts for the services rendered by them to investors. This gave rise to uncertainties surrounding the taxability of carried interest from a GST perspective. It is therefore crucial that certain clarification is issued to remove the ambiguity around the treatment of carried interest.

Funds under IFSCA

  • Clarity of taxation of IFSCA AIFs: While IFSCA regulations have demarcated AIFs into categories similar to SEBI regulations, there is a lack of a specific tax chapter that deals with IFSCA-incorporated AIFs. Further, as argued above, there is a need to replace the earlier AIF categorisations with a different structure that provides the Asset Manager with the ability to self-select the fund structure and choose appropriate taxation. This is all the more critical for IFSCA AIFs given the much higher complexity of the domicile of intended investors in the AIF.
  • Management of multiple funds: Since IFSC has been demarcated as an SEZ, entities set up there can enjoy 100% tax exemption on business income for 10 consecutive years out of 15 years (aka Tax Holiday). As per 80LA of the IT Act, a certificate of registration is required for each unit with SEZ authorities. However, IFSC recognizes FME as a registered entity operating a single scheme. Thus, to qualify for the Tax Holiday, separate unit registration for funds/ schemes regulated under the IFSCA (FME) Regulations would be required. But in the case of AIFs, separate offices may not be required considering that the funds can be managed from the same office of the investment manager. Therefore, for AIFs, relaxations should be allowed under the IT Act for separate registration of schemes and the SEZ approval process should be removed.
  • Rationalisation of Surcharge rates: There is a discrepancy in the surcharge rate applicable in the case of LLP AIF (which is 12%) and Trust AIF (which is 37%), even though both may be formed for the same purpose. Hence, there should be a consistent surcharge of 12% applied to all IFSC AIFs, irrespective of how they are formed as legal entities.

The above concerns if taken up for resolution in the upcoming Union Budget or near term will not only aid the next level of growth in the AIF asset base but also remove several operational hurdles and the scope of any litigation.

 

The article has been covered in ET Markets (Online) on January 30, 2023. You can read it here:

What to expect from the upcoming Union Budget 2023 as an AIF Asset Manager

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.

Revolutionizing the AIF space

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India’s AIF industry has come a long way since its inception a decade ago. What is striking about the industry is its pace of growth. The commitments raised, which denotes amount clients are willing to invest in AIFs, are expected to surpass INR 7 lakh crores within a decade in the Sep 2022 quarter. However, the mutual fund industry, which currently sits with an average AUM of ~INR 40 lakh crores (as of Nov 2022), achieved an AUM of the same level over four decades in mid-2009, after the first scheme (US-64 by UTI) was launched in 1964.

Due to increasing awareness and recognition of AIFs as a preferred alternative investment vehicle, the growth in the number of schemes was phenomenal with new entrants and demand for new schemes. In less than three years, the number of schemes more than doubled from 506 in FY20 to 1019 in FY23 (till Oct ’22).

The major factor that is driving the growth in AIFs is their low correlation to public markets, regulatory support, and their ability to provide a diversified investment portfolio, mitigating the risk profile of investors. Hence, high net-worth individuals (HNIs) and family offices are increasingly preferring AIFs instead of limiting themselves to asset classes like traditional equity and bonds to diversify risk in their portfolio. Higher volatility in the market for traditional investments due to economic consequences of Covid-19, geo-political tensions, and surging inflation have been a major concern. Given these issues, AIFs fit well into the criteria with higher risk-adjusted returns and inflation hedging.

Huge room for growth

Despite the rapid growth in the number of schemes and commitments, the AIF industry is yet to mature to a much larger size given the lesser restrictions it enjoys with respect to investment in the unlisted universe compared to mutual funds and the risk-return spectrum it offers. Its potential to grow can be gauged from its share in the overall asset size of pooled investment vehicles in the country, which is much smaller than what it is in other developed countries.

As evident from the charts, AIFs in developed regions like the US and Europe account for ~30% to ~40% of the asset size of pooled investment vehicles, whereas in India it is only about 15%!

The engines of growth

(i) HNI base

Is there inherent strength to support the growth potential of AIFs in India? There is indeed a significant pool of wealthy individuals who all can be the target group to tap the underpenetrated market. As per a recent report, the number of high net-worth individuals (HNIs), with a net worth of over US$1 million, is expected to nearly double from ~0.8 million in 2021 to ~1.4 million in 2026.

If we compare the CAGR of India’s HNI base with other countries, we found that it exceeds or is equivalent to some of the top economies across the world.

(ii) Accreditation

The Accreditation Investors framework, initiated by SEBI in 2021, holds the key to the paradigm shift in the AIF industry. This is primarily because the market watchdog has allowed Accreditation Investors under the framework to invest with ticket sizes that are lower than the stipulated minimum amount of INR 1 crore. The premise of the framework is based on a class of investors, who are equipped with good knowledge about the risk and returns of financial products, have the ability to make informed decisions about their investments, and meet certain income eligibility criteria.

Certificates for Accredited Investors would be provided by Accreditation Agencies, which can be subsidiaries of stock exchanges or depositories (National Securities Depository Limited or Central Depository Services Limited) or any other institution that meets the eligibility criteria.

The relaxed criteria in minimum investment will be able to unlock the potential of the AIF industry by enabling investors to enter the market who were previously backing off due to higher ticket sizes. The widening of the investor base, for instance, can be gauged from that of the size of the market for Portfolio Management Services (PMS), which requires a minimum investment of INR 50 lakhs per investor.

The investor base of PMS was ~1.4 lakh as of Oct 2022. Hence, given the fact that there could be 15,000 to 20,000 unique investors across all AIFs registered with SEBI, and considering the PMS base, we are looking at growth in the AIF base, which is 7-9x the current size for the near term.

(iii) Digitisation

Some mutual funds have a fully digitised onboarding process which allows seamless transaction processing with minimal Turnaround Time (TAT). Given the potential growth of AIFs due to the inclusion of smaller ticket size investors with an Accredited Investor framework, there is a need for digitising the onboarding process for AIFs.

We suggest Accreditation Agencies to consider building a digital infrastructure for AIFs for the onboarding process that would

  • Reduce TAT to issue Accredited Investor certificate to the minimum, and
  • Remove any back and forth between investors and Accreditation Agencies by providing a standardised format of the NW certificate.

(iv) Listing of fund units

The development of a secondary market for AIFs is essential to ensure liquidity in the AIF industry. As per Section 14 of SEBI’s AIF regulations, units of close-ended AIFs may be listed on a stock exchange subject to a minimum tradable lot of INR 1 crore, after the final close of the scheme. However, we are not aware of any AIFs listing their units till date.

The listing of AIF units would

  • Ensure liquidity by allowing investors an easy exit opportunity (subject to KYC) due to dematerialisation and enabling price discovery in a demand-supply mechanism.
  • Create a more enabling environment for Pension Funds, which are more inclined to investing in listed securities according to PFRDA guidelines, to invest in AIF units.

In this regard, clear operational guidelines should also be established by the regulator with respect to standardisation of contribution agreements, handling of fractionalised units, tradable lot sizes for Accredited Investors, and involvement of merchant bankers in the listing process.

 

The article has been covered in ET Prime on January 20, 2023. You can read it in the below mentioned link

Thinking beyond traditional investments: here’s what could revolutionise AIFs

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Demystifying ESG (Part III)

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In Part I and Part II, we have discussed ESG risk & opportunities and explained the enormous power and responsibility the financial sector holds in terms of funding and transitioning towards sustainability. Taking this forward, we would focus more on the different ESG risk integration strategies and how Vivriti Group as an organization has redefined the due diligence of its portfolio companies to include impact & sustainability.

The real equation is turning ESG theory into action. Today it not only matters how the business is performing financially but also how it operates and what it stands for. So, the real question is how to make a purpose-driven investment decision. And what are the factors that directly impact how a company operates?

According to research conducted by George Serafeim, professor of business administration at the Harvard Business School, businesses are most successful financially and in terms of ESG when combined efforts are made to focus only on factors that directly impact how a company operates—referred to as material ESG factors. For example, for a sole proprietor having a small online jewellery trading business with 10 employees, data security would be a material ESG issue because the business handles user data while its labour practices would be considered immaterial at its current start-up stage.

ESG metrics can be extremely useful to investors for purpose-driven decision-making. Due to the lack of official standards yet on how to incorporate ESG factors into decision-making, one tries to choose from the below investment strategies which align best with his sustainability goals and existing risk integration frameworks.

At Vivriti, we started with the goal of constructing a values-aligned portfolio (Negative exclusionary screening/ Positive best-in-class screening, and Portfolio tilts). The organisation has taken a step forward to include and integrate ESG risk assessment in its existing risk framework.

Vivriti has developed its in-house Sustainability Assessment Model across 37 sectors assessing all its borrowers and originators on their environment, social, and governance parameters and identifying the ESG risks and opportunities. The taxonomy of which is based on global frameworks such as Global Reporting Initiative (GRI) standards, Task Force on Climate-Related Financial Disclosures (TFCD), and Indian ESG/ Sustainability reporting standards such as Business Responsibility Report (BRR)/ Business Responsibility and Sustainability Reporting (BRSR).

The on-field due diligence carried out by the ESG analyst alongside business and credit analysts reinstalls the importance of sustainability in the final decision-making. The observations and assessments are translated into a report that also includes an action plan & a stewardship engagement plan to mitigate the ESG risks. The stewardship centers around four principal parameters – talent, society & environment, corporate governance, innovation & customer trends.

The transition to the integrated framework could be time-consuming but it is definitely a foot forward in our sustainability journey. One might wonder how Vivriti’s portfolio companies have reacted to the ESG due diligence. Well, curiosity is the fuel for discovery, inquiry, and learning. It has been reassuring to discover how smaller companies are willing to incorporate ESG practices in their business activities as they recognise the long-term rewards both financially and for the greater good; it is the direction that is lacking!

Sustainability is a collective journey and Vivriti believes in charting the course along with its business partners.

Disclaimer: The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

COP 27 Climate Summit: What’s next for the Clean Energy Financing in India (A note)

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As about 190 countries gather during the 27th Conference of Parties or COP27, Climate Summit by the United Nations (UN) at Sharm el-Sheikh, Egypt, the agenda of clean energy financing steals the limelight again on the global stage. The parties to the UN convention are required to present their progress towards the ambitions to cut the emission of greenhouse gases like carbon dioxide and agree on new treaties and measures to achieve the targets.

The concerns for climate change are undoubtedly alarming. Recent reports suggest that not enough has been done to avert a climate crisis. The World Meteorological Organization (WMO) revealed at the beginning of this year’s summit that the last eight years have been the hottest on record while the rate of increase in the sea level has doubled since 1993 with the last two and half year’s accounting for 10% of the overall rise.

The Intergovernmental Panel on Climate Change — a scientific group created by the UN to monitor and assess global sciences related to climate change — warned that global warming over pre-industrial era levels was inching close to 1.5 degrees Celsius (currently 1.15 degrees Celsius as per WMO estimates) and the warming at and beyond this level could wreak havoc on some of our ecosystems.

Member states have stressed boosting the global ambitions significantly to meet the 1.5°C objectives. They identified that Nationally Determined Contributions (NDCs) submitted by nations (done every five years like 2020, 2025, 2030, etc) outlining the plan to mitigate climate change and their updates as insufficient and, hence, need to be strengthened during COP27.

India’s updated NDC included measures such as cutting the carbon emissions per unit of GDP and lowering the use of fossil fuels to generate electricity. At COP27, Indian negotiators stated that meeting the long-term goal of the Paris Agreement “requires phase down of all fossil fuels” by countries.

At the COP26 Summit in Glasgow in 2021, PM Modi proposed the vision of “LiFE – Lifestyle for Environment”, which suggested that the “consumption pattern of the world is mindless and pays scant regard to the environment”. It called for a change in the people’s mindset from ‘use and throw’ to ‘reduce, reuse and recycle’.

Climate Financing Target

The UN has identified financial resources and investments as keys to addressing climate change issues that range from emissions reduction, adaptation to the already occurring impacts, and building resilience. At the COP15 in 2009, the developed countries committed to providing $100 billion in assistance per year to developing countries for climate reforms by 2020. The funding was supposed to be drawn from public, private, and alternative sources of financing. However, wealthy nations have failed to reach their targets. For instance, Asia received only ~25% of global climate finance despite being home to ~60% of the world’s population. The question arises is $100 billion per year enough to act on the climate action pledges?

As per a report by the New Climate Economy — a flagship project of the Global Commission on the Economy and Climate — effective climate actions can result in $26 trillion worth of economic benefits for the globe by 2030. However, the benefits of that gigantic size cannot be achieved with an annual investment of $100 billion. The report by the United Nations Environment Programme stated that developing countries need annual adaptation (refers to adjustments in ecological, social, or economic systems in response to climate change impacts) support of $160 billion to $340 billion by 2030 and $315 billion to $565 billion by 2050.

Taking account of these factors, developing countries including India have asked for a new global climate finance target by 2024, known as the new collective quantified goal (NCGQ). As per estimates, the Global South/less-developed nations are spending 5x more on debt repayments than on climate change spending. Hence, in NCGQ, which is expected to be finalized by 2024, developing nations are seeking funding in trillions to implement the Paris Agreement. At the same time, they are looking at alternative sources of financing beyond conventional sources of loans and grants.

India’s stance and the significance of alternative sources of financing

The government of India set a target to achieve renewable energy (RE) capacity of 175 GW in India (excluding large hydro projects), which would include 100 GW of solar energy, 60 GW of wind energy, and 15 GW via small hydro projects, biomass projects and other renewable technologies by Dec 2022. Till Jun 2022, ~114 GW of RE capacity has been installed in India, as per information provided by the Ministry of New and Renewable Energy (MNRE). The remaining targeted capacity of ~61 GW is under various stages of implementation. Also, under the Paris Agreement goal, the government of India is also committed to generating 50% of installed energy capacity from non-fossil fuel sources by 2030.

To achieve the ambitious target, investment in the sector needs to be scaled up significantly. As per MNRE, India would need an investment of US$18-24 billion annually for its long-term commitments in the RE space. However, estimated annual investments in the sector in the last few years have been in the range of US$9 billion only, which implies a huge gap between the required and actual investment.

Achieving an investment target of this enormous size could be a daunting task unless new investor classes are tapped via the debt market since 70% of funds in RE projects are sourced via debt. Although established companies are able to get success in financing, other players, which are mainly MSMEs, smaller energy service companies, and unlisted, and lower-rated companies face difficulties in raising finances from capital markets despite having a sound business model. Further, new technologies require a higher risk appetite from debt investors that the mainstream market finds difficult to provide.

Such a barrier to clean energy financing can only be solved via alternative sources of financing like Alternative Investment Funds which can pool together commercial and impact capital, and especially lock in large international pools of capital. Such Alternative Investment Funds help RE players get access to early stage/construction financing, as well as affordable capital for project finance.

Due to increasing energy demand in India led by strong economic growth, capacity additions in the renewable energy space needs to accelerate at a faster pace. After a hiatus due to Covid, investments in the sector more than doubled in FY22 over FY21. Thanks to the rising participation of several private players including the behemoths like Reliance and Adani and a steady increase in FDI inflow, driven by growing commitments to meet clean energy targets under the Paris agreement, and an increasing pool of impact investors.

