policy landscape affecting first generation entrepreneurs in india · 2013-04-16 · • india‟s...

© 2011 Intellecap. All rights reserved www.intellecap.com

Policy landscape affecting First Generation

Entrepreneurs in India

December, 2011

© 2011 Intellecap. All rights reserved

Challenging for small and startup FGEs to source debt or equity due to

concerns with policy design, implementation and eco-system issues

2

EXECUTIVE

SUMMARY

Introduction

• Entrepreneurs are a vital catalyst for India‟s economy. However, many first generation entrepreneurs (FGEs) are unable to take the

plunge due to lack of access to finance and a business environment that is difficult to navigate for first-timers.

• This report provides a review of the specific challenges that FGEs face to start, run and scale their businesses. It then goes on to map out

policies and interventions that address and exacerbate these challenges. In most circumstances, we have also provided initial thoughts on

the scope for improvement in these policies.

Debt Financing

Equity

Financing

Non-financial

aspects

Next steps

• Debt is the dominant source of formal capital, accounting for 95% of India‟s business capital (excluding business‟ own investments).

• Low supply of institutional funding plagues the „Micro‟ and „Small‟ enterprise segments, as they are considered too risky to be served by

large banking institutions, and too large to benefit from Microfinance, leading to a significant financing gap.

• Various enabling policies and interventions exist to address financing challenges to FGEs. However, a significant scope for improvement

exists in terms of policy design and last-mile implementation issues. There is a need for policies which act as incentives to lenders.

• India‟s VC industry does reasonably well in international comparisons. However, the share of early stage deals, vital for FGEs, is low.

There is a lack of an enabling ecosystem for FGEs, and high startup risks make investing in this segment riskier for investors.

• According to investors, India‟s regulatory framework is inhibiting, changing and ambiguous. This environment compounds the riskiness of

investing in Indian enterprises and hampers investments in smaller deals and startups.

• Over the last decade, the RBI and SEBI have introduced certain measures to ease regulatory bottlenecks, however, there is scope for

further development.

• Heavy paperwork and compliance requirements, and limited enforceability of legal contracts make doing business in India challenging

and increase the possibility of failure, especially for FGEs.

• Limited levels of infrastructure – resulting in high transport costs, underdeveloped supply chains, lack of office space, etc. – increases

costs and makes certain businesses unviable in India. There is scope for the public education system to improve its contribution towards

providing employable youth across sectors.

• Reforms in regulatory procedures to start a business; more government focus on skill development are addressing some of these risks.

• Nearly 40 government policies and interventions are discussed in this report. The next step is to identify a prioritized list of 4-6 workable

policy recommendations that can have a huge positive impact on FGEs. These policies should be feasible for the government to

implement.

• These recommendations will be whetted by experts. After this, we will work with policy makers and other stakeholders to influence

policies, government interventions and schemes that encourage First Generation Entrepreneurship in India.

© 2011 Intellecap. All rights reserved 3

i. Executive Summary

ii. Table of Contents

iii. Acronyms and Abbreviations

1. Introduction

2. Overview of Financing to FGEs

3. Debt Financing

a) Challenges

b) Policy Landscape

c) International best practices

4. Equity Financing

a) Challenges

b) Policy Landscape


5. Non-financial Aspects

a) Challenges

b) Policy Landscape

6. Concluding Thoughts and Next Steps

iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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Table of Contents TABLE OF

CONTENTS


Abbreviation Full form

ARC Asset Reconstruction Company

BC Business Correspondent

BF Business Facilitator

CART Credit Appraisal & Rating Tool

CCI Controller of Capital Issue

CERSAI Central Electronic Registry of Securitization Asset

Reconstruction and Security Interest of India

CGTMSE Credit Guarantee Fund Trust for Micro and Small

Enterprises

CIBIL Credit Information Bureau India Limited

CIC Credit Information Company

CLCSS Credit Linked Capital Subsidy Scheme

CONFIDI Credit Guarantee Consortium (Italian)

CRA Credit Rating Agency

CRISIL Credit Rating Information Services India Limited

DC Development Commissioner

DFCF Discounted Free Cash Flow

DIC District Industries Centre

DMCC Dubai Metal Commodity Centre

FDI Foreign Direct Investment


FEMA Foreign Exchange Management Act

FGE First Generation Entrepreneur

FI Financial Institutions

FINO Financial Information Network & Operations

FSLRC Financial Sector Legislative Reforms Commission

FVCI Foreign Venture Capital Investor

FY Fiscal/Financial Year

HR Human Resources

HTIL Hutchison Telecom International Limited

INR Indian Rupee

IOSCO International Organization of Securities Commission

IPO Initial Public Offering

ISARC India SME Asset Reconstruction Company

IRDA Insurance Regulatory Development Authority

IT Information Technology

ITES Information Technology Enabled Services

KVIC Khadi and Village Industries Commission

LIS Low Income States

LLP Limited Liability Partnership

MFI Microfinance Institution

MGS Mutual Guarantee Societies

Acronyms and Abbreviations (1) ACRONYMS &

ABBREVIATIONS



MoF Ministry of Finance

MSE Micro and Small Enterprises

MSME Micro, Small and Medium Enterprises

MSMECDP MSME Cluster Development Program

MSMEFDP MSME Financing and Development Project

MRIP Modified Rural Industries Programme

NBFC Non Banking Financial Company

NES North Eastern States

NGO Non Governmental Organization

NKC National Knowledge Commission

NMPC National Manufacturing Competitiveness Programme

NSTEB National Science & Technology Entrepreneurship

Development Board

OBE Off-Balance Sheet Exposure

PE Private Equity

PFRDA Pension Fund Regulatory and Development Authority

PLI Primary Lending Institution

POS Point of Sale

PSU Public Sector Undertakings

RAM Risk Assessment Model


RBI Reserve Bank of India

RRB Regional Rural Bank

SARFAESI Securitization and Reconstruction of Financial Assets

and Enforcement of Security Interest Act

SBI State Bank of India

SCB Scheduled Commercial Bank

SEBI Securities and Exchange Board of India

SFC State Financial Corporation

SICA Sick Industrial Companies (Special Powers) Act,1985

SIDBI Small industries Development Bank of India

SIDC State Industrial Development Corporation

SIIC SIDBI Innovation and Incubation Centre

SSI Small Scale Industries

SMERA SME Rating Agency

SVCL SIDBI Venture Capital Limited

TBI Technology Business Incubator

UCB Urban Cooperative Bank

USD United States Dollar

VC Venture Capital

VCF Venture Capital Fund

Acronyms and Abbreviations (2) ACRONYMS &

ABBREVIATIONS





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


First generation entrepreneurs are a vital catalyst for the economy;

important to ensure conducive policies are in place to support them

7

INTRODUCTION

About this report: How policies affect India‟s first generation entrepreneurs

Entrepreneurs are a vital catalyst for India‟s economy. However, many first generation entrepreneurs (FGEs) are unable

to take the plunge due to lack of access to finance and a business environment that is difficult to navigate for first-timers.

In this report, we analyse the specific challenges that FGEs face and map these challenges to the various policies and

interventions by the Government of India.

Many policies seek to address the difficulties faced by FGEs but often have room for improvement. For example, the

Ministry of Micro, Small and Medium Enterprises (MSME) introduced a Credit Guarantee Scheme to enable

entrepreneurs to access debt without collateral. Considering lack of collateral is a major impediment in raising debt for

FGEs, this scheme had a huge potential for impact. However, this guarantee is accompanied by various clauses which

limit it‟s attractiveness amongst banks to lend using this “guarantee”. One such requirement is to declare a loan as a

non-performing asset (NPA) before claiming a refund. Since most banks wish to bring down the number of NPAs, this

clause reduces the attractiveness of lending under this guarantee, making it not altogether different from collateral-

based lending. This could be an example of a well-meaning policy not having the desired impact due to design issues.

There is also scope for improvement in the on-ground implementation of various well-meaning policies or interventions.

For example, various State Governments have set up incubators to provide office and equipment facilities for first-time

entrepreneurs. The effectiveness of this intervention, aimed at creating a strong ecosystem support for FGEs, is limited

in places because the government-run incubation offices may not be functioning properly. Therefore, while an

incubation centre has been allocated, in practice, there is a need to utilise this facility more efficiently.

Finally there is a need to review certain policies, as they sometimes contribute to exacerbating existing challenges faced

by FGEs. Consider one last example: foreign equity investors in India cannot issue a loan to an entity they have already

invested in. The government places this restriction because it wants to guard the ability of foreign capital to provide

loans (which has implications on monetary policy and inflation). However, this has the unintended effect of preventing

investors from supporting FGEs they are associated with by, say, issuing a short-term loan. Limitations such as these

compound the existing risks of doing business in India and make investors more risk-averse, especially towards FGEs.

This report provides a baseline of all such policies and interventions that affect the ability of FGEs to start, run and scale

their businesses. In most circumstances, we have also provided initial thoughts on the scope for improvement in these

policies. In the future, we will be streamlining the findings in this report into a specific and prioritized list of workable

policy recommendations for the government. The final aim is to go beyond the report and support policy makers in

making India‟s business landscape more attractive for FGEs.


Features of this report

8

INTRODUCTION

Scope

Research Methodology

Definitions

Most terms and concepts used in this report are explained as

and when they come up. The following three terms, however,

are used extensively throughout the report and hence defined

here:

• First generation entrepreneurs: all entrepreneurs whose

parents did not run businesses. The basic premise is simply

that FGEs do not have an existing ecosystem to support

them and find it harder to run businesses and raise capital

compared to second generation entrepreneurs.1

• Policy: All Acts and Regulations authored by Central

Ministries or autonomous Government bodies, such as the

Reserve Bank of India.

• Interventions: Government schemes and actions where

resources of the exchequer are expended beyond

administrative purposes. For example, a State Venture

Capital Fund or Credit Guarantee Scheme.

We used the following four methods to complete the research

for this report:

• Review of government policy documents and policy drafts

as available on the internet.

• Secondary research on challenges and government policies

& interventions affecting FGEs.

• Interviews of investors, lenders and FGEs.

• Existing Intellecap knowledgebase, where available.

Structure of report

The rest of this report is as follows.

Chapter 2 sets the context by providing a

brief overview of the debt and equity

financing landscape in India. This overview

provides the broad contours of debt and

equity financing for businesses and

compares them vis-à-vis each other.

Chapter 3 delves into the challenges that

FGEs face while trying to access debt

capital and how various policies and

government interventions are addressing

or exacerbating these challenges. The last

section of this chapter lays out in detail

each of these policies, their impact or

benefits and what, if any, is the scope for

improvement. Chapter 4 follows a similar

pattern for equity financing.

Chapter 5 covers the non-financial

challenges of running a business in India,

especially for FGEs. As in the previous two

chapters, policies that are interfacing with

these challenges are detailed therein.

Chapter 6 concludes with a final

assessment of the report‟s findings and

delineates next steps in the direction of

making policy recommendations and

influencing policies in this arena.

The topic of policies affecting FGEs in

India is broad. Therefore, to get traction on

key issues, we have defined the scope of

this report as follows:

• While all aspects of doing business in

India is covered, the report will

especially focus on access to finance

for FGEs. This is because financing is a

major hurdle for most FGEs; further,

most non-financial issues affect access

to finance as well.

• Most policies in India that affect the

functioning of FGEs do not refer to

FGEs specifically as a target base.

Therefore, for debt, we focus on

government policies directed to

MSMEs. For equity, we look at

government policies affecting seed and

early stage enterprises. The rationale

for these choices are explained on

page 11.

• We cover FGEs in all sectors.

However, we do not cover sectoral

policies, such as, say, a subsidy for

clean energy businesses.

• We focus on Central level policies and

look at the State level only if relevant.

1 Source: National Knowledge Commission, 2008, Entrepreneurship





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


Debt and equity are complementary sources of finance for FGEs;

currently in India, debt is the dominant source of capital

10

FINANCE

OVERVIEW

0

2000

4000

6000

8000

10000

12000

14000

16000

18000

FY 2007-08 FY 2008-09 FY 2009-10 FY 2010-11

Gross credit to industry Total VC/PE investments

Debt vs. equity to Indian enterprises (INR bn)

Notes: VC/PE investments, usually expressed in USD, were converted @ INR 45 to 1 USD. The term

'industry' includes small, medium and large enterprises.

Sources: Credit data: Handbook on Statistics on Indian Economy 2010-11, Reserve Bank of India.

Equity data: India Private Equity Report 2011, Bain Capital, Inc.

• Debt accounts for over 95% of India‟s business capital needs,

excluding business‟ own investments.

• Even when equity investments peaked in 2007, it only

accounted for 8% of total business capital in India.

• The above graph includes large and late stage enterprises;

therefore, share of equity capital to FGEs is likely to be smaller.

• The dwindling share of equity capital during 2008-09 was a

result of dwindling foreign capital owing to the economic crisis.

Overview of debt financing to the MSME sector in India

• The main categories of suppliers of debt capital include Scheduled

Commercial Banks (comprising public sector, private sector and foreign

banks), Government institutions such as Urban Cooperative Banks, State

Financial Corporations and Non-Banking Financial Companies.

• Public sector banks are the largest suppliers of institutional finance to MSMEs.

• Products offered through institutional finance cater to a variety of requirements

ranging from short term to long term credit needs, and include fund based

products (e.g. cash credit, overdraft, etc.) and non-fund based products (e.g.

letter of credit, bank guarantee, etc.). There is a skew towards fund based

products, and short term working capital loans in particular.

• While branch banking continues to be the main delivery channel to cater to

these enterprises, „branchless banking‟ initiatives via business

correspondents, mobile phones, etc., have emerged recently.

Debt is dominant capital source for businesses

Overview of equity financing to seed and early stage FGEs in India

• Equity investors provide risk capital to enterprises in hope for commensurately

high returns. While there is a high variability, investors typically expect to exit

their investments within 3 to 7 years.

• Since investors seek potential for high growth (to accrue high returns), only

certain type of enterprises get access to such capital. In India, early and growth

stage investments have focussed on Information Technology (IT) and IT

Enabled Services (ITES).

• For FGEs, there are two formal sources of equity infusion: a) high net worth

individuals called “angel investors”, who provide seed and early stage funding,

and b) Venture Capital Funds (VCFs), which provide equity for early and

growth stage enterprises.

• FGEs can get equity infusion by agreeing to dilute ownership of the company

with the investor. The specific structure of each transaction, however, has many

variations and can include a combination of instruments like preferred stock,

convertible debt, mezzanine debt, etc.


• Equity investors predominantly target

energy, real estate, financial services

and telecom to invest in. These are

large and relatively “safe” sectors .

• Among smaller deals, IT & ITES

dominate, accounting for around

20% of deals from 2004-10.

• Of all VC backed firms in India, 50-

60% are based out of Bangalore and

Mumbai. Around 98% of the firms are

concentrated in 6 Indian cities,

though operations extend to smaller

cities and urban India as well.

11

By Size By Stage By Sector/ Geography

• Early-stage enterprises in the

MSME sector face challenges with

respect to access to institutional

finance.

• Reliance of traditional banks and

financial institutions (FIs) on

established track records, as one

of the key parameters for issuing

loans, constrains supply to early-

stage enterprises.

• According to a survey conducted by

the National Knowledge Commission

(NKC), FGEs believe that access to

early stage finance from banks is

very difficult at the startup stage, and

is relatively easier at the growth

stage.

• Only around 15% of equity deals

are for seed & early-stage

businesses.

• Growth-stage deals (companies with

an established business model and

team and are looking to expand)

account for around 20% of all equity

deals.

• Over 60% of equity deals are for late

stage and private investments in

public equity (PIPE) because

investors consider them safer. These

have little bearing on FGEs.

• The average deal size in early and

seed stage deals in India is USD 3

million (INR 15 crores) from 2006 to

2010. In the US, this average is

almost half at USD 1.7 million in PPP

terms.2 This indicates that VCFs in

India are not supporting smaller

FGEs compared to their American

counterparts.

• While data on angel investments are

not available, qualitative information

suggests that there are far lesser

angel investments in India as well.

Insights on financing by size, stage, sector & geography; analysis

of which FGEs to focus on in terms of debt and equity capital FINANCE

OVERVIEW

• Information asymmetry, dearth of

credit history, high transaction costs

and susceptibility to shocks

constrain supply of finance to

micro enterprises, making them the

most difficult segment for banks.

• Medium enterprises are considered

more equipped to absorb external

shocks, and are better served than

other segments.

• Micro enterprises mainly use fund-

based products, where as mature

small and medium enterprises also

utilize non-fund based products.

• Working capital contributes to a large

extent of debt demand as

manufacturing enterprises face

high trade credit requirements and

enterprises in the service sector are

labor intensive.

• Knowledge based service

enterprises due to intangibility of

operations and limited collateral face

challenges in accessing debt finance.

• Penetration of institutional finance in

North Eastern States (NES) and

Low Income States (LIS)1 in India is

restricted due to low levels of

industrialization, infrastructure, high

cost of operations and an unstable

political environment.

