The Working Capital Loan Gap in India
I arrived back to the cozy office of Global Easy Water Products (GEWP) with Pratyush Pandey, the company’s Managing Director, after a long day of visiting farmers on the outskirts of Aurangabad, Maharashtra. These farmers were customers of GEWP’s “KB Drip” irrigation products. After countless visits with GEWP over the past two years, one thing has become clear to me: there is no lack of demand for KB Drip. To date, hundreds of thousands of farmers have seen an immediate benefit in their yields and their incomes. This puts GEWP at such an exciting point of growth. The company is distributing in seven states across India and has doubled its annual sales in 2009 – and is likely to do so again in 2010.
Despite the growth projections, the reality for an agriculture business like GEWP is a strong seasonality of sales. Between February and June, GEWP’s sales skyrocket as farmers are planting pre-monsoon. This means that GEWP has to build up significant inventory in the off-season in order to meet peak demand. Even more, if GEWP wants to pay suppliers up front in order to minimize costs and to extend credit to dealers in order to stimulate sales, the company requires significant cash reserves to cover the spread (i.e., from the time GWEP pays suppliers up front to the time they receive cash from sales). For many small and medium enterprises (SMEs) in manufacturing, distribution and retail, meeting this “working capital requirement” is the crucial bottleneck to scale. And I have been extremely disappointed by the risk-aversion of the Indian public and private banking sector to address this need and opportunity.
Before we get deeper, let me first take a step back and explore the demand for SME financing: In India, Acumen Fund’s portfolio of twelve companies is among a pool of more than 11 million SMEs. Small-scale industry (SSI) comprises around 40% of India’s industrial production and manufactured exports and has historically recorded above-average growth rates—not to mention that the SME sector employs more than 28 million Indians, second only to agriculture. This is not an Indian phenomenon. Globally, 99.7% of all enterprises in the world are SMEs. (source: Department of Scientific & Industrial Research) Access to finance ranks among the top barriers to growth for SMEs. Further, while credit to SMEs is always tricky, working capital is an added challenge, since many distribution companies lack fixed assets to be used as collateral.
As active investors, Acumen Fund is working with GEWP and a number of other portfolio companies to address their needs for working capital. The ideal solution is to access an affordable line of credit from a reputable bank and, by doing so, establish the company’s credit record. Commercial banks are much better placed to scale with the financing needs of these fast-growing companies. Five years from now, GEWP will require a credit limit far greater than any social investor can provide on its own. Moreover, five years from now, GEWP (as a more profitable and successful enterprise) will hopefully not require a social investor and should start to engage with the commercial banking now in order to plan for that trajectory.
So, we began knocking on doors. We started by reaching out to agencies within the Government of India that had established funds to commercialize appropriate domestic technology—such as drip irrigation for Indian farmers. Entities like the Department of Science and Technology (DST) and the Department of Scientific and Industrial Research (DSIR) are offering term loans at 2-5% interest. After a few conversations, it became clear that “commercializing” a technology can be viewed quite differently. I would define “commercialization” as proving that profitable businesses can be established along the value chain. DST defines “commercialization” as the first unit sold out of the laboratory. There is clearly a role for their capital in India, but they are not addressing the needs of technologies on the brink of viability. I guess that is the role of the banks.
Next, we approached the public sector banks like the Small Industry Development Bank of India (SIDBI), which was established to “empower the Micro, Small and Medium Enterprises (MSME) sector with a view to contributing to the process of economic growth, employment generation and balanced regional development.” This has been a tremendous lesson in traversing bureaucracy. Before heading to the office of the SIDBI General Manager, my colleague, Uma and I did research on working capital loans from SIDBI. We printed a page from the website that stated SIDBI’s expansion into working capital. You can imagine our surprise when the General Manager unequivocally told us that SIDBI financing is limited to term loans for fixed assets. Hmmmm. On top of that, he emphasized that the National Bank for Agriculture and Rural Development (NABARD) would turn us down for the same reason. Bankers want to invest in capital equipment, not trading. We will keep pushing on this front, but in the meantime, we had to move on to the next target.
From there, we initiated conversations with a number of commercial banks and knew from the get-go that this would be tough—especially after one banker told me that they define “small businesses” as companies with revenues of R.50-150 crore (that is USD $10-100 million)! The commercial banks look at SMEs and see high transaction costs and high risk. Maybe I think about risk too much like a venture capitalist and not enough like a banker. So far, the Indian commercial banks that we talk to want a 100% guarantee, usually as company cash reserve or personal promoter guarantee. This may be the only option for getting commercial banks comfortable with the credit-worthiness of a company like GEWP. It is far from an ideal option. We have not given up on the mainstream banks. We will continue our current conversations and push for innovative thinking.
The Reserve Bank of India has strong mandates for “priority sector lending,” (source: Reserve Bank of India) which requires both public and private banks to invest a certain percentage (currently 40%) of their portfolio in sectors like agriculture, SSIs, small business, microfinance, housing and education loans. Moreover, there are strict penalties for non-compliance, which include being forced to subscribe to low-interest bonds from NABARD to supplement the shortfall.
I am not an expert on RBI’s priority sector lending policy and I’m trying to get up the learning curve (I would of course welcome input from Indian bankers on how they manage the priority sectors into their portfolio). But, I want to push the question that, with such high priority sector lending requirements, why is RBI still highlighting the enduring lack of credit to SMEs (See: May 04, 2009 circular). Are there enough financing opportunities in agricultural processing and housing finance to crowd out small businesses? Or are small businesses simply not considered creditworthy due to fledgling financial systems, thin management and new markets? We welcome any input from our community, as Acumen has just begun to look at India’s priority sector lending more rigorously.
In sum, government agencies want earlier stage companies, public-sector banks want to lend for fixed assets, commercial banks want a 100% guarantee. Where does this leave us? The unfortunate reality may be that early-stage companies must finance working capital through equity, prove that their model is viable, and grow to a significant enough size to raise debt. If that is the case, what is the tipping point, in terms of size of business performance, after which banks really will gain comfort?
I know that Acumen Fund is not the only entity grappling with this. I would like to commend IFMR Trust for its new initiative to raise an SME debt fund, and we are eagerly waiting for that vehicle to be up and running. In addition to independent debt funds, the scope of demand for SME financing will require a number of alternative structures.
We have been approached by a numerous foundations recently that want to use their grant capital to spur social enterprise. My advice: instead of giving grants to entrepreneurs to seed financial viability (which is subject to an inherent contradiction—grants to incentivize financial sustainability), think about leveraging your grant money to guarantee low-cost debt to SMEs or social enterprises. Not only will your philanthropic dollars address a vital unmet need, but these dollars will stimulate an institutional shift where the banking sector can increase its risk tolerance for SME finance. (The next step will be to reduce transaction costs for small loans, so banks can further reduce high interest rates.)
I welcome any challenge on the points above, any advice for small businesses in India and beyond, and I hope we can prompt a rich discussion that gets us closer to busting this bottleneck of scarce SME debt—very specifically for working capital—to companies like GEWP.