Bharat Financial's earlier avatar SKS's quest to become a bank started in right earnest from the day it realized that once small finance banks are in place, it would be difficult to successfully run the microfinance business
Seven years ago, on 11 October 2010, the Andhra Pradesh government notified an ordinance that almost killed SKS Microfinance Ltd (SKS), now known as Bharat Financial Inclusion Ltd (BFIL). On the same date in 2017, the boards of BFIL and IndusInd Bank Ltd (IndusInd) approved the merger of the two entities, giving yet another lease of life to India’s largest micro lender, albeit in a different form. Following the Rs15,486 crore all-stock deal, for every 1,000 BFIL shares held, an investor in IndusInd will get 639 shares of the bank. None of BFIL’s 15,284 employees will lose their jobs, at least for the first three years after the merger is formalized, which is likely to happen by July 2018.
Even the independent directors on BFIL board will become members of the advisory committee of the business correspondent (BC) subsidiary of IndusInd (the entire operating infrastructure of BFIL will be a part of this subsidiary, including BFIL employees) for two years after the merger is completed. The BCs operate as intermediaries between banks and their customers.
BFIL’s Rs10,971 crore loan book will be absorbed by the bank and all these loans will be treated as so-called ‘priority’ loans which Indian banks are required to disburse to the extent of 40% of their overall loan book. Loans to agriculture, micro enterprises and weaker sections of the society comprise priority loans.
Following this, the share of micro loans on IndusInd’s book will rise from 3% to 7%. Backed by the bank’s low-cost funds, the cost of money to be given as micro loans will drop by 3-4 percentage points. Besides, IndusInd will benefit as the risk weight of such loans is less than that of other loans (75% versus 100%). This will free up the bank’s capital.
IndusInd will also get 6.8 million customers of BFIL, its 1,410 branches, spread across 100,000 villages and 347 districts in 16 Indian states. The bank currently has 1,210 branches and 999 vehicle finance outlets of its own and 10 million customers.
Romesh Sobti, managing director and chief executive of IndusInd, said that the subsidiary model would allow BFIL to retain its infrastructure and “culture". According to him, the merger will be “value accretive" from day one for IndusInd. This means, it will increase the bank’s earnings per share even as most analysts say investors in BFIL have got a better deal than the bank investors.
I am not planning to dissect the merger. Instead, let me narrate the story behind the merger.
BFIL has had a chequered history. Its earlier avatar, SKS was the world’s second microfinance entity (and India’s first) to get listed on stock exchanges. The stock was mauled within months as the investors en masse rushed to sell it, following the Andhra Pradesh law which severely clamped down on microfinance business in the southern state, the hotbed of micro loans those days. The initial public offering price of SKS was Rs985; on its listing day (16 August 2010) it rose to Rs1,159, a level it could never reclaim in the past seven years. The stock’s lifetime high has been Rs1,490.70 (28 September 2010).
While quite a few microfinance entities had to bite the dust following the clampdown, SKS could clean up its balance sheet as it had money raised from the market at a hefty premium. After seven successive quarters of losses, it returned to black in December 2012 with a Rs1.2 crore profit.
When the Reserve Bank of India (RBI) opened the window seeking applications for small finance banks in January 2015, SKS threw its hat in the ring along with 71 others but it could not make it even though eight of the 10 licence-getters were MFIs. It came very close to getting it. If market reports are to be believed, the final list was trimmed at the last moment from 11 to 10 and SKS was out of it, ostensibly because of issues with the promoter, the sacking of its managing director and chief executive officer who had successfully led the listing.
SKS’s quest to become a bank or part of a bank started in right earnest from that day as it realized that once the small finance banks are in place, it would be difficult to successfully run the microfinance business. There are many reasons for this assumption. For instance, unlike a bank, an MFI does not have access to cheap public deposits. Besides, no micro borrower can take loans from more than two microfinance institutions (MFIs), a norm which is not applicable to banks, including the small finance banks. This “regulatory arbitrage" means that the small finance banks can poach the customers from MFIs. Also, the spread between the cost of money and the loan rate for an MFI is capped at 10% (unlike banks which are free to fix the loan rates).