1 LIS includes Bihar, Uttar Pradesh, Rajasthan, Chhattisgarh, Jharkhand, Madhya Pradesh & Orissa and NES includes Sikkim, Assam, Meghalaya, Arunachal Pradesh, Tripura, Nagaland, Manipur, Mizoram 2 In exchange rate terms, this is USD 5 million. In Purchasing Power Parity (PPP) terms, USD 1 is approximately equal to INR 16, or approximately one-third of the exchange rate.

Source: http://nextbigfuture.com/2010/02/implied-ppp-and-big-mac-exchange-rates.html; India Private Equity Report 2011, Bain Capital, Inc.; Stanford Business School conference on venture capital in India; Primary interviews

De

bt

Eq

uit

y

FGE Focus

From this analysis, it is

clear that the most

under-served FGEs

are micro & small in

size and tend to be in

early stages of their

businesses.

For this report, we

look at FGEs by size

and focus on access

to debt for micro &

small FGEs. This also

corresponds to most

government policies

and interventions in

this space.

In terms of equity, the

most under-served

FGEs are those in

seed and early stage

businesses. Therefore,

we focus on policies

affecting such

enterprises.

We also look at

policies affecting

FGEs that are looking

for smaller deals.

http://nextbigfuture.com/2010/02/implied-ppp-and-big-mac-exchange-rates.html


















1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


≤ 25 Lakhs

13

Small

Micro

Informal sector

4.7%

Overview of MSME sector by initial investment; size, sector and other features

Medium

Source: 4th All India MSME Census (2006 – 2007), MSME Annual Report, 2010

.

95%

0.21%

DEBT FINANCE

CHALLENGES

Source: MSME Development Act 2006, 4th All India MSME Census (2006-07), MSME Annual Report 2010

Definition of MSMEs in terms of initial investment (INR) Size: The number of enterprises in the MSME sector in India amounted to 26.1 million

units as per the 4th MSME Census (2006-07) with the Micro segment accounting for

95% of units in the sector.

Registration: 24.5 million enterprises in the MSME sector are unregistered

enterprises, amounting to nearly 94% of total enterprises in the sector.

Sector: The Services sector dominates over the Manufacturing sector amongst

MSMEs, with ~71% of enterprises engaged in the Service sector.

Type of organization: Close to 95% of enterprises in the MSME sector are

Proprietorships, followed by Partnership form of organization.

State-wise distribution: more than 55% of units are in 6 states: Maharashtra, Tamil

Nadu, Andhra Pradesh, Karnataka, Uttar Pradesh and West Bengal.

Overview of Micro, Small and Medium Enterprises; MSMEs contribute

significantly to the Indian economy, but face significant funding shortages

Share of Manufacturing output (in terms of value): 45%

Share of total exports (In terms of value): 40%

Contribution to GDP: 8%

Contribution to employment: 60 million

The MSME sector has consistently registered a higher growth rate than the rest of the Industrial sector

Manufacturing

sector

Services

sector

> 25 Lakhs and

≤ 5 Crores

> 5 and ≤ 10

Crores

≤ 10 Lakhs

> 10 Lakhs and

≤ 2 Crores

> 2 and ≤ 5

Crores

Landscape of MSME sector

(In terms of enterprises)

To provide context for analyzing policies related to debt to MSMEs, here we describe important

features of this sector…


0

50,000

100,000

150,000

200,000

250,000

Public SectorBanks

Private SectorBanks

Foreign Banks GovernmentInstitutions

FY 2008 FY 2009

93%

5%

2%

No Finance/SelfFinance

Finance throughInstitutional Sources

Finance through Non-Institutional Sources

14

Debt is the predominant source of capital for businesses. However, given a low penetration of institutional debt to MSMEs, there is a

pressing need to strengthen the role of Banks and Financial institutions in providing institutional finance to enterprises in this sector.

• Close to 95% of enterprises in the MSME sector do not have

access to finance from Institutional sources

• Heavy dependence of MSMEs on personal savings and Non-

institutional sources such as borrowing from friends and family,

money lenders etc. owing to limited supply of institutional finance

• Propensity amongst Banks/ Financial Institutions (FIs) to

undertake lending decisions based on availability of collateral and

established track record

• High risk perception of enterprises in the MSME sector, and high

transaction costs involved in serving these enterprises often

deters certain Banks / FIs from lending to the sector

A large number of enterprises in the MSME sector face severe

challenges with respect to funding from Institutional sources

1. Notes:

• Government institutions comprise Urban Cooperative Banks (UCBs), Regional Rural Banks (RRBs), State Financial Corporations

(SFCs), State Industrial Development Corporations (SIDCs) and SIDBI (Direct Credit to MSE)

• NBFCs excluded from graph due to unavailability of official data regarding NBFC financing to the sector

2. Sources: RBI Annual Report 2009-10, Report on trends and progress of Banking in India 2009-10, MSME Annual Report, 2010,

SIDBI MSME Database, 2010

Sources of Finance to MSME units (No. of units) Snapshot of Outstanding credit to MSEs in India from Institutional sources (INR crore)

Source: 4th All India MSME Census (2006 – 2007).

Scheduled Commercial Banks

“Only 4-5 % MSMEs are covered by Institutional funding, given that approximately 95 % of villages are not covered by banks.

There is, therefore, a need to bridge this gap through enabling policies.” - Dr. K C Chakrabarty, Deputy Governor, RBI (May, 2010)

• Scheduled Commercial Banks are the key sources of institutional financing for the sector,

with ~88% of outstanding credit to the MSE sector in FY 2009 contributed by Public sector

banks, Private sector banks and Foreign banks together

• Public sector banks account for a clear majority (~75% of outstanding SCB credit to MSE

sector) when compared to Private sector and Foreign banks

• Credit outstanding to the MSE sector from SCBs grew increased to INR 364, 012 crores in

2009–10, with Public sector banks continuing to outpace Private sector banks and Foreign

banks with a y-o-y growth of ~45% (over 2008–09)

DEBT FINANCE

CHALLENGES


• Government institutions such Urban Cooperative Banks

(UCBs), State Financial Corporations (SFCs), State Industrial

Development Corporations (SIDCs), Regional Rural Banks

(RRBs) etc. have been instrumental in serving the MSME

sector due to greater access to entrepreneur information

and an extensive network

• However, a large number of these institutions have been

displaying signs of weakness, highlighting the need for

measures to improve governance, financial health, reduce

Non-Performing Assets (NPAs) etc.

• Scheduled Commercial Banks are down streaming

operations to serve the MSME sector

• Public sector banks are the leading suppliers of debt capital to

the MSME sector on account of their wide branch footprint,

with State Bank of India leading bank financing in the sector

• As Private sector banks and Foreign banks are largely

present in urban areas, they have limited outreach in the

MSME sector

• The NBFC segment comprises of large NBFCs that serve

Medium and Large enterprises and niche NBFCs that serve

the Micro and Small enterprise segment

• MFIs are also up-scaling their operations beyond the Informal

sector to cater to the Micro enterprise segments

UCBs, SFCs, SIDCs, RRBs

etc.

Niche NBFCs

TYPE OF ENTERPRISE

Informal

sector Small Micro Medium

DEBT

FINANCE

SUPPLIER

MFIs

Large

Government

Institutions

Private sector Banks &

Foreign Banks

NBFCs

Public Sector Banks

Scheduled

Commercial

Banks

Large NBFCs

Players in the Debt landscape operate at varying risk segments,

leading to a significant financing gap, especially for the MSE sector

Suppliers of Debt finance operate at various parts of the spectrum. However, differing risk appetites limit the supply of finance to the

MSME sector, which is generally perceived as risky by Banks and Financial Institutions

Largely unserved by Institutional finance

Low supply of institutional funding plagues the „Micro‟ and „Small‟ Enterprise segments, as they are considered too risky to be served by

large banking institutions, and too large to benefit from Microfinance, leading to a significant financing gap.

DEBT FINANCE

CHALLENGES

Source: Intellecap Analysis; Primary Interviews





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


Lead Actor1 Acts; Regulations; Policy Documents

Reserve Bank of India (RBI)

• RBI Guidelines for Banks;

• RBI Guidelines for Priority Sector Lending,

• RBI Guidelines on Business Correspondents and Business Facilitators (2006)

Ministry of MSME • MSME Development Act 2006, Package for Promotion of Micro and Small Enterprises (2007)

Ministry of Finance

• Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002

• Department of Financial Services: Credit Information Companies (Regulation) Act (2005)

• Policy Package for Stepping up Credit to Small and Medium Enterprises (2005)

Ministry of Consumer Affairs,

Food & Distribution • Warehousing (Development and Regulation) Act (2007)

Ministry of Corporate Affairs • Limited Liability Partnerships Act 2008

• Provincial Insolvency Act 1920 (Covers Proprietorships and Partnerships)

Regulatory framework guiding lending practices in India and

Government Committees on issues of commercial debt financing DEBT FINANCE

POLICIES

RBI is the main regulator of debt capital; rules and regulations initiated by various Central Government Ministries

Four Step process for raising debt capital in India

Lead Actor Recommendatory Reports

Prime Minister‟s Office • Report of the Prime Minister‟s Task Force on MSME (2010)

Committees / Working Groups

instituted by various

Government institutions

• Report of the Committee on Comprehensive Regulation of Credit Rating Agencies (2009)

• Report of Working Group on Rehabilitation of Sick SMEs (2008)

• Report of the In-house Working Group on Asset Securitization (1999)

• Report of Working Group to review the Credit Guarantee Scheme of the CGTMSE (2010)

• Report of the Working Group on the Issues and Concerns in the NBFC Sector (2011)

Various steering committees instituted by the Government provide policy recommendations on key issues

1 The Acts listed under the various ministries (in green) affect most the Ministry indicated here, but also has ramifications on other Government institutions.


DEBT FINANCE

POLICIES

Information asymmetry, risk of doing business & high transaction costs

are key concerns for banks when lending to MSMEs

Banks / Financial Institutions rely to a great extent on availability of

adequate collateral and an established track record to evaluate credit

worthiness of firms; conditions largely unmet by firms in the sector

This leads to MSMEs availing of non-institutional

sources of finance as they may not have the

required collateral or track record

Concerns/ challenges faced by Banks/ Financial Institutions when lending to the MSME sector stem from the following reasons:

Lending to

MSMEs is

RISKIER

Lending to

MSMEs is

COSTLIER

Limited Financial

Transparency

High Information

Asymmetry

Low levels of Financial

Literacy

Vulnerability of Business

operations

High mortality of units and

weak creditors rights

High transaction costs

Limited outreach

• High risk perception of MSMEs and limited risk appetite of banks/ financial institutions at

times due to internal policies which encourage cautious lending impact credit flow

• Lack of suitable financial information & an inadequate information infrastructure

leads to information asymmetry between lenders and enterprises in the MSME sector.

• Limited information on the enterprise inhibits access to finance, as banks consider

accounting systems and financial records of these firms to be inadequate in many cases

• Insufficient information with respect to collateral, and lack of relevant credit history

information leads to challenges in risk assessment and recovery on loan defaults

• Entrepreneurs in this sector usually have limited information on financial sources,

products and services available., and limited skills with respect to the same

• Weak financial strength of enterprises on account of vulnerability to demand and market

shocks, shortage of working capital and rising NPAs contribute to lenders‟ concerns

• High turnaround time of processing MSME loan applications due to limited information

regarding the credit history of enterprises.

• High transaction costs involved (cost of sourcing, acquisition and servicing) in serving this

sector often adversely affect lenders‟ inclination to lend

• Limited outreach of commercial banking institutions and lack of tailored products to cater

to needs of this sector, contribute to higher transaction costs


16. Cluster Development Programmes to

leverage economies of scale (Financing &

Non-Financing aspects)

1. Sector specific act defining MSMEs: MSME

Development Act (2006)

2. Inclusion of Credit to MSEs in Priority Sector

Lending Guidelines (RBI)

3. Promotional Programmes/ Policy Packages:

o PM‟s Task Force on MSMEs (2010)

o Package for Promotion of Micro and Small

Enterprises (2007)

o Policy Package for Stepping up Credit to

Small and Medium Enterprises (2005)

19

DEBT FINANCE

POLICIES

Mapping policies and interventions to the various financing

challenges

Concerns/ challenges faced by Banks/

Financial Institutions when lending to the

MSME sector: Need to increase Supply of

Capital

Lending to

MSMEs is

RISKIER

Lending to

MSMEs is

COSTLIER

Limited Financial

Transparency

High Information

Asymmetry

Low levels of Financial

Literacy

Vulnerability of Business

operations

High mortality rate and

weak creditors rights

High transaction costs

Limited outreach

Challenge Faced Enabling Policies Enabling Interventions

4. Schemes/ Programmes by Ministry of

MSME to promote MSME sector. Overview

of schemes implemented through:

o Office of Development Commissioner

(MSME)

o National Small Industries Corporation

5. SIDBI: Financing & Non-Financing

initiatives

6. Other enabling institutions: SFCs, UCBs

& District Industries Centre (DIC)

7. Facilitating Asset recovery and reconstruction:

SARFAESI Act (2002)

9. Credit Guarantee Fund Trust for Micro and

Small Enterprises (CGTMSE) to enable

collateral free loans

10. Instituting a new form of collateral:

Warehousing (Development and Regulation)

Act (2007)

11. Establishment of Credit bureaus: Credit

Information Cos. (Regulation) Act (2005)

Infrastructure support to mitigate

Information asymmetry and risk:

8. Asset Re-construction Company (ARC)

12. Credit Bureaus (E.g. CIBIL)

13. Collateral Registry (E.g. Central Registry

maintained by CERSAI )

14. Credit Rating Agencies (E.g. SMERA,

CRISIL, ICRA etc.) and Performance &

Credit Rating Scheme (NSIC)

15. Institution of Branchless banking initiatives: RBI

Guidelines on Business Correspondents &

Business Facilitators (2006)

Constraining

Regulations /

Policies

17. Archaic Bankruptcy laws for Proprietorships and Partnerships (Provincial Insolvency Act 1920)

18. Inadequate legal & regulatory framework for alternative forms of working capital finance such as

Factoring/ Securitization of receivables

19. Regulations constraining on-lending to NBFCs (other than MFIs categorized as NBFCs) limit their

access to debt finance from banks (Exclusion from Priority Sector Lending guidelines)


All debt-related policies are

marked using the same

numbers on page 19, the

policy overview page

Enactment of a sector-specific law and inclusion of credit to MSEs

as Priority Sector Lending were significant steps for the sector

20

DEBT POLICY

ENABLERS

Sector-specific

Act governing

promotion and

development of

sector: MSME

Development Act

(2006)

Policy Overview Impact / Benefit Scope for improvement

• Clear legal definition of units that fall

under the MSME sector

• Expansion of plant and machinery

limits and recognizing that investments

in service units may be smaller.

• Facilitated formulation and execution of

schemes and funds for promotion and

development of the sector

• Provisions for penalties on late

payments aim to encourage smoother

cash flow to micro/ small units

• Simplification of registration processes

• Proposed procurement policy to guide

purchase of supplies and Exit policy to

regulate liquidation of sick units

• Guidance from National Board in policy

formulation and programme execution

• The MSME Development Act came into

force from October 2, 2006.

• Classified units in the Micro, Small and

Medium category, based on total

investment in plant and machinery for

manufacturing units and equipment for

service units

• Facilitated formation of the National

Board of MSME - an apex, statutory,

advisory body to advise the Government

on issues relating to the MSME sector

• Imposed penalties for delayed

payments by large companies to Micro

& Small enterprises

• Made provisions for development of

future policies such as a procurement

preference policy and exit policy

• Stronger enforcement of policies such

as penalties for delayed payments are

required to ensure a continuous stream

of working capital

• Need to introduce policies mentioned

in the Act, such as the Procurement

preference policy and Exit policy

• Scope to include special provisions for

promotion of women entrepreneurs in

procurement policies etc.

• Tendency amongst Financial

Institutions to use annual sales for

definition of units, leading to

inconsistency with government

mandates at times

Inclusion of

Micro & Small

Enterprises in

„Priority Sector

Lending‟

guidelines

• Aims to address the shortage of funds

in the MSE sector, by targeting bank

lending to this sector

• To ensure allocation of sufficient

financing to MSEs, RBI has accepted

the following recommendations by PMs

Task Force on MSMEs (2010):

o Year-on-year credit growth of 20%

to MSEs

o Micro segment to account for 60%

of annual outlay to MSE sector

o Target of 15% growth per annum in

number of micro enterprise

accounts in commercial banks

• As per RBI mandates, „Priority Sector

Lending‟ targets are 40% of Adjusted

Net Bank Credit (ANBC) or Off-Balance

Sheet Exposure (OBE) (whichever is

higher ), for domestic commercial banks

while it is 32% for foreign banks

• Lending to the Micro & Small

enterprise sector is considered in

computing performance of domestic

commercial banks under the overall

PSL target, while foreign banks have

sub-targets of 10% of ANBC or OBE

(whichever is higher).