India has overshot its commitment made at COP21 by achieving 40% of its power capacity from non-fossil fuels about 9 years before time with phenomenal growth in the share of solar and wind in the overall energy mix. Unit economics have been improving due to technological developments, increasing awareness, and strong support from both the public and the private sectors. The next level of growth is expected to get boosted due to emerging technologies such as hydrogen, battery storage, low-carbon steel, et al.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Clean Energy Financing in India: Opportunities, Challenges, and the Role of AIFs (PART II)

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Right from creating a dedicated financial institution in the late 1980s to rolling out incentive schemes in the early 1990s, the govt has provided several avenues for clean energy financing in India. This apart, alternative funding avenues are created for the sector in the form of mechanisms like the National Clean Energy and Environment Fund (NCEEF) and instruments like green bonds and renewable energy certificates. Below we discuss some of the operational sources and schemes of financing in the sector and the challenges faced by them.

Avenues of clean energy financing and incentive schemes in India

1. Public financing

The Centre created a dedicated financial institution called the Indian Renewable Energy Development Agency Limited (IREDA) under MNRE in 1987 to provide financial aid such as soft loans, counter guarantees, and securitization of future cash flows to RE projects in India. However, as per a report by the Asian Development Bank Institute (ADBI), 2018, IREDA loans reportedly suffer a delay in sanctioning loans.

Apart from IREDA, state-run organizations like the Power Finance Corporation (PFC), Rural Electrification Corporation (REC), and National Bank for Agricultural and Rural Development (NABARD) provide finance to the RE sector.

 (i) Bank Priority Sector Lending (PSL)

In 2015, RBI has included RE financing under the ambit of PSL, which is aimed at boosting employability, building basic infrastructure, and strengthening the competitiveness of the economy. The central bank has kept the loan ceiling of INR 30 crores per borrower for RE projects. However, the ADBI report pointed out that the financing flow to RE under PSL has not been turning out as expected. One reason for the shortfall is the inclusion of RE under the broader umbrella of energy causing a flow of credit to non-RE sectors.

 (ii) Green Banks

Green Banks are conceptualized as a tool to accelerate clean energy financing. The first green banking initiative was undertaken by IREDA in 2016 to mobilize private funds to meet green energy targets. However, the idea has not yet taken off in India as it did abroad in countries like Japan, Australia, Switzerland, and the UK with a goal to facilitate the financing of clean energy projects at a cheaper rate. This could be attributed to the lack of mechanisms to recognize such institutions in India.

2. Green bonds

Funds raised via Green or Masala bonds are invested in green or RE projects. The tenure of green bonds in India ranges between 18 months and 30 months and they are issued for a period of up to 10 years.

India is the second country after China to have regularity guidelines formulated by SEBI for green bond issuances. They can be issued by the govt, multilateral organisations (such as ADB, the World Bank, etc), financial institutions, and corporates. They are increasingly being issued in India (listed either/both domestically and internationally). For example, SBI, India’s largest public sector lender, has launched dual listed green bonds worth US$650 million on the India International Exchange (India INX) and Luxembourg Stock Exchange. The size of total green bond issuances in India stood at ~US$7 billion in 2021. However, the issue size comprises less than 1% of the domestic bond market.

Despite creating a conducive environment, green bond issuances are yet to be a success in India because their acceptance largely depends on the risk perception of the investors. The riskiness of these bonds is similar to other bonds. They are required to be rated to attract institutional financing. The perceived risk of investment in such bonds becomes higher as some investors fear funds garnered via these bonds may not be utilized for the purpose for which they are issued. Secondly, there is an inclination of investors toward higher-rated issuers creating an asymmetry in the market.

3. Incentive schemes

Public financing in the sector also goes as support funding to incentivize the flow of private capital into the sector and tends to work as an enabling framework with a perception that the private investors have the potential to fund clean energy projects. Some of the incentive schemes rolled out for the RE sector include

  • Accelerated Depreciation: The AD scheme, introduced in 2009, incentivize investors by relaxing their tax liability on the investment. It allows depreciation of investment in assets like a solar power plant at a much higher rate than general fixed assets so that tax benefits can be claimed on the value depreciated in a given year. The scheme was withdrawn in 2012 and reinstated in 2014.
  • Generation-based incentive: The GBI scheme offers an incentive per kWh of energy generation in solar and wind projects. The primary intention of this scheme is to promote renewable power generation rather than only setting up RE projects. This scheme was later withdrawn mostly for utility-scale projects due to the fast growth of the RE market that resulted in near parity of RE tariffs with thermal power tariffs.
  • Viability Gap Funding: VGF is a type of smart incentive scheme to finance economically justifiable infrastructural projects. It is provided as a one-time grant by the govt to make projects commercially viable and has been used by the Solar Energy Corporation of India (SECI) to promote solar energy.

Apart from these incentive schemes, policy instruments that exist in India to push India’s RE sector include renewable portfolio obligations (RPO), renewable energy certificates (REC), and feed in-tariff (FiT) schemes.

4. Foreign equity

Globally, there is strong momentum in capital flow to the energy sector away from coal and coal-fired power generation in the last few years. Over the 12 years, the cumulative FDI inflow to India’s RE sector stood at ~US$12bn. Currently, 100% FDI is allowed in the RE sector under the automatic route that needs no prior approvals. Here’s how the FDI flow took place in the last five years —

The steady increase in FDI inflow, except in the year of Covid’s first wave, is driven by growing commitments to meet clean energy targets under the Paris agreement and an increasing pool of Impact Investors, who are keen on aligning their investment goals to UN Sustainable Development Goals by 2030. However, India is yet to attract a larger flow of foreign capital to clean energy as the domestic flow still dominates about 80% of the overall finance flows.

Lt Col Monish Ahuja, Chairman & MD of Mumbai-based Punjab Renewable Energy Systems, a provider of bioenergy and biomass solutions, expects India to become a sweet spot for global investments in the RE space. However, he believes, achieving the 2030 RE targets could be a tough ask as the investment hurdle rates required are very high unless concerted efforts are made to create a more friendly investment environment in order to access the vast pool of global capital towards sustainable ESG compliant RE businesses, including Biomass-Bioenergy, Green Hydrogen, et al.

Ahuja further added, “smaller players need to tie up and align themselves with the strategies of larger global players interested to invest in India. This will enable them to be backed by corporate guarantees / structured finance of the large balance sheet from these larger global players. Secondly, smaller players have to collaborate and come together under government programs where they can increase their bargaining power on a collective basis. Industry bodies like the Confederation of Biomass Energy Industry of India and CLEAN, a non-profit organization committed to supporting, unifying, and growing clean energy enterprises, are diligently working towards making capital accessible to the stakeholders.”

Role of Alternative Investment Funds (AIFs)

As per a study by the International Finance Corporation, India would need US$450bn in financing to meet its clean energy targets by 2030. Assuming a debt-equity split of 70-30, this means ~US$315bn has to come from the debt market. Accumulating financing of such an enormous size could be a daunting task unless new investor classes are tapped in and capital in existing projects is recycled.

However, small and medium RE project developers do not get the right access to the bond market due to the skewness of the market appetite towards G-sec and higher-rated corporate bond issuers, as discussed in the section ‘Asymmetry in debt financing’ in Part I. This creates a barrier to clean energy financing, particularly in the short to medium term. In such a scenario, AIFs fit in, not only because it provides short-medium term access to the capital market, but also due to the fact that they can

  • Invest in start-ups or unlisted securities and adopt complex trading/leveraging strategies unlike other investment vehicles like mutual funds.
  • Help crowding in many institutional investors for a single project due to diversification limits set by SEBI (Cat I and Cat II AIFs are not permitted to invest more than 25% of their funds in a single investee firm while, for Cat III, the limit is 10%).
  • Enhance the credit rating of bond issuance by using structured finance, where the AIF sponsor could provide a partial credit guarantee using a subordination/waterfall structure and customized periodic cashflows.
  • Enable private credit towards financing segments of the market such as Commercial & Industrial RE, hybrid technologies, EV network financing, etc where banks aren’t highly active yet.
  • Finance standalone mid-sized projects without relying on sponsor support.

This way AIFs can enable RE developers to reduce their cost of capital and help them repay loans taken from banks/NBFCs using the proceeds from bond issuances. On the other hand, investors are assured of coupon payments as they are backed by cash flows from stable and operational projects.

The emergence of more and more AIFs in the clean energy space would increase the confidence of investors in the sector by helping them undertake calculated risks, invest for impact, and giving exposure to complex and new clean energy tech. On the other hand, it will help RE entities, which are so far reliant on few lenders like IREDA, REC and PSU banks, achieve diversification in the borrowing mix.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Clean Energy Financing in India: Opportunities, Challenges, and the Role of AIFs (PART I)

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The global oil crisis in the 1970s and 1980s led to the genesis of renewable energy (RE) development in India similar to other parts of the world where research into alternative energy technologies such as wind turbines, solar panels, etc. began during the same time. The shortage in oil supply caused its prices to skyrocket from ~US$3/barrel in 1972 to ~US$35/barrel in 1980. Supply-related uncertainties and the adverse impact on the balance of payments due to drastic price increases led India to establish the Commission for Additional Sources of Energy (CASE) in the Department of Science & Technology in March 1981. In 1982, India created the Department of Non-conventional Energy Sources (DNES), that incorporated CASE. A decade later, India became one of the first countries to set up a Ministry of Non-conventional Energy Resources (by converting DNES), which was rechristened in 2006 as the Ministry of New and Renewable Energy (MNRE).

Amid the decades-long dependence on conventional sources of energy (mainly coal), the contribution of renewable sources to the overall energy mix in India started increasing at a fast pace in the last decade as depicted in the below charts. Thanks to various state and central incentives due to the increasing focus on reduction in CO2 emissions and concerns for global warming.

If we consider the energy mix within the renewable sector (by generation) this is how it looks

Back in 2014, the government of India set a target to achieve an RE capacity of 175 GW in India (excluding large hydro projects), which would include 100 GW of solar energy, 60 GW of wind energy, and 15 GW via small hydro projects, biomass projects and other renewable technologies by Dec 2022. Till Jun 2022, ~114 GW of RE capacity has been installed in India, as per information provided by MNRE to the Parliament. The remaining targeted capacity of ~61 GW is under various stages of implementation.

Under the Paris Agreement goal, the government of India is also committed to generating 50% of installed energy capacity from non-fossil fuel sources by 2030. India has set a long-term goal to reach ‘net zero’ by 2070.

Investment gap

Meeting the transformative goal in RE capacity calls for a significant investment in the sector. As per MNRE, India would need an investment of INR 1.5-2 lakh crore annually for its long-term commitments in the RE space. However, estimated annual investments in the sector in the last few years have been in the range of INR 75,000 crores only, which implies a huge gap between the required and actual investment. But recent trends in RE investment look promising!

Currently, India devotes ~3% of its GDP to investments in energy. Due to the rise in commitments from corporates, banks, and financial institutions to increase non-fossil fuel investments, the share of RE investments has been going up in the overall mix.

Investments in FY21 dipped ~24% due to the fall in energy demand amid the nationwide lockdown. However, as the demand revived, investment jumped 125% from FY21 and ~71% from the pre-pandemic level (FY20) in FY22.

The asymmetry in debt financing

PSUs play a dominant role when it comes to the financing of energy in India. However, a substantial amount of finance from govt-owned financial institutions flows into conventional sources of energy instead of RE. This is because over 50% of conventional power generation capacity is under the direct ownership of central and state governments. Hence, the onus to arrange finance of energy capital and development of RE capacity falls on the private sector.

Some of the biggest private sector players have already embarked on a massive clean energy journey. Reliance Industries has announced a target to reach net-zero carbon by 2035 and is investing over US$10 billion (INR 75,000 crore). Adani Green, the largest renewable company in India by market capitalization and the top project developer in solar and wind, with a portfolio of ~14,000 MW, announced debt financing of over INR 10,000 crores till Mar 2021 for its RE projects. Other key players in the sector include Tata Power (one of the highest revenue earners in the industry) and ReNew Power.

Among the state-run players, NTPC is a notable example of business diversification. The company is following a target of 60 GW of net renewable energy capacity by 2032. Coal India is also considering building capacity for solar wafer manufacturing.

On an overall basis, the clean energy sector still lacks scale and diversified access to financing. Although established companies like Reliance, Adani, and Tata are able to get success in financing being behemoths, other players, which are mainly MSMEs, smaller energy service companies (ESCOs), and other unlisted and lower-rated companies face difficulties in raising finances from capital markets despite having a sound business model or meeting financial benchmarks like the minimum debt-service coverage ratio or DSCR (the ratio of net operating income to current debt obligations) requirements.

However, “small and medium enterprises are going to be crucial to the growth of the RE sector”, said Saurabh Marda, the Managing Director of Hyderabad-based Freyr Energy, which provides rooftop solar solutions for residential and commercial customers. Marda added, “Most of these companies operate on an asset-light model and one of the things holding back their growth is the ability to finance projects. Most traditional lenders ask for collateral that is not feasible beyond a point. Another gap is that most lenders even today do not understand solar as an asset class, especially at the branch level. If this understanding improves and lenders start looking at solar project financing or discounting cash flows from solar customers, the overall financing situation can improve”.

The financing pattern of RE projects is such that 70% of funds are sourced from debt and the rest 30% are mobilized as equity funding. Sadly, the debt servicing costs of renewable energy projects in India are 20%-30% higher than in the US and Europe (calculated on Levelized cost of energy). The banking sector also depicts some level of reluctance while lending to smaller players due to its perceptions of associated risks and uncertainties with RE projects of such players.

When it comes to the financing of greenfield RE projects by banks and NBFCs, the following are the characteristics (IEA, CEEW, Dec 2021) noted in RE loans (the terms vary with the level of the project’s riskiness): —

  • Long-tenure and floating-rate debt with periodic reset clauses
  • A moratorium period of up to one year after the project’s scheduled commissioning date
  • Debt-service reserve account (DSRA), a cash reserve set aside to meet debt-servicing requirements for a period, requirements of typically one to two quarters
  • Minimum DSCR of 1.1

The cost of debt comprises the internal benchmark rates (based on the marginal cost of lending rate for banks and the prime lending rate for NBFCs) and the spreads over them. The spreads component is determined by the creditworthiness of the power offtaker (which are electricity distribution companies or discoms), the type of project site, the creditworthiness of the sponsor, and any additional corporate guarantees. For example, if the project is set up on a solar park site, its borrowing costs become ~25 basis points (bps) lower than the one set up on a non-solar park site. If the developer has signed a PPA with a highly leveraged state discom, it could add up to 50 bps in borrowing costs compared to a PPA signed with a central govt entity or a low-leveraged state discom. The below chart depicts how the cost of debt for developers varies as per the determinants.

In the next post, we will discuss what are the avenues of financing for clean energy projects in India, both domestically and internationally, and how AIFs fit well in mending the financing gap.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Demystifying ESG (Part II)

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In the first part of the series, we primarily discussed what is ESG, where is India in this equation & how Vivriti kick-started its sustainability journey. Taking this forward, we would focus more on Vivriti’s ESG & Impact philosophy to include our sector choices as well as our ESG risk & opportunity assessments.

Our ESG & Impact philosophy

In order to move a step closer to our goal, we need businesses and entrepreneurs to adapt to the Indian ecosystem and traditions in such a manner that sustainability and impact become key outcomes and not end up merely as checkboxes.