Over the past few years, banks have been successfully leveraging the BC structure permitted by RBI for originating, collecting and managing micro finance loans through subsidiary and other alliances. Based on recent research reports, currently only 30% of the small loans are being disbursed by the MFIs and the rest are done by small finance banks and BCs. A recent study says the share of the MFIs is slated to come down to 20% in next 18 months.
The demonetisation announcement in November 2016 dealt a body blow to MFIs. The withdrawal of high-value Rs1,000 and Rs500 notes, 86.9% of the currency in circulation, led to a nationwide cash crunch, hurting all MFIs as their borrowers primarily deal with cash. More than the withdrawal of Rs1,000 and Rs500 notes (they were replaced by Rs2,000 and Rs500 notes but it took time), BFIL (in June 2016 SKS rechristened itself as BFIL) was hurt because even Rs100 notes disappeared from the market as people started hoarding them. Unlike banks and BCs, MFIs were not allowed to accept cash from their customers. BFIL even moved the Prime Minister’s Office, seeking relaxation to accept cash. Since cooperative banks too were not allowed to handle cash, the norms could not be relaxed for MFIs.
The income tax rule that stipulates that any financial transaction worth Rs20,000 or more cannot be in cash also added to the problem post demonetisation. Even though it was relaxed for MFIs (not for other non-banking financial companies), BFIL tried to find ways to make cashless disbursements of loans. Going by its latest presentation to the analysts, the average size of outstanding loans has been less than Rs20,000. The company has successfully migrated to making cash-less transactions for 98% of its new loan disbursements.
In Odisha and north Karnataka, BFIL has successfully completed two pilot projects, experimenting with cash-less loan repayments. This was done by using the local kirana stores as proxy for ATMs. In both the centres, a kirana store —an outlet that sells groceries and other sundries—was turned into a cash dispenser as well as a cash receiver. BFIL disbursed the loans of a group of borrowers by transferring money to the bank account of the kirana store, and the store, in turn, withdrew the money from its bank and disbursed to the borrowers in stages. For loan repayment, a reverse system was followed. However, this effort needed a robust banking infrastructure for maintenance of savings accounts of the borrowers.
Apart from cash crunch, some of the state assembly elections in early 2017 intensified the problem for MFIs as there was a virtual competition among Indian states to announce loan waivers to farmers, hit by successive droughts. Even where the states were not aggressively pushing for loan waivers, local politicians were promising it. Central and eastern Uttar Pradesh and the Vidarbha region of Maharashtra (Nagpur and Amarabati divisions in northern part of the state) turned into a nightmare for many MFIs, including BFIL, as local politicians incited borrowers to default on loan payments. The loan repayment rates of BFIL dropped from 99% to 92% in February-March 2017.
Adding to all these problems, BFIL’s erstwhile president and the second in command in the organisation S. Dilli Raj had to leave the company after he was arrested for alleged irregularities in an earlier employment before joining BFIL.
The steady fall in loan repayment rates in January-February sounded the alarm bells. BFIL follows a prudent policy for bad loans. If a loan remains unpaid for 60 days, it starts setting aside money or providing for it (at the rate of 50% of the outstanding loan amount) and after 180 days, if a loan is still not paid, it makes 100% provision. This means, on an average loan book size of around Rs9,000 crore, if the loan defaults rise to 10%, BFIL needs to provide for Rs900 crore—a sum which can wipe out at least two years’ profits of the company. So, when the loan defaults threatened to inch close to 10%, BFIL was left with no choice but to either become a bank or look for a merger with a bank. As a result of such provisioning, more conservative than what RBI dictates MFIs to do, BFIL reported a loss of Rs37 crore for the quarter ended 30 June (it has not announced its September quarter earnings) after posting a Rs235 crore loss for the quarter ended March 2017.
The success of two pilot projects on cash-less transactions encouraged BFIL to announce a plan in June for rolling out 200,000 kirana points across its network in 16 states in partnership with leading banks. Its borrowers could walk into any of the kirana points to make basic financial transactions such as repaying loan, depositing into and withdrawing money from savings accounts, remitting money to other accounts and making bill payments. The owners of such stores are from BFIL’s existing borrower families, who have taken microloans from the company to set up or expand business.