• Scope to fix a sub-sector target within

the overall priority sector ceiling (40%),

as MSEs have to compete with

Housing, Education etc. for the residual

12% after sub-targets fixed for

agriculture and weaker sections

at18% and 10% respectively

• While current regulations focus on

large commercial banks serving

MSMEs, there is a need to recognize

that smaller financial institutions such

as NBFCs, can complement the

services of large commercial banks

2

1

Source: Micro, Small & Medium Enterprises Development Act, 2006; Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); „Entrepreneurship Development in the Micro Small and Medium Enterprise Sector in India‟ - A Report by

Shamika Ravi, Indian School of Business (July 2009); RBI Master Circular - Lending to Priority Sector (July 1, 2011); http://www.sme.in/CurrentNews.aspx?NewsID=1824

http://www.sme.in/CurrentNews.aspx?NewsID=1824


1. Prime Minister's Task Force on MSME (2010):

• Set up to evaluate the issues raised by various

MSME associations and develop an action plan to

address the issues of the sector

• Final report submitted on January 30, 2010, with

recommendations on issues relating to credit,

taxation, marketing, labor, exit policy, infrastructure/

technology/skill development and packages for North

East, Jammu & Kashmir etc.

2. Package for Promotion of Micro and Small

Enterprises (2007):

• Consists of various proposals/schemes to support

MSMEs with respect to credit, fiscal matters, cluster-

based development, infrastructure, technology and

marketing

• Package also focuses on capacity building of MSME

associations and support to women entrepreneurs

through guarantee covers, financial assistance etc.

3. Policy Package for Stepping up Credit to Small and

Medium Enterprises (2005):

• Package was introduced aiming to double the credit

flow to the sector within five years

• Measures to increase the quantum of credit include

directives for banks to attain a minimum 20% year-

on-year growth in credit to the MSME sector and

provide credit cover on an average to at least 5 new

MSMEs at each of their semi-urban/urban branches

annually

The Government has undertaken efforts to provide stimulus to

MSME financing and capacity building via policies and packages

21

DEBT POLICY

ENABLERS

Government

support through

Policies/

Promotional

Packages

Overview of intervention Impact / Benefit Scope for

improvement

• Stipulations in the Report of the PMs

Task Force on MSMEs with respect to

the following are likely to facilitate

credit flow to MSMEs:

o Strict adherence by banks to 20%

year-on-year growth for MSE

lending with 60% allotment for Micro

sector

o Creation of a fund with SIDBI called

„Special Fund for Micro Enterprises

using shortfall against MSE credit

targets for commercial banks

• The Task Force also indicates

introduction of a Public Procurement

Policy with a target of at least 20% of

annual purchase volume from MSEs

for government departments and

PSUs, need to re-engineer and

strengthen the District Industries

Centers (DIC) to facilitate promotion

and capacity-building of MSMEs etc.

• In addition to bank targets for lending,

measures in the Policy package for

stepping up credit include the need for

banks to follow a transparent rating

system to determine cost of credit,

adoption of a cluster based approach

for SME financing etc.

• Implementation closely monitored by

RBI and Government, facilitating

accountability and adoption

• Issues in

implementation, long

turn around time etc.

often limit

effectiveness of such

support. E.g.

Introduction of Public

Procurement Policy

mentioned in the PMs

Task Force Report on

MSMEs (Target of

>20% of annual

purchases from

MSEs) has seen

limited progress

• Need for formulation

of concrete plans of

action and/or fund

allocations in order to

ensure effective

execution of indicated

measures, in line with

urgency of

requirement

• In addition, there is

scope for increased

private participation

for implementation of

various government

schemes

3

Source: business.gov.in; Report of Prime Minister‟s Task Force on MSME (GoI) – January 2010; Package for Promotion of Micro and Small Enterprises (Ministry of Small Scale Industries & Agro & Rural Industries) – February 2007; Policy Package for Stepping up Credit to Small

and Medium Enterprises (Announcements made by Union Finance Minister) – August 2005;www.rbi.org.in,dcmsme.gov.in,www.iiaonline.in


1. Ministry of Micro, Small & Medium Enterprises:

• Nodal Ministry for development of policies/

Programmes/ schemes to promote and advance the

MSME sector, execution and co-ordination

• Supported by the Office of Development

Commissioner (MSME), National Small Industries

Corporation (NSIC), Khadi and Village Industries

Commission (KVIC) and Coir Board

2. Schemes operated by DC (MSME):

• Credit Linked Capital Subsidy Scheme (CLCSS)

for technology upgrades: Aims at facilitating

technology upgrades by providing15% capital

subsidy to MSEs on institutional finance availed by

them

• National Manufacturing Competitiveness

Programme (NMCP): Aims to improve

competitiveness of MSMEs across value chain of the

sector and involves 10 components. NMCP includes

programmes such as setting up of new tool rooms,

product and process quality improvement, cost

reduction etc.

• Other schemes include a scheme for capacity

building (to strengthen MSE database), MSE-CDP

(Cluster Development), CGTMSE etc.

3. NSIC: Public Sector enterprise set up to provide

technical, financial and marketing assistance to MSMEs

• Undertakes schemes related to raw material

procurement, product marketing, credit rating and

technology support such as the Marketing

Assistance Scheme, Performance and Credit Rating

Scheme etc.

Schemes to promote and develop the MSME sector have been

formulated and executed through varied implementation agencies

22

DEBT POLICY

ENABLERS

Ministry of MSME

& Implementing

Partners:

Programmes &

Schemes


improvement

• Establishment of a distinct Ministry for

the MSME sector facilitates the

formulation and implementation of

targeted policies/ programmes/

schemes aiming to increase the

competitiveness of MSMEs and

facilitate credit flow to the sector,

amongst other advantages

• Setting up of a Call Center of the

Ministry – „Udyami Helpline‟,

contributes to improving the financial

literacy of FGEs by providing a single

point facility for information on

formalities for setting up an enterprise,

obtaining bank loans, subsidies etc.

• The DC (MSME) functions as an apex

body supporting Government in

developing and implementing policies

and programmes for the sector, and

provides assistance in varied areas

such as marketing, technology,

entrepreneurial development etc.

• Schemes implemented by NSIC assist

MSMEs in raw material procurement

and marketing of products (through

consortia and tender marketing, single

point registration for government

purchase, credit support for

procurement etc.), and contribute to

enhancing the competitiveness and

marketability of their products

• The „Strategic Action

Plan of Ministry of

Micro, Small and

Medium Enterprises‟,

notes that a key

challenge is

multiplicity of

programs/ schemes

undertaken by

various departments/

ministries for the

same target group.

This duplication with

respect to design,

implementation and

communication often

leads to confusion

• Need for effective

coordination between

various stakeholders,

with synchronization

of communication

strategies

• In addition, there is a

need for greater

involvement of the

private sector in

scheme execution

and improved

awareness building

initiatives

4

Source: msme.gov.in;nsic.co.in; business.gov.in; Strategic Action Plan of Ministry of MSME


• Principal Financial Institution for promotion, financing

and development of MSME sector and co-ordination of

related activities of organizations

• Financial support is provided through Direct lending,

Refinance to eligible Primary Lending Institutions (PLIs)

such as Banks, State Financial Corporations (SFCs),

State Industrial Development Corporations (SIDCs) etc.

and financial assistance through loans, grants, equity/

quasi-equity to NGOs / MFIs for on-lending to MSMEs

• SIDBI funding schemes relate to composite loans,

financing marketing activities, equipment finance etc.

• In addition to finance, SIDBI has undertaken various

initiatives with respect to non-credit requirements such

as equity capital, credit rating, credit guarantee,

technology up gradation etc.

• SIDBI is the implementing agency of the MSME

Financing and Development Project (MSMEFDP), a

multi activity, multi-agency project on financing and

development of MSMEs through provision of financing

and non-financing services, and development of an

enabling eco-system. The project components include:

o Credit facility from World Bank & KfW Germany used

for extending credit to existing and new MSMEs

o Risk Sharing Facility (Piloted through CGTMSE)

o Technical Assistance by DFID UK, KfW and GtZ

Germany covering capacity building of banks /

financial institutions and borrowers, addressing policy

and regulatory issues, promotion of market oriented

business development services etc.

• SIDBI‟s Modified Rural Industries Programme (MRIP)

aims at stimulating viable rural enterprise through

facilitating availability of business development services

As the apex institution for promotion, financing and development

of the MSME sector, SIDBI has a prominent role to play

23

DEBT POLICY

ENABLERS

Small Industries

Development

Bank of India

(SIDBI):

Financing & Non-

Financing

support


improvement

• Provides financial support through

Direct lending and Refinance, along

with Development & Support services.

• Facilitates development of an enabling

eco-system by varied initiatives:

o Establishment of an Asset

management company managing

Venture Capital funds: SIDBI

Venture Capital Limited

o Credit guarantee support to

collateral free loans: CGTMSE

o MSME specific credit rating agency

for transparent and comprehensive

risk profiling: SME Rating Agency of

India (SMERA)

o Establishment of India‟s first MSME

focused Asset Reconstruction

Company for quicker resolution of

NPAs: India SME Asset

Reconstruction Company (ISARC)

• SIDBI has also undertaken efforts to

promote Microfinance across India to

cater to enterprises which do not have

access to institutional finance

• The MSMEFDP aims to make MSME

financing an attractive and viable

option for banks/ financial institutions in

India, and caters to financing and non-

financing needs of MSMEs

• MRIP caters to MSE needs relating to

financial & non-financial services such

as market linkages, technology etc.

• The Report of the

PMs Task Force on

MSMEs (2010)

recommended the

institution of

measures to

enhance resource

support to SIDBI and

to make available

cheaper resources

for on-lending at low

interest rates to the

sector

• There is also scope

for SIDBI to

encourage private

players to set up

Venture Capital

Funds catering to the

sector

5

Source: Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); business.gov.in; SIDBI; www.msmefdp.net; Business Standard


1. State Financial Corporations

• A key objective of SFCs is to

contribute to regional development

in their areas of operation

• SFCs and twin-function State

Industrial Development

Corporations (SIDCs) are the key

sources of long term finance for

the MSME sector at a state level

2. Urban Co-operative Banks (UCBs)

• Refers to primary cooperative

banks located in urban and semi-

urban areas

• In urban areas, UCBs largely

finance varied types of people for

self-employment, industries, small

scale units, home finance etc.

• UCBs undergo duality of control,

with banking related functions

regulated by RBI and registration,

management, liquidation etc.

governed by State Governments

3. District Industries Centre (DICs):

• Key function is to develop and

promote „Cottage and Small Scale

Industries‟ in the district (SSI

defined as Industries with

investment up to Rs.1 Crore in

Plant & Machinery)

• Envisioned as key agencies for

promotion of MSME sector

While smaller banking institutions such as SFCs and UCBs have

played a pivotal role in financing MSMEs, they face viability issues

24

DEBT POLICY

ENABLERS

Other Enabling

institutions:

SFCs, UCBs and

DICs

Overview of intervention Impact / Benefit Scope for improvement

• SFCs have assisted in the

development of MSMEs as majority

of their efforts at financing and

promotion in their respective states

are directed towards this sector,

with the objective of attaining

balanced regional growth,

generating employment, stimulating

investment etc.

• In addition, SFCs supported many

FGEs at a time when venture capital

and angel funds were not prevalent,

and have undertaken special

schemes of seed capital assistance

for women entrepreneurs.

• Similar to SFCs, UCBs have played

a pivotal role in development of the

MSME sector through timely

financial assistance, and act as an

important financial intermediary

providing financial services to the

unorganized sector

• The Report of the PMs Task Force

on MSMEs (2010) envisaged the

role of DICs to be that of a facilitator

providing Business Development

Services to prospective and existing

entrepreneurs by undertaking

activities such as information

dissemination, financing linkages,

marketing support, facilitating skill

development etc.

• Need to strengthen SFCs‟ role as regional

development banks, due to large scale

sickness observed on account of:

o Losses due to rising NPAs, low return on

investment in MSME sector, and long

gestation period of loans to MSME

o Need for greater transparency

o Dependence on state government rules

and political environment of state

o Inability to keep pace with market

competitiveness

• The Report of Working Group on

Rehabilitation of Sick SMEs recommended

that State Governments be directed to make

available a one time financial support for

recapitalization of viable SFCs, and arrange

for the winding up of unviable SFCs ,

including settlements with creditors/ lenders

• Many UCBs have displayed signs of

weakness on account of low profitability,

growing NPAs, limited operational and

managerial efficiency and inadequate

corporate governance. Thus, there is a

need to consolidate and strengthen the

UCB segment, and introduce greater

transparency and accountability

• Need to re-engineer and strengthen DICs

by providing funds for upgrading existing

infrastructure and capacity building of

existing human resources to contribute

more actively in advocacy and capacity

building for entrepreneurs

6

Source: Report of Working Group on Rehabilitation of Sick SMEs; business.gov.in; dcmsme.gov.in; Rediff; iem.edu.in; www.mucbf.org; www.dicgc.org.in; Report of Prime Minister's Task Force on MSME (January 2010)


Measures to improve the recovery of debt include enabling regulations like

the SARFAESI Act and formation of Asset Reconstruction Companies

25

DEBT POLICY

ENABLERS

Facilitating Asset

recovery and

reconstruction:

SARFAESI Act

(2002)

Overview of Intervention Impact / Benefit Scope for improvement

• Prior to the Act, an underdeveloped

legal framework led to slow recovery of

defaulting loans and rising NPA levels

of banks and financial institutions. The

Act facilitates an organized mechanism

for managing mounting NPA stocks

• As intended in the Act, it has:

o Enabled banks/ FIs to realize long-

term assets, manage liquidity

problems and asset-liability gaps

o Improve recovery by taking

possession of securities, selling

them and reducing NPAs by

adopting recovery or reconstruction

measures

• The Securitization and Reconstruction

of Financial Assets and Enforcement of

Security Interest Act, 2002 enables

Banks / Financial Institutions to recover

their non-performing assets (NPAs)

without the intervention of the Court

• Permits Banks/ financial institutions to

seize and auction collateral assets

when borrowers fail to repay loans

• Empowers banks/ financial institutions

to reduce NPAs by undertaking

measures for recovery or

reconstruction

• Provides a framework for debt

recovery and creditor right protection

• The benefits of the SARFAESI Act are

applicable to a limited type of lenders,

with small institutions like NBFCs

currently excluded from the coverage of

this Act

• The „Report of the Working Group on

the Issues and Concerns in the NBFC

Sector‟ (Aug 29, 2011) recommended

the inclusion of NBFCs under the

coverage of the Act to enable quicker

recovery of their NPAs

• Empowering NBFCs to utilize the

provisions of the Act to enforce their

security interests would encourage

NBFCs to better serve the sector

Managing NPAs:

Asset

Reconstruction

Companies

(ARC)

• Accumulation of substantial NPAs in

the banking sector due to low levels of

credit recovery, lengthy legal recourse

etc. results in blocking of funds in

NPAs and diversion of management

and financial resources from core

business to NPA resolution efforts

• ARCs, vested with special powers and

relevant professional expertise in

recovery, reduce the significant time,

effort and costs involved for banks/ FIs

in NPA resolution, and result in cleaner

balance sheets for banks/ FIs

• ISARC aims at tackling the high levels

of NPAs in Banks/ FIs through its focus

on the MSME sector, deemed as „risky‟

• Asset reconstruction refers to purchase

of any right or interest of any bank/

financial institution in any financial

asset for the purpose of realization

• Under the SARFEASI Act (2002),

establishment of ARCs was identified

as a focus area for NPA resolution

• ARCs aim at speedier resolution to

unlock idle NPA assets for productive

purposes and enable improved credit

flow from the banking sector to MSMEs

• SIDBI and many public sector banks

have launched the India SME Asset

Reconstruction Company Limited

(ISARC) to deal with NPAs related to

the MSME sector.

