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Facilitating Capital Flows to Inclusive Businesses
in India and Sri Lanka
Position Paper for the Asian Development Bank1
PREPARED BY NOAH BECKWITH
15 OCTOBER, 2012
1This document is is a proposal to ADB, prepared by an ADB consultant. It does not necessarily
reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors orthe governments they represent. ADB does not guarantee the accuracy of the data and
information provided in this report.
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Table of Contents
Section Page Number
Introductory Remarks 3
1. India 4
2. Sri Lanka 16
3. Key Additional Considerations 20
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Introductory Remarks
The Need for an Inclusive Business Facility in India and Sri Lanka
The creativity of the private sector in addressing urgent social and environmentalchallenges with inclusive business (IB) strategies in India and Sri Lanka generally has,
unfortunately, not been matched with the availability of appropriate financing for
growth. The preference of commercial banks and funds to finance larger, more
established companies in both countries not only starves the SME sector of working
capital (let alone equity), but it also hampers the ability of the private sector to develop
innovative solutions to pressing problems which the public sector has neither the
capacity nor the funding to confront effectively.
The above observations are, however, general. They are contrasted with encouraging,important examples of businesses that are incorporating the poor into supply chains and
demand segments as consumers, producers, suppliers and employees for two reasons:
because it makes sound commercial sense and because they see profitable avenues for
providing solutions to social challenges.
The importance of the IB Facility (the Facility), therefore, is to provide such companieswith working capital, the lifeblood they require to grow. For regulatory, fiscal, structural
and cultural reasons, companies across South Asia struggle to access finance of up to
US$10m. Similarly, microfinance institutions (MFIs) struggle to access debt from the
wholesale marketseven more so following over-indebtedness and suicides amongseveral Indian borrowerswhich impedes innovation of inclusive, pro-poor products in
key sectors, including agriculture, healthcare, clean energy and housing, among others.
The strong conclusion of this Position Paper is that there is an opportunity for an IBFacility, seeded and sponsored by the Asian Development Bank (ADB), to make debt
available to selected companies and financial institutions that are positioned to advance
inclusive business initiatives in scalable and replicable ways. Moreover, ADB is uniquely
positioned to harness internal expertise and bring financing mechanisms to bear which
will enable it to foster interest in, and attract capital to, a modality of investment which
could be genuinely transformative.
In summary, initial due diligence suggests that there is a critical role for a US$100m-US$150m debt facility providing loans of US$1m-US$10m to selected businesses and
financial institutions in India and Sri Lanka that are pursuing strategies to engage with
the poor as consumers, suppliers, producers and distributors.
There is no reason to suppose that, if well managed, a Facility of this nature could notgenerate double-digit returns for investors. Furthermore, if ADB and like-minded
institutions are able to bring innovative instruments to bear, such as credit
enhancements, a liquidity facility and foreign-exchange depreciation mitigation
strategies, returns could be increased significantly.
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1. India
General Observations
1. The Prospects for an Inclusive Business Facility in India
Indias demographic composition and the incidence of poverty, coupled with burgeoningdemand for basic goods and services, make inclusive business interventions not only
timely, but critical. Population pressure and evolving consumption patterns mean that
mass-market solutions are urgently required in healthcare, education, energy,
transportation, water, housing, sanitation and agriculture, among many other sectors.
Given that 53.7% of Indians were living below the poverty line in 2011, according to theMulti-Dimensional Poverty Index developed by the Oxford Poverty and Human
Development Initiative, it could be argued that many investment initiatives will likely (or
necessarily) affect base of the pyramid (BOP) incumbents in some way, either as
consumers, producers, suppliers or employees. With such strong prospects for BOP
engagement at many levels of economic activity, therefore, the question becomes the
modality and conditions of engagement, and whether sustainable improvements in
livelihoods can be achieved as a result.
Initial due diligence as part of the ADB IB initiative suggests that focusing on threespecific modalities of BOP engagement might be particularly effective for the Facility:
incorporating BOP-owned/managed businesses, broadly within the small and medium-
sized enterprise (SME) sector2, into the supply chains of larger companies; improving
access to and quality, affordability, choice and availability of critical goods and services
for the BOP; and engaging the BOP as distributors to reach under-served populations.
There are various reasons for this dual focus articulated below, including the nature of
obstacles to access to finance in India, the type of finance required, the role of the
Indian banking sector, and the strategies and performance of existing non-bank
purveyors of capital, among others.
