Shrinking structures for Indian SMEs

While large-scale financings support the majority of India’s infrastructure needs, the country has also been attracting an increasing number of micro or small-scale finance structures. Many of these are using trade-related financing tools to support SMES as well as the agricultural sector. Rebecca Spong takes a look at the latest deal to close in this market.

Names such as Reliance Industries or Tata Steel may often be the first to jump to mind when considering potential financings in India. However, investor interest has grown to such an extent that there is significant liquidity from both the international and local markets supporting these names, and with the growing competition between lenders, pricing has become inevitably fine.

From the perspective of the Indian banks, the cost of funding has also been on the rise, particularly following moves by the Reserve Bank of India to restrict liquidity in the system. Last month, the bank initiated a number of monetary policies aimed at stabilising prices and controlling inflation.

Inevitably, coupled with other factors, this has resulted in hikes in interest rates and rising transaction costs. With the borrowing costs for Indian corporates on the increase, deals are often being won through bids on increasingly tight margins.

In light of these obstacles both Indian and international players have been developing some innovative microfinance facilities, incorporating elements of trade-related finance, and targeting the less frequently tapped SME market.

Such deals have the potential for increased yields, and margins of between 100 to 150 basis points.

Adapting for aircraft financing
The small to medium-sized Indian firm Ran Air has been the beneficiary of a newly developed financing solution: a US$6mn integrated trade credits and rupee term loan.

It features a financing package usually applied to larger infrastructure projects, but never before used for the SME sector. It is promoted as a unique structure that could signify a brand new branch of financing in the Indian market.

The transaction involved the import of two aircraft from the US for US$6.25mn, and Ran Air approached the Indian institution Yes Bank for a rupee term loan to finance this deal. Deutsche Bank also played a significant role in this transaction.

Unlike previous aircraft import deals, such as the three-tranche transaction raised for Air India via ABN AMRO, ICICI Bank and State Bank of India earlier this year, this particular transaction was unable to tap US Ex-Im financing as the aircraft were used.

The previous large-scale aircraft financing featured a US$1.3bn US Ex-Im supported portion. Ran Air is also not in the position to tap for a conventional FX loan, as its SME status would result in high transaction costs.

Setting up the deal
The underlying aim of this transaction is typical of deals in the Indian market, with the essential requirements being to keep transaction costs as low as possible, and the turnaround time on the deal extremely short.

To meet these targets, Yes Bank needed to consider what kind of tenor to apply to the transaction. If it opted for an initial tenor of three years, it would allow for better hedging to mitigate price risk as well as reduce the need for subsequent and potentially expensive intervention during the life of the transaction.

However, ultimately it was decided that a one-year tenor to be rolled over to three years would be the cheaper option that would allow easier amortisation.

Deciding on which currency the loan should be raised in was also a key factor in the structuring process. Initially US dollars would be the obvious choice given that the imports had to be paid in US currency, as well as US dollar to Indian rupee hedging being easier and cheaper.

However, other currencies such as Swiss francs or Japanese yen would reduce the transaction costs by lowering costly withholding tax payments.

Given that the life of the transaction will cover three years, the deal also needed to incorporate a way of ensuring that cost-effective systems were implemented to ensure timely repayments, and would remove the need for excessive dependence on transaction managers during the three years that opens the potential for human error.

Foreign bank participation
Once the final structure was approved, Yes Bank sanctioned a rupee term loan equivalent of US$6.25mn. A rupee facility of Rs61mn (US$1.48mn) was disbursed to Ran Air for advance payment, and the corporate then pays Rs61mn to the aircraft suppliers.

The loan facility is also disbursed under a buyer’s credit, and Yes Bank brought in Deutsche Bank as a foreign lender for the buyer’s credit financing, requiring the bank to issue a guarantee covering Ran Air’s principal and interest payments.

“By keeping the rupee term loan as the base facility and the buyer’s credit as a sub-facility, we were able to rely on existing rupee term loan documentation which was customised for this transaction – thus eliminating the costly and lengthy process of evolving fresh documentation,” explains Somak Ghosh, president, corporate finance and development banking, at Yes Bank in Mumbai.

Incorporating foreign bank involvement into an Indian transaction brings other benefits, particularly given that international players usually have access to cheaper funds.

From the perspective of foreign banks, partnering up with local institutions brings its own bonuses, particularly in the SME sector. It is far more straightforward for foreign lenders to evaluate risks in the Indian banking system than those of Indian companies in the SME market.

Foreign involvement also aids Indian banks in that they are not permitted to take on the credit risk for Indian companies regarding their external commercial borrowings.

However, they are allowed to guarantee trade credit obligations of Indian companies for three years for the import of capital goods. Here the foreign player steps in to provide funds based on the Indian banks’s credit guarantee, with the Indian bank taking the credit exposure on their books.

Once the advance payment of Rs61mn is disbursed, Yes Bank then opens a letter of credit in favour of the aircraft suppliers, and security is created for the rupee facility. Upon the maturity of the LC, Deutsche Bank disburses a US$4.6mn equivalent Japanese yen-denominated loan, which enables the transaction to minimise withholding tax, a major component of transaction costs.

