India’s Impact Enterprises Need More Debt Financing to Grow: Here’s How Businesses, Lenders and Regulators Can Make That Happen
Naveen Krishna founded an electric-powered rickshaw company in Varanasi, India five years ago, with a vision to provide manual rickshaw pullers with a clean, safe, affordable alternative. Krishna’s fledgling social enterprise, SMV Green Solutions, soon did well enough that he sought a US $28,000 loan to expand into a second city. It almost didn’t happen.
Multiple banks turned him down. They required three years of balance-sheet data and two years of profitability, a bar too high for a break-even startup. And private investors wanted to charge 20% interest to offset the perceived risk – an unaffordable rate. Eventually, Krishna secured a small, unsecured loan from a U.S.-based investor.
SMV Greens Solutions’ quest for debt financing is typical of the experience faced by India’s social entrepreneurs. They seek to grow impact enterprises that deliver social or environmental benefits along with financial returns. Growth often requires timely infusions of borrowed money to purchase inventory or equipment, or to cover operating expenses. But debt is hard to come by, especially for India’s impact enterprises.
Banks typically steer clear of these companies, as young enterprises can’t meet banks’ requirements for collateral to backstop loans. India’s non-banking financial companies (NBFCs) specialize in servicing enterprises that banks consider too risky. Yet the interest rates that NBFCs charge tend to be significantly higher than banks’, making NBFC loans non-viable for growing impact enterprises.
For their part, India’s impact investors have shown far more interest in buying stakes in impact enterprises than lending money to them. Impact investors have poured over US $10.8 billion into India’s impact enterprises over the past decade. But they favor owning equity over lending money by a multiple of three-to-one, according to research from India Impact Investors Council (IIC) and The Bridgespan Group.
To better understand the challenges Indian impact enterprises face in borrowing money, IIC and Bridgespan joined in a research project on the debt landscape. We published a report which identifies barriers to debt financing, and proposes avenues for making debt more accessible. The report features analysis of financial data from more than 400 impact enterprises, and insights from interviews with over two dozen impact investors and impact enterprise leaders. Below, we’ll discuss some of the findings it presents.
Are Impact Enterprises Debt Worthy?
A balance sheet analysis of 422 impact enterprises found that most (60%) of these enterprises are creditworthy. Yet creditworthiness does not necessarily mean access to credit. The report estimates a debt shortfall of INR 1,564 crore (US $216 million) among this group of leading impact enterprises. This debt-financing gap for a sample of India’s impact enterprises is indicative of the struggle faced by every impact enterprise. Closing the debt gap will require addressing multiple barriers—enterprise, investor and regulatory—that stand in the way of supplying impact enterprises with the capital they need to develop and grow.
Enterprise challenges: Social entrepreneurs have low awareness of the tradeoffs between equity and debt financing. As a result, they tend to resort to raising equity. They also lack the right networks and don’t know whom to approach for debt. Most don’t have the money to pay for match-making platforms to connect with lenders.
In addition, impact enterprises typically lack collateral for traditional asset-backed lending. Owners are unwilling to take on debt if it requires personal guarantees. And in many cases, enterprises have weak management and reporting systems that lead to low-quality financial statements. Without accurate financial statements, impact enterprises cannot get credit ratings or build underwriting track records.
Investor challenges: In the early 2000s, India’s impact investors focused on microfinance. As that sector matured, they shifted to new opportunities in financial services. Today 90% of debt financing from impact investors remains concentrated in financial services outside of microfinance. Meanwhile, impact enterprises devoted to agriculture, education, energy, healthcare and technology struggle for debt financing.
Investors note the difficulty they have in identifying attractive opportunities for debt investments in areas outside of financial services. Moreover, the traditional tools for assessing and underwriting credit risk (e.g., financial statements, ratios, credit ratings) aren’t well-suited for impact enterprises. Many investors have minimum turnover and cash-flow requirements, or high collateral requirements, which stand in the way of financing young, growing enterprises.
Regulatory challenges: India lacks a formal regulatory structure that defines impact investments as a distinct asset class. Designating impact investments as an asset class would allow regulators to apply a different set of standards for risks and returns to impact investors and enterprises.
Moreover, the country’s strict regulations regarding overdue loans eliminate banks’ flexibility to make loan modifications by delaying or revising payment schedules to accommodate fluctuations in an impact enterprise’s cash flow. Regulations also limit the use of foreign capital. And the Reserve Bank of India tightly regulates external commercial borrowing, limiting its appeal.
How can more debt reach impact enterprises?
In the report, bankers and impact investors describe a number of approaches to channel more debt financing to India’s impact enterprises. They fall into three broad categories:
1. De-risking investments to attract reluctant investors: Loan guarantees by third parties, including foundations and development finance institutions, serve as a credit enhancer, making debt deals more attractive to risk-averse investors. Loan guarantees also can help to validate impact enterprises as an asset class, thereby allowing the sector to become more “debt worthy” in the eyes of investors over time.
In addition, pooled bond and loan structures can provide debt financing to small enterprises that may otherwise find it difficult to access mainstream capital markets at competitive prices. Companies in need of debt can issue bonds that are backed by a third-party partial guarantee: This serves as a credit enhancement, helping to raise their credit rating sufficiently to attract mainstream investors. Pooled loans work in a similar way.
2. Offering flexible debt products: Alternative Investment Funds (AIFs) have grown in popularity in recent years as a way for institutional investors and high-net-worth individuals, domestic or foreign, to invest in India. Compared to other forms of foreign investment, AIFs pose lower regulatory hurdles. As of September 30, 2020, AIF funds that invest in debt or debt securities had raised a cumulative INR 133,815 crore (US $18 billion).
The growing venture debt market also benefits impact enterprises. Venture debt is available to companies that do not have positive cash flow or significant assets to use as collateral. Lenders combine loans with warrants, or rights to purchase equity, to compensate for the higher risk of default. Venture debt is also regarded in India as a bridge to the next round of equity financing.
Another option is cash-flow lending, an approach which the Reserve Bank of India’s Expert Committee on Micro, Small and Medium Enterprises recommended in a June 2019 report that banks should consider more frequently. Cash-flow lending allows banks and NBFCs to extend loans based on present and projected cash flows, rather than the traditional demand for collateral. While not aimed specifically at impact enterprises, cash-flow lending would no doubt benefit them.
3. Developing new approaches to due diligence and underwriting: While there are proprietary platforms that incorporate new ways to pursue due diligence and credit underwriting, their methods remain the exclusive domain of their developers. Some impact investors have developed their own due diligence and underwriting methods to assess the creditworthiness of potential investees. However, the sector would benefit from the standardized tools and platforms broadly available to banks and other financial institutions.
Impact enterprises, lenders and regulators alike share responsibility for creating the barriers that prevent India’s social entrepreneurs from obtaining the debt financing they need to grow. They also share responsibility for removing those barriers in order to create a stronger, more vibrant debt finance ecosystem. If they do, as that ecosystem matures, debt may live up to its promise as a game-changer for India’s impact enterprises.
Sudarshan Sampathkumar is a partner in The Bridgespan Group’s Mumbai office, where Anuja Kadam is an associate consultant. The IIC/Bridgespan report, “Giving Credit Where Due: A Case for Debt Financing in Indian Impact Enterprises,” is available from The Bridgespan Group’s website.
Photo caption: A beneficiary of SMV Green’s “Vahini” program, an inclusive program to enable women to enter the mobility space in India. Image courtesy of The Bridgespan Group.