With traditional banks in the country having their risk-taking activities increasingly curtailed by an anxious regulator, non-banking financial corporations are flourishing. They look set to keep growing, reports Elliot Wilson.
In November 2008, at the height of the financial crisis, Sanjay Nayar, one of India’s foremost investment bankers, made a defining career move.
The 23-year veteran and latterly country chief at Citi in Mumbai surprised his contemporaries by abandoning the ailing bank operations he had helped to build and instead become the Indian chief executive officer for Kohlberg Kravis & Roberts (KKR), the world’s most instrumental and infamous buyout firm.
Nayar made the move in part because he was interested in conducting private equity deals’ in the past two years KKR has completed five buyout deals worth US$1.1 billion.
But the veteran banker also saw the opportunity to build something else: a non-banking financial corporation (NBFC).
He’s not the only one. The rise of NBFCs in financial India has been largely overlooked, in part because they have been slow to take root and grow. But with the country’s banks being discouraged from lending to risky and capital-hungry companies, demand for the funding provided by these companies is on the rise.
The founders of these non-bank firms can greatly vary, but each NBFC has one thing in common: they lend to higher-risk companies via complex structured finance deals, with the aim of generating higher returns.
It’s a growth space. Experts in the industry estimate that NBFCs already account for US$3 billion-US$4 billion in funding a year, and this is growing at up to 30% per annum in demand.
Such rapid expansion, combined with potentially outsized returns, is proving a powerful draw for many of the good and the great within India’s investment banking.
Credit Suisse’s Ashish Rao is one. The bank’s head of India structuring runs its NBFC, which boasts fresh capital of US$253 million and was created in January 2009, 20 months before the Swiss banking group received its formal India banking licence.
This is the wave of the future and the way forward, Rao declares. The traditional source of funding for corporates in India has always been bank funding. But you are now looking at sponsors seeking to raise capital through more exotic financing channels.
NBFCs are on the rise. They are becoming a very relevant vehicle outside the banking system, agrees a prominent banker familiar with the industry.
With a fear of risk paralysing much of India’s regular banking sector, the importance of NBFCs may only be beginning.
RBI’s risk revulsion
Structured finance might be regular in Hong Kong or Sydney, but in Mumbai it’s a new phenomenon.
One reason for this is India’s schizophrenic attitude toward risk. The Reserve Bank of India (RBI) has always abhorred uncertainty, specifically because of the fact that it needs to guarantee individual bank deposits in the case of a full or partial banking failure.
The global financial crisis only exacerbated this fear, and as a result the RBI is clamping down on what risk banks can take on, be it in equity and commodity finance, in corporate debt (particularly lower-rated firms), or in structured lending.
As a result Indian real estate, left in a thoroughly parlous state by the crisis of 2008-2009, has found it almost impossible to raise money through traditional banking channels. Most companies have had to rely on initial public offerings (IPO), or existing cash reserves to get by instead. Small and medium-sized companies of many descriptions are finding it similarly challenging.
Normally promoters, or the families that typically own these companies, would turn to the capital markets for support if they found themselves struggling to gain funds from local and foreign banks.
But India’s Sensex stock market is becalmed, trading 5% down on the year to April 26 to just above the 19,500 mark. As a result primary equity activity has been moribund.
It’s a frustrating combination for many companies. India’s economy is growing apace, in the high single digits for the past few years, yet these businesses are struggling to get the sort of capital they need to fully exploit such growth.
Filling a funding hole
This is where NBFCs come in.
The non-bank companies come in many forms and straddle multiple sectors. At the most basic level, they provide basic lending services to everyone from farmers to tradesmen and mine operators, while at the more complex end of the spectrum sit the financial NBFCs.
Most investment banks, including Citi, Barclays Capital and Standard Chartered, boast one, usually a unit tucked away inside the corporate’s main body. Other institutions have created NBFCs slightly outside company walls.
This list includes KKR, British buyout firm 3i, Morgan Stanley, JM Financial, and Indostar Capital Finance, which was created in March 2011 by three private equity groups: Everstone Capital Management of India, Britain’s Ashmore Group, and the buyout arm of Goldman Sachs Group.
The founders may be disparate, but all of them seek to offer complex structured debt funding to capital-starved, higher-risk companies.