• ARCs are at a nascent stage in India,

and faced with a limited investor base

and low inclination amongst investors

for securitized investment instruments

• Need for flexibility in ARC controlling

structure, to foster private participation

• Scope for simplification and reduction of

registration fee and stamp duty to

lessen transaction costs involved

• Formulation of laws to speed up the

lengthy recovery process

• Need for periodic monitoring of ARC

operations for greater transparency

• Possibility that ISARC may face issues

similar to mainstream ARCs, especially

with regard to transaction costs

8

7

Source: SARFESI Act, 2002; Report of the Working Group on the Issues and Concerns in the NBFC Sector (RBI); Business Standard ; Hindu Business Line; www.dnb.co.in; http://wirc-icai.org; www.lawguru.com; SIDBI; india-financing.com


Innovative forms of risk underwriting have been introduced through credit

guarantee schemes and warehouse receipt financing

26

DEBT POLICY

ENABLERS

Collateral free

loans to MSEs:

Credit Guarantee

Scheme


• Facilitation of credit flow to MSE sector

by enabling the availability of bank

credit to enterprises in this sector

without the hassles of collateral or third

party guarantees

• Enables lenders to secure credit

provided purely on the primary security

of assets financed (through credit

guarantee cover provided under this

scheme)

• Aims to encourage composite credit to

borrowers so both term loan and

working capital can be obtained from

the same source

• The scheme, operational from January,

2000 was implemented by establishing

Credit Guarantee Fund Trust for Micro

and Small Enterprises (CGTMSE) by

Ministry of MSME and SIDBI

• Credit facilities include term loans and

working capital which are covered

under the scheme up to Rs. 100 lakh

per borrowing unit, extended without

any collateral security/ third party

guarantee to a new/ existing micro and

small enterprise

• The guarantee cover available is to

the extent of 75/ 80/ 85% of the

sanctioned amount depending upon

the quantum of underlying credit

• Scope to include NBFCs as eligible

Member Lending institutions to make

their portfolio more secure

Limited uptake of scheme due to:

• Low awareness among potential

beneficiaries and branch level functions

of banks

• Limited utilization by banks due to

partial credit guarantee cover,

procedural hassle of initiating legal

proceedings and lock-in period of 18

months prior to lodging claims etc.

• Protracted claim settlements

• Need to record NPAs prior to claims

contributes to banks displaying lesser

leniency during credit assessment

.

Building credit

infrastructure

(for agriculture):

Warehouse

Receipt financing

• The pledging of agricultural produce

with a legal backing (through

negotiable warehouse receipts)

provides a new, reliable form of

collateral for the agricultural sector

which was largely dependent on land

• Provides assistance to farmers in

obtaining better credit facilities by

enhancing the bargaining power of

farmers, and helps in avoiding distress

sales

• Reduces risks involved in extending

credit to farmers and could potentially

contribute to improved warehouse

standards, supply chains etc.

• The Warehousing (Development and

Regulation) Act, 2007, came into

force from Oct 25, 2010.

• In addition to mandating the

negotiability of warehouse receipts, it

directs the procedure for registration of

warehouses and issue of negotiable

warehouse receipts

• The Act also prescribes the setting up

of a Warehousing Development and

Regulatory Authority (a regulatory

body) to register and accredit

warehouses, and establish a system of

quality certification and grading of

commodities

• Still a nascent concept in India amongst

banks and NBFCs. SBI, HDFC, UTI etc.

are some of the banks pioneering this

effort.

• Need for promotion of awareness and

capacity building amongst end-users to

increase uptake.

• Lack of suitable processes has led to

instances of fraud receipts, low quality

of storage etc.

• Currently, paper receipts are issued by

accredited warehouses. Need for

transition to electronic warehouse

receipts for improved transparency.

10

9

Source: www.cgtmse.com; RBI Master Circular: Lending to MSME Sector; SME World; Report of Working Group to review the Credit Guarantee Scheme of the CGTMSE ; A 100 Small Steps: Draft Report of the High Level Committee on Financial Sector Reforms (2008)


• The role of a Credit Information Company (CIC) is to

provide accurate information to lenders to enable

effective credit decisions, risk assessment, reduce

adverse selection of customers and to enable a person

to obtain his/ her own credit information

• The CIC Act (2005) is a legislation passed to regulate

the actions of CICs and to facilitate the efficient

distribution of credit and for related matters

• Effective December 14, 2006, with Rules & Regulations

issued under the Act coming into force on this day

• Provisions of the Act include the following:

o Rules provide that appropriate policies and

procedures should be framed by the credit institution

and CIC with respect to data collection, processing

and collation, security and protection of data and

credit information, and suitable measures for

maintaining accurate, complete and updated data.

o Regulations provide for principles and procedures

relating to personal credit information with regard to

method and purpose of collection of personal data,

solicitation of personal data, accountability in data

transfer to third party, protection of personal data etc.

o The privacy principles indicated in the regulations

include accuracy, security, secrecy, adequacy of data

collected and limitations on the use of data

• In addition, the Act mandates that every credit institution

has to become a member of at least one CIC within a

period of 3 months from commencement of the Act or

any extension permitted by RBI

• CICs in India include Credit bureaus such as Credit

Information Bureau (India) Limited, Experian, Equifax

etc.

The passing of the Credit Information Companies Act facilitated the

setting up and regulation of credit bureaus in the country

27

DEBT POLICY

ENABLERS

Credit

Information

Companies

(Regulation) Act

(2005)

Policy Overview Impact / Benefit Scope for

improvement

• The benefits of CICs include:

o Enabling lenders to take informed

decisions leading to efficient risk

assessment and credit allocation

o Empowering lenders to make fair,

consistent and profitable lending

decisions in a quick manner

o Protecting lenders against fraud

o Assisting in faster and improved

access to credit for borrowers

o Protecting customers against over

indebtedness by providing credit

exposure information

• Laws comprise elaborate provisions

governing who can become members

of a CIC (Credit Institutions, CIC,

Specified users such as Insurance

companies, Cellular/phone company,

Rating agency etc.), regulating the

collection and provision of information,

permissible uses of credit information

etc. thereby facilitating the functioning

of CICs in India

• The CIC laws also offer credibility to

the sensitivity of credit information , as

they encompass numerous provisions

with relating to accuracy, completeness

and protection of credit information,

privacy guidelines for CICs and

members, and provisions relating to

security of and access to credit

information

• Dispute resolution in

case of complaints

regarding information

privacy, data

protection etc. are

covered to a limited

extent. There is a

need for complete

provisions regarding

complaints and

remedies, and

resolution of credit

reporting disputes.

• In cases of a dispute

for which no remedy

has been provided

under the Act, it shall

be settled by

arbitration. As the

course of arbitration

legislation is fairly

cumbersome, there is

scope for another

remedial approach.

• While the Act currently

covers the tracking of

only credit information,

the inclusion of

additional information

would greatly assist

credit assessment in

the sector.

11

Source: Credit Information Companies (Regulation) Act, 2005 (Summary of Draft Rules & Regulations released by RBI for feedback on April 5, 2006); eport.equifax.co.in; www.experian.in; idpl.oxfordjournals.org


Formation of the supporting information infrastructure has been initiated

through establishment of Credit bureaus and Collateral registries

28

DEBT POLICY

ENABLERS

Enabling flow of

credit

information:

CIBIL

Overview of Intervention Impact / Benefit Scope for improvement

• Composite credit bureau with a

centralized database of credit

information on both commercial and

consumer borrowers

• Provides comprehensive credit

information to lenders by collating and

disseminating the same on demand, in

the form of credit information reports

• Credit reporting leads to greater

transparency, thereby reducing

problems of adverse selection and

moral hazard, and more ease in

making funding decisions

• Aims to limit NPAs and improve

lender‟s portfolio quality by assisting

lenders in the loan appraisal process

Credit Information Bureau (India)

Limited (CIBIL):

• India‟s first credit information bureau,

containing credit history of commercial

and consumer borrowers, available to a

closed user group of members

• Members include Banks, FIs, NBFCs,

SFCs, Housing Finance Companies etc.

with data sharing based on the principle

of reciprocity

• The consumer bureau covers credit

availed by individuals while the

commercial bureau tracks enterprises

• Current database size of 170 million

consumer and 6.5 million company

records provided by 500+ members

• Credit bureaus in India are still fairly

nascent with limited MSME data

• As many MSMEs may not have historic

credit information, information obtained

regarding non-financial parameters

such as discipline with utility bill

payments, cash flow assessment etc.

would be useful alternative modes of

credit appraisal for banks, as they

could be tracked to evaluate credit

worthiness of enterprises

• Scope for setting up of a CIBIL like

credit and non-credit information

platform focused on the MSME sector,

which utilizes non-traditional models to

analyze credit behavior

Information

Infrastructure

support: Central

Collateral

Registry

• Insufficient information relating to

collateral (ownership, pledge history

etc.) increases time and cost of

assessment for Banks/ FIs and issues

in case of default regarding liquidation

• Dealings relating to securitisation and

reconstruction of financial assets and

mortgage by deposit of title deeds to

secure loan/ advances by banks/ FIs,

are to be logged in the Central Registry • Availability of records with a Central

Registry will contribute to prevention of frauds involving multiple lending against security of the same property, and fraudulent sale of property without disclosing security interest

Central Registry of Securitization Asset

Reconstruction and Security Interest of

India (CERSAI):

• Set up under the SARFAESI Act, 2002,

CERSAI is a government company

licensed under Companies Act,1956

• Set up by RBI and National Housing

Board, operational March 31st, 2011

• To avoid fraudulent loans, transactions

using property as collateral to obtain

loans from Banks/ FIs are to be

recorded with a Central Registry

maintained and operated by CERSAI • Records maintained by the Registry are

available to lenders/ other persons keen to deal with the relevant property

• The Central Registry records

transactions related to immovable

collateral only. Registration of movable

collateral such as inventory is

fragmented, with need for a

comprehensive legal framework

• Due to lack of adequate provisions

regulating movable collateral, a large

number of banks/ FIs do not accept

movable collateral for credit lending

• Scope for establishment of a collateral

registry maintaining pledge information

of both movable and immovable

assets, thereby providing a

consolidated information infrastructure

13

12

Source: Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); www.cibil.com; www.igovernment.in; cersai.org.in; Economic Times; foundation.moneylife.in


1. SME Rating Agency of India Ltd. (SMERA):

o First MSME focused third-party rating agency in India

o Aims to provide comprehensive, transparent and reliable

ratings and risk profiling

o Established in 2005 by SIDBI, CIBIL, Dun & Bradstreet ,

and numerous leading banks in India

o SMERA has pioneered a rating model tailored to the

MSME sector which considers the applicants‟ financial as

well as non-financial factors, nature of industry and

business environment

o CRISIL & ICRA are examples of mainstream credit rating

agencies (CRA) that undertake SME ratings

2. NSIC „Performance and Credit Rating Scheme for Small

Scale Industries‟ (SSI):

o Developed by NSIC along with stakeholders such as

Indian Banks‟ Association, rating agencies such as

CRISIL, ICRA, Dun & Bradstreet etc.

o Aims to encourage SSI units to obtain credit ratings from

reputed credit rating agencies

o Implementation undertaken through empanelled agencies

such as CRISIL, ICRA, SMERA etc.

o The unit‟s rating is arrived at based on a combination of

performance and credit worthiness of the unit

o Partial reimbursement of rating fee through NSIC with a

turnover based fee structure

3. In addition, the Policy Package for Stepping up credit to

SMEs advised banks to: o Follow a transparent rating system, linking cost of credit to

credit rating of the enterprise o Utilize models like Credit Appraisal & Rating Tool

(CART) and Risk Assessment Model (RAM) developed by SIDBI for risk assessment and rating of SME proposals

Setting up of an MSME focused credit rating agency and subsidy

schemes aim to encourage firms to get themselves rated

29

DEBT POLICY

ENABLERS

Risk

Management:

Credit Rating

for MSMEs

Overview of Intervention Impact / Benefit Scope for

improvement

• The benefits of Credit Rating include

the following:

o Enabling banks/ FIs to manage

credit risk by providing an

objective, reliable third party

opinion on capabilities and credit-

worthiness of enterprises

o Contributes to reduction of

information asymmetry, helping

banks to lessen paperwork and

turnaround time, thereby leading to

reduced transaction costs

o Facilitating quicker and cheaper

access to credit for enterprises by

enhancing credibility and

acceptability in the market

o Favorable borrowing terms such

as lower collateral requirements,

reduced interest rates, simplified

lending norms etc.

o Enabling enterprises to determine

their strengths and weaknesses

and take remedial measures to

enhance capability

• Schemes such as NSIC‟s

Performance and Credit Rating

Scheme incentivize enterprises to get

credit themselves rated through a

subsidized fee structure, with eligible

SSI units enjoying rating fee subsidy

up to 75%

• Recommendations of the

Report of the Committee on

Comprehensive Regulation of

Credit Rating Agencies (2009)

include:

o Need to avoid conflict of

interest and maintain CRA

independence through

enhanced disclosure of

revenues from issuer/

borrower, and non-rating

services like advisory

o Scope for a lead regulator

model to overcome

multiplicity of regulators

(E.g. SEBI, RBI, IRDA)

governing the rating of

varied products

o Mandate of process and

compliance audits

o Need for voluntary CRA

compliance with the IOSCO

code of conduct (Relates to

quality, integrity of rating

etc.)

• In addition, SME credit rating

is impacted by limited SME

data, and difficulty in

assessing historical

performance of nascent/

smaller units

14

Source: Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); www.smera.in; Union Minister's Policy Package for stepping up credit to SMEs (2005); www.nsic.co.in; NSIC Performance & Credit Rating scheme for Small Industries; rbi.org.in;

Report of the Committee on Comprehensive Regulation of Credit Rating Agencies appointed by GoI; Study by the National Institute for Securities Markets entitled An assessment of the long term performance of the Credit Rating Agencies in India; www.msmestartupkit.com


• Branchless Banking refers to the

outsourcing of transaction processing

by banks to third-party agents, in order

to reduce costs of servicing clients and

enable greater accessibility for clients

• In January 2006, RBI issued new

guidelines permitting the use of 2

categories of intermediaries by banks -

„Business Correspondents‟ and

„Business Facilitators‟, creating a

new model of „Branchless banking‟

• The circular enabled banks to use the

services of NGOs/ SHGs/ MFIs etc. as

intermediaries in providing financial

and banking services, to increase

outreach of banking sector

• Under the BF model, intermediaries

may be used for providing facilitation

services including identification and

fitment of borrowers, processing of

loan applications, awareness building,

post sanction monitoring etc., but

cannot transact on behalf of the bank

• BCs in addition to activities

undertaken by BFs, are permitted to

carry out small value transactions on

behalf of the bank as agents

• RBI has oversight and regulatory

responsibility over these channels

• Examples of a Bank/ BC relationship:

SBI/ FINO Fintech

While the Business Correspondent guidelines were instituted to enable

reduction of transaction costs, they have faced limited success

30

DEBT POLICY

ENABLERS

Branchless

Banking:

Business

Correspondents

& Business

Facilitators


• Significant costs in processing

MSME loan applications and service

delivery lead to high transaction

costs. Branchless banking initiatives

contribute to reducing transaction

costs and information asymmetry of

MSME lending, and improved

access to finance for the sector

• It also increases convenience for

the clients, thereby facilitating

increased client coverage and

financial inclusion

• BCs complement the branch

network of banks as they facilitate

extension of financial services to

unreached clients beyond the

bank‟s branch network

• BCs are a better alternative when

compared to setting up bank

branches as they enabler outreach

faster and at a lower cost

• As these banking channels involve

significant reputational, operational

and legal risks, technology based

solutions are being adopted to

manage the risk, such as POS

devices, Mobile phones etc.

• Doorstep banking and loan

facilitation by local channels leads to

better accessibility and enhanced

quality of assets through greater

client familiarity and reduced risk

• Mixed responses to BC guidelines, with

scope for greater flexibility to enable viability

of the model. Issues faced by banks are:

o Operational issues such as irregular

accounting of transactions by BCs, risk

of fraud, high cost cash handling

operations due to largely cash

transactions, challenges in technology

integration with BCs etc.

o Viability issues such as large number of

inactive accounts, losses in BC

operations as compensation structure

doesn‟t cover costs etc.

o Regulatory issues such as interest

capping which results in banks not being

able to recover higher delivery costs,

limiting distance requirement of 15kms

from partner bank branch, cash

settlement within prescribed 24 hour

timeline, low value transactions etc.

• Need to lay emphasis on financial viability

of the BC model, in addition to focusing on

number of accounts opened and

achievement of financial inclusion targets

• Capacity building of BCs through trainings

on products, systems, technologies etc.

• With respect to regulations, settlement

timelines should be more relaxed given

inaccessibility of areas of operation, and the

thrust of location criteria should be on ability

of bank to effectively supervise BC

operations, rather than physical distance.

15

Source: RBI Circular on „Financial Inclusion by Extension of Banking Services - Use of Business Facilitators and Correspondents‟ (January 25, 2006); www.microfinanceindia.org


• A Cluster refers to a sectoral and geographical

concentration of MSE units, which produce and sell a

range of related products and are, therefore faced with

common opportunities and challenges.

• MSE units operating in such clusters enjoy competitive

advantage from closeness to raw material sources and

other inputs, presence of sufficiently tailored business

development services, abundance of clients and

availability of a skilled workforce

• In addition, the similarity of needs and requirements,

speeds up best practice dissemination and distribution of

fixed costs, leading to economies of scale. Cluster

development programs involve adopting a coordinated

and combined action to address the needs of such

clusters in terms of infrastructure, technological and

marketing support

• The government has identified Cluster development as

a key strategy for promotion of the sector, and has

encouraged banks to adopt a cluster based approach

for financing the SME sector due to benefits such as

lower transaction costs and risk mitigation

• The Ministry of MSME has launched the „Micro and

Small Enterprise Cluster Development Programme

(MSE-CDP), implemented by the DC (MSME) for overall

development of selected MSE clusters through

management of the value chain on a co-operative basis

• Includes measures for collective capacity building of

cluster units, skill development, credit facilitation,

marketing support, technology up gradation, quality up

gradation and certification, improvement of infrastructural

facilities, establishment of common facility centers (for

testing, training etc.)