Four additional conditions in the Indian context make an ADB IB Facility particularlyfortuitous: first, the predominant focus of the banking sector on larger transactions
(with some notable exceptions) due to the perceived lower risk; second, the resulting
dearth of debt finance available to SMEs in the US$1m to US$10m range; third,
regulatory constraints which make the deployment of debt by non-bank financial
companies (NBFCs) very difficult in India; and fourth, the increasing interest among
development finance institutions (DFIs), family offices, high net-worth individuals
(HNWIs) and foundations, among others, in supporting IB strategies.
2It is critical to note that the term SME in the India section of this Position Paper denotes companies
that require up to US$10m of finance(in some cases even more)whether debt or equity. This is insharp contrast to Sri Lanka. The different orders of magnitude must be borne in mind in order for the
conclusions of the document to make sense.
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2. Determining a Strategy for the Facility in India
Faced with Indias vast geography, poverty and urgent demographic challenges, it isimportant for the Facility to develop a focused strategy, recognising the impracticality of
reaching all sectors, states and population segments through one intervention. Similarly,
it must recognise that an attempt to engage with the BOP through all modalitiesi.e., as
employees, consumers, producers, suppliers and distributorsis probably unrealistic
and could adversely affect both the Facilitys financial performance and potential
impact. Furthermore, it should be remembered that the medium of the Facility itself is
investment, and that two of its central objectives are to achieve proof of concept and a
demonstration effect encouraging replication thereafter. For these reasons, elaborated
further below, it is recommended that the Facility focus on business models that engage
the BOP as consumers, suppliers and distributors.
1. BOP as consumers: Facilitating access to key goods and services for under-servedpopulations will provide the Facility with a broad spectrum of investment
opportunities whose commercial thesis is predicated on strengthening BOP
engagement, and where technical assistance (TA) can help in that process.
Investments of this kind can be sub-divided into three themes:
i. Overcoming consumer engagement obstacles: Working with businessesthat have recognised the BOP as a viable, attractive market segment, but
struggle to adapt pricing strategies and revenue models to the cash flow
volatility of lower income groups, or to challenges such as physical
remoteness, absent or limited availability of energy and technology and soon.
ii. Introducing technology: Some businesses that recognise the BOP as anattractive segment are unfamiliar with technology that can facilitate new,
pro-poor engagement models such as remote tele-sales, mobile distribution,
subscription-based purchases, tele-medicine and so on. The Facility will find
opportunities to invest in companies in which the application of technology
could open up new demand segments to be serviced.
iii. Access to finance: Although the regulatory environment makes investing inIndian financial institutions complex, the Facility will have opportunities to
work with NBFCs to develop products that enable the poor to access key
goods and services both in the personal and productive sectors. With regard
to the former, access to clean energy and solar power is a particularly
prominent theme, along with micro-housing. Where the productive sector is
concerned, there are numerous opportunities, including micro-venture
capital, micro-insurance, crop/disaster insurance and input financing.
2.
BOP as suppliers: Engaging the BOP as suppliers is arguably the domain in whichmost progress has been made in the development of IB strategies by larger Indian
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businesses. Most prominently in agriculture, some aggregators have recognised the
tangible and intangible returns on investment that derive from facilitating farmers
access to inputs, information and finance, for example, or from training them in best
practices. Similarly, variations on contract financing models have emerged where
aggregators arrange access to funds which enable poor suppliers to cover the cost of
goods sold, thereby enabling them to be integrated into the supply chains of the
former. This not only fosters loyalty, but also it improves quality and productivity,
and over time, suppliers can outgrow the need for this interim financing mechanism.
3. BOP as distributors: Successes in developing micro-entrepreneurs with localknowledge and networks have been well documented in Latin America, Africa and
India, especially in the area of solar lighting solutions. Where the Facility could have
a particular impact in India, however, is working with traditional financial institutions
and NBFCs to develop financing solutions whilst also helping distributors develop
delivery models that are tailored to vastly-differing states and even regions withinthem. Moreover, the incentive mechanisms which have been key to the effective
design of BOP-led distribution models mean that there is dual engagement of the
poor: as distributors and as employees.
It is suggested that Facility not focus explicitly on BOP as employee investmentopportunities for two reasons. First, companies of the size that require finance which
will enable them to hire significant numbers of poor peoplefor instance, in
manufacturing or retailwould likely have other sources of debt or equity available to
them. Second, other than improving environmental, social and governance (ESG)
practices within large investments of this kind(note that ESG improvements will,
anyway, be required by investors in all Facility portfolio companies)increasing the
quantum and quality of employment opportunities will be an objective common to all
Facility investments.