Notes Credit Suisse’s Rao: You saw this trend starting two years ago when Lehman [collapsed], when the credit lines available for private equity funds dried up and markets corrected. Then, people had to go back into the primary pre-IPO market in search of liquidity and that is when the market started moving more toward the structured lending platform.
This is among the initial steps to develop a mezzanine and high yield mix, adds Nayar. NBFCs are on the rise. They are becoming a very relevant source of financing in addition to the banking system.
For the risk-averse RBI the NBFCs offer a much-needed pressure valve on India’s financing markets.
All of the companies operate under the jurisdiction of the central bank (which continues to keep an attentive eye on the nascent industry) but aren’t limited by how much capital they lend, or to whom they lend it. However the RBI isn’t legally required to bail out any investor (many of whom are based overseas anyway).
As a result any single failure would be contained; there would be no broader market contagion.
Many believe the RBI is implicitly encouraging the growth and diversity of NBFCs, for which it is not accountable, in favour of the traditional banking sector, for which it is.
The regulator declined to comment when these suggestions were laid at its door. But it is clear that India has a banking regulator that is quite happy to allow NBFCs, for which it has no personal financial responsibility, to thrive.
A virtue of necessity
Smaller companies love mezzanine lending from NBFCs, which consists of a hybrid of debt and equity that sits between secure senior debt at the top and equity at the bottom of a company’s liabilities. So do construction firms. Distressed businesses bearing solid assets are also turning to structured financing to tide themselves over, as are shareholders seeking a management buyout of other investors.
Another key area of growth is the infrastructure industry, notably in areas like port development, where Indian promoters have an almost insatiable appetite for capital, but don’t want to hand out large chunks of equity to private equity players.
On April 19, for instance, Moser Baer Projects, a thermal power company run by up-by-the-bootstraps tycoon Deepak Puri, announced it was in talks with Standard Chartered Private Equity and Nayar’s KKR to raise 200 million (US$333.23 million) through a mezzanine structure offering 16% return on capital.
Also in April, Eight Capital, a US-Indian alternative asset manager announced the launch of its US$250 million Mezzanine Income Fund, which will parcel out capital to high-growth Indian corporates.
For KKR and other buyout specialists there is a simple reason behind their interest in setting up an NBFC: necessity.
With chunky private equity deals hard to come by some estimates put the number of private equity firms knocking around in India at 500 and rising, meaning that literally hundreds of firms are all vying for the same type of mid-market deal the structured lending route offers Nayar and others the chance to generate capital returns of around 15%-18% a year.
That’s not quite in the private equity league, where returns of 25% are commonplace, but it’s not too shabby either. In fact, much of the new structured lending market seems to be driven by private equity firms with lots of cash and too little to do in the traditional buyout space.
Each NBFC has its own aim and focus. Indostar’s management is geared toward infrastructure development, while others like KKR tend to aim to create complex structured funding arrangements for mainstream and smaller corporates.
As NBFCs gain acceptance with both promoters and regulators they’re becoming bolder and more imaginative in the products they offer.
As one senior Mumbai based investment banker notes, NBFCs can raise money through any sort of bond or mix debt with equity. Or they can link the return on a bond to a basket of stocks or the price of coal.
This market really started to take off around one to two years ago, the banker adds. Demand for higher yielding paper started emerging, and that business is driven by demand for higher-yielding wealth.
Deals might be created because a promoter wants to monetise existing assets (say, a biofuel plant or a Bollywood film studio), or perhaps he is prepared to raise cash by pledging his company shares against new raised capital, an increasingly common phenomenon post-crisis.
These are mature products in places like Europe, North America, Japan and Australasia, where higher-yielding paper is issued every day by institutions (such as insurers) sitting outside the traditional banking sector.
Take mezzanine financing. After years of barely being noticed it is now in fashion. Mezzanine finance is typically used by companies to raise operational and capital expenditure, and since it requires very little due diligence on the part of the lender and almost no collateral from the promoter-borrower, it can be completed very quickly.
Most importantly for investors mezzanine financing can generate returns of up to 25% or even 30%.
Tapping up talent
As the difficulty of gaining funding from regular sources encourages investors and promoters to turn to NBFCs for capital, many of India’s brightest bankers find themselves being drawn to the sector too.