We cater to the diverse needs of our customers across various sectors including but not limited to financial services, renewable energy, healthcare, agriculture, and infrastructure. We seek to implement our mission through two business models. Firstly, through our NBFC entity Vivriti Capital, where we build credit history and robust lending processes. Secondly, through our AMC arm Vivriti Asset Management, which aims to channel global capital to its funds’ portfolio companies. Both these businesses are set up with a clear goal of ensuring inclusive and equitable growth for mid-market enterprises in India.

To deliver the impact where it matters the most, we employ a sector agnostic strategy, thus broadening the scope to a wider audience. We have delivered both direct & indirect forms of impact through multiple channels as discussed below:

Direct impact through thematic lending and investment in sectors such as microfinance, small and medium enterprises, Agri finance, healthcare, and clean energy.

For instance, Vivriti has financed an emerging leader in the underserved solar power market, infusing the requisite capital for the latter’s growth plans. Similarly, Vivriti helped an SME lender commence its capital market journey by investing in its first listed bond.

Our financial services portfolio, largely comprising of retail NBFCs, has the last-mile reach fuelling credit to millions of households and microenterprises. This enabled us to not only target financial inclusion but also fundamentally reduce economic inequalities through the empowerment of women & promotion of rural entrepreneurship.

Indirect impact through better ESG engagement by proactively embracing the opportunity to introduce new ways of stewardship. As part of its diligence process, Vivriti has been advising its portfolio companies on better governance and disclosure practices, in turn helping them tap the right avenues of capital in the long term. We have also suggested improvement in processes that enable companies to drive ground-level impact for their end customers.

For instance, we encouraged a mid-sized asset financer to employ a better auditor helping it attract an institutional pool of capital. On another occasion, when one of the rural financing lenders lacked employee enabling policies, through our engagement, we were able to drive home the point that employee well-being initiatives and processes are necessary for the company’s long-term growth strategy.

ESG Risk & Opportunities assessments

Adopting ESG assessment presents both risks and opportunities for an organisation. Our comprehensive framework enables us to identify, evaluate, monitor, and manage ESG risks. We follow a risk-based approach where clients/transactions that carry high ESG risks are subjected to enhanced evaluation and due diligence by a specialised ESG team for approval.

We intend to measure and monitor the ESG footprint of our portfolio companies by integrating the ESG risk assessment process with on-field diligence and periodic risk monitoring. This would also help us enhance our stewardship efforts and strengthen our engagement with the portfolio companies.

The Future of ESG

Today, ESG research is going deeper and becoming more sophisticated. As the taxonomy of ESG has evolved, so too has the ability to use data to analyse the world of ESG. Integrating ESG metrics into research on a thematic or issue-led basis, such as how various exclusion strategies will impact a portfolio or integrating ESG factors into investment recommendations, is seeking attention. Over the past decade, the growth in awareness and the adoption of ESG has been one the most dominant trends in the investment industry and is likely to be true for the next decade as well.

As per a 2022 study on global ESG trends by the Harvard Law School, the momentum toward the adoption of ESG in the investment approach continues. Europe took the lead in ESG charge, all of which are depicted in the chart below:

The focus is also shifting from what a company invests in to how it invests, and that trend will gather pace in the coming years. This is a growing but niche part of the ESG market that aims to get to the core of what responsible markets are. This is likely to result in significantly greater scrutiny of investment practices and bring institutions into the ESG world as contributors to rather than facilitators of the ESG movement. In the past decade, ESG has moved from a niche investment area to an overlay of a foundation of investing, permeating every aspect of capital markets and the investment industry.

Looking at Performing Credit amid the funding winter in India

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The venture capital (VC) funding, provided to emerging enterprises in return for an equity stake, seems to have entered the winter. Things have started going downhill lately due to adverse macroeconomic scenarios led by geopolitical tensions, low anticipated growth, and rising interest rates amid multi-year high inflation. Many VC firms have reportedly asked their portfolio companies to cut costs and revise budgets and projections to adapt to the funding winter. Some firms even believe the situation is worse than the first wave of Covid when ultra-loose monetary policies adopted by central banks and expansionary fiscal policies by governments supported the market.

The chilling effect on the VC funding has set in from the third quarter of CY21 as evident in the chart below —

If we examine the nature of the decline in VC funding in the recent past, we see that late-stage funding has hit the most while early-stage funding has more or less retained the momentum. This is because the crossover funds, which invest in both publicly traded and privately held companies, comprise a significant part of late & growth stage deals and turned their back from making new large bets in the private market.

The rise in Venture Debt

As VC funding is drying up, emerging enterprises and start-ups are increasingly shifting towards non-equity-based funding, in other words, debt. Talking about debt, it could be available from banks, however, that is an option mired with difficulties such as placing collaterals or pledging shares against the loan. Moreover, bank loans tend to be standardised with repayment schedules not matching the underlying cash flows generated by the entity’s business. In such a situation, Venture Debt (VD) becomes an alternative, however again, that is an option, whose terms are not entirely based on debt and include an equity component.

VD is a type of loan offered to early-stage, high-growth companies, which are already backed by VC firms. The VD deals are structured to include an equity component, aka “equity kicker”, which is there in the form of warrants, preference shares, rights, or options. Equity kickers serve to sweeten the deal and provide returns over and above the fixed income portion of the deal.

VD can be done by dedicated VD funds. The factors which make VD favourable are

  • It can be offered to companies that may not be cash flow positive yet
  • It can be provided to companies without existing collateral
  • It does not require a valuation to be set for the business
  • It gives way to less dilution for existing shareholders compared to VC funding as explained below

With gradual awareness, VD funding picked up in India over the last 5-6 years and has become a popular route for emerging enterprises to raise capital without diluting equity. The first VD that entered India was SVB India Finance, which started lending in 2008 and rebranded as Innoven Capital in 2015 when Temasek Holdings acquired the firm from Silicon Valley Bank. Since then, the VD market has been dominated by players like Trifecta Capital, Alteria Capital, and Stride Ventures apart from Innoven.

Despite a gain in momentum, VD investments still account for ~2% of the size of VC investments in India, a share which is ~20% in the US. A venture debt deal runs for 2-3 years whereas a VD fund has a life of 7-8 years allowing them to recycle capital at a much higher pace.

Performing Credit – white space in the Indian debt market

As we move away from AAA to AA rated bonds down to BBB rated companies, a lucrative opportunity for investors exists in a white space, known as the Performing Credit (PC), that exists between mutual funds and distressed debt funds & others at the two extremes. To better understand the depth and coverage of the market let’s see how the market players are positioned given their yield and ratings.

The range of up to 8% is mostly covered by mutual funds. The portfolios operating in this range are disproportionately skewed towards safety due to risk parameters set by SEBI and low liquidity risk on account of being open-ended vehicles. At the other extreme, there are Venture, Distressed Debt, and Real Estate funds operating in the above-16% yield range.

Profitability

PC space consists of papers issued by rated and stable companies which are undiscovered and yield high risk-adjusted returns. These are the companies that are operating mature and established business models with steady cash flows. Over and above, as the below chart suggests, over 90% of these companies in any rating bracket are EBITDA positive (in FY21).

Further, the overall credit performance of the rated universe, including the Performing Credit space, has been improving since FY21 as depicted in the trend in Credit Ratio (upgrades to downgrades) below —

The above chart indicates that the credit ratio improved to over 5x in the second half of FY22 compared to under 3x in the first half of FY22.

However, when we analysed ~80 VD investee portfolio companies we found that they are largely EBITDA negative with limited ability to throw cashflows.

Asset quality

The VD portfolio comprises companies that are typically unrated unlike the companies in the PC space. This could make the asset quality in the VD universe inferior, although VD investors have lately been considering the underlying business model, path to profitability, positive unit metrics, and longer runways for evaluating their investment decisions.

The asset quality in the PC space can be evaluated by plotting default rates across the rating scale and comparing them with respective yield spreads over 3-year G-sec.

The above chart depicts that the premium of return over risk till BBB, which is the space including PC investee companies, increased disproportionately. However, if the VD companies are ever rated, they would possibly lie in the BB and below bracket since they have unproven business models, lower vintage, mostly negative EBITDA, implying a higher risk on even principal repayments.

Apart from the asset quality, investors in VD funds need to look at the pricing of future rounds of VC investment, which determines the upside potential to overall returns. VD funds fundamentally rely on VCs to price the investee companies fairly, which enhances the value of the equity kicker. If they are not, the value of the equity kicker gets affected thereby affecting the overall returns from the fund. However, the returns from funds in the PC space are predictable as they are entirely dependent on returns from debt instruments making the risk-return spectrum not as distorted as VD funds.

Note:Excerpts from this article have been published on the 12th of Sep 2022 edition of LiveMint. To read it, please click here

Disclaimer:The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

How far the new MFI regulations have been implemented in India – A closer look

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It’s been over five months since RBI has come up with the new regulatory framework for microfinance (MFI) loans. With respect to financial and operational standpoints, NBFC-MFIs faced several headwinds, particularly after Covid-19, with escalated credit costs being one of the challenges.

The revised guidelines were earlier made effective from Apr 1, 2022. But later the effective date was extended to Oct 1, 2022, when some regulated entities (REs) notified RBI about difficulties with respect to their implementation.

The new guidelines are expected to have a positive impact on the NBFC-MFI sector. They are applied to all commercial banks (excluding payment banks), primary/state/district central co-operative banks, and NBFCs, including MFI and housing finance companies (HFCs).

However, to what extent the new guidelines have been implemented, and how far they are adopted? Vivriti Asset Management has spoken with 14 NBFC-MFIs across India to find that out. Let’s take a dig at some of the parameters of the new regulatory framework to examine and evaluate their responses.

1) Definition of MFI loans/Qualifying asset

As per earlier regulations, loans were classified as ‘qualifying asset’ in the NBFC-MFI framework if it meets some of the following criteria

Indian MFIs have long been in discussion with the Reserve Bank of India (RBI) to raise the limit of inflation-adjusted household income for taking loans to INR 3 lakhs/year to widen the scope of eligible borrowers. It has been estimated that the hike would add ~5 crore MFI customers to the current count of ~6cr.

Implementation and implications

Considering indebtedness at a household level is a welcome move for the industry, in the long run, and so is the hike in the cap for annual household income for qualifying assets, which is expected to increase the market size for MFIs. Let us examine these two aspects one by one:

(i) Ascertaining the household income

Upon interacting with 14 NBFCs across India, it is revealed that their field staff has started capturing the source of income of each member of the household. The assessment is done via discussion with the entire household.

We believe assessing the income of an MFI borrower/household is a challenging task as the majority of the income is unorganised, seasonal, and earned in cash and most of the MFIs will gravitate towards self-declaration. This results in a mismatch in the evaluation of the level of household income by different entities. For example, the household whose income level is determined as less than INR 3 lakhs by an MFI could be determined as more than INR 3 lakhs by an NBFC leaving no standard data points of reference.

As per the latest Consumer Pyramids Household Survey by CMIE, Indian households are divided into five income classes where the INR 2 lakhs-5 lakhs bracket comprises the majority of households, a share which rose from ~33% last year to ~50% recently.

(ii) Ascertaining household indebtedness

When it comes to loan obligations, a few conservative MFIs have set internal fixed obligations to income ratio (FOIR) thresholds of 40%-45% for the households. For monthly loan obligations, bureau checks are being carried out on the entire household. The issue is that monthly EMIs are only available for MFI loans and not all retail loans. Very few MFIs have designed EMI calculators to compute EMI based on the total outstanding and tenor of the loan. Most MFIs are considering the EMIs based on a discussion with the borrower/bank pay-outs. For loans such as gold loans/Kissan Credit Card loans, most MFIs are not considering them for computing indebtedness. Some MFIs are also considering the indebtedness only on account of self-declaration.

In order to assess indebtedness at a household level accurately, credit bureaus will take roughly 3-6 months to report EMIs of all outstanding facilities of the household. System alignment will take time. Originations will have a dual reporting mode, both manual and system-driven, resulting in higher oversight by the operations/credit team in MFIs.

Further, in the near term, MFIs will see higher rejections on account of bureau-linked indebtedness levels, overdue loans of spouses or children, and incorrect information being captured by field staff.

Overall, the TAT to onboard a client has increased by 1-2 days since verifying indebtedness levels and FOIR for the household is taking time and customer eligibility is now known at the head office instead of the tab instantaneously under the previous regime for some MFIs. The delay will result in higher operating expenses along with an increase in the cost of the bureau in the near term. In order to adhere to the guidelines, most MFIs are taking self-declaration of household income and of household indebtedness.

Given the varied practices adopted by MFIs for assessing and onboarding a borrower due to regulatory interpretation, there is potentially less homogeneity among players, making benchmarking between companies more arduous in times to come.

2) Minimum tenor and ticket size of loans

Earlier there were thresholds placed on NBFC-MFIs with respect to the minimum tenure, which is 24 months for loan amounts exceeding INR 30,000. No such thresholds exist in the new regulation. However, our survey revealed that despite the removal of the thresholds, many MFI lenders continue to have an internal threshold on ticket size based on credit quality and the cycle of customers. We believe these internal caps on ticket size by MFIs are conservative and necessary.

3) Minimum requirement for MFI loan mix

For entities to qualify as an NBFC license, RBI earlier required NBFC-MFIs to have at least 85% of their net assets in qualifying assets. Under the new regulation, the minimum requirement was modified to 75% of total assets, which includes cash and other assets. The inclusion of total assets instead of net assets expects to put higher stress on the liquidity of NBFC-MFIs. As a result, entities that had a higher mix of non-microfinance loans as of Mar 2022 and entities that had maintained higher liquidity are (a) reducing higher liquidity buffers, (b) reducing the extent of loan write-offs (c) and pausing disbursements of non-MFI loans till the mix of microfinance loan increases.

4) Pricing of loans

(i) Interest rates

Earlier, RBI has stipulated the interest rates that are to be charged by NBFC-MFIs in a manner that is lower of

a. Cost of funds + 10% — for entities with an outstanding portfolio of greater than 100 crores — and 12% for Others,

OR

b. 2.75x of the average base rate of the five largest commercial banks

Over the last two fiscal years, NBFC-MFIs began facing a rise in annual credit cost by 2%-4% (compared to ~1% at the pre-pandemic level) due to the pandemic-related provisioning and the increased stress on the restructured book. Problems emerged when banks started reducing their interest rates with the easing monetary policy leading to a fall in the Base Rate (the minimum rate set by RBI below which banks are not allowed to lend). This led the interest rates to be set as per criteria (ii) above, the trajectory of which has been shown below

The falling interest rates posed a problem for small to medium players/lower-rated entities due to higher pressure on their margins/spreads given the interest cap by RBI. However, the margin pressure for the large NBFC-MFIs was not as severe as small/medium players as the cost of borrowing of large NBFC-MFIs was lower compared to small/medium ones.

The revised guidelines enhanced the flexibility in setting the interest rates stating that the pricing of loans should be sanctioned by a board-approved policy. However, this came with a rider that lending rates and other charges/fees on microfinance loans should not be usurious. These imply that MFIs would be able to price the cost of delivery of their service under the new regime and help smaller MFIs serve underpenetrated areas.