With regard to investment size, there is a clear, urgent need for debt finance in India inthe US$1m-US$10m range discussed extensively below. This implies a focus on lower
middle market opportunities with strong growth prospects which, to a large extent, have
remained unrealised due to lack of access to finance, above all working capital.
Attempting to deploy capital below the US$1m level in the so-called unorganisedsector would be ill-advised(note, importantly, that in BOP as supplier investments,
some Facility portfolio companies will themselves incorporate this segment in their
supply chains)as would trying to invest significantly larger amounts. This is because
there is fierce competition for larger transactions, requiring a different skill set.
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Access to Finance: Unattended Demand and Supply-side Challenges
3. Access to finance remains a key constraint to inclusive microeconomic growth
Access to financeboth debt and equityremains a fundamental constraint on faster,more broad-based SME growth in India, and it should be noted that the challenge
pertains to companies that require US$10m as much as it does to those that need
US$500,000 or US$1m. In other words, it refers not only to the mom and pop and so-
called unorganised segment, but also to lower-middle market companies, especially in
Indias Low Income States (LISs).
The literature on access to finance in India is extensive, and this Position Paper does notset out to summarise it. However, the following key dimensions of the access to finance
problem should be highlighted in the context of the Facility:
Supply-side bottlenecks: Although Indian banks are obliged to lend a certainpercentage of assets to priority sectors including micro- small and medium-sized
enterprises (MSMEs) and agriculture, they do so largely under duress.
Moreover, with few exceptions, they approach the SME sector with a corporate
lens and erect insurmountable barriers to finance in the form of unrealistic
collateral requirements, submission of at least three years detailed financials
and long, bureaucratic form-filling exercises. Banks urgently require training in
appraisal, monitoring and evaluation SME loans. Currently, they gravitate
towards the M segment because it is more familiar and viewed as less risky.
Where public sector involvement is concerned, significant debt finance is
theoretically available to Indian SMEs through the Small Industries Development
Bank of India (SIBDI). Moreover, guarantees and credit enhancements are also,
theoretically, available. In practice, however, many potential borrowers lack of
awareness of SIDBI products, combined with labyrinthine bureaucracy make the
debt almost impossible to access. Worse still, the application process is so
cumbersome and time consuming that banks administering the SIDBI funds
increase loan prices accordingly. The result is that what was intended as a
concessional product ends up being prohibitively expensive.
At a more general level, lending has been constricted by the absorption of vast
amounts of credit in the infrastructure and real estate sectors during the boom,
much of which was for projects requiring government approval which has since
been delayed indefinitely or withheld. Banking sector assets have been depleted
through this over-exposure.
Demand-side constraints: In consequence, SME growth is hindered as ownersoften resort to taking personal loans at monthly interest rates of 2%-5% to try to
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inject working capital into their businesses. Further pressures on SMEs result
from the following factors, among others:
The frequent mismatch between loan terms and supplier and customerpayment terms if SMEs do manage to access formal finance;
An inability to invest in research and development and technologies thatwould improve efficiencies;
The absence of information technology (IT) and managementinformation systems (MIS) that would enable improved supply chain and
inventory management;
An inability to develop effective marketing strategies resulting in limitedvisibility to vendors and customers; and
Failure to attract fresh talent.
4. Breaking the deadlock: making debt available to SMEs
The demand for debt in India clearly far outstrips supply across sectors, company sizesand geography, and it is the strong conclusion of the due diligence exercise that the
Facility should focus on providing debt rather than equity (see below). More specifically,
the Facility should take three aspects of the problem with access to debt into
consideration, including affordability, security and tenor of debt:
i. Affordability: Demand for working capital from Indian SMEs is fuelled as muchby the lack of affordability of debt from formal financial institutions as scarcity.
Affordability, it should be noted, refers not just to loan price, but also to
repayment terms, which often fail to accommodate revenue seasonality and
cash flow volatility. The Facility must therefore ensure that it provides debt at
affordable rates and that it accommodates the volatilities highlighted above.
ii. Security: Few SMEs are able to meet banks rigid collateral requirements.Providing security and personal guarantees can be a struggle, and traditional
sources of collateral such as land often fail to provide anywhere near the
amount of coverage needed. Training in cash flow-based lending must be
provided to intermediaries administering Facility funds, otherwise collateralconstraints will once again prevent many companies from accessing them.