Programs for financing and capacity building of MSMEs have been

aggregated through Cluster Development Programs

31

DEBT POLICY

ENABLERS

Leveraging

Economies of

Scale: Cluster

Development

Programs

Overview of Intervention Impact / Benefit Scope for

improvement

• Benefits of a cluster based approach

for SME development include:

o Opportunities for information and

knowledge networks, co-operation

and collective learning

o Emergence of specialized

infrastructure and services based

on cluster specific needs/ skillsets

o Optimal scale of operations and

improved efficiency can be

achieved through specialization

o Economies of scale, leading to

reduced transaction costs

o Improved access to credit

o Enhanced bargaining power of

enterprises through capacity

building of MSEs for joint action via

SHGs, consortiums etc.

o Technology, Skill and Infrastructure

up gradation

• To step up credit to the MSE sector,

the PMs Task Force on MSMEs,

recommended that banks should open

more MSE focused branches at

identified MSE clusters to enable easy

access to bank credit .

• The benefits of a cluster based

approach to lending include availability

of greater information for risk

assessment, ability to deal with definite

and familiar groups, enhanced

monitoring etc.

• Limited clarity in

cluster definition has

led to identification of

a large number of

clusters beyond the

current capabilities of

of institutions

involved in cluster

development

programmes

• Thus, there is a

needs for clearer

definition of clusters

in the guidelines of

the cluster

development

programme, to

enable a more

focused and viable

set of clusters for

improved

effectiveness of

interventions under

the programme

16

Source: www.dcmsme.gov.in; www.centralbankofindia.co.rbi.org.in; finmin.nic.in; planningcommission.nic.in; www.dnb.co.in; www.smeworld.org; www.nabard.org


Archaic bankruptcy laws and limited enforcement of creditor rights

impact sick enterprises and associated creditors

32

DEBT POLICY

CONSTRAINTS

Sick enterprises:

Need for avenues

to support

Enterprises and

Creditors

Challenge Faced Constraining Policy Scope for Improvement

As per the Report of PMs Task Force on

MSMEs (Sub-Group on Exit Policy):

• Insolvency of corporate entities like

companies/ LLPs are ruled by the

Companies Act, 1956, Sick Industrial

Companies (Special Powers) Act,1985

(SICA), SARFAESI Act 2002, Limited

Liability Partnerships Act 2008 etc. with

avenues for revival, rehabilitation of

units or restructuring of financial assets

• However, insolvency in proprietorship/

partnership firms is governed by the

Provincial Insolvency Act 1920, which

has largely stayed the same, focusing

on recovery of unsettled dues through

the courts rather than rehabilitation or

organized exit in the event of failure

o No stay against proceedings

initiated such as for recovery of

statutory dues, during the interim

period when the insolvency petition

is awaiting disposal

o Entrepreneur is faced with

significant social stigma while

attempting to revive the unit, and

could be prosecuted and penalized

under various regulations.

o The entrepreneur‟s ability to raise

finance again/ seek employment is

inhibited as he/ she continues to be

declared insolvent, if unable to

settle the debt.

• Some of the key reasons for sickness

in the MSME sector include lack of

demand, shortage of working capital,

raw materials, labor problems etc.

• The MSME sector is faced with limited

options upon insolvency with respect

to rehabilitation, and /or smooth exit,

and creditors rights. Challenges include:

o Unlimited liability of the entrepreneur

upon default, as majority of

enterprises are either proprietorships

or partnerships, with no separation of

business and personal liability

o Absence of provisions for a

„standstill‟ period for temporary

protection from statutory dues or

other creditor action, to enable a

distressed unit to focus on its revival

o Social stigma upon insolvency and

exit due to restricted options for

clearing dues with non-financial

creditors such as suppliers, labor etc.

o Low enforcement of creditors rights,

with legal challenges affecting

financial institutions with respect to

collateral claims and liquidation,

increasing the service cost and risk

perception of MSME financing

o Lack of an efficient and transparent

liquidation process to repay creditors,

inhibiting entrepreneurship and re-

entry into the marketplace

• Need for development of an MSME

sector specific law/regulation to

manage insolvency, assist enterprises

in coping with sickness through

rehabilitation or graceful exit, and

improve the safeguard of creditor rights


Rehabilitation of Sick SMEs noted:

o Need for an institutional mechanism

for timely identification and remedial

action for rehabilitation of viable

units by business restructuring etc.

o Need for a sound, transparent and

equitable exit policy focusing on

efficient liquidation of nonviable

units, fair treatment of creditor rights

• Recommendations in the Report of the

PMs Task Force on MSMEs include:

o Setting up of a rehabilitation fund

under the Ministry of MSME to

provide bridge finance towards

promoters‟ contribution to the same

o Standstill period for statutory dues

o Formulation of a revised insolvency

code for proprietorships/

partnerships with provisions for a

quasi-judicial body to assess

viability and develop time bound

revival/ closure plans, a holding

period for revival, segregation of

business assets from personal, and

speedy winding up of unviable units

17

Source: Report of Working Group on Rehabilitation of Sick SMEs ; Report of Prime Minister's Task Force on MSME ; „Scaling-Up SME Access to Financial Services in the Developing World‟ (G20 Stock taking report on MSME) – IFC


Scope for comprehensive regulations with respect to alternative

sources of finance like factoring/ securitization of trade receivables

33

DEBT POLICY

CONSTRAINTS

Limited legal

& regulatory

framework

for factoring/

securitization

of

receivables


• Limited legal and regulatory framework to

protect/ encourage institutions providing

factoring/ securitization limit these services

• Challenges faced include:

o Lack of suitable legislation

o Need for greater clarity on accounting and

taxation treatment unclear

o Unviability of transactions due to high

incidence of stamp duties payable, which

lack uniformity across States

o Lack of awareness and understanding

• The Report of the In-house Working Group

on Asset Securitization (1999) noted the

need for:

o Defining securitization in „Transfer of

Property Act‟ for a uniform approach

o Standard rate of 0.1% for stamp duty on

all securitization transactions

o Inclusion of securitized instruments in

„Securities Contract Regulation Act‟

o Scope for an „umbrella legislation‟

covering all aspects of securitization


Rehabilitation of Sick SMEs (2008)

suggested that banks be encouraged to

introduce factoring services, especially for

MSMEs by: o Introducing legislation for factoring o Exemption of stamp duties/ prescription of

ceiling on the same o Refinance at concessional rates from

SIDBI/ RBI

• Working capital demand in MSMEs tends to

be high due to high receivable days, long

production cycles etc. Units face severe

shortage of working capital

• The gap between allocated and actual

working capital could be addressed by

factoring, reverse factoring and

securitization of trade receivables

• Factoring refers to a receivables

management and financing service where a

business sells its accounts receivables to a

third party (Factor), at a discount, involving

transfer of ownership and rights related to

the receivables to the factor. In non-

recourse factoring, the factor assumes

credit risk.

• Reverse factoring refers to the discounting

of supplier bills in respect of regular client

purchases

• Securitization refers to a process where

non-tradable or illiquid financial assets are

transformed into liquid marketable securities

• Advantages include immediate liquidity by

conversion of accounts receivable to cash,

thereby improving cash flow and covering

risk on credit sales

• The services of commercial banks in the

MSME sector could be augmented by

factoring and securitization of receivables,

reducing the working capital strain on

enterprises

• Need to review existing legal and

regulatory framework on factoring/

securitization and evaluate inclusion of

special provisions for MSMEs

• The Report of the PMs Task Force on

MSMEs (2010) recommended

development of workable legal structures

and provisions for securitization of trade

credit receivables and promotion of

factoring. It also noted that RBI has

formed a Working Group on

Securitization of Trade Credit

Receivables to study alternatives for

liquidating receivables before maturity

• The Regulation of Factor (Assignment of

Receivables) Bill, 2011 was approved by

Parliament on 27th December, 2011.

o Aims to regulate the business of

factoring through a mechanism for

assignment of receivables to a factor

and payment by the factor to the

industrial unit

o Aims to protect factors by providing

legal recourse to recover assigned

debt and receivables from buyers While the Bill is a significant step to address liquidity problems of MSMEs, it is a recent development, therefore ramifications and enforcement of the Bill are yet to be assessed

18

Source: Report of Prime Minister's Task Force on MSME, 2010; A 100 Small Steps, Dr. Raghuram Rajan; Report of Working Group on Rehabilitation of Sick SMEs, 2008; Report of the In-house Working Group on Asset Securitization, 1999; Express India; PRS India; Hindu Business

Line; www.isb.edu; Access to financing for SMEs - Sankar De Executive Director, Centre for Analytical Finance, ISB; ww.rbi.org.in; www.vinodkothari.com; Nishith Desai Associates - SECURITISATION IN INDIA (Daksha Baxi & Vikram Shroff); tradeindia.com


Exclusion of NBFCs (except MFI NBFCs) from PSL guidelines impacts debt

funding to NBFCs with majority of portfolio in MSE lending

34

DEBT POLICY

CONSTRAINTS

Regulations

constraining on-

lending to NBFCs

(other than MFIs

categorized as

NBFCs) affects

their access to

debt finance


• As per RBI‟s circular dated May 3,

2011, titled „Bank loans to Micro

Finance Institutions (MFIs) – Priority

Sector status’, loans sanctioned for on-

lending with effect from April 1, 2011to

NBFCs (other than MFIs which adhere

to the specified RBI criteria), are not

included under priority sector lending

• The exclusion of loans given to NBFCs

from the priority sector aims to prevent

instances of arbitrage due to conditions

associated with bank loans to MFIs,

which impacts on-lending to MFIs

• Subsequent to RBI‟s directive to

commercial banks to discontinue

priority sector lending through NBFCs

(excluding MFIs categorized as

NBFCs), sources of debt funds to

these institutions has been affected

• Likely to have an unfavorable impact

on credit flow to MSMEs, as NBFCs

due to their organizational flexibility

and outreach were able to serve rural,

semi-urban areas etc. and high risk

enterprises through unsecured

products, segments which commercial

banks may have limited exposure to

• In addition, commercial banks prefer to

provide debt financing to established

NBFCs, on account of the unsecured

nature of their portfolio

• Limited outreach of commercial

banks impacts availability of finance to

the MSME sector, as a number of

enterprises are located in semi-urban

and rural areas. Public sector banks on

account of an extensive branch footprint

are better able to serve the sector, when

compared to private sector banks and

foreign banks who have a smaller

branch network

• As the branch footprint of NBFCs is

far wider than that of commercial banks,

especially private sector and foreign

banks, and in light of the significant role

of relationship/ branch banking in the

Indian context, a large number of private

sector and foreign banks utilize NBFC

intermediaries to deploy small and micro

loans and gain last-mile reach

• In addition, NBFCs provide customized

products by leveraging local intelligence,

involving reduced turn around times,

lesser collateral requirements, tailored

service etc.

• However, RBI has mandated that bank

loans to NBFCs, excluding Microfinance

Institutions categorized as NBFCs,

would not be classified as priority sector

loans. This has adversely impacted the

flow of funds from banks to NBFCs

which focus on the Micro and Small

enterprise segment

• Need to review the inclusion of NBFCs

who have a majority micro and small

portfolio (non-MFIs) under Priority

Sector Lending. To prevent the risk of

fund misuse, inclusion in priority sector

lending could be restricted to a distinct

class of NBFCs with Micro and Small

enterprise (MSE) accounting for

majority of their portfolio

• In addition, the unsecured nature of the

portfolio of these NBFCs limits the

availability of debt financing to them.

Hence, there is scope for formulation

of a credit guarantee fund which can

possibly facilitate small NBFCs with a

focus on MSE sector to obtain debt

finance from commercial banks by

reducing the risk perception associated

with them through a guaranteed

portfolio

19

Source: RBI's Priority Sector Lending Guidelines: (Circulars on): Master Circular - Lending to Priority Sector; Bank loans to Micro Finance Institutions (MFIs) – Priority Sector status ; Economic Times; Rediff





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


Best

Practice Example Features Benefits

Scope for India

Adoption

Provision of

multi-level

partial

guarantees

to increase

on-lending

to MSMEs

Italy

CONFIDI

(Credit

Guarantee

Consortium

)

• CONFIDIs serve as intermediaries

between member MSMEs and banks/

Financial institutions

• Mutual Guarantee Consortia (MGC)

formed at a national level by aggregation of

numerous CONFIDIs

• CONFIDIs extend partial guarantees for

loans to their member enterprises, which is

counter-guaranteed by MGCs to enable

on-lending to MSMEs

• Lessens risk perception about MSME, thereby

facilitating financing

• Lower collateral requirement benefits MSMEs

with respect to easier and quicker access to

credit from the banking system

• Decentralized approach improves the outreach of

the guarantee program

Establishment of a guarantee

fund through aggregation of

multiple local / regional

Mutual Guarantee Societies

(MGS) at a central / state

level

Provision of

credible

credit

information

and ratings

on SMEs

Credit

Bureau

Malaysia

• Initiative of the Credit Guarantee

Corporation Malaysia Berhad (CGC) to

improve SMEs access to financing

• Provides lenders with a useful one stop

centre to obtain credit information and

ratings for credit assessment

• Leading supplier of comprehensive and

reliable credit information and ratings on

SMEs in Malaysia

• Bridges the information gap through access to

timely and credible information on SMEs

• Enables enterprises to develop a track record and

credit standing for quicker processing of credit

applications, and facilitates good payment

behavior

• Ratings calculated by the Bureau are dynamic

and updated every time new credit information is

available

Scope for incorporation of

Ratings into services offered

by credit bureaus, as linking

ratings to credit information

ensures availability of

updated ratings

Encouraging

financing

against

Movable

Assets as

Collateral

Collateral

Registry of

China and

Property

Law

• China undertook a reform of its movable

collateral framework since 2004, with

development of the Property law in 2007,

creation of an electronic receivables

registry for pledged assets and training of

lenders to utilize movable collateral for

lending

• The registry enables SMEs to use movable

assets such as inventory and receivables

as a basis for borrowing

• The Property law improved the legal framework

for asset-based finance in China, as it expanded

the scope of movable collateral, enabled ease of

creation of security interest, established clear

priority schemes for creditors etc.

• The Registry reduces risk of lenders by making

pledges in movable collateral transparent, and

encourages financing against movable assets

such as inventory and receivables

Development of an enabling

collateral regime comprising:

• Laws permitting a wide

range of permissible

collateral (especially

movable collateral)

• Modernized registries also

tracking movable collateral

• Effective enforcement of

collateral upon default etc.

Evolved legislations and interventions in various countries could

serve as a guide for Indian practices (1/2) DEBT BEST

PRACTICES

Source: The Global Best Banking Practices in MSME Financing and Development (SIDBI); Scaling-Up SME Access to Financial Services in the Developing World (IFC)(G20 Stock-taking report); Italy CONFIDI; Credit Bureau Malaysia; Collateral Registry China;


Best Practice Example Features Benefits Scope for India

Adoption

Comprehensive

laws for revival

of troubled

units, and/ or

liquidation

proceedings

U.S.

Bankruptcy

laws

• Repay of debts by liquidating assets or by

creating a repayment plan.

• Enterprises seeking protection under the

US Bankruptcy Code may file a petition for

relief under:

o Chapter 7: Governs the course of a

liquidation bankruptcy (i.e. sale of a

debtor‟s non-exempt property and

distribution of proceeds to creditors)

o Chapter 11: Permits reorganization

under the bankruptcy laws , whereby a

Chapter 11 debtor proposes a plan of

re-organization to keep the business

afloat and pay creditors over time

• Provision of a grace period for enterprises

to deal with distress, through an automatic

stay against creditor action when a

bankruptcy petition is filed

• Chapter 7 provides important protections:

o Discharge of an entrepreneur‟s

unsecured personal and business debt

and exemption of future earnings from

the obligation to repay debt, thereby

enabling a “fresh start”

o Exemption levels for current assets

which vary by state, whereby non-

exempt assets beyond the state‟s

exemption levels are to be surrendered

to repay debt

Need for comprehensive laws

which ensure that insolvency

of enterprises is dealt with in

a manner enabling revival or

rescue prior to liquidation,

and whereby entrepreneurs

can gain a fresh financial

start and pursue productive

lives unaffected by past

financial issues

Utilizing

“Mobile

branches” to

enable

Branchless

banking

Opportunity

International

Bank of

Malawi

• Provision of banking services in rural areas

via mobile vans which are equipped with

GPS tracking systems, satellite linkages,

ATMs etc. for real time processing of

transactions

• Extension of Microloan and deposit

services through the mobile branch facility

• Increased accessibility and enhanced

access to finance for microenterprises

• Widening outreach to cover areas not

served by physical branches, with limited

investment when compared to a physical

branch

Scope for formulation of

necessary regulatory

framework for granting of

branch licenses to banks/ FIs

to cater to MSMEs in rural

areas through mobile van

based banking services

Deployment of

web based

warehouse

receipts to

increase on-

lending to

MSMEs

Dubai Metal

Commodity

Centre

(DMCC)

• Web based warehouse receipt system

which enables financing against physical

inventory pledged

• Certification of goods by issuer of the

receipt providing reassurance to the lender

regarding quality of inventory

• Reduced chances of fraud by avoiding

multiple lending against the respective

inventory

• Reduced processing time and monitoring

cost for lender due to quality assurance and

periodic monitoring by issuer

Need for development of an

electronic warehouse receipt

system to enable greater

efficiency, security and

standardization of

transactions

Evolved legislations and interventions in various countries could

serve as a guide for Indian practices (2/2) DEBT BEST

PRACTICES

Source: US Bankruptcy laws; Report of Working Group on Rehabilitation of Sick SMEs ((Submitted April 17, 2008); Report of Prime Minister's Task Force on MSME (January 2010); The Global Best Banking Practices in MSME Financing and Development (SIDBI) - 2011





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


India‟s VC industry ranking falling in international comparisons

owing to limitations in the regulatory framework

EQUITY

FINANCE

OVERVIEW

15.7

18.4

20.3

16.2

21.0 21.2

23.8 25.9

12.0

14.0

16.0

18.0

20.0

22.0

24.0

26.0

28.0

2007 2008 2009 2010

India USA

%ge share of early stage deals

out of total – India & USA

Notes: Early stage data for India gleaned from a graph. Calculations exclude data on buy-outs. To see note on PPP, see slide 11.