Upon interacting with 14 NBFCs across India, it has been revealed that NBFC-MFIs rate hikes have been executed by sections of the industry in the range as depicted below—

Our survey also revealed that most MFIs have increased the yield at a uniform rate irrespective of risks across customers and geographies. A limited number of MFIs raised the yield by following a risk-based pricing approach based on

  • Underlying risk of borrowers (linked to their CIBIL scores)
  • High-risk geographies
  • Non-home state geographies

In our view, the new guidelines provide headroom for absorbing higher credit costs as pricing is driven by market forces or the cost of borrowing. We expect rates will continue to be at elevated levels in the near term till the industry recovers the losses on account of Covid, after which competitive pressures and a different policy rate trajectory may influence pricing.

De-regulation of interest rates provides a good opportunity for the industry to have differentiated pricing based on the riskiness of borrowers even within the same group. This will eventually pave the way to an improvement of the credit habit of borrowers as it will reward them with lower interest rates and vice-versa. Going forward, MFIs could eventually charge interest rates based on the underlying risk of each borrower.

(ii) Processing fees

Processing fees are another part of the pricing of MFI loans which was limited to 1% of the gross loan amount previously. However, the restriction has been lifted in the new RBI regulations. Our survey revealed that most MFIs have increased the processing fees by 100 bps to 2% after the new rules were implemented.

We have already mentioned the increase in operating expenses due to higher TAT for onboarding customers, frequent training, and CIBIL being run for 3-4 members per case instead of 1 (under the previous regulation) for NBFC-MFIs due to new regulations. Hence, lifting the restrictions on processing fees seem plausible as the increase in fee is expected to cover the immediate increase in operating expenses of NBFC-MFIs.

Here are a few takes of the market practitioners regarding the new regulations:

Kartik Mehta, MD of Ahmedabad-based Pahal Financial Services, said “The entire eco-system will need to reinvent themselves to be able to follow the new regulations. Entities will need to have a certain minimum level of technological evolution to be able to sustain in this segment. Also, the front-end acquisition teams of all the REs will need to be retrained to be able to capture the essence of the new regulations.”

When asked about the de-regulation of interest rates, Mehta said, “By introducing risk-based pricing, the regulator has created a window for good customers to get a competitive pricing thereby navigating the REs towards a more market-led efficient delivery model.”

As per Vivek Tiwari, MD, CIO & CEO of New Delhi-based SATYA MicroCapital, “The new regulations are instrumental in making more credit available to the mass population with increased income limit. In a way, they will help increase the market potential of microlending by at least double in the near term. They will also bring more product innovations, a larger reach, and competitiveness in customer service and pricing. With relaxed pricing norms, institutions will be able to serve under-penetrated markets even with higher operating costs.”

With respect to the impact of new regulations on the rejection rate, Tiwari commented, “We have seen an increase in rejections in existing areas of operations across 100 districts. Now, we will be looking for an opportunity with a deeper penetration in new territories with lesser credit offtake at present. Product innovations coupled with new reach will reduce rejections going forward which will, in turn, include more people in the microlending net in the next 2-5 years.”

Conclusion

NBFC-MFIs are not only an economic tool to further financial inclusion in India but also a medium to impact livelihoods in rural and urban areas and to empower women who comprise the largest part of their borrower base. The new regulations are expected to fuel growth in the industry once the challenges with respect to their implementation are sorted out in the near term.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

What to expect post-RBI MPC meeting – A short note

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The Reserve Bank of India-led Monetary Policy Committee (MPC) raised the repo rate for a straight third time this financial year citing elevated risks of inflation, which is expected to remain above the upper tolerance level of 6% through the first three-quarters of FY23. The repo rate was unanimously increased by 50bps to 5.4% with immediate effect, taking the aggregate hike of 140 bps in three months.

The retention of the stance at “withdrawal of accommodation” implies that further hikes are likely in order to control inflation while supporting growth. However, similar to the FOMC, the RBI MPC remained non-committal and did not provide any guidance about the future trajectory of hikes, which makes sense given the uncertain macro environment.

RBI kept its inflation forecast unchanged at 6.7% for FY23, driven largely by elevated core inflation (which remains sticky around 6%) and global uncertainties. We believe there are downside risks to RBI’s inflation forecast due to falling commodity prices on fears of a recession in advanced economies. However, the bar for easing remains very high since inflation is still expected to be higher than RBI’s upper tolerance band. Hence, we see hikes to continue taking the terminal repo rate to 5.75-6% by the end of the year.

The Indian bond market spooked as it was expecting RBI to take a softer path due to slide in commodity prices, in particular crude. The 10Y G-sec yield clocked the highest single session rise in three months, surging 16bps to close at 7.3% on the day of the MPC meet. The rise in corporate bond yields is depicted in the chart below.

Impact on mid-market debt

The transmission of the benchmark interest rates would pick up pace as hikes continue and RBI keeps its hawkish stance intact. Until now, the transmission of hikes was more pronounced with higher credit-rated issues like AAA and AA. But going forward mid-market firms are expected to witness the pinch of rising borrowing costs as well, which could dampen the growth of these firms to some extent. This, along with a volatile macroeconomic environment, might deter them at the margin for greenfield expansion. However, significant deleveraging that has taken place in the space and stable operating metrics of these firms are expected to make the impact and future movements on their balance sheets lenient.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Demystifying ESG (Part I)

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Over the recent years and particularly after Covid-19 investors, corporates and stakeholders globally have started realizing that Environmental Social and Governance (ESG) practices have a significant impact on financial performance and enable better access to capital and business opportunities. As per a study by American investment research firm Morgan Stanley Capital International (MSCI) on global and emerging corporates over 2015-19, companies that are rated higher by ESG scores are found to have lesser exposure to systematic risks (which are risks inherent in the entire market affecting all industries) compared to ones with low ESG-ratings.

The accelerating embrace of ESG practices globally is changing the way businesses perceive and report on sustainability. Thus, in a rapidly evolving ESG landscape, developing an understanding of ESG parameters has become crucial to today’s corporate management and investors alike.

What is ESG?    

ESG is primarily a risk assessment and mitigation tool that provides a framework for evaluating an organisation’s environmental, social, and governance performance beyond traditional financial performance indicators. ESG performance of a company is complementary to its bottom line, contributing to the creation of long-term stakeholder value while being responsible towards society.

The three interconnected dimensions E, S, and G are explained as follows:

Setting on the path to a net-zero future, climate-related risk disclosures have gained momentum. This has led to global market players’ adoption of formal ESG reporting frameworks and standards such as Global Reporting Initiatives (GRI), Sustainability Accounting Standard Boards (SASB), Task Force for Climate-related Disclosures (TFCD), Carbon Disclosure Project (CDP), EU Sustainable Finance Disclosure Regulation (SFDR), and Integrated Reporting.

At the onset, the adoption of these frameworks was primarily done by the larger listed entities globally. As per the KPMG Survey of Sustainability Reporting, 80 out of the top 100 companies by revenue in 52 countries, aka N100, reported on sustainability in 2020, showing an improvement of 5% since the last survey in 2017. The below chart depicts the increasing trend in the adoption of sustainability reporting by N100 companies:

Where is India in this equation?

With the changing global dynamics of how business is done and the advent and active adoption of ESG practices in the West, India began its own journey when SEBI mandated the top 100 listed entities to report on ESG by introducing Business Responsibility Report (BRR) in 2012. In 2021, SEBI replaced the existing BRR with a more robust Business Responsibility and Sustainability Report (BRSR). The core aim of BRSR is to empower all the stakeholders of the capital markets with the non-financial information of an organization through ESG reporting. It will be applicable to the top 1,000 listed entities by market cap and contain disclosures related to:

  • ESG risks and opportunities
  • Sustainability-related goals, targets, and performance
  • Environmental impact covering aspects including resource usage, emissions, waste management, etc, and
  • Social impact covering the workforce, value chain, communities, and consumers.

Similar to the BRR, the BRSR framework is also based on the nine core principles of the National Guidelines on Responsible Business Conduct. However, unlike BRR where disclosures were limited to Yes / No responses to a questionnaire, BRSR expands itself into both qualitative and quantitative ESG data for each of the nine principles drawing references from international reporting frameworks such as GRI, SASB, CDP, TCFD, and EU SFDR. BRSR has been made mandatory from FY23.

Though BRSR doesn’t pertain to unlisted companies at this point, the need of the hour demands that they start crafting their ESG strategies into their businesses as well to tap new opportunities to access global capital more favourably. The shift will further be primed by a pared-down Lite version of the BRSR framework that SEBI is currently consulting on for the unlisted companies of India to eventually bring them up the curve.

As the financial sector solves for today and plans for tomorrow and beyond in the face of uncertainty, it is imperative for the sector to develop resilience and response to risk management. Hence, robust governance on one hand and social and environmental aspects on the other hand hold equal prominence for businesses to flourish and benefit the people and the planet. The financial services sector needs to lead the way in driving the transition to a sustainable economy.

Vivriti’s ongoing ESG journey

As a purpose-led organization, Vivriti Group’s prime motto has been to deepen the debt markets for mid-market enterprises by solving a multitude of issues including information asymmetry, structuring, risk perception, and liquidity. Vivriti’s efforts are deeply mission-driven, to equalise access to debt and build capital market access for mid-market enterprises that are critical for India’s progress and sustainability.

To enable access to deep pools of capital from international and domestic capital markets, Vivriti has invested in ESG risk measurement, as well as impact assessment of its portfolios. Vivriti has also followed a proactive approach to ESG risk mitigation, through active engagement with its portfolio companies. Further, Vivriti has invested significantly in its own ESG framework – in key social aspects such as diversity, gender equality, inclusion, and employee well-being, as well as in becoming a net-zero organisation. Keeping up with our commitment towards a sustainable future, we have come up with our first sustainability report – Sustainability at Scale. The report highlights Vivriti’s ESG initiatives during FY22, its commitment to responsible investing, and its contribution to India’s growth story by aligning the business objectives with the UN Sustainable Development Goals 2030.

Engaging in sustainable practices and meeting the ESG criteria is the need of the hour today. The new equation is turning ESG theory into action and driving sustainable outcomes from meaningful change to the measurable value. Extending the theory around ESG, our next posts will focus on ESG in the unlisted segment, and materiality for debt investors including challenges and noise around ESG, throwing more light on greenwashing.

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

India’s ABS market: A detailed look at Small Business (MSME) Loans

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Micro, small, and medium enterprises (MSMEs) are one of the backbones of economic development in India. There are over 6 crores of MSMEs in the country contributing roughly 30% to the GDP and employing over 11 crores of people. Unfortunately, these enterprises lack access to the right kind of debt.

As per World Bank and International Finance Corporation estimates, Indian MSMEs account for a credit share of 6%-7% and face a credit gap of nearly US$400 billion with formal lending sources addressing only ~US$150 billion of financing needs.

The credit gap can be attributed to the vicious cycle that MSMEs face. Many are reluctant to finance MSMEs because it’s difficult to assess their creditworthiness due to a lack of good credit history while they can’t establish a good credit history due to the reluctance of the lenders.

The huge credit gap is making debt expensive for MSMEs, which are lying between large corporates widely funded by formal lenders and bottom players being served by microfinance institutions. The reduction in the credit gap will not only help these enterprises scale up their businesses and increase their competitive edge but also lead to their formalization in the economy

Securitisation of Small Business Loans (SBL)

Securitisation of SBL could be an alternative and effective source of funding for small finance companies to reduce the credit gap in the MSME sector. The profile of borrowers in such ABS pools are small/medium industrial units mainly engaged in tertiary activities like auto ancillary, plastic makers, power looms, etc., and individuals running small businesses in essential services like medical shops, dairy units, Kirana shops, etc.

So far, the share of SBL securitisation volumes in the overall market has been minuscule due to difficulties in assessing the risk of the MSME portfolio for securitisation. Also, there has been a persistent decline in the share of SBL volumes from the onset of the pandemic in FY20, as the below chart suggests, due to rising perceived risk about the asset class.

As per Kiran Agarwal Todi, CFO, Ashv Finance, “The first wave in FY21 and second wave in H1FY22 have impacted securitisation volumes across the asset classes largely because there were concerns on the collection efficiency of these assets due to massive disruption in economic activities. However, the volumes have picked up starting Q3 of FY22 and consistently improved over Q4 FY22. There was almost a 50% rise in the volumes of securitisation of SBL pools in FY22 over FY21.”

Considering only PTCs, it is to be noted that pools in the upper band of the rating scale mostly comprise secured business loans, also known as LAP, as they are secured by either residential mortgages or business premises owned by borrowers. However, pools in the lower band of the scale predominantly comprise unsecured loans. “At A and BBB rating categories, the proportion of unsecured business loans could be anywhere in the range of 50%-70% and it is much higher in the below-rated pools. As this proportion reduces, the rating profile gets better for the pool. At AA rating and above, the proportion of unsecured business loans would be south of 25%”, said Todi.

The below diagram shows how the market is divided between the key players as per the nature of underlying loans and issuer ratings.

Considering only PTCs, SBL securitisation volumes stood at ~INR 2,000 crores during FY22 compared with the overall PTC volumes of ~INR 56,000 crores in the market during the same period.

When it comes to pricing, there is a wide disparity seen at the lower end of the rating scale than that at the upper end for pools during the settlement period of FY22. Deepak Goswami, CFO, NeoGrowth Credit, said “NeoGrowth has observed the disparity in pricing, which has so far been driven by the type of investor an NBFC can attract on the basis of the rating of the company and the pool.”

Performance of SBL pools

The performance of SBL pools remained largely stable before the pandemic. As the pandemic was hit, the cash flow cycle of underlying borrowers in the pools was disrupted leading to a dip in collections during the moratorium period of Mar-May 2020. As the lockdown was eased, a pickup in collection efficiency was noted over Jun-Sep 2020 as most of the borrowers were involved in the businesses of essential services in semi-urban and rural areas. The median collection ratio (MCR) was improved further and peaked at ~100% in Mar 2021, which is generally the highest month of collections in a fiscal year.

The MCR again got impacted during the second wave as both borrowers and employees of lenders got impacted hampering the collection efficiency. This led MCR to reduce to ~80% in Jun 2021. As the lockdowns eased, collections started improving and climbed to 90% and beyond after Aug 2021 finally hitting ~100% in Mar 2022. This whole trajectory of MCR has been captured in the image below.

Outlook

“The quality of the portfolio originated during and post-Covid along with the macro-economic factors will largely determine the future performance of pools”, said Goswami. Although various government schemes like Emergency Credit Line Guarantee Scheme (ECLGS) and Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) have provided support to MSMEs in general to fix temporary cash flow mismatches, most of the rated pools possess inherent strength to sustain the stable performance unless black swan risks like Covid-19 strike. “The continued focus on collections, uninterrupted business activities, and continuity of stringent norms for onboarding the MSME customer will play a significant role in the future performance of SBL pools”, said Todi.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

What is the overall growth driver for India’s asset securitisation market given the current macro backdrop? VIVRITI ASKS

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The scare of liquidity erosion and recovery in overall volumes to the pre-Covid level are some of the concerns facing India’s burgeoning asset securitisation market. Vivriti caught up with Abhishek Dafria, Vice President & Group Head of Structured Finance at ICRA Limited, to seek views on the concerns and the factors that are shaping up the market.

Q. There is a visible asymmetry in India’s asset securitisation market with respect to the exposure of small and medium players in sectors like CVs, MFI, etc. How is that asymmetry playing out currently?

Abhishek: The asymmetry would continue. The market had grown in 2019 and 2020 but got disrupted due to Covid. In this period, it has only been the larger players that, at least in terms of volumes, have been carrying out securitisation of big-size pools. The asymmetry with respect to the weaker rated entities is true even now.