Investment banks should be worried. Many NBFCs are run by former investment bankers, and they are beginning to tap up former colleagues frustrated by the constrictions of the regulatory market for normal banks.
And they have a compelling argument to make. While the fee pool for India’s investment banking industry has been stuck at around US$500 million-US$600 million for several years, the sky is the limit for NBFCs (at least for now).
One executive search specialist says he is inundated by calls from investment bankers clamouring to join NBFCs ½ but none seeking to make the reverse journey.
The next big wave here is NBFCs, he says. is still under the radar but it is happening. More importantly, for many bankers, NBFCs often pay a hell of a lot better than banks.
Adds Credit Suisse’s Rao: The market is growing, so the demand for people is growing. It’s not easy to find the type of talent you need. In structure lending, and within NBFCs, you need people who understand a bit of everything: a bit of debt, a bit of equity distribution. People who have the ability to go out and originate deals in this extremely competitive mid-market segment.
To be fair, NBFCs do not appeal to all. Investment banks provide their staff with a comforting corporate cocoon, and pay a guaranteed salary plus bonus. At non-bank finance companies you eat what you kill; fixed salaries or bonuses are eschewed in favour of performance-related pay.
It’s riskier, but NBFCs often reward success instantly. The recruiter notes that he recently placed a director-level banker at a recently-launched NBFC that paid him US$1.2 million last year, a three-fold increase over his 2009 salary.
The money, and the challenge, is a draw for many.
Some top managers are feeling asphyxiated [within banks]; I certainly do, says a top debt banker in Mumbai. A lot of growth within banks comes from using your balance sheet and using risk, and if [regulators aren’t] letting you do that, then your effectiveness is being undermined.
Bankers are slowly but surely making the switch. Indostar, the Goldman-Ashmore-Everstone creation, is being led by Vimal Bhandari, the former chief executive officer of Aegon India, and Sandeep Baid, hired from Bank of America-Merrill Lynch where he was head of debt capital markets.
KKR’s Nayar is looking to add to his team of three NBFC bankers in the near-term, and he can afford to be choosy over who he picks. We need people who are client centric, solution oriented and have a deep understanding of the structure and corporate finance skills within the existing regulatory framework, he says.
These people have to be entrepreneurial and capital market savvy as the whole idea is to develop and institutionalise a new asset class.
And we are looking for people who have a fertile brain, he adds. We want people who are very creative but who know the rules and are naturally law-abiding.
For all the industry’s appeal to motivated bankers a few wrinkles still need to be ironed out of the industry. One is the mis-pricing of risk.
NBFCs are keen to help companies arrange higher yielding bonds, large chunks of which they then buy, but they tend to price the coupons far too low. This is mostly because they don’t want to price themselves out of a deal, and also because Indian promoters typically prefer to get bad advice for a pittance than overpay for the best possible guidance.
Notes KKR’s Nayar: Returns are still in the mid-teens and should be in the higher teens for this kind of risk. Risk in general is still mispriced here.
NBFCs in turn tend to syndicate out deals to no more than two or three institutions usually local or foreign NBFCs, along with a raft of special funds set up to by the likes of 3i and local investment house Edelweiss Capital while keeping a piece of the deal for itself.
Another potential risk is the return of the capital markets. While it may be difficult to raise capital right now this is unlikely to remain the case forever. And once it does become simple conduct a convertible bond or vanilla equity offering once more, the appeal of complex structured debt may weaken.
Still, for the time being at least promoters love the new industry. While no figures exist to measure the size or growth of NBFC?funding, experts reckon that NBFCs create 10 new mezzanine structures every day.
For now, the structured lending market tends to be geared toward fund raising for smaller or more heavily geared corporates (notably real estate) unable to raise credit in more traditional ways.
But this is changing. With India’s economy growth in the high single digits and banks hamstrung in their attempts to finance domestic mergers and acquisitions, promoters are increasingly tapping up NBFCs and their syndicates of investors for capital.
Risk is an essential part of life, and India desperately needs financial products that offer higher returns in exchange for an added dollop of risk. In short the country needs NBFCs.
This is just as well, because they are here to stay.