Sources: India: India Private Equity Report 2011, Bain Capital, Inc. USA: Yearbook 2011, National Venture Capital Association

Share of early stage deals in India lower but comparable to USA

10

20

30

40

50

60

Y2006 Y2007 Y2008 Y2009 Y2010 Y2011

Brazil Russia India China

Global rankings of attractiveness

of VC industry

• The share of number of early stage

deals is lower in India than the US.

The differences seem to widen

during better growth years for

India, 2007 and 2010. See graph.

• The average deal size for early

and seed stage investments in

India is USD 3 million, while it is

USD 1.7 million in America (in PPP

terms), indicating that equity

financing is going to much larger

firms in India.

Source: The Global Venture Capital and Private Equity Country Attractiveness Index, 2011, Ernst & Young, by A. Groh, H

Liechtenstein and K Lieser,

India‟s VC industry behind China due to regulatory issues

• India‟s VC industry is ranked 29

out of over 80 countries in terms of

attractiveness to investors.

• India has placed 2nd amongst BRIC

countries since 2006 (see graph).

South Africa and Malaysia are

ahead of India in global rankings.

• However, far from improving,

India‟s ranking has steadily fallen

since 2006, while China is 9 ranks

ahead of India at 18th in 2011.

• According to the underlying data,

the main contributing factors to this

drop are India‟s inhibiting

regulatory and tax policies.

India‟s regulatory framework described as

inhibiting, ambiguous and changing

Inhibiting policy: Example

• SEBI has placed restrictions on the ability of foreign capital

to structure equity investments. For example, VCs cannot

issue non-convertible debt unless they comply with External

Commercial Borrowing Guidelines of the RBI.

Ambiguous policy: Example

• As seen in the Vodafone case, India‟s tax policies are

ambiguous about the IT department‟s jurisdiction to tax off-

shore deals on Indian companies.

Changing policy: Example

• Recently SEBI released a draft on new regulations that

proposes to classify funds by investment mandates, such as

VCFs, Real Estate Funds, Infrastructure Funds, etc.

Investors have had mixed responses to this move and are

citing it as an example of the changing policy landscape

Lack of an enabling ecosystem & startup

risks make investing in FGEs riskier Startups in India offer an inferior risk / return profile as

compared to bigger deals, such as buy-outs and PIPE deals.1

There are three main reasons for this:

• One, India does not have an enabling ecosystem for

startups to succeed easily. There are few peers to get good

advice from; also, various facilities such as office space,

equipment, HR services are not easily accessible to FGEs.

• Two, given the high risks and small ticket sizes, transaction

costs to conduct early-stage deals are much higher.

• Three, it is difficult for FGEs to do business in India due to

heavy paperwork, compliance requirements, etc.

39

1 Recently 4 investment managers from the VCF Sequoia split to focus on PIPE deals

and cited higher returns in the latter as one of the reasons for the shift.


Investors lament regulatory constraints and an underdeveloped

ecosystem to support FGEs; FGEs have reservations about equity

40

EQUITY

FINANCE

OVERVIEW

“If you look at the e-commerce space, I think a lot of money is

chasing a few quality deals. There is a lot of competition. In other

sectors, such as agri-business, services, etc., there are more

entrepreneurs trying to raise equity capital without understanding why

equity investors invest.”

Venture Capital Investor

“VCs don‟t do enough early stage funding in India. It‟s too expensive to manage investments of the size of around USD

250,000. A VC investor prefers to invest in a late stage of USD 5 million than 5 early stage investments of USD 1 million

each. They don‟t want to spread themselves too thin.”


“I think the missing part in India is a larger eco system supporting

startups. In the Silicon Valley, for example, there are many eco-system

players such as firms that provide accounting support, HR support, IT

support for startups. Some even take equity positions and don‟t charge

fees! Universities are also an important ecosystem support.”


“I feel India‟s regulatory framework does not provide a level playing field for investors. Policy changes are unpredictable

and often confusing. For example, if you invested in mobile payments in 2008, you will see that the business model after

the regulatory guidelines came in have completely changed. It becomes too hard to navigate with this uncertainty.”


Regulatory

constraints to

invest in India

Teasers received:

100%

Tentative term sheets

submitted: 3%

Detailed due diligence done: 2%

Submitted investment

bid: 1%

Only 1% of proposals received by

VC/PE firms reach bidding stage

“I have to admit, I am a little averse to angels and sleeping investors

because I have to keep explaining my plans and actions; I am not

keen on that. I don‟t think equity investors can add value so early on.

Perhaps at the right stage, I will look for a strategic investor, someone

who will invest keeping in mind business synergies.”

First Generation Entrepreneur

These issues are covered in other

sections of this report • Low access to debt

• Heavy regulation to start and run businesses

• Limited Infrastructural support

• Inadequate training institutes

Source: India

Private Equity Report

2011, Bain Capital, Inc.

Investing in FGEs

is Riskier:

1. Limited

ecosystem to

support FGEs

a) Little advisory

support to FGEs

b) Inadequate

facilities to

support FGEs

c) FGEs often

uncomfortable

or unaware

about equity

infusion

2. High transaction

costs to invest in

FGEs

3. Difficulty to do

business in India





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


TARGET

COMPANY Target company

can be a domestic

Indian company or be a

MNC subsidiary.

Restrictions on investing

in listed companies.

VCFs also invest

using different

routes depending

on their

registration and

source of capital

The FVCI route has advantages over the FDI route (slide 44).

However, given the challenges in registering as a FVCI, this route is

less common. Another route is Foreign Institutional Investment (FII);

however this is usually for investment in listed shares.

TARGET

COMPANY Target company

can be a domestic

Indian company or be a

MNC subsidiary.

Restrictions on investing

in listed companies.

Regulatory framework guiding equity investments in India and

investment options for domestic and foreign investors EQUITY POLICY

LANDSCAPE

42

VENTURE

CAPITAL FUND This can be a domestic or

offshore fund. Either can

raise fund from domestic

and international sources.

VCFs usually choose the

companies to invest in.

Direct route (Used by individuals, corporates, investment funds) DOMESTIC INVESTORS Includes individuals, investment funds,

corporate bodies

FOREIGN INVESTORS Includes individuals, investment funds,

corporate bodies FDI Route (Used by individuals, corporates & investment funds)

FVCI Route (Used by various types of investment funds)

OP

TIO

N O

NE

:

Inve

st

dir

ec

tly

Direct route DOMESTIC INVESTORS Includes individuals, investment funds,

corporate bodies

FOREIGN INVESTORS Includes individuals, investment funds,

corporate bodies FDI Route

FVCI Route

OP

TIO

N T

WO

:

Inve

st

usin

g V

CF

Lead Actor Acts; Regulations; Policy Documents; Approval processing

Securities and Exchange Board of

India (SEBI)

• SEBI (Venture Capital Funds [VCF]) Regulations 1996 (two Amendments in 2006 and one in 2010)

• SEBI (Foreign Venture Capital Investors [FVCI]) Regulations 2000 (Amendments in 2004, 2006 & 2010)

Reserve Bank of India (RBI) • Foreign Exchange Management Act 1999 (FEMA)

• Sectoral caps on FDI & stipulation of sectors in “automatic route” (approvals not required to invest in these sectors)

Ministry of Finance

• Foreign Investment Promotion Board: Approvals of FDI that do not come under the automatic route

• Department of Revenue: Income Tax Act 1961 (Amendments later)

• Department of Revenue: Double Taxation Avoidance Treaty with Mauritius, Singapore, Cyprus and other nations

Ministry of Commerce & Industry • Dept. of Industrial Policy and Promotion: Foreign Direct Investment (FDI) in India – Policy and Procedures

LE

AD

AC

TO

RS

AN

D

DO

CU

ME

NT

S

RBI, SEBI, Ministry of Finance and Ministry of Commerce & Industry are the main regulators

Investors can invest directly or through a Venture Capital Fund into a target company in India


Mapping challenges in equity space to enabling and constraining

policies and interventions EQUITY POLICY

LANDSCAPE

Regulatory

constraints to

invest in India

Inhibiting regulations

Ambiguous regulatory

framework

Changing and unpredictable

regulations

Limited ecosystem

to support FGEs

Little advisory support to

FGEs

Not enough investible FGEs

Inadequate facilities for FGEs

FGEs unaware or not keen on

equity infusion

High transaction

costs to invest in

FGEs

Small ticket size leads to low

profits & capital inflow

Challenges in India‟s equity investing space Policy landscape interfacing with these challenges

1. SEBI 1996 & 2000 VC regulations

created space for risk capital

2. FDI 2000 regulations paved the way

for foreign investments

3. FVCI regulations ease restrictions

for risk capital

4. FEMA regulations enables easier

repatriation of invested capital

5. India-Mauritius tax treaty enables tax

holidays on capital gains.

6. RBI relaxed pricing norms for sale of

shares b/w residents & foreigners

7. RBI dropped approval requirements

for transfer of shares

8. SEBI places restrictions on the

instruments that foreign capital can

use to invest in India

9. Capital gains tax is double for sale of

unlisted shares vs. listed shares

10. Ambiguity in the Vodafone case is

indicative of India‟s unclear tax laws

11. SEBI & FEMA rules differ on the

investment options of FVCIs

12. Pass-through tax laws are

inconsistent and often unclear

13. SEBI‟s new proposal seeks to

classify funds by sector; move gets

mixed responses from VCFs

Policies addressing regulatory issues

with scope for improvement

Policy landscape exacerbating

regulatory issues with scope for change

14) Various government institutions

setting up incubators to promote

FGE ecosystem

15) Government institutions sponsoring

Venture Capital Funds to invest in

SMEs

16) SME exchange creates an

alternative platform for raising capital

17. India‟s pension funds are a large

untapped source of funds for

stimulating entrepreneurship

Policies addressing lack of an

ecosystem and high transaction costs

Policy exacerbating ecosystem issues

with scope for change

Next few slides will go into details of each of these policies…

43


All equity-related policies are

marked using the same

numbers on page 43, the

policy overview page

FDI and VC regulations paved the way for foreign investments into

Indian enterprises EQUITY POLICY

ENABLERS

Policy / Intervention Overview Impact / Benefit Scope for Improvement?

SEBI 1996 and

2000 regulations

on VC funds

paved the way

for structured

equity

investments

• VCFs have invested in over USD 50

billion from 2004 to 2010 alone. While

this only caters to about 5% of India‟s

total business financing needs, most of

the investments have been into sectors

to which banks do not traditionally lend.

• Venture capital has been pivotal in

spurring innovation and funding high-

risk but high-growth businesses.

• Various seed & early stage deals have

enabled FGEs to get the requisite

funding to run their businesses

• SEBI (Venture Capital Funds)

Regulations, 1996 paved the way for

structured equity financing of private

sector enterprises in India. These

regulations laid down the procedures

and eligibility criteria for starting a VCF

and regulations to guide broad

investment practices.

• SEBI (Foreign Venture Capital

Investors) Regulations, 2000 paved the

way for international investors to get

special concessions to invest in

potentially risky Indian ventures.

• One important scope for improvement

is broadening the type of instruments

investors can use to invest in

companies in India. See page 48. 1

FDI 2000

regulations

paved the way

for foreign

investments

• FDI increased from USD 165 million in

1992-93 to USD 37 billion in 2009-10,

or over 200 times.

• Foreign investment into Indian

companies has not only meant an

infusion of capital but also technology

and global best practices.

• Venture Capital Funds have also used

the FDI route to channel their funds

into early and growth stage

businesses.

• After India liberalized it‟s economy in

1991, it opened its doors to Foreign

Direct Investments.

• Initially, certain sectors were opened

for investment without government

approval. In 2000, an FDI policy was

established which allowed investment

into all but a few specific sectors

without prior approvals. In the

remaining sectors, either investment

caps were specified (such as 49% in

aviation) or a total ban was placed

(such as in tobacco and lottery).

• There are still, however, several

restrictions or paperwork requirements

put on FDI in India. Some of these

restrictions are meant to avoid capital

flight and safeguard other aspects of

India‟s economic and strategic

interests. However, these have

unintentionally come in the way of risk

capital investments in India by VCFs.

• In view of this, SEBI has established

another route for Foreign Venture

Capital Investors (FVCI). See the next

page for the restrictions removed using

the FVCI route. Therefore, while FDI is

an important channel, going forward,

improvements need to be made in the

FVCI route.

2

44

Source: SEBI VCF Regulations, 1996; SEBI FVCI Regulations, 2000 “FDI Policy in India”, Invest India, Ministry of Commerce and Industry, FICCI “Foreign Direct Investment in India: A Critical Analysis of FDI from 1991-2005”, 2005, Kulwindar Singh, Centre for Civil Society; Private

Equity Report 2011, Bain Capital, Inc


FVCI regulations ease restrictions on risk capital but significant

last-mile issues remain EQUITY POLICY

ENABLERS


FVCI regulations

ease restrictions

on risk capital

but significant

last-mile issues

remain

• Venture Capital into FGEs seek high

returns for the risks involved. Having a

mandatory lock-in period post IPO

went against the grain of this need and

hence dropping that requirement for

FVCIs has encouraged many Venture

Capital Funds to use this route.

• Freeing up FVCI from FEMA‟s pricing

guidelines frees buyers and sellers of

shares to determine prices

independently. This is important

because the pricing guidelines put non-

resident investors at a disadvantage as

it creates a price ceiling on which they

can sell their shares to residents.

• Not having to adhere to RBI‟s pricing

guidelines under FEMA and not having

to take permission from FIPB for

certain investments, also reduce the

procedural hassles for FVCIs. For

example, ascertaining prices as per

FEMA involved the additional step of

taking an opinion from a third party

accountant or banker.

• In 2009, FVCI investments into India

amounted to around USD 23 billion,

while that of FDI was around USD 35

billion.

• Foreign capital can invest in Indian

companies using two routes: Foreign

Direct Investment (FDI) and Foreign

Venture Capital Investor (FVCI).

• The latter category was formed to ease

restrictions to attract more risk or

venture capital into India.

• Using the FVCI route over FDI has

various advantages. One, there is no

lock in period to hold shares once a

company has gone public (if pre-IPO

holding was over 12 months). Under

FDI, investors are locked into their

investments until 12 months post IPO.

• Two, a FVCI does not have to adhere

to the pricing guidelines stipulated in

FEMA for transfer of listed and unlisted

shares between residents and non-

residents.

• Three, in certain sectors, investors

need to take approvals from the

Foreign Investment Promotion Board.

In the case of FVCI, if the permission is

acquired once, they do not need

permission again if the investment in

the same sector. *

• While the FVCI route is meant to make

it easier for risk capital to enter India,

the paperwork involved in getting a

FVCI registration has been described

as difficult and lengthy by investors.

• In addition, the RBI has also been

cautious in granting approvals from its

side. One concern of the RBI is that

those not investing in “risky” sectors

are also using this route, such as real-

estate investors. In 2008, around 50

registration forms were pending

because of this concern.

• Another concern of the RBI is thin

capitalization of some of the funds. To

this end, SEBI now requires applicants

to show a firm commitment of USD 1

million from its investors.

• While RBI‟s concerns are genuine,

there is a need to ensure that genuine

venture investors are not affected

adversely undoing the purpose of the

FVCI regulations.