The market in itself lacks depth. So, you will mainly have investors looking for AA- and AAA-rated pools as these ratings are normally preferred on the PTC side. They would not prefer BB- or BBB-rated category on the Senior Tranche. Again, smaller entities would typically be the ones with a lower to medium size portfolio and hence their funding needs would also be lower. So, the percentage of securitisation of smaller players on the overall volume would also be lower. About 75% of the volume of securitisation is undertaken by entities with AA-category and AAA ratings.

Q. Will the current macroeconomic conditions make the market asymmetry even worse?

Abhishek: It’s difficult to say whether it will make it worse. The overall driver would be the growth in credit demand in the NBFC space and, based on that, the funding requirement of all sorts of players would increase. If the credit demand remains buoyant, one would still see growth in overall volumes across the rating categories because we are anyway sitting with a lower base due to the Covid impact in the last two years. But if these macro factors lead to subdued credit demand, then it will impact all the entities in terms of volumes. But the preference would still be there for higher-rated players and the asymmetry is not expected to go away anytime soon.

Q. Issuers at the lower end of the rating scale lack due access to the market as their originator volumes are way lower than AAA-rated issuances. Given this scenario, would the price discovery of securities at the lower end improve if the market is flushed with liquidity? Hence, do you think due to the gradual tightening by RBI, the demand for such issuances could get impacted?

Abhishek: Price discovery would improve if the instruments were either listed or there is a secondary market where trading happens regularly. Both are not the cases for securitisation. The pricing for PTCs at present is linked to the demand-supply in the market and the relationship between the two parties – investors and originators. For price discovery, the secondary market needs to open up, which would require a larger base of investors coming into the market who are willing to buy out these instruments based on their risk assessment and yield perception.

The market is not exactly driven by liquidity but largely by the need of the originators to raise funds and the willingness of the investors to buy out these pools. Banks are the key investors. The drying liquidity could, in fact, boost securitisation because lot of NBFCs with healthy liquidity are now seeing an increase in disbursements and they would relatively carry lower liquidity on the balance sheet compared to the Covid period. Hence, due to central bank’s actions to suck out liquidity, their funding needs would in fact go up and they would be even more prompted to sell down their pools in the market. From the banks’ side, it’s a funding tool, where either they lend on the balance sheet or look at PTCs and DAs. So, the drying up of liquidity wouldn’t negatively impact securitisation.

Q. Securitisation pools based on CV loans have depicted stable collection performance historically despite events like the demonetisation and GST implementation in India. Now, a significant rise in fuel prices could cause difficulty for the vehicle operators to pass on the price hike to customers, leading to margin erosion and higher delinquencies. In such a scenario, do you think CV pools could get affected or show similar resilience as it did historically?

Abhishek: We have seen a few months of elevated crude prices. In this period, the collection efficiencies (CE) of CV pools have remained fairly manageable. In Apr 2022, the CE was close to 100% in the rated pool, in March it was above 100%, including OD collection. It is estimated to remain at similar levels in this scenario. So, we do not expect any material deterioration in terms of collection. Further, since the base for the CV industry had gone down due to Covid, the demand should actually go up as activities pick up. Hence, the ability of the vehicle owners to pass on the fuel prices would actually be high. There would not be any material changes in asset quality due to the fuel price hike for now. Its difficult to say what would happen in the long term. But the Government has also taken some steps to correct fuel prices such as the cut in excise duty, which would have some positive bearing.

Q. Despite accounting for a meager ~2% of securitisation volume in India, pools based on two-wheeler loans are expected to be the emerging asset class in the market once the secondary market valuations of the vehicles and other nuances are recognized. The market has potential as about 75% of two-wheelers in the country are purchased using loans. How is the 2-wheeler ABS market shaping up currently?

Abhishek: There are limited 2-wheeler financiers who use securitisation as one of the funding tools. There is not any major change in the market shape or size lately. Basically, it is driven by a few entities about how much they would be disbursing and how much they would use securitisation as one of the ways to raise money. If the market grows, more entities will look at securitisation.

Q. How the rising interest rates expect to impact the MFI pools? Do you think RBI’s removal of interest rate ceiling on loans offered by NBFC-MFIs would help?

Abhishek: The RBI regulation should help as most MFIs have started increasing borrowing rates after the regulation came into force. Going forward, as far as the new pools are concerned, it will have a bearing on the Excess Interest Spread (EIS) available in the transaction since pool yield would go up, though the benefit may be muted if the PTC yields also start increasing.

Q. MFI securitisation volumes, which hit ~INR 29,000 crores in FY20, are yet to recover to pre-Covid levels despite showing significant improvements lately. Given the current macroeconomic conditions, when are the volumes expected to recover to the pre-pandemic level?

Abhishek: Q1 is not the period to assess the volume as a lot of transactions happens in Q4 due to PSL requirements similar to the last year. Going forward, it will go to the pre-Covid level. In the fourth quarter of FY22 and thereafter, we have seen the recovery in volumes have been better compared to FY21. We are witnessing DAs and PTCs pick up meaningfully since Q4, which is expected to continue. As disbursements are picking up for many players, securitisation volumes are also expected to go up.

Q. Coming to the MSME pools, the liquidity cushions of the MSME sector have eroded due to the prolonged effect of the pandemic and much of its survival has remained dependent on govt support like the Emergency Credit Line Guarantee Scheme (ECLGS) scheme, which has been extended till Mar 2023. What do you think will happen to the performance of the pools once the govt schemes like that wind-up? Can the sector build up inherent strength to continue without the support?

Abhishek: The overall economic activity has improved. In addition, most of the contracts mainly in our post-Covid pools are contracts that have not availed ECLGS loans. These are cherry-picked contracts, which are not restructured, not availed moratorium or ECLGS. Hence, concerns about the pools would relatively be lower. The inherent strength is there for the securitised pools.

Q. What is your view on other asset classes in India’s securitisation market?

Abhishek: Consumer loans is probably one of the asset classes where securitisation could pick up. But as of now, there are very few entities (like some fintech entities) who carry this out. We are seeing good traction in the personal loan space too where the securitisation volumes could witness some meaningful growth.

India’s ABS market: A detailed look at Microfinance Loans

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The origins of microfinance institutions in India can be traced back to 1974 when a Gujarat-based trade union Self-Employed Women’s Association (SEWA) established SEWA Bank to provide financial services to underprivileged women in rural areas. The bank along with other organisations like Working Women’s Forum (Chennai) immediately preceded the emergence of Self-Help Groups (SHGs) in India.

SHGs are a small group of 15-20 people, mostly women, formed to encourage habits of thrift, impart micro-credit, and promote micro-entrepreneurship among the members. The SHG model intended to create a common pool using contributions from members, who in turn can take loans from the pool during emergencies, mostly at flat interest rates. Thanks to the NGO, Mysore Resettlement and Area Development Agency (MYRADA), which started the SHG movement in the 1980s in South India. By 1986-87, there were roughly 300 SHGs under MYRADA.

As SHGs grew large enough and their credit needs increased, MYRADA started linking the entities to banks in 1984-85. In 1989, the SHG model was adopted by the National Bank of Agriculture and Rural Development (NABARD), which launched the SHG-bank linkage programme (SBLP) in 1992. SBLP formed the premise of microfinance activities and led to the recognition of the MFI sector in India.

In 1996, RBI decided to put SHGs under the “Priority Sector Lending (PSL)” portfolio of banks. The model became successful in states like Andhra Pradesh, Tamil Nadu, Kerala, and Karnataka, all receiving 60% of SBLP credit by 2005-06. Eventually, two models of microfinance emerged involving bank linkage as follows:

1. SBLP: Direct financing of SHGs by commercial banks, regional rural banks, and cooperative banks

2. MFI: Financial institutions like NBFCs, cooperative societies, trusts, and companies constituted under Section-25 of the Companies Act, 1956 extending microcredit to low-income groups for short tenures without any collateral for income-generating activities as well as for consumption, housing, and other purposes.

As the microfinancing sector grew and strengthened its position in furthering financial inclusion in India, concerns regarding regulating the sector arose in order to monitor, supervise, and promote MFIs in India. While NBFCs fell under the purview of RBI, other financial institutions (as mentioned in the MFI model) didn’t. The regulatory issue was exacerbated when the microfinance crisis struck in Andhra Pradesh (the motherland of the sector) in 2010 when some MFIs were accused of practicing a forced recovery process that purportedly led suicide of some borrowers. In the wake of the crisis, RBI eventually introduced a comprehensive regulatory framework in 2011, integrating customer-centric principles in the operations of NBFC-MFIs.

The need for asset securitisation for MFIs

Despite serving the objective of financial inclusion, Indian MFIs, mostly the small and medium ones, often get deprived of subsidized credit used for lending. The problem had been exacerbated post crises in the sector (like the one in Andhra Pradesh in 2010), which made the funding to the sector mire in political and other external risks. The below chart on the debt funding over FY18-20 describes the scenario.

From the above chart, it is evident that a major part of the funding had been sourced by Large NBFC-MFIs (mostly from banks), who have a gross loan portfolio (GLP) of over INR 500 crores, while Small (GLP<INR 100 crores) and Medium (GLP of INR 100-500 crores) NBFC-MFIs (majorly dependent on other NBFCs for funding) found it difficult to arrange funding. Hence, it became critical for small and medium players to look for an alternative source of funding like asset securitisation that not only frees up their capital and helps them sustain higher portfolio growth but also lets them avail transparent and market-linked financing as opposed to opaque bilateral deals.

Notably, the nature of loans in the MFI sector makes them an ideal instrument for asset securitisation due to the following reasons:

  1. Granular structure
  2. Related to diversified business activities, mostly agriculture and allied activities, while the rest are linked to non-agriculture activities (trade, service, manufacturing), and household finance (education, medical, etc.)
  3. Short tenor, typically 12-24 months
  4. High frequency of repayment (weekly or monthly starting immediately after loan disbursement unlike bank loans), which matches well with periodic cash flow from borrowers’ livelihood and enhances the predictability of cash flows to SPVs, which issues ABS

The trend in MFI securitisation and the market asymmetry

Owing to the need for alternative sources of funding and the ideal nature of microloans, asset securitisation has been increasingly preferred as a tool for raising funds by NBFC-MFIs.

In Chart 2, if we compare FY20 vs FY18, we see that there is a ~9x increase in securitisation volumes for large NBFC-MFIs and ~4x rise in volumes for medium NBFC-MFIs over the same time frame. However, if we look at the market share across the sizes of NBFC-MFIs a strong asymmetry is visible as the securitisation volumes are highly skewed towards large players.

Contribution of Secularisation in Total Fundraising

Performance of MFI pools

Pre-pandemic era

In the pre-pandemic era, the microfinance sector has been exposed to several crises such as the moneylending acts in Andhra Pradesh (2011), demonetisation in 2016, political debate, natural disasters, etc. Despite the negatives, the asset quality in the sector remained stable over 2017-20.

One example of resilience in the sector could be the period post the demonetisation in Nov 2016. Collections in the sector had recovered to ~98% by Jun 2017.

Post demonetisation, disbursement models of MFIs became cashless; nevertheless, collections in the sector remained largely cash-based. This could be attributed to the women borrowers, the majority of which receive their income in cash.

Post-pandemic era

The pandemic has significantly impacted the securitisation of MFI pools at the onset. The share of funding via securitisation to the disbursements of NBFC-MFIs fell from ~35% in the pre-pandemic era to below 20% after the pandemic. The pandemic also had a meaningful impact on the MFI volume in the securitisation market as shown below

However, the collection efficiency had quickly recovered after the first wave due to the higher exposure of NBFC-MFIs to rural areas (which contributes ~75% of loan portfolio), which were less affected by the pandemic. The scenario was different after the second wave though. Collections dipped after Apr 2021 due to high infections that deeply affected the rural belts as well. As the infections started abating, a strong recovery in monthly collection efficiency was witnessed (to nearly 100%) after the first quarter of FY22.

In the first nine months of FY22, micro loan securitisation volumes improved significantly to ~INR 6,200 crores from ~INR 1,900 crores in the comparable period a year ago. However, volumes are yet to recover to pre-Covid levels (~INR 29,000 crores in FY20). “Given the substantial pickup in DA and PTC deals in the fourth quarter of FY22 and thereafter, the recovery in volumes seems better than FY21”, says Abhishek Dafria, the Vice President and Group Head of Structured Finance at ICRA Limited. “As disbursements are picking up for many players, securitisation volumes in the sector are also expected to go up”, he adds.

Outlook

Going forward, collections in MFI pools expect to remain healthy with the easing of lockdowns, vaccination of the population, and resilience in economic activities. Although the rising interest rates scenario is a concern, MFIs expect to be not as hit as previously. Thanks to the RBI regulation that removed the interest rate ceiling on loans offered by the NBFC-MFIs effectively from Apr 2022, enabling them to pass on the rate hike to the borrowers. “With a proven track record across multiple crises, MFI securitisation – a unique asset class when compared to the global asset classes – would find traction among the global investors too, owing to its multiple ESG positives and a huge market to invest”, said Dipen Ruparelia, Head of Products at Vivriti Asset Management.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

“Accredited Investors” framework: A welcome move for AIFs

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SEBI approved the framework for Accredited Investors for the Indian securities market in June 2021. The market watchdog aimed to create lighter regulations for a class of investors, who are equipped with good knowledge about the risk and returns of financial products — mainly the complex ones such as alternative investment funds (AIFs) and portfolio management services (PMS) — and have the ability to make informed decisions about their investments. SEBI also allowed Accredited Investors to invest with ticket sizes that are lower than the stipulated minimum amount as per the regulations in respective financial products. Per SEBI, these moves will eventually help it focus more deeply on regulatory resources for vulnerable sections of the investors class to protect them from malpractices such as mis-selling.

The concept of Accredited Investors is not new though. It has emerged in asset management jurisdictions of countries like the US, Singapore, and Hong Kong, where regulatory norms are relaxed for a class of sophisticated investors (for example, “Qualified Clients” in the US) due to their higher industry knowledge and larger appetite for risk.

Eventually, SEBI came up with detailed modalities of the framework for Accredited Investors framework and amended the regulations for AIFs, PMS, and Investment Advisers accordingly.

Who all can be Accredited Investors?

Who will provide the certification for Accredited Investors?

Certificates for Accredited Investors would be provided by Accreditation Agencies (AAs), which can be subsidiaries of stock exchanges or depositories (National Securities Depository Limited or Central Depository Services Limited) or any other institution that meets the eligibility criteria. For the subsidiaries to qualify as AAs, the stock exchanges should meet a few conditions like minimum of 20 years of presence in the Indian securities market, an NW of at least INR 200 crores, presence of nationwide terminals, etc.

As of May 2022, three entities have been recognised by SEBI as AAs. They are:

  1. BSE Administration & Supervision Ltd (wholly owned subsidiary of BSE Ltd)
  2. CDSL Ventures Limited (wholly owned subsidiary of CDSL)
  3. NSDL Database Management Ltd (wholly owned subsidiary of NSDL)
Responsibilities of Accreditation Agencies

If the applicant meets the eligibility criteria, they will be issued an Accredited Investors certificate, which will have

  • A unique accreditation number
  • Name of the accreditation agency
  • PAN of the applicant
  • Validity of accreditation

It is to be noted that the accreditation certificate will be given for either one year or two-year periods. It will be valid for one year if granted based on the financial information of the past one year, and two years, if the applicant meets the eligibility criteria for each of the preceding three years and submit the supporting documents for that period.