iii. Loan tenor: When SMEs do manage to access debt from formal sources, thetenor is often inappropriate. Many businesses require what are effectively
working capital facilities which are both long term (if not open-ended) and take
into account fluctuations in monthly revenues. To the extent that the Facility can
incorporate patience and flexibility into the tenor of its loans, the contribution
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that it will make to the financing landscape and, critically, the demonstration
effect it will have on other financial institutions will be significantly enhanced.3
5. The Facilitys modality of finance: debt versus equity
Whilst many Indian companies struggle to access finance of all kinds, there are severalcompelling reasons why the Facility should avoid providing equity:
Unfamiliarity with equity: Not only do many businesses in the Facilitys targetsize range have opaque ownership structures and informal or non-existent
governance arrangements, few owners are open to dilution. This is even more
prominently the case in LISs and remote areas. Additionally, the absence of the
repayment discipline of debt, which is immediate, can foster an approach to
equity as free money, especially among family-owned and less sophisticated
businesses.
Unrealistic valuation expectations: Although there has been a significantcorrection in the market since early 2011 and many large private equity funds
are either under water or may, at best, return capital to investors, business
owners valuation expectations remain unrealistic. This is particularly the case in
the SME sector, where owners lack a thorough understanding of the drivers of
excessive valuations in the mid-to-late 2000s.
Absence of transactional infrastructure: With the exception of largetransactions (US$20m and above) undertaken by large private equity houses,
India does not have the intermediaries, knowledge or transactional
infrastructure that facilitate equity deals. This becomes an even more significant
obstacle in transactions and is more acute in remote areas and LISs.
Inability to accompany equity with debt: Under current regulations, the abilityof funds to deploy debt alongside equity is limited, cumbersome and expensive.
Although the regulations can be circumvented (to a degree) by using mezzanine
structures such as convertible debt and preference shares, it is rumoured that
SIDBI may close such loopholes. Given that it is usually more working capital that
companies appropriate for Facility funding lack (and are positioned/structured
to absorb) rather than equity, debt is the more logical modality than equity.
In addition, the performance of private equity funds, especially those of 2004-2007vintage years, is trending towards mediocre at best to disastrous at worst. Entry prices
were justified by inflating growth assumptions, and a mutually-reinforcing vicious circle
developed whereby owners came to expect exaggerated valuations and funds failed to
attract investors unless they promised commensurate returns.
3The question naturally arises whether loans on such terms would distort the market. However, given
that most banks focus on larger commercial opportunities, the opportunity cost of the distortion thatmight transpire is outweighed by the demonstration effect the Facility could have in alerting banks to
the viability and, ultimately, profitability of financing the missing middle.
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By contrast, the advantages of debt are significant, including; Risk profile: The discipline of immediate and regular repayments, which
provides insight into businesses cash flow positions, coupled with the exit
realisation inherent in debt significantly reduces the risk profile of a Facility.
Return profile: This need not, however, imply that the higher returns generallyattributed to equity must be foregone (and they are certainly not being achieved
at present!). Indeed, significant upside generated from sales multiples are not
likely,4 but medium and long-term debt at annual interest rates of 16%-18%
would be highly competitive and attractive to many target companies.
Moreover, the ability to return cash to investors frequently, whilst recycling
proceeds from interest payments, will help to counteract the impact of currency
depreciation on the Facility.
Need for working capital: Even larger, more sophisticated companies thatmanage to secure equity investment from private equity funds or other sources
still need access to working capital, and indeed often end up using the equity in
this way, which is very costly and inefficient in the long run.
Opportunity to stimulate complementary lending: Banking in India isrelationship based, particularly at the SME level. Relationships are especially
important in LISs and remote areas (when there is access to formal financial
institutions). As highlighted above, given that many business owners have to
take out personal loans to fund working capital requirements, the Facility should
help to mobilise complementary lending from banks that take comfort from itswillingness to lend to sponsors they already know (but may have rejected for
business loans) from personal banking relationships. The presence of the Facility
should, therefore, act as a catalyst for breaking down such barriers between
personal and commercial lending, and strategic use of TA funds could be critical
in this regard (see below).
Proposed Focus and Structure of the ADB IB Facility for India
6. Inclusive business: where access to finance and impact intersect
The conclusion of initial due diligence in India is that the timing for an IB debt Facility isfavourable. In fact, it is arguably urgent owing to several features of the Indian financing
landscapesome long-standing, some more recentwhich are exacerbating the impact
of financial exclusion. These include:
Turmoil in the microfinance sector: Following the scandals in variousmicrofinance institutions (MFIs) in Andhra Pradeshover-indebtedness leading,
4Note that it may be possible to deploy mezzanine structures in some cases to capture upside for
investors, however, this should not be relied upon as regulatory arrangements are subject to change.
