MFI – Transformation: Why, How and the Impact

V.NAGARAJAN Indus Knowledgeware Private Limited Indus.knowledgeware@gmail.com At Goa, for SA-DHAN members, March 25, 2010 MFI – Transformation: Why, How and the Impact Indus Knowledgeware

About us….. V. NAGARAJAN & Co. Chartered Accountants INDUS KNOWLEDGEWARE PRIVATE LIMITED Soft Solutions to Hard Problems Indus Knowledgeware

Who are we? • We are a firm of Chartered Accountants and a Consulting Company, specializing only in microfinance institutions. • Provide support for cost effective, simple software solutions, instituting financial and accounting controls, accounting systems, audit services and other allied services relating service tax, income tax, company law and RBI, FDI related matters. • In another avatar, we also help in “transforming” NGO-MFIs into NBFC-MFIs, in every step. Indus Knowledgeware

How do we operate and service MFIs? • Our audit firm, V.NAGARAJAN & CO., Chartered Accountants, with offices and service centers at Delhi, Hyderabad, Chennai, provide audit, accounting and tax services. • Our consulting company, INDUS KNOWLEDGEWARE PRIVATE LIMITED, provide transformation service to MFIs and software support. • With a staff strength of 50 and 10 senior C.A.s and consultants we reach out to MFIs / NFIs • We, together, provide a holist approach in building MFIs in India. Indus Knowledgeware

What we have done so far? • With an association with this industry over 20 years, we had nurtured many MFIs and almost all the top 8 to its present form. • We did innovate methods in legal and financial structuring to get the MFIs take off, and the proof is…. • All the investors are laughing their way to banks! • Both bouquets and brick bats are being given, but when it came to strong legal structure and wealth maximization, our innovations never failed! Indus Knowledgeware

Micro Finance Investment Vehicles • With our efforts, four funds dedicated for Micro finance industry were structured, instituted and put in place with more than USD 5 -50 Million in each case. • They are: Bellwether Fund, Mannaveeya (Oiko credit), DIA VIKAS (Opportunity International), Ananya (FWWB). • Many more would have come, but for US melt down! Indus Knowledgeware

What is our score so far? • So far, some 55 plus NGOs have been converted into NBFC MFIs, including start ups as NBFCs also. • We have secured about 7 fresh license from RBI for Micro finance sector, (most of them without any capital). • Four MFIVs have been instituted. • More are coming but now in dozens, it is only a beginning! Indus Knowledgeware

Some Innovations! • Convert a long term loan into equity through Holding and subsidiary companies. • Bringing capital through Community based Mutual Benefit trust to capitalize MFIs. • Using Preference Shares are Foreign Direct Investment to get low Indian Capital and high foreign capital, tweaking the FDI Norms • Using Differential voting rights to bring large foreign capital and low Indian capital, when 1 and 3 are plugged by Govt. • Nobody is complaining! Indus Knowledgeware

The Transformation Tangle • Micro finance is still a sunrise industry in India. • The only industry provide maximum return on capital and grows at a speed of 250% every year as if tomorrow does not exist. • Starting as a NGO, and metamorphosis into NBFC is a challenge! Indus Knowledgeware

What is a MFI? • Loosely called and often confused with NBFCs practicing micro finance is actually a term for all institutions practising micro finance • All MFIs need not be NBFCs and trust, societies, cooperative societies and banks also can do micro finance and still be a MFI! • All NBFC doing micro finance now, need not do only micro finance but can indulge in other financial activities and services also! Indus Knowledgeware

What is a transformation? • Again, Loosely called so, but legally, financially no transformation happens in its literal sense! • What is really needed is change in the mind set, re-orientation of the existing practices suitable for outreach and expansion, through growth! • The people, management , staff and owners need to transform themselves to deal with profit orientation, commercial approach and learning to look at ‘bottom line’. Indus Knowledgeware

Why transformation is needed? Equity Capital for Capital Adequacy Legal Compulsion To build credibility with Financial Institutions and Investors, Enabling lenders to create charge against assets. Share Risk and Rewards of Entrepreneurship. Greater diversification and mobilization of funds. Exploration of the untapped market, both in rural and urban areas. Greater diversification of products, thereby satisfying the emerging needs of the members. Indus Knowledgeware

Why change to a NBFC? • Every institution, engaged in micro finance aspires to become a NBFC, thanks to success stories and obnoxious wealth it had created! • Besides, wealth and profits, if micro finance has to reach out millions and millions (both borrowers and amount), then proper legal vehicle is required. • The only available legal option in India which is workable, easy is a NBFC. Indus Knowledgeware