Ran Air then pays the supplier and receives the aircraft.  Then, following the maturity of the buyer’s credit after three years, Yes Bank disburses the remaining rupee term loan to replace the amortised buyer’s credit.

Added value
This structure has enabled Yes Bank to create total incremental value addition of 3% per year for three years, and Ran Air’s interest expense on the facility for the first three years is reduced by over 15%.

“While the transaction itself is small, we are extremely proud of this deal because we were able to innovate and increase transaction value addition using sheer financial structuring skills in a matured business,” comments Ghosh at Yes Bank.

This transaction has set the benchmark for future deals, with Yes Bank intending to fully launch a new product range for SMEs aimed at benefiting clients by 100-250bp and benefiting Yes Bank by 100 to 150bp in a transaction. The bank is already involved in structuring other import financings for infrastructure equipment like cranes, rigs and aircraft for borrowers in the SME sector that previously had great difficulty or no access to cheaper foreign currency denominated trade credits.

Cultivating tools
Trade finance-related tools are also beginning to be applied to the Indian agricultural sector, with facilities incorporating elements of warehouse receipt financing and purchase bill discounting.  Such structures transfer the credit risk of supposedly ‘unbankable’s smallholdings to the marketable commodities or larger and more creditworthy clients.

These solutions aim to overcome the key problem of Indian agri-commodity supply chain, that of the fragmented nature of the farming economy. With the sector dominated by small-holdings, operational costs of credit delivery rise, and it becomes extremely difficult to enforce contractual arrangements.

However in just the last 12 months, interest in financing this sector has been growing, with financial players exploring ways in which they can aggregate the credit for these small farms, reducing the cost as well as mitigating the credit risk transactions, and enabling smallholdings to become bankable.

Large corporate houses getting involved in these facilities include Adani Group, Reliance (Mukesh Ambani) Group, and AV Birla Group.

Typically these kinds of microfinance deals involve an established corporate house identifying suitable clients and bundling up the various financing requirements of a small group of borrowers, and then completing the necessary documentation, monitoring and collection.

In rural areas, loans are given as group loans, so members of the group help to keep repayment risk low. They are often used for income generation or livelihood purposes, but can incorporate trade finance elements and improve flow of the agricultural supply chain.

Among the Indian bank players Yes Bank has been particularly active in this field of finance, using warehouse receipt financing as a tool to supply funds to farmers at far more manageable interest rates.

Last year, it closed a small but unique US$3.5mn transaction using a warehouse receipts to supply funds to small-scale honey farmers in northern India. The financing had a tenor of up to six months, and the structure transferred the credit risk of the ‘unbankable’s farmers to the actual stocks of honey secured in the warehouses. The money was directed to the farmers via Kashmir Apiaries Export (KAE) who bought the honey supplies from the individual farmers.

The financing needs of the farmers were bundled up and maintained by KAE, who acted as managing and collecting agent.

As yet, this type of financing is being done at such small volumes that individual deals are too small to share risk on, with deals typically featuring just one mandated lead arranger (MLA).

However, the various small-scale deals can be aggregated and then partially placed with another lender. Again, in the case of Yes Bank, six deals were bundled together with a cumulative value of US$25mn, of which US$10mn was placed with another bank. This was not strictly done as an MLA but as a loan sell-down.

Talking in reference to the KAE deal and similar transactions, Yes Bank’s Ghosh comments: “The primary purpose was to test the market for such transactions, and create an appetite for such deals in the future. As part of our overall strategy, it is important from a risk and earnings perspective to be able to find other lenders and not be the sole lender in the market for such transactions.”

Zero default
The most obvious risks when dealing with small-scale borrowers with no track record and no collateral is the possibility of default. However, in the case of Yes Bank, it has a zero default rate on all its transactions so far, although the bank’s portfolio of such deals is still in the early stages of development.

Despite common perceptions, overall default rate on microfinance deals (whether trade-related or not) is usually better than larger facilities and industry default average is around 2%. The other benefit of the microfinance sector is that small-scale lending is not strictly correlated to broader macro-economic trends, and therefore not immediately affected by fluctuations in the wider global economy.

However, this positive aspect might alter if and when larger institutional players start to enter this sector, and with it tie the market more closely with the world economy.
But the downside of this type of financing is that although microfinance promises relatively high yields, banks need to build up significant volumes of deals to offset the high operational costs of the deals.

“At a steady rate, after scale up has achieved, we expect that banks would be able to generate at least 200bp higher yield (net cost of funds and operating costs,” predicts Ghosh.

The potential for further steady growth in the microfinance sector of India looks positive, and is beginning to attract a range of local and international participants. As an example of this interest, in early August the IFC, Netherlands Development Finance Company (FMO) and Deutsche Bank announced a joint investment in a microfinance private equity company Aavishkaar Goodwell, an investment supporting the launch of 60 greenfield microfinance organisations.

Demand for microfinance facilities in India is estimated to be around US$13.5bn, a proportion of which could be met with trade-related tools. Approximately four-fifths of this is met by informal financing or local money lenders, usually at high interest rates that prevent sustainable development of the agricultural sector.

With declining margins in the larger transactions, opportunities in the microfinance and SME sector could provide another means for banks to boost yields. By providing fairer and more accessible financing, these types of products also fall in line with the trend for banks to integrate some form of corporate social responsibility within their business plans.