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in some cases, to suicidesmicrofinance has, to some extent, become a dirty
word in India. The relevance of this to the Facility is that, although most MFIs
had been focused on aggressive growth of their loan books, a few were focused
on the development of new, inclusive products and mobile payment methods
especially targeting women and the illiterate. Innovation has since all but ceased
due to MFIs difficulty in accessing debt from the wholesale markets and
because of restrictive new legislation introduced by the Reserve Bank of India
(RBI, the central bank). In addition to forcing many micro-entrepreneurs to seek
finance from money lenders, pawn shops and gold tradersdepending on their
proximity to innovative MFIs, they might have been able to access small
business loansMFIs are struggling to upscale with and for their clients
because of nervousness in the sector. It should be noted that, particularly in
agriculture, this was a significant source of finance (again, depending on
location) for some BOP suppliers and producers.
Debt funds are a relatively new phenomenon: The emergence of debt funds isrecent, and is being led by two formidable players in international finance: KKR
and a breakaway team from Citibank. Unsurprisingly, they are seeking to raise
large funds that will be focusing on substantial transactions. Whilst other fund
managers may follow suit, there is no evidence to suggest that there will be a
focus on lower middle market companiesi.e., deals of below US$20mlet
alone SMEs as more traditionally defined.
The start-up space is relatively robust: In contrast, seed capital, even for socialenterprises, has remained relatively robust in India, although admittedly it is
more difficult to access in LISs and remote areas. There is little indication that
there has been a significant decline in the availability of such finance in the wake
of the international economic slowdown and financial crisis of 2008-2011.
In essence, therefore, the orientation of equity towards large transactions, combinedwith the relative accessibility of venture capital and the limited availability of innovative,
inclusive financial products from MFIs that had been venturing down this path, creates a
compelling role for the Facility to focus on the unattended segment of broadly US$1m-
US$10m debt transactions.
5
Furthermore, given the relative costliness of bank finance in India, and the difficulty ofaccessing it post-crisis, many companies that require amounts in excess of US$10m are
able to fund their needs through substantial cash accruals. Focusing on such companies
would likely be a distraction, as there would be no compelling reason for them to pursue
Facility financing (unless, of course, they needed to complement equity with debt
financing that they were unable to source).
5Note that the Facility would also have opportunities to lend to MFIs to support innovation of new,
inclusive products. It would be important, however, to ensure that such activities did not replicate,overlap or confuse activities associated with the US$400m line of credit that ADB has extended to
SIDBI.
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7. Suggested parameters for the ADB IB Facility in India
With the above discussion in mind, this section proposes some parameters andobjectives for the IB Facility in India, and attempts to highlight areas where it could
make a highly significant contribution through innovation and flexibility:
i. Geography: An exclusive LIS focus is neither necessary nor prudent for severalreasons. First, the quality of deal flow in LISs is generally poor. Second, with the
exception of Pragati, there are few competent fund managers focussed on LISs.
Third, in order to achieve a balanced portfolio from a risk perspective, it is advisable
to combine an opportunistic effort to reach LISs and remote areas with transactions
in other states. Recommendation: If the Facility is apportioned among several
managers, a significant allocation to Pragati (subject, of course, to full due diligence)
would be an effective strategy for ensuring LIS coverage.
The issue of geography should also be considered from the perspective of rural and
urban settings. Given the raid, unplanned, widespread urbanisation throughout
India, urban and peri-urban poverty have become as urgent as rural poverty. This
suggests that a focus on basic infrastructurewater, sanitation, housingin
secondary and tertiary cities could be as impactful as a rural focus per se.
ii. Sectors: If the above-suggested orientation for the Facility is acceptedtargetingthe BOP as consumers, suppliers and distributorsseveral target sectors naturally
stand out, including:
i. Agriculture: With a particular focus on value capture and value additionthrough supply chain development. For example, bringing technology and
TA to bear to introduce or improve pre-cooling, dehydration, resin and
enzyme extraction, steam sterilisation and so on. Some large aggregators
have attractive growth prospects and steady cash flows reflecting steady
contracts, but struggle to fulfil orders because SMEs in the supply chain
cannot access finance to boost capacity. Another area within agriculture
which has a disproportionate impact on the BOP is infrastructure, such as
food chain and cold chain strengthing (or introduction where absent).