What are the steps - NGO? • Segregate the Micro finance business • Arrive at a correct value • Enter into a preliminary agreement for sale • Get permission from the Board / General Body of NGO • Also secure the permission of Lenders to transfer the business • Fix the consideration, determine the method and mode and time of payment by buyer • Get ready to receive the consideration Indus Knowledgeware

How the process is done? • Through few different steps and procedures related to each step. • Though they overlap and done simultaneously • Achieve them with minimum possible time. Indus Knowledgeware

Indus Knowledgeware Pvt. Ltd. Provide Professional Services for Transforming MFIs to NBFCs By Acquisition/ Licensing of NBFC Legal/ Financial structuring & Transfer of Business/ Transformation Setting up of Operations, or re organising Indus Knowledgeware

Acquisition/ Licensing of NBFC Identify and Select existing NBFC Form a NBFC Seek License from RBI Get NBFC ready for Operations/ takeover contd.. Indus Knowledgeware

Legal/ Financial structuring & Transfer of Business/ Transformation Legal structuring Business valuation Transition Management Business Transfer services Capital structuring NBFC, Operating entity Control vs. Ownership vs. Funds brought in MOU for transfer Lender Approval Holding, Apex bodies contd.. AOA Terms of Capital infusion Capital structure analysis BTA B 2 B contd Indus Knowledgeware

Setting up of Operations Mentor, discuss & Provide option of Various MF Practices Freeze on Method Product Design Provide Operation Procedures format Computer software/ specifications Loan Insurance Savings Train on Operations & Software Operational Manual Trainers Tools Capital in Apex Bodies Manual / Online help Trained Staff Undertake BPO services Apex Body Structures & Operational Setup procedures contd.. Indus Knowledgeware

How to get NBFC? • By applying to RBI and seeking a CoR, with minimum of Rs. 2.20 crores locked in fixed deposits for at least six months or more. • Detailed procedures to the last details along with a lot of patients and perseverance is required. • A good business plan, and impeccable promoter background is needed. Indus Knowledgeware

The next alternative NBFC • Acquiring one already available. • If low cost one required, NBFCs registered prior to 1997, they far and few and come with lot of baggage. • If one is not very careful, could give headaches, associated additional costs, tax troubles etc. etc, Indus Knowledgeware

What are the steps – NBFC buyer? • The buyer, a company, should be ready with CoR from RBI to run the lending business. • NBFC also should be ready with capital and money to settle the business acquisition consideration to NGO. • This need to be done in one go or within the financial year • The consideration may be settled in cash, or in shares or a combination of both. Indus Knowledgeware

How a ‘transformation ‘ is effected • By selling the Micro finance business of the NGO to a for profit entity. • The real transformation is carrying on the existing business from a “Charitable Mode” to “For Profit Mode” • Hence a For Profit entity is needed. • The best option to day is a Limited Liability Company with necessary valid and sustaining “Certificate of Registration” from Reserve Bank of India Indus Knowledgeware

What advantage NBFC provide? • A legal status duly recognized by Reserve Bank of India. • Unlimited entry of capital in the Company, if performance and returns are assured! • This leverages borrowers and hence further lending and into a vicious circle of growth! • No interest rate restriction, no restriction on other services also, except savings and deposits. Indus Knowledgeware

Why RBI enters into this picture? • In India, every finance company, which does not require a Banking License, requires a Certificate of Registration from RBI to conduct their business. • Micro finance is also a part of Finance company, except that the loan size is restricted and mainly collateral free. • RBI encourages micro finance based business activities to promote financial inclusion, which banking sector is finding difficult to do. Indus Knowledgeware

How RBI and Govt. Completes the picture? • Every lending to such Micro finance NBFCs are also treated a Priority Sector loans. • All the banks are per mandate to provide these loans, as a % of their total loans, but when fails, they provide to MFI-NBFCs. • The potential to reach out is literally unlimited for MFI-NBFCs, with a bank of 300 Million people and about Rs. 300,000 crores as loans. Indus Knowledgeware

The next leap forward…. • Thus, it makes sense to MFIs engaged in micro finance, to become a NBFC-MFI. • Capital is possible, on-lending funds are easy, borrower market is unlimited …. What else one need for a successful business venture. • If the Social Worker of the NGO engaged in Micro finance, now becomes an Entrepreneur with unlimited desire to grow, dream big and earn even bigger! ……………………And • This is actually the “transformation” Indus Knowledgeware

The Transition Management. • Is a serious and complicated matter. • At the same time, within a span of few weeks the lenders, borrowers, new owners of the company need to be handled with new skills and new goals. • Staff and existing systems are another two matters. • Transferring the business to a new entity, over night, is like a the turning an electric switch requires detailed planning, hard work and commitment. Indus Knowledgeware