3

* A fourth benefit is that In case an FVCI remains invested after an IPO, it can sell back its shares to the promoter without triggering an “open offer”. However, the SEBI has recently eased the open offer trigger from a minimum of 15% to 25% for all investors. It is unclear what is

the position of FVCIs under this new stipulation

Source: Key Structuring Issues for Investing in India, Wilson Sonsini Goodrich & Rosati; An Update on Structuring Venture Capital and Other Investments in India, undated, Fenwick & West LLP, by F. M. Greguras and S. R. Gopalan; FDI Statistics - Flow of Funds by Country,

2011, Department of Industrial Policy and Promotion, Ministry of Commerce and Industry, GoI.

45


FEMA regulations makes repatriation of invested capital easier;

India-Mauritius Tax Treaty enables tax holidays on capital gains EQUITY POLICY

ENABLERS


FEMA

regulations

makes

repatriation of

invested capital

easier

• This is fundamental to allow foreign

capital to come into India. Only with the

guarantee that all profits, capital gains

and dividends can be repatriated will

investors consider investing in India.

• Foreign capital in India can be

repatriated along with capital gains as

long as due taxes are paid within India

and the investment was made on a

repatriation basis.

• RBI approvals are still required as

these represent capital account

transactions.

• Investors have suggested that despite

these regulations the RBI is wary of

excessive funds leaving Indian shores

and is prone to be stringent on all the

paperwork. However, as long as there

are no excessive delays, this kind of

due diligence is perhaps healthy and

doesn‟t affect investor confidence.

4

India-Mauritius

Tax Treaty

enables tax

holidays on

capital gains

• In India, in most cases, sale of

company shares in a public offering is

not liable for a capital gains tax (15% if

sold within one year). Therefore, the

India-Mauritius tax treaty primarily

benefits when exits are likely to be in a

private sale.

• The efficacy of this treaty is evident

from the fact that Mauritius is the single

largest investor into India. From April

2010 to February 2011, 42% of total

FDI in India was routed from Mauritius.

Singapore and the US ranked at a

distant second and third position with 9

and 7% share of total FDI into India

during this period.

• Under the India-Mauritius tax treaty, a

Mauritius-based company can invest in

an Indian company and sell it for a

profit without attracting a capital gains

taxes either in India or Mauritius.

• To make use of this treaty, an offshore

company establishes a Mauritius

based subsidiary to invest in India.

• Certain restrictions exist for such

investments: a) the Mauritius company

cannot be set up for the purpose of

trading in shares in India, b) the

Mauritius company should not be seen

to be managed from India (though this

is a subjective assessment), and c) the

Indian subsidiary should not be

deemed a “permanent establishment”

in India – i.e. it should not be

independently contracting business,

etc.

• This three-decade treaty has at times

been subject to criticism for loss of

revenue to the Indian Government. In

addition, it is not clear whether such

tax holidays are necessary to attract

investment into India.

• A transparent and fair tax policy is

likely to be more efficient. Because of

this tax treaty, almost all international

investors create front companies in

Mauritius (and other countries with

which India has similar tax treaties).

• However, given various other

restrictions to investing in India,

removing such tax holidays will be met

with stiff resistance.

• The Indian Government has insisted on

review of the clauses of the treaty

since 2006, but has not received an

enthusiastic response from Mauritius.

5

46

Source: “RBI relaxes norms for transfer of shares”, News flash, November 2011, ALMT Legal; Destination India: Overview of the tax and regulatory framework in India, 2010, PricewaterhouseCoopers; “India pushes to review Mauritius tax treaty amid revenue leaks”, Reuters, by

M. Kumar; Mauritius TT - “An Update on Structuring Venture Capital and Other Investments in India” by Fed M. Greguras & S.R. Gopalan


RBI recently eased pricing guidelines and dropped approval requirements

for transfer of unlisted shares between residents & non-residents EQUITY POLICY

ENABLERS


RBI dropped

approval

requirements for

transfer of

shares

b/w residents &

non-residents

• This significantly reduces the

procedural formalities associated with

transferring of company shares

between resident and non-resident

parties.

• In addition to reduction in paperwork, it

smoothens the process for undertaking

such transactions.

• As of November 2011, the RBI relaxed

norms for transfer of shares of an

Indian company between non-residents

and residents.

• Earlier, if a foreign investor wanted to

exit his/her investment in an Indian firm

by selling the unlisted shares to an

resident Indian, required RBI approval

• After this recent relaxation, as long as

the transfer follows the pricing

guidelines stipulated by RBI (above),

India‟s FDI policy and exchange

control regulations, no prior RBI

approval is required.

• Not applicable.

7

RBI recently

eased the pricing

guidelines under

FEMA

• These policies affect investments

through the FDI route as the FVCI

route is exempt from adhering to these

guidelines.

• The DFCF methodology is considered

more scientific and since one buys

shares with a view of future

performance, it stands to reason to use

a pricing norm that is aligned to this.

• The DFCF method is likely to result in

higher valuations than the CCI

methodology.

• RBI‟s FEMA regulations stipulate price

floors for sale of (listed and unlisted)

shares from residents and non-

residents and price ceilings for transfer

of shares from non-residents to

residents.

• Earlier these pricing norms were

arrived at using Controller of Capital

Issue (CCI) Guidelines which looks at

a company‟s historic performance to

arrive at a valuation.

• As of 2010, these prices are calculated

using the Discounted Free Cash Flow

method (DFCF), an assessment of the

company‟s future performance.

• Scope to review the need for a pricing

norm, as leaving pricing decisions to

the market, as is done in the FVCI

case, may be more prudent.

• It may be alright to stipulate a price

floor to insure resident shareholders

from excessive losses. However, fixing

the same price floor as a price ceiling

for foreign investors may lead to a non-

level playing field between resident and

non-resident investors, and could act

as a deterrent to foreign investors in

India.

6

47

Source: An Update on Structuring Venture Capital and Other Investments in India, undated, Fenwick & West LLP, by F. M. Greguras and S. R. Gopalan; FDI Statistics - Flow of Funds by Country, 2011, Department of Industrial Policy and Promotion, Ministry of Commerce and

Industry, GoI.; “New pricing guidelines for issue and transfer of shares”, Taxand; “New FEMA Pricing Guidelines for transfer of shares”, May 2010, Tax Egde, BMR Advisors


SEBI places restrictions on using non-convertible debt and other

instruments that foreign capital can use to invest in India EQUITY POLICY

CONSTRAINTS

SEBI places

restrictions on

the instruments

that foreign

capital can use to

invest in India


• Investors prefer the flexibility to lend to

their portfolio companies without the

obligation of taking more equity. This is

done if there is a need for short-term

working capital or if a second round of

fundraising is taking longer than

expected. However, the restrictions on

issuing non-convertible bonds makes

this illegal in India. In other economies,

this is a simple procedure that once

decided takes less than a day to

execute.

• As per SEBI regulations, foreign direct

investment (FDI) and foreign venture

capital investors (FVCI) can use only

three instruments for investing in

Indian unlisted companies: a) shares,

b) fully and mandatorily convertible

debentures, c) fully and mandatorily

convertible preference shares.

• Therefore, foreign investors cannot

issue non-convertible debt.

• Given the difficulty for Indian firms to

access debt in the first place, there is a

pressing need to consider revoking this

policy.

• The underlying aim of not allowing

foreign capital to provide loans is to

ensure that the power of RBI‟s

monetary policy is not impacted as

interest rate hikes can be circumvented

by borrowing from foreign sources.

However, it is important to think

through a policy change that addresses

concerns of both the RBI and foreign

investors.

8

Capital gains tax

is double for sale

of unlisted

shares vs. listed

shares

• Venture capital investors find it

“archaic” to doubly tax capital gains on

unlisted shares. In the US, for e.g.,

long term capital gains are generally

taxed at 15% (and 10% for those in

lowest income bracket) regardless of

listing of shares.

• On the other hand, India‟s short term

capital gains taxes are only at 15% for

listed shares, while it is about 30% on

average in the US.

• It is also important to note that the

India-Mauritius tax treaty enables all

capital gains taxes to be avoided

enabling many investors to work

around these tax laws in any case.

• The capital gains tax on long-term

capital assets that are listed is either

exempt or 10% depending on the

category of the listed assed. However,

the capital gains tax on unlisted long-

term capital assets is 20%.

• Further, while residents can index the

acquisition cost of the asset (to

account for inflation), this option is only

available to non-residents for purchase

of shares that are not in foreign

currency.

• It is unclear what is the logic behind the

double taxation of unlisted shares.

Depending on the motivation for double

taxation, the MoF can consider doing

away with this differentiation.

• There is also scope, as mentioned

earlier, to have a more transparent and

fair taxation system and do away with

circumvention of tax obligations via tax

havens.

9

48

Source: Foreign Investments in India, 2010, RBI; http://www.rbi.org.in/scripts/FAQView.aspx?Id=26; Economic Timrs; Destination India: Overview of the tax and regulatory framework in India, 2010, PricewaterhouseCoopers; Private Equity Report 2011, Bain Capital, Inc; US

capital gains tax info from wikipedia


India‟s tax laws are often ambiguous and contribute to investor

concerns EQUITY POLICY

CONSTRAINTS

The ambiguity in

the recent

Vodafone case is

indicative of the

need for clarity in

India‟s tax laws


• While this case is between two large

multinationals on a high-value deal, tax

ambiguities in general have a huge

effects on FGEs.

• Therefore, the main implication of the

eventual Supreme Court verdict goes

beyond this case. Currently, many

investors feel that India‟s tax laws are

ambiguous in many respects, including

this case, which is about its jurisdiction

to tax such transfers.

• Various investors are seeking clarity

from the Supreme Court‟s verdict on

this case. They wish that the Court will

articulate clear, just and internationally

comparable principles on how India will

treat all such cases in the future (and

the past).

• The recent Vodafone tax case in India

has highlighted certain ambiguities in

India‟s taxation policies.

• To briefly explain the case, Vodafone

bought over Hutchison Essar in May

2007 for USD 11.2 billion. The transfer

was between Hutchison Telecom Int‟l

Ltd (HTIL) in Cayman Islands and

Vodafone Int‟l Holdings in Netherlands.

The parent companies are based in

Hong Kong and United Kingdon

respectively. Since none of the asset

transfers were within India, the

transaction did not pay capital gains

tax in India.

• India‟s Revenue Department issued a

show-cause notice to Vodafone

arguing that the transfer of Indian

assets and hence liable for tax in India.

• The issue, now with India‟s Supreme

Court, is complex and it is not clear

which way the hearing will go. The

main issue is to determine if it can be

argued that a transfer of Indian assets

took place and if so, of what value and

between which entities. This will be the

basis for taxation in India.

• There is a need for a holistic review of

India‟s exhaustive regulatory

framework and the linkages between

various policies.

• To that end, the Ministry of Finance

has constituted the Financial Sector

Legislative Reforms Commission

(FSLRC). This commission has been

tasked with reviewing over 60

Acts/Rules/Regulations and rewriting

financial sector legislations, simplifying

them, enhancing clarity and covering

gaps. This Commission is due to

submit draft legislations to the MoF by

March 2013. The ramifications of the

above remain to be assessed, with

respect to the extent new Acts and

policies are enacted based on the draft

legislations.

10

49

Source: Frequently Asked Questions, Foreign Investments in India, 2010, RBI, http://www.rbi.org.in/scripts/FAQView.aspx?Id=26; Economic Times; “Vodafone case: What the HC really decided”, Nov 22 2010, G N Gupta, Business Standard; “India: International Taxation –

Recent significant pronouncements”, Jan 2009, Tax & Corporate News Bulletin, Vaish Associates Advocates


India‟s regulatory framework is fairly unpredictable and changing EQUITY POLICY

CONSTRAINTS

SEBI and FEMA

regulations differ

on the

investment

options available

to FVCIs


• The implications of such ambiguities go

beyond just this particular example. It

is indicative of the confusion and

multiple interpretations possible across

various rules and regulations.

• As per SEBI regulations, FVCIs and

VCFs are allowed to invest up to

33.33% of their funds in listed

companies. However, as per FEMA

regulations, FVCIs can only invest in

either a) a domestic unlisted company

or b) in a VCF. Therefore, as per

FEMA, it seems that FVCIs are not

allowed to invest in listed companies.

• As mentioned above, such ambiguities

in India‟s regulatory framework need to

be ironed out to ensure that investors

and entrepreneurs, alike, face a

streamlined set of rules to guide their

actions.

• Once again the FSLRC, mentioned

above, has potential to address such

ambiguities.

11

50

Changes in tax

pass-through

regulations

create

unfavorable

terms for

domestic VCFs

• This has adversely affected domestic

investors because foreign investors

anyway tend to route their money

through Mauritius or other tax havens.

• This creates disadvantages at two

levels: a) it becomes difficult for VCFs

to raise funds from domestic sources,

b) it indirectly restricts investments that

VCFs can undertake using domestic

capital to nine specific sectors.

• This also has a significant impact on

early stage funding as domestic

investors play a bigger role in funding

seed and early stage deals.

• India‟s tax laws allow VCFs to pass on

tax liabilities to their investors.

Therefore they only accrue taxes on

their own business income.

• However, this “pass through” status

has recently been restricted to nine

sectors such as nanotechnology,

pharmaceuticals etc.

• The logic for introduction of this change

does not seem apparent, and hence,

greater clarity is required regarding the

objective. Pass-through laws ensured

that VCFs were only taxed for their

own business income and not that of

their investors.

• There is scope to consider revoking

this change, as it appears to have an

adverse impact for domestic investors

and VCFs.

12

Source: “The ambiguous FVCI and VCF Investment Regime – Whose line is it anyway?”, Mar 21 2011, Aashit Shah and Siddharth Shankar, Bar & Bench; “Regulatory Reforms in Venture Capital”, 2007, Sameer Rastogi, India Juris


SEBI‟s new proposal seeks to classify funds by sector; move met

with mixed reactions from VCFs EQUITY POLICY

CONSTRAINTS

SEBI‟s new

proposal seeks

to classify funds

by sector; move

gets mixed

reactions from

VCFs


• While the main aim of this proposal is

to facilitate more capital towards seed

and early stage funding, the restrictions

it imposes, according to industry

experts, is more likely to detract

investors rather than attract capital.

• For one, classification means that

sector agnostic investors will be forced

to choose between sectors. This will

not be an attractive proposition for

many global investors. This will also

create excessive paper work for VCFs

if they wish to maintain investment

freedom, they have to operate two

entities and seek separate

registrations. It is not clear, whether

this will be permitted in the first place.

• More generally, this note also feeds

into the notion that India‟s regulatory

framework is a changing environment

and new positions by the regulators

often have unintended consequences.

• In August 2011, SEBI released a

concept paper on new draft regulations

to oversee Alternative Investment

Funds (AIFs). The final version of this

draft is meant to subsume the existing

VCF and FVCI regulations.

• One of the main objectives of bringing

in these changes is to better target

regulations and concessions as per the

investment mandate of the fund. Noting

that the initial impetus to VCF and

FVCI regulations was to incentivize risk

capital to early stage enterprises, SEBI

feels that currently various other deals

are being done using the same routes.

• To better “target”, SEBI proposes to

classify funds by broad investment

mandates, such as Venture Capital

Funds, Real Estate Funds,

Infrastructure Funds, etc.

• It also stipulates that VCFs should

have a maximum size of Rs. 250 crore.

• Various other changes have also been

mentioned in the note, such as PIPE

investors being allowed to invest in non

convertible debt. The key change,

however, is the classification of funds.

• SEBI has put out these drafts for

comments. Many VCFs have sent their

detailed feedback on this note.

• The main feedback has been to restrict

the classifications to two or three broad

categories – say, VC Funds, PE Funds

and Alternative Funds.

• Further, the current draft seeks to

mandate funds to invest in early stage

undertakings. Instead, it has been

suggested that it would be better if

SEBI set up adequate incentives for

such transactions. These may increase

the attractiveness of such deals and

draw in more capital and lead to more

enterprises getting funded.

13

51

Source: “Concept Paper on Proposed Alternative Investment Funds Regulations for Public Comments”, 2011, SEBI; “SEBI Draft Regulations for PE/VC Industry May Raise Cost Of Business”, 2011, Vijay Sambamurthi, VCCircle; Interview with Mahendra Swarup, Chairnman,

IVCA


Government has set up incubators that facilitates FGE ecosystem,

but impact is limited due to implementation issues EQUITY POLICY

ENABLERS

Various

government

institutions

setting up

incubators to

promote FGE

ecosystem


There are two primary benefits from these

incubators:

• These centres train entrepreneurs on

technical skills as well as business

skills to set up successful enterprises.

This capacitates more FGEs to take up

businesses.

• These centres make fundraising easier

and enables better access to advice

and start up facilities, such as office

space, etc.

In terms of impact:

• Various enterprises have successfully

left these incubator to continue

independent operations. As of

November 2008, there were 8 such

enterprises from SIIC.

• However, the impact of these

incubators have only been on the

margin and have not made a significant

dent in creating a thriving

entrepreneurship ecosystem. VCs are

not aware of some of these incubators.

• National Small Industries Corporation

(NSIC) has set up Training cum

Incubation Centres.