ii. Access to finance: Working with selected NBFCs and MFIs on new productdevelopment, including crop insurance, disaster insurance, micro-health
insurance, micro-venture capital, access to clean energy and so on (seefootnote 4 above, however). Access to finance opportunities could also be
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pursued by lending to SME financing companies that provide finance of
$500-$15,000 to SMEs. The opportunity in such companies would be to help
them to enhance credit and risk analysis, and to support development of
new products that assist them in retaining and growing with their clients.
iii. Distribution: Distribution of solutions that are vital to, and affordable for,the poor, such as solar lighting, clean cooking solutions, clean water,
sanitation, secondary and tertiary irrigation, and so on. (Note the dual BOP
engagement here: BOP as distributors (i.e., employees, in a sense) and the
impact on end-users.
iv. Housing: Affordable housing for the poor, although initially launched bysome companies such as Mahindra as a corporate social responsibility (CSR)
initiative, has proven to be profitable in parts of India whilst, of course,
being desperately required.
v. Education: With a focus on last mile solutions, i.e., focusing on cost-reduction and hence affordability of vocational, primary and remedial
education (note that investment in K-12 is restricted by the Indian
government).
vi. Healthcare: Owing to poor quality and a general mistrust of publichealthcare, there is a tradition of paying for private care, even among lower
income groups in India. This makes investments in healthcare delivery and
last mile solutions more viable.
iii. Innovation: There are three areas in which, if innovative, the ADB Facility couldmake an enormous contribution to the financing of IB initiatives in India.
a. Incorporation of a liquidity facility: Especially post-crisis, investors reactnegatively to lock-ups or gate provisions, and tend to prefer funds which
provide redemption facilities (at least quarterly) at the prevailing net asset
value (NAV). Given the mismatch between the tenor and liquidity of assets
and liabilities, illiquid instruments are difficult to sell down in order to meet
redemptions. Recommendation: A liquidity facility (LF), provided by a
counter-party with an AAA rating such as ADB, could be used to meet
redemptions to the extent that asset sales are infeasible at any given time.
All or part of ADBs commitment would remain un-drawn to meet liquidity
requirements to fund draw-downs or redemptions. In case of drawdowns,
they would happen at NAV. Meanwhile, the un-drawn portion of the LF
would generate returns for ADB on an un-funded basis on the committed
portion of the Facility. Further upside would be available to ADB by capturing
the bid-offer spread in case of redemptions.
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b. Credit enhancement: Foreign investors neither understand nor recogniseIndian rating agencies methodologies and rating scales. Not only do
investors have concerns about the ability of the former to assess the credit-
worthiness of investee companies, but they are also worried about Indias
debt rating as a sovereign. Recommendation: Providing protection on
principal commitments (at the portfolio level, not the individual credit level)
could mitigate such concerns of private-sector investors that might
otherwise not participate in the Facility.
c. Currency hedging: Giventhe considerable depreciation of the Indian rupeein 2012, many private-sector investors prefer to hold their investments in
hard currency, and may even be willing to forego upside in order to
minimise currency exposure. Furthermore, the Indian rupee has become
extremely expensive to hedge, and is rarely available beyond a one-year
time horizon. Recommendation: Leverage the expertise of ADBs capitalmarkets department to provide the operating currency to those investors
who may otherwise not participatei.e., non-DFIsin a cost-effective
manner at the Facility level.
In summary the table below provides sample terms for an ADB IB Facility in India:ADB IB Debt Facility US$150,000,000
Investors DFIs, foundations, HNWIs, local and international banks
Fund managers 1-3 depending on due diligence
Facility life 7 years
Investment period 4 years
Lending term 36 months
Target return 14-18% per annum
Minimum commitment US$5 million
Management fee 2% per annum
Carried interest 20% above a hurdle rate of 8%
If a key objective of the Facility is not only to enhance awareness of inclusive business asa tool for achieving social outcomes andproducing attractive returns, but also to attractprivate-sector players into the space, then the incorporation of the innovations listed
above, combined with the attractive returns that could be generated, would enable ADB
to make a critical contribution and to move the market.
Depending on due diligence, the Facility could either be administered by one manager,or divided among several. There are advantages and disadvantages to both approaches.
Working with a single manager simplifies logistics and communications and would
enable ADB to develop a very close working relationship through which it could get a
very granular sense of lessons learned. Disadvantages of this approach would include
single-manager exposure risk.
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It is suggested, therefore, that ADB adopt an agnostic approach on this issue and, at theappropriate time, evaluate all potential managers (of which there are not many) on their
merits. If there is a positive relationship between the ability to cover multiple sectors
and geographies and deploying capital with several managers, then it probably makes
sense to work with several.
Regarding time to market, there is significant pressure on many DFIs to restrictengagement with India to LISs or activities which will have a clear impact on the poor.