How to prepare for transfer? • Segregate the Micro finance business from other charitable activities of the NGO. • Define the Micro finance business well. • Assign a reasonable value to sell the same to a third party so that the transaction is considered as conducted at “Arms Length” • Keep the NBFC ready with adequate capital. • Financially, get the best value of the “Property” of the NGO from the buyer. • The buyer may be a interested party (in the buddy net) and hence may be subjected to Income tax scrutiny in NGO Indus Knowledgeware

How to Trasnfer? • Generally, an agreement for sale is first entered into for buying and selling the business • Since normally, huge liabilities towards banks and F.I.s are involved, their concurrence or no objection is required to sell the business. • On the Appointed day close the accounts and transfer the business to the NBFC, for agreed value Indus Knowledgeware

Business Transfer Formalities • Seal the transfer through a Business Transfer Agreement • Based on the lenders agreeing to transfer the liability to the NBFC, or not agreeing, execute another Back to Back Agreement for settling the borrowings • Assign the loans with the NGO borrowers to the NBFC. • The NGOs ceases to be the owner of the micro finance business and NBFC becomes the owner, allowing it to grow Indus Knowledgeware

The book keeping of Business Transfer • Based on the value arrived at close the business in NGO books on the appointed day and debit the net balance to a “Business Transfer Account” • Credit the amount agreed to be paid by Business Transfer Agreement and arrive at the balance • The gain or loss to be carried to the Trust account and the Micro Finance Books will stand closed Indus Knowledgeware

The Valuation Game • Often the work valuation is misunderstood by every body in the arena. • The valuation of business for the purposes of sale to NBFC is different from valuation of the shares in the NBFC by potential investors! • One is about the past and other one is about the future. • Tradition preserves the past and planning preserves the future! Indus Knowledgeware

Many methods of valuation • In both cases, the valuation is a new concept. • It is more an art than a science. • Expert help is needed to convince about the same, which is finally tested by: • Absorbing the past values paid, within reasonable future out of profits • Yet after taxes and other provisions, provide a return to the prospective investor. • Providing high returns on the capital is a betrayal of the NGO assets sold, and charging too much will betray the future of the company itself for want of capital. • A fine balance to be struck in a deadly cocktail! Indus Knowledgeware

The Regulatory Angle – at NBFC • Service tax on financial services • Income tax on profits – Provisioning, bad debts and interest de-recognistion remains a contentious issue. • Setting apart of statutory reserve and compliance with prudential norms as per RBI norms. • Capital Adequacy and Minimum Net Owned Funds • Write off of Good will cost at the time of transfer is allowable deduction – if structured correctly as per IT law. Indus Knowledgeware

The tax at NGO • Any excess over the book value of the business is income for the NGO in the year of its accrual. • This could include past accumulated profits, maintained in the form of loan assets, and additional claim made, treated as good will / IPR value. • Otherwise also, continuing business in NGO will attract tax in the present form of IT law Indus Knowledgeware

The RBI issues and control • RBI does not control NBFCs directly, but only through strict audit and statutory directions. • Violations are viewed leading to withdrawal of CoR. • However, NBFCs with above Rs. 100 crores assets are regularly monitored, inspected and reviewed by RBI. • The recent directions, notifications, circulars are really complex, cumbersome and strict. • You need a good Auditor and Company Secretary to be on the toes always! Indus Knowledgeware

The Capital Adequacy syndrome • Present law, required 12.5% of risk weighted assets, a formula provided by RBI. This is will go up to 15% • Or say roughly, 6-7 times of the Net Owned Funds. • However banks may require much higher capital adequacy to lend, so that they can remain in comfort zone, particularly when the corresponding assets are not collateral based. • Thus regular pumping of capital will remain a challenge to fuel growth or else it could get dwarfed to the extent of profitability only. Indus Knowledgeware

What you can not do in a NBFC? • No deposits, savings in any form. Strictly no, no and no. • No external commercial borrowing is possible, as of now. • Foreign equity is restricted with voting control caps and minimum capital induction. • Preference shares to foreigners (unless convertible) are not considered as equity and is not possible, since it is treated as ECB. Indus Knowledgeware

Other issues! • Capital Structuring • Careful negotiation with prospective investors • Institution of complete control over operations • Good Internal Audit / External Audit systems • Transparent Financial Statements • Corporate Governance • Ultimately business like approach, no mercy to the poor! Indus Knowledgeware

T H A N K S Indus Knowledgeware INDUS KNOWLEDGEWARE PRIVATE LIMITED Indus.knowledgeware@gmail.com A 1, PalamVyapaar Kendra, PalamVihar, GURGAON 122 017. Haryana, India. 91-124-4078742-44 Or Contact, V.Nagarajan, Director 0- 98100-07448

MFI – Transformation: Why, How and the Impact