The bank linkage is an integral part of this innovation. BFIL has been in search of the bank since demonetisation hit it hard. It appears that it explored the possibility of taking over a small finance bank but it was not sure about meeting the regulatory approval for such a move. RBI might not have found it “fit and proper" for a banking licence. For the same reason, it has not applied for a universal bank licence which has been put on tap by the regulator. How could it get a universal banking licence when it was not found fit even for a small bank licence just two and half years back?
So, the only option left before BFIL was to be taken over by a bank. The current state of public sector banks’ health and the problems of bad loans at many of the new private sector banks made the search for an ideal suitor difficult. Besides, at a market capitalization of over Rs11,000 crore and book value multiple of over four times, a bank would have needed to spend at least Rs1,100 crore (without any premium) to pick up a 10% stake in BFIL—not a small sum for bad loan-laden, capital-starved state-owned banks. The larger non-banking financial companies and business houses might have shown some interest but they do not have the ability to offer a pan Indian banking infrastructure which BFIL was looking for. Media reports suggest that there were discussions with the larger new private sector and old private sector banks, including RBL Bank Ltd, Kotak Mahindra Bank Ltd, Federal Bank Ltd and IndusInd Bank Ltd.
It seems that Kotak Mahindra Bank, which last year acquired Bengaluru-based BSS Microfinance Pvt. Ltd (99.49% stake for Rs139.2 crore) with a loan book of Rs483 crore and a customer base of 217,000 spread over 78 branches, was initially keen but withdrew itself, looking at BFIL’s relatively higher valuation.
That left IndusInd and RBL—a relative late entrant —in the fray. Investment bank Credit Suisse’s Indian arm and consulting firm EY were handholding BFIL through long meetings at Four Seasons Hotel at Worli, south Mumbai, led by its managing director and chief executive officer M.R. Rao. BFIL was looking for a 15-20% control premium from the acquirer.
After it made liberal provisions for bad loans in the June quarter, investors started buying the stock, despite it recording loss for second consecutive quarter, and the stock price started rising. The flow of money into Indian equities which saw BSE Ltd’s benchmark Sensex crossing 30,000 (in April) and National Stock Exchange’s Nifty rising beyond 10,000 (in July) also helped it. Its high valuation was coming on the way of striking a deal but the price was not coming down as the market was factoring in an acquisition premium —a tricky situation for the prospective buyer. Given a choice, BFIL might have preferred to be merged with RBL as its loan assets would have been around 40% of the combined balance sheet in contrast to less than 15% of IndusInd’s merged loan book as this could have ensured a better say of the MFI in the future running of the merged entity.
IndusInd and BFIL had entered into an exclusivity agreement on 11 September to evaluate the merger scheme but even a week before both IndusInd and RBL were neck and neck in the race. IndusInd moved ahead by agreeing to offer a premium, promising to keep all BFIL employees on rolls for three years (and even willing to accommodate some of them in the bank which BFIL employees and senior management team did not want) and offering 20% ex gratia or one-time “good will" payment to all BFIL employees. A marginally higher price, combined with these sweeteners helped IndusInd clinch the deal. RBL was not willing to match the IndusInd offer.
Stitching such a merger is never easy for a company like BFIL which does not have a promoter; its board is predominantly made of independent directors. BFIL has no known anchor investor; around 20 private equity funds own almost 70% of the company. With no “owner", the board had to be sensitive to all three constituents while signing off the merger —the customers, the employees and the shareholders. Indeed, the presence of international, long-term investors on its board helped BFIL in decision making but building a consensus was an arduous and time-consuming process.
Going by the regulatory norms, the independent directors in banks and large financial intermediaries which have no promoter must take the final call on such mergers. Housing Development Finance Corp. Ltd, HDFC Bank Ltd, ICICI Bank Ltd, Axis Bank, Federal Bank, RBL Bank and similar other professionally run banks and non-banking companies fall into this category.
Following such deals, the board of directors and particularly independent directors, of the acquired entity lose their jobs. For them, it’s not an easy decision, even if it’s for the best interest of the company. Their unwillingness can scuttle such mergers.
Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. He is also the author of A Bank for the Buck; Sahara: The Untold Story, and Bandhan: The Making of a Bank.
His Twitter handle is @tamalbandyo.
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