For this reason, a Facility which explicitly targets inclusive business as a means of
achieving pro-poor outcomes is extremely timely and would likely be well received by
various DFIs, notably CDC, Proparco, Sifem, DEG and FMO.
Strategic use of TA has also already proven to be of interest to various donors inconjunction with the Facility (see below for a discussion of technical assistance).
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(note that one fund sponsored by LR Global, is attempting to raise US$30m for
US$1m-US$5m equity deals and is approaching a first close). Transactions above
US$2-US$4m are difficult to come by, and business owners are hesitant to open
their ownership structures to external shareholders. As highlighted above on the
lending side there is, conversely, a chronic shortage of debt available to SMEs.
Even when banks are willing engage with SME clientsand this assumes that
they have well-prepared financials, suitable governance structures, sufficient
collateral and a strong operating historyit is generally not below interest rates
of 20% or more. Furthermore, bank capacity for assessing opportunities in the
SME segment is weak, and varies significantly between branches and regions
(beyond Western Province and the greater Colombo area, it drops off
vertiginously). Thus, few banks are equipped to recognise attractive commercial
opportunities in the SME segment and reject potential clients outright.
There is therefore a critical gap to be filled with debt, both in the upper echelonsof the SME space, and in the transitional space between the largest loan sizes
that MFIs can provide and more traditional small-scale banking. It is important
to clarify the implications of this for the Facility: because of the dearth of small-
scale finance in the countrybroadly speaking, loans of US$10,000-
US$250,000many small business-owners take out multiple loans from MFIs
but use them for so-called income generating activities. So the opportunity for
the Facility becomes a two-pronged strategy: addressing both the absence of
small-scale finance and facilitating innovation in the microfinance sector (see
below) in order to help foster a continuum of finance for SMEs.
ii. Promoting innovation in MFIs: Microfinance has a long, established history inSri Lanka and emerged from the non-governmental organisation (NGO) and
donor-driven model of the 1980s and 1990s. Largely focused on the group
lending model, geographical coverage of microfinance is impressively high and is
being extended to areas that were impenetrable during the civil war. That
microfinance is a priority for the government is evidenced by legislation pending
in parliament which, from 2013, will enable MFIs to take deposits, mobilise
savings and will facilitate the creation of a credit bureau by forcing all
microfinance practitioners to register with a central authority. (This particular
development will be key to reducing the incidence of multiple loans).
This background is critical because the new legislation will pave the way for
much-needed innovation in microfinance, and it is in this domain that the
Facility can play a vital role. More specifically, there are 5 sub-sectors which
urgently require the development of inclusive, pro-poor financial products that
the Facility can support:
a. Agriculture: There is burgeoning demand among subsistence and small-holder farmers for:
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Insurance products, covering disease (crop and livestock), andnatural disasters such as floods and drought;
Access to inputs, such as seeds, pesticides, insecticides,herbicides, fertilizer and so on; and
So-called cultivation loans, which allow farmers flexiblerepayment terms (i.e., not monthly), removing the asymmetry
between harvests and payment schedules.
b. Value-chain clustering and reverse investment: LOLC Microcredit, forexample, has developed an innovative co-operative investment product,
whereby it takes a stake in a farming co-operative and provides finance
to farmers for purchasing inputs. A pool of permanent working capital is
created, whilst TA funding supports the administration of the entity.
Farmer incomes increase as the co-operative, with the support of LOLC,
cuts out middlemen by establishing fair-trade contracts and developingnew export opportunities. The scheme has been successfully piloted
with 800 cinnamon farmers, and requires significant additional capital.
c. Micro-health insurance: The vulnerability of household livelihoods toillness, especially in the agriculture sector, is extreme. There is scope to
introduce products that have proven very successful in Sub-Saharan
Africa which apply new modelling techniques to at-risk groups. The
result is a win-win for communities and MFIs, where effective yet
profitable coverage is provided.
d. Small-scale renewable energy: One MFI has experimented with small-scale biogas projects, whereby 25 families pool animal and crop waste
to create clean energy for cooking needs. A fertiliser by-product is also
produced. The MFI provides the finance for design and implementation,
resulting in a sustainable energy solution and attractive return on
investment.
e. Micro-housing: Some MFIs have been experimenting with micro-housing loans, whereby clients with strong track records of multipleloans with the MFI are able to borrow up to US$10,000 to construct
small homes. The MFIs have recognised an opportunity to leverage long-
standing client relationships, and need additional capital to expand the
programme.