Implications for AIFs

SEBI’s Accredited Investors framework is expected to help AIFs source more funds from the market and develop highly customised products. The higher ticket size of INR 1 crore made AIFs more or less exclusive to high net-worth individuals (HNIs) and financial institutions.

With the new Accredited Investors framework, investors will be able to infuse an amount in AIFs that could be lower than the stipulated minimum amount of INR 1 crore, subject to appropriate disclosures and terms of the agreement between the investor and fund manager.

Large value funds

While amending AIF regulations, SEBI has introduced the concept of “large value funds” (LVF) for Accredited Investors. LVF for Accredited Investors refers to AIF schemes where each investor (other than the manager, sponsor, employees, or directors of the AIF or employees or directors of the manager) infuses at least INR 70 crores. Accredited Investors in LVF can avail of regulatory relaxations, which are as follows

1. Relaxed norms for portfolio diversification: Category I and II AIFs and allowed to invest up to 50% of their investable corpus in a single investee company. This is compared to the earlier 25% limit for other AIFs of the same category. Also, Category III AIFs are allowed to invest up to 20% of their investable funds in a single investee company compared to the earlier limit of not more than 10%.

2. Extension of AIF tenure: Previously, AIF regulations permitted a two-year extension of the fund tenure of close-ended AIFs (subject to approval of two-thirds of the unit holders by value of investment in AIF). This was not considered by many investors and investment managers as the economic option for the fund. The amendments now allowed LVF AIFs to get an extension beyond two years, subject to the consent of investors, terms of the agreement between the investor and investment manager, and other fund documents. This is expected to provide the Accredited Investors of LVFs with higher flexibility in shaping the fund’s own course.

3. PPM requirements: Earlier AIFs were mandated to file a private placement memorandum (PPM), which is the offering document laying out objectives, risks, financials, and terms of the funds, at least 30 days prior to the launch of the scheme and required them to provide comments of SEBI on the PPM within 30 days of filing the PPM. The new regulations have exempted AIFs (in the LVF category) from the requirement of SEBI comments and allowed them to launch schemes by filing the PPM with SEBI before the launch. This is expected to ease regulatory scrutiny for AIFs falling in the LVF category.

No doubt, the framework of Accredited Investors and the latest amendments by SEBI could provide a conducive environment for asset managers in the AIF space. To know how to participate in our funds as Accredited Investors, please contact us!

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  


India’s ABS market: A detailed look at Auto Loans

Posted on by vivriti

The first securitisation program in India in 1991 was based on an auto loan portfolio with Citibank. The investor base in the deal was limited to mutual funds because other financial institutions were reluctant to foray into the space due to its unsecured nature, lack of clarity with respect to the at-par treatment of the certificates with other debt securities, and very low volume in the secondary market.

At the turn of the last century, there had been increasing participation by companies like Kotak Mahindra and Ashok Leyland Finance, who started securitizing their auto loan portfolio to buyers like ICICI and Citibank, with many of them being rated by credit rating agencies. However, most of these deals were bilateral instead of SPV-based.

The surge in auto loans-based ABS was driven by multiple factors such as

  • Increasing participation of international players in the Indian auto market
  • Presence of features (like instalment and hire purchase finance) in auto loans meeting securitisation criteria
  • Safety due to title over assets
  • Development of a resale market for cars that let financiers use foreclosures effectively in delinquencies

CV loans

The pools based on commercial vehicle (CV) loans have been the dominant class in India’s ABS market and form a major part of rated auto loans-backed ABS pools. Commercial vehicles, which are used for transporting goods or passengers, are classified into Light, Medium & Heavy depending upon their gross vehicle weight. The market for CV loans is estimated at Rs. 5 lakh crores. The five states — Maharashtra, Tamil Nadu, Rajasthan, Uttar Pradesh, and Gujarat account for 45% of all CV loans.

Banks and captive financiers mostly dominate the New CV financing while NBFCs dominate the Used CV financing. The NBFC space includes major players like Cholamandalam Finance, Sundaram Finance, Shriram Transport Finance, Tata Motors Finance, etc.

It is to be noted that a large portion of used CV financing is still controlled by the unorganised sector (mainly moneylenders). Hence, the share of NBFC expects to increase with the formalization of the financing sector. Cholamandalam Finance is one of the leaders in Used LCV financing. Emerging players like SK Finance, Kogta Financial, and others expect to gain a significant share in the market with formalization of the sector.

Performance of CV-based ABS pools

As per a Dec 2021 study by ICRA, securitisation pools based on CV loans have depicted stable collection performance historically, including events like demonetisation and GST implementation in India. It is the segment that depicted faster resilience after a sporadic fall in collection efficiency due to nationwide lockdown in the first wave of COVID. Thanks to the steady performance of Light CVs due to a booming e-commerce sector and pick-up in demand for Medium & Heavy CVs due to the government’s focus on infra and real estate spending.

Over 2012-2021 (up to Sep), the cumulative collection efficiency of CV pools (except the ones that originated in 2020) remained above 90%. It has been noted that, historically, collections remained the weakest in the first quarter of every fiscal year and the strongest in the last quarter of every fiscal year. This happens due to urges of the CV financiers to boost collections at the end of the financial year to bring down the ratio of non-performing assets (NPA) and cut the provisioning requirement that hits their bottom line.

If we look at the issuers’ ratings across CV pools, the market is highly skewed towards AAA-rated issuers. In 2021-22, nearly 97% of issuances by volume in the sector were rated AAA(SO), indicating an asymmetry in the market with respect to the price discovery of securities at the lower end of the rating curve.

Factors affecting CV financing and pools

The growth in CV financing depends on sales numbers, penetration of the financial market, and a rise in average ticket size of loans. As evident in the below chart, sales volume has been recovering post-Covid in FY22 (sales grew 26% YoY) but is yet to recover to the pre-pandemic level. Thanks to the recovery in demand from construction, e-commerce, and mining sectors with gradual unlocking of the economy and higher infrastructural spending by the Centre on large projects.

The performance of CV securitisation pools depends on the factors discussed below—

Fuel prices: The performance of auto loans-backed ABS pools is linked to fuel prices as vehicle loans are repaid from CV operators’ earnings, which are highly impacted by the fuel costs they bear. A significant rise in fuel prices could cause difficulty for the vehicle operators to pass on the price hike to customers, leading to margin erosion and higher delinquencies. However, strong growth in economic activity could be a savior supporting the earnings of CV operators and positively impacting the delinquency rate.

Freight rates: Higher freight rates help the CV operators protect their margins leading to lower delinquencies. The economic downturn during Covid dampened the demand for transportation of goods and negatively impacted the freight rates. However, with a recovery in the economy and higher spending by the government on infra projects, freight rates and fleet utilization have been improving lately.

Monsoon: Normal monsoon brightens the outlook of CV loans-backed pool performance. A bumper harvest season due to favorable monsoon pushes up the demand for medium- and heavy-duty CVs and result in the availability of better freight rates.

Two-wheeler loans

Despite accounting for a meager ~2% of securitisation in India, pools based on two-wheeler loans are expected to be the emerging asset class in the market once the secondary market valuations of the vehicles and other nuances are understood. About 75% of two-wheelers in the country are purchased using loans, where banks and NBFCs comprise 60% and 40%, respectively.

As the impact of the pandemic start abating, collections in two-wheeler ABS pools started recovering from the second quarter of FY22 and stood at ~94% in Dec 2021. Delinquencies in the pools are expected to be similar to the pre-pandemic level.

The two-wheeler loan segment is expected to grow at an annual rate of more than 10% over the next five years due to factors such as a rise in demand for electric two-wheelers owing to higher preferences for EVs and government subsidies for the same, steady increase in disposable income, rural development, etc.

Stay tuned to know about microfinance segment of the ABS market in our next post.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Dissecting the segments of India’s asset securitisation market: Prologue

Posted on by vivriti

In the US, the asset securitisation market is dominated by mortgage backed securities (MBS). The reason for its easy take-off was the comfort of investors based on the belief that mortgaged properties do not depreciate in value, unlike other physical assets. However, in India, asset backed securities (ABS) took precedence over MBS starting predominantly with auto loans. Although the MBS market has huge potential, it did not grow as large as the ABS market in India primarily due to issues like

  • long tenure of loans
  • complex foreclosure norms
  • low spreads
  • RBI regulations with respect to Minimum Holding Period (MHP) — the duration (earlier 12 months) for which a bank or NBFC is required to hold the loans on its book before selling them — and Minimum Retention Ratio (MRR) — which required NBFCs to hold a minimum percentage of the book value of the loans being securitised to ensure their adequate skin in the game even after securitisation. These norms were later relaxed though where MHP was reduced to 6 months and MRR was lowered to 5% of the book value of the loans (irrespective of the tenor) being securitised in the case of MBS.

The majority of traction that India’s securitisation market gained over the years is due to Priority Sector Lending (PSL) by banks. RBI has mandated the banks to lend to priority sectors like agriculture, micro, small & medium enterprises (MSMEs) to boost financial inclusion in India.

The non-banking financial institutions sold PSL pools via securitisation to banks as and when they fell short of their PSL target. Historically, PSL securitisation has accounted for three-fourths of the market. However, the market share of PSL volumes has started coming down over the past few years due to increasing interest in the non-PSL segment, particularly MBS and receivables backed by auto loans, two-wheeler loans, gold, etc., with rising participation from mutual funds, NBFCs, and Development Financial Institutions (DFIs) like MUDRA, Nabsamruddhi Finance (a subsidiary of NABARD), Small Industries Development Bank of India (SIDBI), etc. In India, NBFCs and housing finance companies act as key originators of securitization deals, while banks act as the leading investors in these pools due to their PSL targets.

Investors are increasingly shifting toward non-PSL assets due to a higher appetite for yields. The yields on non-PSL-backed assets/PTCs are at least 50 basis points (bps) higher than PSL-backed PTCs, both belonging to the same originator.

If we look at the issuers’ ratings across securitisation pools, we see that the market is highly skewed towards AAA-rated issuers in terms of volume as shown below.

The AAA-rated issuances mainly comprise pools based on commercial vehicles, MBS, and loan against property (LAP). Originators like Fullerton, HDB, Indiabulls, Mahindra, Sundaram, Shriram Transport, and Cholamandalam are mostly crowding these issuances.

However, in terms of the number of issuances, the number of issuers at the lower end of the rating scale such as A and BBB is as good as that in the upper end. Hence, combining Figures 1 and 2, it’s evident that issuers at the lower end of the rating scale lack due access to the market as their originator volumes are way lower than AAA-rated issuances. Given this scenario, the price discovery of securities at the lower end can only improve if the market is flushed with excess liquidity prompting the investors to go for such issuances. This was evident during the quantitative easing post-Covid, however, with gradual tightening amid rising inflation lately, demand for such issuances could get impacted.

Here’s a look at the category-wise break-up of pooled assets in the Indian securitisation market (FY21):

If we look at the number of issuers at the lower end of the rating curve such as A (SO) and BBB (SO) ratings, the structure of category-wise break-up changes as shown below (FY21):

Next, we will take a deeper look at individual segments of the ABS market.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Supreme Court clears the air on governance for India’s NBFCs

Posted on by vivriti

On May 10, India’s Supreme Court (SC) has given the verdict that non-banking finance companies (NBFCs) cannot be regulated by the State-enacted moneylending legislation. This brought a respite to NBFCs bothered by the 13-year-long cases in Kerala and Gujarat, which tried to regulate the business of NBFCs, including the level of interest rates charged by them to borrowers.

The Case

In 2009, several NBFCs filed applications in the Kerala High Court (HC) after the State government asked them to obtain licenses under the Kerala Money Lenders Act, 1958, failing which penal consequences were threatened. However, Kerala HC ruled in favour of the State government in November same year causing non-bank lenders to move the SC for resolution.

A similar crisis struck in Gujarat around the same time but there was a different outcome. The office of the Prevention of Money Lenders in Gujarat asked NBFCs to register under the Bombay Money Lenders Act. Opposing the move, the NBFCs filed pleas at the Gujarat HC, which had ruled in favour of the lenders in 2010. Again, in 2011, the State asked NBFCs to register under the Gujarat Money Lenders Act but failed after the HC ruled in favour of lenders in the same year. This led the Gujarat government to file an appeal against NBFCs before the SC.

What is moneylending legislation and how it’s different from NBFC regulation?

In India, moneylending legislation was introduced to curb non-regulated indigenous lenders from charging exorbitant interest rates to borrowers. It requires licensing of moneylenders, imposing a ceiling on the rate of interest (which, in the Kerala Act, was a maximum 2% above the maximum interest charged by commercial banks), mandating moneylenders to keep books of accounts and give receipts, etc. One of the earliest moneylending regulations in India is the Bengal Moneylenders Act, which was enacted before Independence, in 1940.

As per the scheme of the Constitution, there are three Lists with respect to the allocation of powers between the Union and the States. List 1 is the Union list, where only the central government is competent to make laws, List 2 is the State List, where state governments are allowed to make laws, and List 3 or the Concurrent List, where both Centre and States are competent to make laws. While giving the verdict, SC has stressed that comprehensive regulations with respect to NBFCs fall in List 1 while moneylending legislations fall in List 2.

The conflict between the two regulations arose because many of the moneylending legislations were imposed at a time when there was no clarity with respect to the regulation of NBFCs by RBI. The Reserve Bank of India Act, 1934 was enacted initially to regulate banks, and the regulation for NBFCs was included at a much later date in the act. However, during the time when the clarity is yet to come state governments faced issues like farmers’ suicide or there could be some political imperative that led them to take action against NBFCs as per the moneylending act.

The NBFCs were anguished by the state government’s attempts to bring them under the moneylender act due to the adverse effect of a dual and disparate regulation on economic efficiency in doing business. Secondly, making NBFC subject to state regulation took away their flexibility of doing business and exposed them to several risks, for example, a decision of moratorium on loans taken by the state government as political imperative would need them to comply with.

Microfinance crisis

Around the same time, in 2010, the microfinance (MFI) sector in Andhra Pradesh (AP) struck with a similar crisis. MFIs operate like NBFCs and provide credit to the underprivileged sector. They started emerging in 1990s, mainly in AP. Due to this, the State is deemed as the motherland of the MFI industry in India. The crisis happened right after the successful listing of a major MFI player in the state, SKS Microfinance (which later renamed as Bharat Financial in 2016 and merged with IndusInd Bank in 2019).

In Oct 2010, the AP government passed The Andhra Pradesh Microfinance Institutions (Regulation of Moneylending), Act following an ordinance to curb the activities of MFIs, which include specifying the area of their operation, rate of interest, and recovery practices. The legislation was passed after a spate of suicide by rural borrowers due to alleged coercive loan recovery methods followed by MFIs. The AP government barred SKS and other MFIs as well as some NBFCs from giving loans causing the MFI sector to collapse and shutdown of many smaller companies.

In 2011, SKS filed a plea in SC challenging the AP MFI Act and sought scrapping of the legislation. In 2013, SC has provided interim relief to SKS to operate in the State until the case is resolved. However, it directed SKS to adhere to the Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act. In 2017, the SC did not give any immediate relief to SKS and asked the company to plead its case before the AP HC only.