• The National Science & Technology

Entrepreneurship Development Board

(NSTEB) has set up Technology

Business Incubators (TBI). Each TBI is

registered as an autonomous society

and focuses on incubating enterprises

for 2-3 years.

• The Small Industries Development

Bank of India has set up a SIDBI

Innovation and Incubation Centre

(SIIC) at IIT Kharagpur.

• National Institute for Entrepreneurship

and Small Business Development has

also set up Training cum Indcubation

Centres. The Centre focuses on

certain sectors such as garments.

There are three broad considerations for

improving current incubation efforts:

• These policies need to be executed on

the ground with greater efficiency. An

incubator in Punjab, for example, had

underdeveloped facilities in the

building, according to an FGE

interviewed.

• In addition to setting up its own

incubators, the government should also

focus on incentivizing the private sector

to set up incubators, and emphasize

efficient management of incubators, to

provide entrepreneurs with apt

business advice and support.

• Mainstream incubation efforts by a)

consolidating the various efforts and b)

advertising these centres prominently.

This will ensure better penetration.

14

52

Source: Risk Capital and MSMEs in India, SIDBI


Government institutions sponsoring Venture Capital Funds to

invest in SMEs EQUITY POLICY

ENABLERS

Government

institutions

sponsoring

Venture Capital

Funds to invest

in SMEs


• Most of the government-backed funds

have investment mandates that focus

on SMEs and on seed & early stage

funding. They therefore have the

potential to be an important source for

finance for FGEs.

• These funds are not necessarily

chasing the best risk-return profiles

and hence can make investments even

with higher transaction costs.

• Various VCFs in India are backed by

the government. They are of 3 types.

• One, funds promoted by development

finance institutions that are controlled

by the Central Government: ICICI

Venture Funds Ltd. or SIDBI Venture

Capital Limited (SVCL).

• Two, funds promoted by certain state

governments: Gujarat Venture Finance

Ltd. or Punjab Infotech Venture Fund.

• Three, funds promoted by public

banks, such as Canbank Venture

Capital Fund.

• There is a strong need to improve the

visibility of these funds. Many of the

privately run VCF investors mentioned

that they have not come across these

funds when competing for investment

bids.

• There is scope to introduce

professional management in these

state government funds to ensure a

more business-minded attitude. A shift

for these funds to professional

managers with investment experience

should be considered.

• In addition, the government could

consider being a Limited Partner to

some of the privately run funds. They

can delineate clear investment

preferences to ensure their SME and

early stage focus is maintained.

15

53

Source: “Venture Capital”, undated, Business Financing, Business Knowledge Resource Online; Kerala Venture Capital Fund website (www.keralaventure.org); Gujarat Venture Finance Limited website (www.gvfl.com)


SME Exchanges being introduced to provide alternate sources for

equity finance EQUITY POLICY

ENABLERS

SME Exchanges

being introduced

to provide

alternate sources

for equity finance


• According to the BSE SME exchange,

around 1 million SMEs out of a total of

30 million will be eligible to raise capital

through this route.

• Around 60 SMEs have already

expressed their desire to use the BSE

SME exchange to raise capital once it

is launched.

• Since, the focus is on smaller

enterprises in tier 2 and 3 urban

centers, this has the potential to serve

a currently large scale

• The Bombay Stock Exchange and the

National Stock Exchange have both

revealed plans to launch an SME

exchange for smaller businesses to

raise equity finance through IPOs.

• SMEs with a post-issue paid up capital

in the range of INR 10 to 25 crore

(USD 2 to 5 million) can list on it as

against the minimum of Rs. 25 crore

for the mainstream exchanges.

• Issues will be 100% underwritten, with

15% being underwritten by the

Merchant Banker used to conduct the

IPO. The banker will also provide

market making support for three years.

• The requirements of merchant bankers

are quite onerous. They have to

underwrite 15% of the issues and

provide market making support for 3

years. Given the low ticket sizes, the

costs of underwriting and support

provision will be very expensive for

most bankers from a profitability

viewpoint. There is a need to review

the terms for Merchant Bankers, and

modify them to more favorable and

practical terms, for successful

development and adoption of these

exchanges.

16

54

Source: “SME exchange targets small towns, cities”, October 18 2011, Shishir Prashant, Business Standard; “NSE aims to launch SME exchange platform”, November 3 2011, The Hindu


India‟s pension funds are a large untapped source of funds for

stimulating entrepreneurship EQUITY POLICY

CONSTRAINTS

India‟s pension

funds are a large

untapped source

of funds for

stimulating

entrepreneurship


• The impact on account of the inability

of pension funds to invest in Indian

ventures through VCs is quite

significant. As an illustration, India‟s

largest pension fund, the Employee

Provident Fund Organisation manages

around USD 70 billion. Even if 2% of

these funds are used to fund early

stage entrepreneurs in India, it will

mean a near 30% increase in risk

capital for India‟s early stage deals.

• Recently the Ministry of Finance

introduced the Pension Fund

Regulatory and Development Authority

(PFRDA) Bill, 2011 in Parliament.

• This bill sets the guidelines governing

the National Pension Scheme (NPS), a

mandatory pension scheme for all

government employees who joined

after Jan 2004, and open to all other

Indian citizens voluntarily.

• India‟s pension funds have traditionally

not been allowed to invest in equity

markets of any sort. However, this bill

seeks to allow fund managers to invest

up to 50% of total assets under

management in the equity markets.

• However, the investment guidelines do

not list venture capital or private equity

as potential investment destinations.

This is very different from international

markets where pension funds are a

vital and stable source of capital for

VCs and PEs. In fact, around 15 of the

world‟s top 20 pension funds invest in

India‟s VC/PE industry.

• If the government can allow 50% of the

total funds of NPS (USD 2 billion on

July 2011) to be invested in equity

markets, a smaller portion can also be

clearly earmarked for the VC industry.

• Doing so is not only a prudent

investment decision, it has the

multiplier effect of boosting India‟s

growth and employment prospects

through entrepreneurship. Therefore,

there is a need for the government to

consider this investment option as is

done in various other countries.

17

55

Source: “Legislative Brief: The Pension Fund Regulatory and Development Authority Bill, 2011”, 2011, M R Madhavan, Sana Ganwani, PRS Legislative Research; “India: putting pension funds to work in the stock market”, Aug 1 2011, Chris Food, beyondbrics, Financial Times

blog; “Funds hope for “free” India pensions”, Jul 31 2011, Ben Leahy, Financial Times; “Detailed investment guidelines for all citizens under the New Pension Scheme”, undated, Pension Fund Regulatory and Development Authority





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


Best Practice Example Features Benefits Scope for India Adoption

Participation of

Government

Pension Funds in

Venture Capital

Funds

FMIEE in

Brazil

FTP in

Peru

• A public private partnership

between Government Pension

Funds, private sources of

finance and professional fund

managers is set up to direct

pension funds to finance

ventures.

• Government provides

regulatory support to pension

funds for this.

• Increase in domestic capital to

seed and early-stage startups.

• Diversified portfolio for pension

funds creates better risk-return

profiles for them.

• Private sector money and

management ensures efficient

deployment of pension funds with

minimal oversight.

• As highlighted above, there is a high scope

for India adoption.

• Currently, the government is already opening

up pension funds to invest in public equity

markets. Directing a portion of funds to

venture capital is likely to improve the risk-

return profile of these investments.

• In addition, as mentioned above, even a

small portion of pension funds invested in

seed and early stage ventures can increase

the capital flow by nearly 30%.

Shared investment

in SMEs between

Angel investors,

Government &

Development

Banks

FINEP

(Brazilian

Innovation

Agency)

• The Angel Investor invests

20% of a SME‟s equity needs;

FINEP invests up to 40%;

remaining is invested by

development banks.

• FINEP also underwrites the

investment by Angel investors.

• The inclusion of an Angel Investor

helps greatly in the due diligence

process, as most banks and

government agencies dealing with

many SMEs are not in the right

position to do such due diligence.

• Enables Angel Investors to

leverage their equity with debt

from development banks.

• Since development banks (like SIDBI) are

already providing risk and debt capital and

there already exist VCFs run by state

governments, there is a high scope to adopt

such a co-investing model that bring in the

private sector investors to increase due

diligence capability and capital flow.

International best practices in equity financing for seed and early

stage ventures EQUITY BEST

PRACTICES

Source: The Global Best Banking Practices in MSME Financing and Development (SIDBI) - 2011





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


Non-financial constraints often make undertaking business in India

challenging & impact access to capital

NON-

FINANCIAL

ASPECTS

Non-financial challenges to doing business in India for FGEs Policy responses

• Heavy-regulation makes it hard to start and run businesses in India, especially for FGEs.

• India‟s global ranking on the ease of starting a business is a at 166 out of 183 countries;

similarly, in terms of the number of compliance issues faced, India ranks at 181.

• The average business in India makes 60 taxation payments, which takes 34 man days to do.

• National Knowledge Commission (NKC) reports these problems are more acute for FGEs.

• While efforts have been made to streamline various process and introduce greater

transparency in procedural requirements, there is scope for much to be done.

Heavy-regulation on

business processes

• Single window clearances

• Composite application form

• It takes on an average close to 4 years to enforce contracts in India, with 5 other countries

faring worse than India with respect to the same.

• India‟s bankruptcy and labour laws are fairly archaic, and there is scope to make them more

business-friendly.

• After filing for bankruptcy, recovery for claimants is 11.6%, compared to 81% in the US.

Legal hurdles and

limited ability to

enforce contracts

• Lack of workspace is a significant problem for FGEs. NKC reports that only 15% of FGE

start ups had access to office space, compared to 56% of second generation entrepreneurs.

• Limited public infrastructure in India is a significant problem for all businesses including that

of FGEs.

• Some examples of infrastructure challenges faced by various sectors include: Agri

businesses are impacted by underdeveloped supply chains; FGEs in manufacturing face

high costs of transportation and frequent power shortages; inadequate broadband capacity

for IT services

Under-developed

supporting

infrastructure

• According to a recent NASSCOM report, only 10-15% of India‟s business graduates and 26%

of its engineering graduates are directly employable after graduation.

• FGE startups find it difficult to source good talent because of cultural issues. Top talent

prefers to work for big brands often not understanding the potential for value creation in

startups. This is likely to change as more and more startups demonstrate success in India.

Lack of adequate

skilled workforce

• Limited liability partnership

• Commercial courts

• Ongoing infrastructure

reforms as part of Central &

State development plans

• Industrial Training Institutes

• Ongoing reforms in higher

education

Reviewed in next page

1

2

3

4

5

x Source: National Knowledge Commission, 2008, Entrepreneurship in India; World Bank, 2011, Doing Business; NASSCOM, 2010, Perspective 2020: Transform Business, Transform India


Single window clearances, composite application forms, new

registration rules – all are easing paperwork requirements for FGEs

Single window

clearances ease

paperwork

requirements for

FGEs


• Having a single-window system brings

down the paperwork requirements, and

streamlines the process for obtaining

the required clearances.

• Many Indian states have introduced a

single-window clearance system to

facilitate all the paperwork related to

starting a business.

• Some states, like Rajasthan, have also

ensured that empowered bodies are

created that can singularly grant all

approvals from different departments.

• In states that have a single-window

system, but no empowered body to

grant all approvals, it still takes

considerable time to get all approvals.

• Hence, there is room for improvement

of the implementation efficiency of

such initiatives

60

NON-

FINANCIAL

POLICIES

One application

form reduces

paperwork

• This step too directly minimizes the

paperwork requirements for FGEs

• Nine Indian states have introduced a

single composite application form,

which enables entrepreneurs to fill up

just one form for all clearances.

• Not applicable.

Registering

startups as a

Limited Liability

Partnership

reduces

paperwork

• This act facilitates the entry of FGEs as

it has the advantages of both – the

informal arrangement of partnership

and the advantages of a company

without its heavy procedures.

• Since the introduction of this Act, many

new enterprises have been registered

as LLPs. Lawyers have described this

form of registration as “very popular”.

• Limited Liability Partnership Act 2008

(LLP) provides for a flexible

governance structure to be determined

by the partners themselves by mutual

agreement, easy compliance

requirements and combined with

limitation of liability to the extent of the

partners‟ contributions.

• Under the Act, provisions have been

made for enabling schemes of revival

as well as liquidation and winding up

through rules to be notified as

subordinate legislation.

• While the LLP act coupled with other

initiatives has greatly enhanced the

ability of FGEs to start businesses,

implementation issues leave scope for

improvement.

1

2

3

Source: Business Standard, 2010, “Punjab industrialists can now submit composite application form online”, February 23


Commercial courts being considered for speedy disposal of

business cases

Commercial

courts being

considered for

speedy disposal

of business

cases


• The potential benefit of a future form of

the bill is faster disposal of commercial

cases, making it easier and faster to

enforce legal contracts.

• This will be especially a boon for FGEs

who do not have the resources to

expend on long court cases.

• The lower house of the Indian

Parliament passed the Commercial

Division of High Courts Bill without

voting in the 2011 winter session,

which the upper house deferred to

incorporate changes.

• The bill argued for a division of a

section of all High Courts to deal

exclusively with commercial cases to

ensure faster disposal of such cases.

• The bill was deferred because it moved

resources of the High Court away from

other legal needs and because it was

found that High Courts are not the best

institution to deal with such cases.

• Not applicable.

NON-

FINANCIAL

POLICIES

Training centers

to focus on

building youth

employability

• For FGEs involved in technical

enterprises, this initiative has the

potential to increase the supply of

skilled manpower.

• In 2007, with the support of a USD 280

million loan from the World Bank,

India‟s Directorate General of

Employment and Training launched

the Vocational Training Improvement

Project.

• This project will focus on a) improving

the quality of vocational training, and

b) aligning training with industry needs.

• It is important for such institutes to

dynamically change training content to

keep up with the industry‟s changing

needs, as far as possible.

• Strict evaluation standards need to be

adopted to understand the true impact

of training centres on incomes and

employability of trainees.

4

5

Source: Parliament of India, 2010, “Report of the Select Committee on the Commercial Division of High Courts Bill, 2009”; Indo Asian News Service, 2011, “Rajya Sabha defers bill for commercial division in high courts”, December 13; World Bank, 2007, “India: Vocational

Training Improvement Project”; Government of India, 2007, “Vocational Training Improvement Project of Government of India: Project Implementation Plan”





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


CONCLUSION Concluding thoughts and next steps

Concluding thoughts…

Overall

• There is a need for a balanced combination of debt and equity forms of financing, as they are largely complementary, and relevant at different stages

and for different types of enterprises. It is also important for equity investors to have access to debt to leverage their investments.

Debt

• Private sector banks and foreign banks have a smaller branch footprint and face constraints on on-lending to intermediaries for credit deployment.

Hence, there is a need to consider both branch based and branchless strategies in order to expand their reach in the MSME segment.

• The focus on large banks moving downstream to serve the MSME sector should be complemented with initiatives to encourage smaller institutions

such as NBFCs etc. which have local context and could serve these markets well

Equity

• Broadly, three changes required are a) more stability in India‟s regulatory framework with regards to equity, b) more clarity in terms of simpler and

consistent laws, and c) lesser restrictions to make deals less risky and more attractive

• Specifically, foreign capital should be allowed to structure deals more freely and use instruments that are as per international benchmarks.

• And, while the government is providing more access to equity via state-run bodies, varied models of delivering this to FGEs should be considered,

such as public-private partnership, or investment of government monies into privately run VCFs, or hiring professional fund managers.

Non-financial

• Heavy regulations and paperwork often make it difficult to start and run businesses in India, especially for FGEs.

• The government‟s current efforts of simplifying registration processes, etc. are laudable but more needs to be done in terms of last-mile

implementation issues.

• Prioritized efforts also need to be made to address various infrastructural bottlenecks and improve the quality of human capital, to develop India‟s

entrepreneurship (and business) landscape.

The next steps with regards to this engagement are as follows:

• From the nearly 40 government policies and interventions discussed in this step, identify a prioritized list of 4-6 workable policy recommendations that

can have a huge positive impact on FGEs and is feasible for the government to undertake and implement.

• Share findings and stress test policy recommendations with experts.

• Work with government policy makers to influence them on making the recommended changes.

Next steps…





1. Introduction


3. Debt Financing

a) Challenges

b) Policy Landscape


4. Equity Financing

a) Challenges

b) Policy Landscape



a) Challenges

b) Policy Landscape


iv. References

pg. 2

pg. 3

pg. 4

pg. 7

pg. 10

pg. 13

pg. 13

pg. 17

pg. 36

pg. 39

pg. 39

pg. 42

pg. 57

pg. 59

pg. 59

pg. 60

pg. 63

pg. 65

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CONTENTS


End of

Document

Contact Details:

Nisha Dutt

Director, Business Consulting

[email protected]

M: +91 8008111418 | T: +91 40 40300200 (extn:218)

5th Floor, Building 8-2-682/1, Banjara Hills Road No 12, Hyderabad - 500034, India


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