3. Recommendations for the IB Facility in Sri Lanka
It is recommended that approximately US$20m of the IB Facility be deployed in SriLanka, apportioned in the following way:
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i. Loans to MFIs for product development: Progress on integrating the poorfurther into supply chains in inclusive ways that enable them to both capture
greater value and increase incomes depends on two developments. First,
engaging with aggregators and influencing their procurement policies and
willingness to engage with suppliers. And second, developing financial products
that help the poor to improve yields and increase output whilst enhancing their
resilience to exogenous shocks.
The MFIs interviewed during due diligence emphasized the need for technical
assistance funding and infusion of expertise from other markets in the
development of inclusive products. They specifically highlighted the importance
of gaining access to some of the risk assessment and modelling techniques that
have proven effective in agricultural insurance and micro-health products in
Sub-Saharan Africa.
ii. Debt finance for SMEs:There is a dearth of debt available for SMEs in the rangeof US$50,000 to US$2m. There are several intermediaries which the Facility
could consider to administer loans to SMEs, whilst supporting them in the areas
of credit analysis and risk assessment, cash flow-based lending and so on. By the
same token, the Facility could opt to work with one or several commercial
banks, were there a genuine commitment to developing expertise in SME
lending in the long term.
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3. Key Additional Considerations
The Importance of Technical Assistance
1. The need for multi-dimensional engagement: finance plus technical assistance
All constituents interviewed as part of the due diligence exercise in India and Sri Lankamultilateral development institutions, DFIs, commercial banks, donors, fund managers
NGOsemphasized the importance of providing technical assistance alongside finance if
meaningful progress is to be made in solidifying the inclusive business concept in the
region.
There are several areas or themes which would be crucial for TA to cover:i. Engagement with aggregators: In the BOP as suppliers model, awareness
needs to be built among aggregators in several areas. First, some still struggle to
distinguish between CSR and inclusive business strategies. In other words, the
long-term value of developing supply chains by engaging with producers with
expertise and/or finance is still not widely recognised. Second, few aggregators
have expertise in working with local financial institutions to encourage them to
provide products to their suppliers that would ease production bottlenecks.
ii. Development of service provision models: Whilst a company may recognise anopportunity to provide goods and services to BOP populations in ways that
enhance access and affordability, they may struggle to develop effective
implementation models to do so. In both India and Sri Lanka, companies struggle
to understand sales, distribution and consumption patterns and need assistance
with developing outreach and market development models. Similarly, the
development of risk-sensitive products and modalities of engagement with poor
and remote distributors and suppliers require training. In many relevant
sectorshealthcare, agriculture, education, for exampleinteresting
breakthroughs and important failures and lessons learned from othergeographies, notably Africa, can be brought to bear through TA in order to
replicate best practices.
iii. Training of local bank staff: Banks incentivise staff to mitigate risk and minimiselosses. This risk aversion underlies their reticence to engage with the SME
sector. TA would be critical to train partner financial institutions in credit
appraisal, cash flow-based lending and, more generally, the ability to identify
diamonds in the rough i.e., SMEs which, despite poorly prepared financials,
ad hoc or absent governance arrangements and loose financial controls, would
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clearly thrive and become solid clients were they given access to finance and TA
to address such weaknesses;
iv. Technology upgrading: SMEs in both India and Sri Lanka of all sizes needtechnology upgrades covering many areas, including:
Accounting systems, management information systems and financialcontrols;
Procurement and inventory management; Supply-chain tracking and management; In agriculture, clean energy production (small biogas, for example),
cooling, storage, transportation;
v. Training: In numerous areas, including: Management capacity and corporate governance; Human resource management, retention, training and incentivisation; Financial controls and accounting; Fiscal management and effective tax planning; Stakeholder engagement: producers, consumers, suppliers, local,
provincial/state government and so on; and
Export development, marketing and new market penetration.vi. Investor-readiness or investibility: Although the use of TA to prepare
companies for investment is controversial6, it might be used to work with
companies considered and initially rejected by the Facility, but which have a
strong chance of securing finance if they meet certain key targets and
milestones. For example, a fund manager might advise a company that,
provided proper corporate governance arrangements are implementeda
board of directors with three external directors, for examplethey will qualify
for a loan. TA could then be used for training on board composition and
effectiveness, and could even be structured as a re-payable grant once the
target becomes a portfolio company.
6Many donors have concerns around free rides and sponsors with take the money and run
attitudes. Additional concerns include the effectiveness of the so-called machine gun approach,whereby TA is sprayed at many potential investees in the hope that some prove worthy of
investment.