The latest SC Verdict

The bench of Justices at the SC held that NBFCs do not fall under the jurisdictions of moneylenders acts of State governments when the financiers are already regulated by the Reserve Bank of India Act, 1934. The top court identified the conflict between the RBI Act and the Moneylenders Act. It implied that Chapter IIIB of the RBI Act covers the cradle to the grave of NBFCs. “As a consequence, the single aspect of taking care of the interest of the borrowers which is sought to be achieved by the State enactments gets subsumed in the provisions of Chapter III­B,” the bench said.

Expected impact

The latest ruling expects to favorably impact NBFCs in the following ways:

Smooth functioning: It expects to enable smooth functioning of NBFCs due to reduced levels of intervention. State governments have often attempted to take steps against NBFCs under their moneylending acts even though the issue was still being subjudice.

No dual regulation: The issue gave rise to the possibility of dual regulation of NBFCs, which is not new in the Indian market though. Previously, some regulatory aspects of Cooperative banks were divided between state governments and RBI. However, it gave rise to lapses and the Centre had to revise such regulations in Sep 2020 and gave RBI more regulatory control. Dual regulations in the NBFC space due to the presence of a State enactment and RBI regulation created a lot of uncertainties, mainly in Gujarat and Kerala, which are expected to go away with the latest ruling.

Lower pressure on NIM: The cost of borrowing of most NBFCs expects to increase in a rising interest rate environment. The latest ruling expects to help lenders lower pressure on their net interest margin (NIM) due to a lack of intervention from state governments while passing on the rate hike to borrowers.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Would the surprise rate hike by RBI impact the mid-market debt?

Posted on by vivriti

On May 4, RBI announced 40 basis points (bps) hike in repo rate (the rate at which RBI lends short-term funds to commercial banks) to 4.4% effective immediately and a 50bps rise in cash reserve ratio (the share of bank deposits held as reserves with RBI) to 4.5%. Both the quantum of hike and timing was surprising for the markets as the central bank was expected to hike rates in June.

RBI has kept the reverse repo rate (the rate at which RBI borrows funds from commercial banks) unchanged and retained the monetary policy stance as ‘accommodative’ while focusing on ‘withdrawal of accommodation’.

Double whammy

A day later, the US Fed announced a 50bps hike (biggest since 2000) in interest rates to the range of 0.75% to 1% and launched the “Quantitative Tightening” program. However, the hike was broadly in line with market expectations and is considered less hawkish as the FOMC Chair retracted the earlier consensus of a 75bps hike in the next meeting. The Fed has indicated a further 50bps hike over the next two meetings.

The European Central Bank (ECB) is expected to join the bandwagon by raising rates soon. Its next meeting is on Jun 9. As per a policymaker at the bank, there is room for up to three hikes this year.

Inflation fear

The surprise hike followed RBI’s shift in focus towards controlling inflation at the April meeting due to global supply bottlenecks and a surge in commodity prices, especially crude oil at US$100+ levels, following geo-political tensions. Food inflation is a major concern due to shortages of key items like wheat and edible oil in international markets. The pressure on food prices expects to intensify further due to higher feed costs and fertilizer prices. Globally, food prices rose 33% year-on-year in Apr 2022.

Recalling the April meeting, RBI raised the inflation forecast from 4.5% to 5.7% for FY23. At the same time, RBI lowered the GDP growth forecast from 7.8% to 7.2% for the fiscal year. Retail inflation rose to a 17-month high at 6.95% in Mar 2022, breaching the upper end of inflation target of 2%-6% of the Monetary Policy Committee (MPC) for three consecutive months.

While raising rates, the US Fed mentioned combating inflation will remain its major focus as the continued pricing pressure due to demand- and supply-side factors were exacerbated by new crises like the Russia-Ukraine conflict and lockdowns in China. ECB is also expected to end its near-decade-long quantitative easing policy due to the rise in inflation to roughly four times its 2% target.

Market reaction

India’s bond market spooked post the surprise hike. The benchmark 10yr g-sec yield rose to its 3-year high at ~7.4% after the rate hike. The anticipated draining of liquidity of INR 87,000 crores by RBI due to a hike in CRR and expectations of forthcoming rate hikes expect to keep the bond yields elevated.

Corporate bond yields across the rating categories have been affected too as depicted in the chart below.

Lending rates set to rise

Since Oct 2019, all banks were mandated to lend at floating interest rates linked to the External Benchmark-Linked Lending Rate (EBLR) to make transmission of monetary policy rates effective.

EBLR has been linked to an external benchmark such as the RBI repo rate or Treasury Bill yield.  Hence, a rise in repo rate implies a higher cost of borrowing for commercial banks, which will lead to a simultaneous rise in interest rates on loans.

Would the mid-market debt be impacted?

Assuming a quick and equivalent transmission of repo rate, the mid-market enterprises that are heavily reliant on the loan market expect to be impacted due to the rise in bank EBLR. Also, the immediate linkage of mid-market debt to bond yields has been found to be stronger with respect to the hike. For instance, if we consider the A-rating space (refer to the chart), the yield has nearly absorbed the repo rate hike on May 4.

Impact on mid-market debt in the Non-Financial Services sector

A rising rate environment is unfavourable for mid-market enterprises, particularly in the discretionary sectors, as well as for long-tenor infrastructure projects with fixed returns. However, companies with established brands can pass on the rise in costs due to a hike in interest rates to consumers. The overall impact expects to be less significant though due to the lower leverage of the corporates on average compared to the previous rising rate environment.

Impact on mid-market debt in NBFC

The rate hike could lead to an immediate uptick in the cost of borrowings for most NBFCs from Q2FY23, impacting their Return on assets (ROA) for a couple of quarters. However, the overall impact on their Net interest margin (NIM) could be limited as the pricing of loans is also expected to increase. If the proposed RBI framework to remove the interest rate ceiling for NBFC-MFIs is implemented, all segments of retail credits are expected to be less impacted.

What about economic growth?

The Indian economy expects to continue its journey on the recovery path due to normalcy in activities post the third wave of Covid, resurgence of private consumption and discretionary spending, and the forecast of a normal monsoon supporting rural demand. Capacity utilisation of India Inc. went up ~72% for the manufacturing sector in Dec 2021 quarter from ~68% in the prior quarter. Imports of non-oil, non-gold, silver and precious metals imports, which is a measure to gauge the strength of the domestic demand, rose ~30% in Apr 2022.

The Federal Open Market Committee chair in the US has also emphasized that ‘growth will remain solid in 2022’ and expects private sector balance sheets to be strong enough to bear the impact of a tightening monetary policy.

Impact on our products

We see no implication on the fund’s current investments. With the increase in the yield, the mid-market player will become dependent on alternative lending sources which will increase the scope for debt asset managers to negotiate for better yields.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Asset Securitisation in India: A look into the burgeoning market (PART II)

Posted on by vivriti

Despite the rapid growth, India’s securitisation market is under-penetrated compared to other developed markets. As evident in the chart, securitisation volumes at $12 billion comprised only 0.46% of GDP in India versus $304 billion or 1.45% of GDP in the US in 2020. It highlights the significant opportunity in the securitisation market.

In terms of asset class, the following chart depicts the break-up in India’s securitisation market.

We are yet to see how far the new securitisation guidelines bridge the market gap. Till date, the investor’s participation in the market has remained limited primarily to banks (to meet private sector lending) and mutual funds to some extent. Foreign Portfolio Investors, FPI have remained virtually non-existent in asset securitisation transactions.

FPIs low participation in the market directly via PTCs has been mainly caused by 3 factors —

  • Complexities in obtaining & submitting documents like PAN Card due to data privacy and other concerns; filing income tax.
  • on income arising from such investments.
  • Absence of any fund focusing on securitization pools that could (a) benefit from the inherent diversification of investing in multiple pools and (b) address the difficulty in hedging forex risk due to unpredictable cashflows of MBS/ABS by pooling cash flows & stabilizing investor payouts.

The growth has also been inhibited by Indian asset managers’ reluctance to design products for offshore investors due to following factors —

  • Higher set up cost in running pooling vehicles in offshore jurisdictions like Mauritius, Singapore.
  • Higher chances of tax litigation while claiming treaty benefits.
  • Difficulty in accessing leverage/borrowing.
  • Poor access to regulators in foreign jurisdictions.

However, there is room for healthy growth as the Indian retail securitisation pools have performed well through the past decade steering through several crises. About 56% of structured finance ratings, which include issue years for asset backed securities and mortgage backed securities spanning over 29 years, were rated “CRISIL AAA (SO)”. These ratings were highly stable as over 98% of them remained unchanged on average.

The above table indicates the migration of transaction ratings, from one rating category to another – both upgrades and downgrades.

 The performance stands even better when we compare the downgrade of domestic AAA (SO) structured finance ratings for one year which is at 1.59% versus 2.32% for S&P AA- and 3.33% for S&P A-rated securitisation pools.

  • This indicates that domestic AAA-rated securitisation pools compare with Fitch AA- and A-rated ABS
  • As a comparison, India’s international rating is Fitch BBB-

The performance of the retail securitisation pools also withstood the recent COVID crisis with rating upgrades significantly outweighing downgrades, and no ABS witnessing a payment default.

GIFT City: Unlocking global pools of capital into securitisation by AIFs

India’s 1st International Financial Services Centre (IFSC), GIFT City solves the above issues and scores over other pooling jurisdictions like Mauritius, Singapore. IFSC was set up to undertake financial services transactions that are currently carried outside Indian soil by overseas financial institutions and foreign subsidiaries of Indian financial institutions. It doesn’t require investors to comply with India’s foreign exchange regime while investing in businesses within IFSC. Special tax incentives have also been provided to units located within the IFSC to incentivize offshore investments.

In IFSC, all categories of AIFs, Cat I, Cat II, and Cat III, can be set up, governed by AIF Regulations of the Securities and Exchange Board of India (SEBI). AIFs within IFSC has been granted special dispensations to provide them with higher operational flexibility.

FPIs are encouraged to invest in securitisation products based in GIFT City due to following reasons:

  • No PAN card or return filing required under the Income Tax Act for the non-resident investors (awaited for Cat III AIFs).
  • Exemption from tax on any income received from the Category III AIF or on transfer of its units.
  • Cat III AIFs could (a) lower credit risk through better diversification, and (b) remove difficulties in hedging forex risk as the asset manager can combine a basket of many securitisation pools in a way that could stabilise cash flows.

An asset manager benefits in the following ways while setting up a Cat III AIF in GIFT City:

  • Enjoy 100% corporate tax exemption for 10 consecutive years out of a block of 15 years.
  • Exemption from MAT.
  • No GST on management fees.
  • No restriction/cap on investment in a single investee company.
  • Ability to enhance returns by taking leverage at the fund level.
  • Lower set up cost due to lower operating expenses.
  • No need to claim treaty benefits, and hence no litigation risk.
  • Access to regulator is better in GIFT than in foreign jurisdictions.

To conclude, the Indian securitisation market looks to be well on track for exponential growth given the favorable regulatory climate and the potential of higher participation from overseas investors/HNIs via AIFs due to the presence of India’s first IFSC.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Asset Securitisation in India: A look into the burgeoning market (PART I)

Posted on by vivriti

The securitisation market kickstarted in the US in the 1970s when home mortgages were pooled by govt-backed agencies. In India, asset securitisation is comparatively new being a little over three-decades long. India’s first credit rating agency CRISIL rated the first such transaction in 1991 when Citibank securitized a pool from its auto loan portfolio. The market was first regulated in 2006 with new guidelines being implemented in 2012 after the global economic crisis and thereafter in 2021. Since then, securitisation in India has been witnessing rapid growth with non-banking financial companies (NBFCs) remaining the main originators of loans to the sector.

The annual securitization volume jumped by nearly 5x to over US$ 26 bn in FY20 before the COVID-19 pandemic took a toll.

Before deep diving into the key factors and framework behind the rising trends in the sector, let us briefly examine how the market operates and its underlying structure.

Securitisation meaning and structure in India

Securitisation is a process where assets like home loans (falls under mortgage backed securities or MBS), auto loans, microfinance loans, credit card debt (all three fall under asset backed securities or ABS) are pooled and repackaged as interest-bearing securities. The transaction involves shifting the assets from the balance sheet of the originator to the balance sheet of an intermediary which could either be an asset reconstruction company (ARC) for stressed assets/bad loans or a Special Purpose Vehicle, SPV (a legal entity typically set as a trust to undertake a specific business purpose or activity) for non-stressed assets/performing loans.

In the Indian market, the pooled assets are sold to the investors either in the form of pass-through certificates (PTCs), which are like bonds, for standard assets, or security receipts (SRs) for stressed assets. PTCs or SRs represent claims on incoming cash flows (like the principal repayments and interest) from such pooled assets. The main advantage that the originator gain from this process is that it frees up its balance sheet creating liquidity and/or rebalances its loan exposure by receiving consideration from the investors much before the maturity of the underlying loans. On the other hand, collections from the underlying loans held by the SPV are passed on to PTC investors.

In India, banks and financial institutions are also allowed to enter Direct Assignment (DA) transactions to sell their loan books at a fixed interest rate to other banks or financial institutions. Such transactions do not involve an SPV or the issuance of PTCs. In fact, the Indian banks and financial institutions predominantly prefer DA structures for securitizing their assets.

Regulatory climate

Over the past few years, the Indian govt has been focusing to develop the securitisation market by providing a robust regulatory mechanism. This particularly happened after NBFC crises like that of IL&FS and DHFL, which accelerated the need to provide alternate sources of funding to Indian corporates. The Indian regulator is also interested in enhancing participation from foreign portfolio investors (FPIs) in securitisation transactions.

The regulator for securitisation of performing and non-performing assets is RBI. When it comes to performing assets, the market is governed by the following RBI guidelines:

  1. The Guidelines on Securitisation of Standard Assets, 2006
  2. The Guidelines on Securitisation Transactions, 2012
  3. Master Direction – Reserve Bank of India (Securitisation of Standard Assets) Directions, 2021

The recent among these brought significant winds of change with respect to the development of a robust secondary market. It is to be noted that the provisions in the new guidelines are applicable to banks, all NBFCs, including housing finance companies (HFCs), NABARD, NHB, EXIM Bank, and SIDBI.

The latest guidelines, issued last September, expect to result in improved transparency, risk-based pricing, and deepening of the market. The introduction of STC (Simple, Transparent, and Comparable) concept should enable better risk assessment, benchmarking, and pricing with criteria around minimum track record and performance history of 5 years and 7 years for retail and non-retail exposures, respectively.

The residential mortgage backed securities (RMBS) expects to prosper with relaxation in Minimum Holding Period (MHP) — the duration for which a bank or NBFC is required to hold the loans on its book before selling them — and reduction in Minimum Retention Ratio (MRR) — which is designed to ensure that the originators have a continuing stake in the performance of securitised assets so that they carry out proper due diligence of loans to be securitised for RMBS.

Given the regulatory climate and advantages that the securitisation market pose, what opportunities exist for the market in India and how to tap them? In the next post, we will answer these questions.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Alternative Investment Funds in India: The ins and outs (PART II) – UPDATED

Posted on by vivriti

The growth of India’s alternative investment funds industry has been phenomenal over the past few years. The industry’s commitments raised, which denotes the amount clients are willing to invest in AIFs, clocked a 5-year CAGR of ~50% to ~INR 7 lakh crores as of Jun 2022. However, the mutual fund industry, which sits with an average AUM of ~INR 41 lakh crores (as on Dec 2022), achieved an AUM of the same level over four decades in mid-2009, after the first scheme (US-64 by UTI) was launched in 1964.

Over the last five years, the growth in the AIF industry has been super steady without any dent even at the onset of Covid-19 unlike mutual funds.

Within the AIF segment, Category II constitutes more than 80% of industry commitments. As of Jun 2022, Cat II commitments jumped ~44% y-o-y to ~INR 5.6 lakh crores. Among other categories, Cat I commitments rose ~27% to ~INR 58,000 crores and Cat III commitments grew ~47% to ~INR 74,500 crores as of June 2022.

What are the catalysts for growth?

The major factor that is driving the growth in alternative investment funds is their low correlation to public markets. Hence, high net-worth individuals (HNIs) and family offices are increasingly preferring AIFs over other asset classes like traditional equity and bonds.

Economic uncertainties led by Covid, and geo-political tensions have added a lot of volatility to the market, higher valuations in the listed space have been a major concern, while inflation hedging is a must. Given these issues, alternative investment funds fit well into the criteria with higher risk-adjusted returns.

Among other factors that led AIFs to gain traction include the regulatory mandate to ensure sponsors’ “skin in the game” as mentioned in Part I. The investments in the funds are managed by a team of seasoned finance professionals and a competent investment committee with the ability to underwrite risk and ensure consistently higher returns.

The robust growth in Cat II AIFs is attributed to their ability to provide a diversified investment portfolio, mitigating the risk profile of investors. Foreign Portfolio Investors (FPIs) have been increasingly taking the AIF route to make debt investments as stringent RBI rules for debt investments by offshore investors do not apply to the route. For instance, as per 2020 circular by RBI, short-term investments by an FPI were limited to 30% of total investment in corporate bonds. Credit AIFs are able to provide flexibility to offshore investors to participate in private debt issuances and generate additional alpha through strategic asset allocation.

What advantages do AIFs gain over other vehicles to capture the Performing Credit opportunity?

When we spoke about the asymmetry in the debt market, we mentioned huge opportunities in the Performing Credit space comprising of issuers largely in the unlisted universe. Alternative investment funds seem to be perfectly fit the criteria in addressing the space.

In 2020, the Securities and Exchange Board of India (SEBI) issued new norms in a circular that placed several limitations for debt investments by mutual funds. It has restricted mutual funds from investing in unlisted debt instruments such as the unlisted commercial papers (CPs), which are short-term debt securities issued by corporates for up to one year. It has allowed mutual funds to invest in unlisted non-convertible debentures (NCDs), used for raising long-term capital, provided the instruments have a simple structure and the exposure to them does not exceed 10% of the scheme’s portfolio. The circular also reduced the exposure to unrated debt from 25% to only 5% of the net assets of a mutual fund scheme.

In contrast, debt AIFs, under Cat II, are allowed to invest in both listed and unlisted investee companies. They are also not subject to restrictions such as sectoral exposure caps or sticking to one class of investments.

Due to the absence of small/retail investors in the space, liberal regulations for AIFs help them stand apart from other vehicles like mutual funds to capture the Performing Credit opportunity.

(Note: The article has been updated to reflect the latest available data for AIF and MF.)

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

Alternative Investment Funds in India: The ins and outs (PART I)

Posted on by vivriti

Alternative Investment Funds are a class of pooled-in investment vehicles, which raise money from institutions and high-net-worth individuals, including Indian, foreign or non-resident Indians with a minimum ticket size of Rs.1 crore. As the name suggests, they provide an alternative to traditional forms of investments like direct equity, mutual funds, and bonds.

The privately pooled funds in AIFs are invested as per a defined investment policy in alternative asset classes such as venture capital, private equity, hedge funds, infrastructure funds, etc. This means they provide long-term and high-risk capital to a diversified set of ventures at all stages of their evolution. The investee universe includes pre-revenue stage companies, early and late-stage ventures, and growth companies that wish to scale their future operations.

Today AIFs are a faster-growing investment vehicle in India when compared to mutual funds. Thanks to a number of factors such as low susceptibility to volatility in the stock market, the ability to generate higher returns than stocks and mutual funds, diversification of risk from traditional asset classes, etc. However, their emergence in India was driven by some fundamental factors.

Emergence of AIFs in India

The govt had been focusing on Venture Capital Funds (VCFs) since their inception in the late-1980s to promote the growth of particular sectors and early-stage companies. However, concessions given to VCFs were unable to produce the desired impact in promoting the emerging sectors and start-up companies due to uncertainties created by various regulations.

Therefore, in 2012, the Securities and Exchange Board of India introduced the SEBI (Alternative Investment Funds) Regulations, to recognise AIFs as a distinct asset class like Private Equities (PEs) and VCFs. The aim was to set up a new category of investments that will finance the socially and economically desirable sectors and ensure a long-term capital flow in India by attracting a different asset class of investors and putting lesser constraints on investments.

Regulation

As per the 2012 regulations, an AIF fund can be established or incorporated as a trust, a company, a limited liability partnership, or a body corporate. However, most of the alternative investment funds are registered with SEBI as Trust in India.

The person who sets up the AIF fund is called the “Sponsor”, which refers to a promoter in case of a company and designated partner in case of a limited liability partnership. In order to ensure “skin in the game”, AIF Regulations require the Sponsor to have a certain continuing interest in the AIF in an absolute amount or certain percentage of the corpus.

To reiterate, alternative investment funds is a strictly privately pooled investment vehicle. Hence, it cannot raise funds by making an invitation or solicitation to the public.

Structure of AIFs

As per classification made by SEBI, AIFs can be divided into three unique categories, which are defined as follows –

Category I

This category of AIFs invests in start-ups, early-stage ventures, social ventures, small and medium enterprises (SMEs), infrastructure, social ventures, or other sectors which are considered by government regulators as positive and beneficial either socially or economically. Hence, Cat I funds are expected to have spillover effects on the economy and the govt might consider giving them incentives or concessions for serving that purpose.

It also includes Angel Funds, which are funds pooling investments from Angel investors. Angel investors can be a corporate body with a net worth of at least Rs. 10 crores; an individual owning tangible assets valued at least Rs 2 crores excluding the value of his principal residence and having experience as a serial entrepreneur, senior management professional & early-stage venture investor; an AIF; or a registered VCF.

Category II

This category of AIFs includes debt funds and private equity funds. The category is created to offer a defensive investment alternative where diversified investment portfolios are built and managed by experienced fund managers to reduce the risk profile of investors. The debt funds that fall under this category invest in debt/debt securities of listed or unlisted investee companies as per the stated objectives of the fund.

Both Cat I and Cat II AIFs are required to be close-ended with a minimum fund life of 3 years. The Sponsor’s interest in each of these categories must be not less than 2.5% of the corpus or Rs. 5 crores, whichever is lesser. For Angel funds, such interest shall be not less than 2.5% of the corpus or Rs. 50 lakhs, whichever is lesser.

Category III

Cat III AIFs apply complex trading strategies such as arbitrage, margin, futures, and derivatives to generate returns. Hedge funds, which trade for short-term gains, and Private investment in public equity (PIPE) funds, which buy publicly traded stock at a below-market price, & other similar types of funds qualify to be registered as AIFs under this category.

Unlike Cat I and Cat II, these funds are allowed to undertake leverage or borrowing (which could be up to two times the fund corpus) in order to make investments in both unlisted and listed derivatives. They can be either be close-ended or open-ended. As far as the Sponsor’s interest is concerned, it must be not less than 5% of the corpus or Rs. 10 crores, whichever is lesser.

In practice, there are two types of Cat III funds: Long-only funds and Long-short funds. In Long-only funds, fund managers follow a strategy of buying and holding stocks like an equity mutual fund with a thematic idea, with no alternative strategy involved. They account for the majority of Cat III funds and gained popularity compared to mutual funds due to lesser regulatory constraints.

Long-short funds are designed based on two types of asset allocation: Equity risk long-short and Debt-risk long-short. The Equity-risk long-short funds hold cash equities with a net exposure of 50%—100% and compete against large-cap equity funds. The Debt-risk long-short funds hold debt papers with a net exposure of 5%—25% and compete against arbitrage or short-term debt funds.

Next, we will discuss what makes alternative investment funds stand apart from other investment vehicles like mutual funds and what advantages they gain over others to capture under-explored markets like the Performing Credits?

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

The Indian debt market: Looking at the asymmetry & opportunities (Part II)

Posted on by vivriti

As we have learned, the yield spread of corporate bonds over g-secs rises sharply as the credit ratings of the bonds go down below AAA. Thanks to the asymmetry and eventual mispricing. Hence, there is a significant return available as we go down the rating curve. But are there enough incentives available to investors if they go down the rating scale? Does the pick-up in yield more than compensates for the increase in risk while delving into that region?

If we look at the default rates across the rating scale and compare them with respective spreads, we come up with surprising results. The below chart suggests that papers with CRISIL AAA rating never defaulted while AA-rated papers have default rates of 0.22% on a 3yr rolling average over the past decade. The numbers go up to ~1.4% for A-rated bonds and 3.6% for BBB-rated ones.

As we plot the default rates on spreads, we see that the premium of return over risk is disproportionately higher if one moves down the rating scale. For example, if we move from AAA to AA-rated bonds, the investors can reap 112bps excess returns over the risk-free rate but take only a 22bps higher impact on their risk profile. When compared with AA-rated bonds, the excess return jumps up to ~800bps for BBB-rated bonds, where investors take ~340bps (=362-22bps) higher impact. In simple words, this means that additional returns that investors might get for taking exposure to bonds in the below-AA part of the rating scale more than compensate for the additional risks when we compare them with AAA and AA-rated bonds.

This looks like a lucrative opportunity for investors but how deep is this opportunity and how far it has penetrated the Indian market? To better understand the depth and coverage of the market we can plot the risk-adjusted return, as measured by the Sharpe ratio, of the corporate bonds and see how the market players are positioned along the line.

The zero to 8% yield range at the bottom part of the median Sharpe ratio line is mostly covered by mutual funds. It mainly comprises Liquid Funds having exposure to g-secs and treasury bills, Duration funds like Short-term & Ultra Short-term, Credit Risk funds (which have at least 65% exposure to AA- or lower-rated bonds), and Corporate Bond funds (having least 80% of their total assets in highest rated instruments). The portfolios operating in this range are disproportionately skewed towards safety due to risk parameters set by SEBI and low liquidity risk on account of being open-ended vehicles.

At the other extreme, there are Venture, Distressed Debt, and Real Estate funds operating in the above-16% yield range. It’s a region fraught with high risk where asset managers focus on promoter funding, financing companies that are turning a page, etc.

The gap between the two extremes is huge and lacks any specific strategy. It is populated by corporates lying mainly in the A to BBB bucket. These corporates have little access to the bond market and huge reliance on the loan market as we have discussed in Part I. However, these are the companies that stand a fair chance given the fact that they are largely profitable. The below chart suggests that over 90% of them in any rating bracket are profit-making.

If we examine more, we will see that over 4,000 companies that are considered in the chart could be either in cyclical or defensive sectors but are very steady. They could be operating in sectors like energy, healthcare, consumer, financial services, manufacturing, supply chain, logistics, etc. To summarise, the huge space in consideration consists of papers issued by stable companies which are undiscovered and yielding high risk-adjusted return. It’s a space called Performing Credit, which is left after accounting for non-performing credit that carries high default risks and most actively traded debt securities like AA and AAA-rated bonds.

As we identify the market, the next question comes about how to explore the market. As many of these companies are not listed and many are completely reliant on loan markets instead of the debt capital market, it is hard to find data and information about them. Hence, there are huge barriers to entry. Even if you nail down some of these companies, other challenges exist like pricing their securities, tracking their performance, etc. Lastly, what investment vehicle is appropriate to address this space? In the next few posts, we will answer these questions.

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.  

The Indian debt market: Looking at the asymmetry & opportunities (Part I)

Posted on by vivriti

The debt capital market, where investors buy & sell debt fixed-income securities mostly in the form of bonds, is an important source for fundraising in a developing nation like India. The Indian market is one of the largest in Asia.

The debt capital market is divided into two parts – Public debt and Private debt. The Public debt comprises Govt securities (G-secs), State Development Loans (SDL), and Treasury bills while the Private debt market includes Corporate Bonds, Commercial Papers (CPs), and Certificate of Deposits (CDs). Here is the share of each type of fixed income securities in total outstanding amount (FY20):

1

The Great Divide

The Indian debt capital market is highly fragmented, both at the broader level and at the segment level. The overall market is dominated by sovereign bonds or g-secs, which account for ~30% of GDP in terms of issuances outstanding (FY20). The corporate bond market, on the other hand, accounts for ~16% of GDP. Despite being Asia’s third-largest economy, the size of India’s Corporate Bond market as a % of GDP stands closer to countries like Thailand and the Philippines.

There is a wide disparity within the Corporate Bond market as well. The investors’ appetite in the market is highly skewed towards higher-rated instruments (AA & above). Also, the share of issuances by top 10 players over total issuances have been scaling up since FY16 and rose to 50% in FY21 as COVID-19 has turned the situation unfavourable against smaller and low-rated issuers with a greater flight of capital towards safer instruments.

The disparity also makes it difficult for thousands of enterprises to access the debt market and leads to mispricing of their bonds. As evident from the issuances volume below, higher-rated (AAA and AA) issuers have been dominating the Corporate Bond market over the last decade.

2

When it comes to corporate bond prices, we can see that the spread in bond yields over (risk-free) g-secs rise sharply as the credit ratings of the papers go down below AAA. The spread of A-rated bonds as of Sep 2020 stood at 7%, which is ~550bps higher than that of AAA-rated bonds. Hence, corporate bond yields are shooting up but disproportionately due to a higher appetite for risk as we go down below the rating curve.

3

The Problem of Asymmetry

Given the volume and yield data, it is now clear that there are hardly any takers for below AA-rated bonds in the market. However, the mid-market corporates who have been issuing these bonds need capital to fund their growth plan. As the bond market is unable to fulfil their borrowing needs, the corporates turn to loan markets for funding. The problem has been exacerbated with a recovery in the economy after COVID as these corporates increasingly need to scale up their businesses.

As the below chart suggests, the ratio of the bond market to bank loans became much lower over the last decade as we go down the rating curve from AAA to BBB and below. Unlike mature economies, mid to large corporates rated below AA are disproportionately reliant on loan markets, creating an asymmetry in the market.

4

The asymmetry became more prominent as Indian banks and NBFCs turned increasingly risk-averse while lending to mid-market corporates posts debt crisis (like that of IL&FS) and financial difficulties faced by these corporates due to COVID. The growth of non-retail loans by public-sector banks to entities rated below AA began to shrink over a year till Sep ‘21 as shown below:

5

Hence, the problem of asymmetry has a two-fold outcome. It hinders mid-market corporates/issuers to access the right kind of capital they need, and, on the other hand, it deprives investors of enjoying superior yields. Resolving the issue might lead to a win-win situation but there is a caveat! Investors stepping into the domain might face companies mired with a high risk of default. However, the perceived risk is deemed to be much higher than the actual risk. But how? Stay tuned for our next post (Part II).

 

Disclaimer:

The views provided in this blog are the personal views of the author and do not necessarily reflect the views of Vivriti. This article is intended for general information only and does not constitute any legal or other advice or suggestion. This article does not constitute an offer or an invitation to make an offer for any investment.