Beckwith _Oct 2012_ Opportunities for an IB Debt Facility in South Asia

7/29/2019 Beckwith _Oct 2012_ Opportunities for an IB Debt Facility in South Asia

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Facilitating Capital Flows to Inclusive Businesses

in India and Sri Lanka

Position Paper for the Asian Development Bank1

PREPARED BY NOAH BECKWITH

15 OCTOBER, 2012

1This document is is a proposal to ADB, prepared by an ADB consultant. It does not necessarily

reflect the views and policies of the Asian Development Bank (ADB) or its Board of Governors orthe governments they represent. ADB does not guarantee the accuracy of the data and

information provided in this report.


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Table of Contents

Section Page Number

Introductory Remarks 3

1. India 4

2. Sri Lanka 16

3. Key Additional Considerations 20


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Introductory Remarks

The Need for an Inclusive Business Facility in India and Sri Lanka

The creativity of the private sector in addressing urgent social and environmentalchallenges with inclusive business (IB) strategies in India and Sri Lanka generally has,

unfortunately, not been matched with the availability of appropriate financing for

growth. The preference of commercial banks and funds to finance larger, more

established companies in both countries not only starves the SME sector of working

capital (let alone equity), but it also hampers the ability of the private sector to develop

innovative solutions to pressing problems which the public sector has neither the

capacity nor the funding to confront effectively.

The above observations are, however, general. They are contrasted with encouraging,important examples of businesses that are incorporating the poor into supply chains and

demand segments as consumers, producers, suppliers and employees for two reasons:

because it makes sound commercial sense and because they see profitable avenues for

providing solutions to social challenges.

The importance of the IB Facility (the Facility), therefore, is to provide such companieswith working capital, the lifeblood they require to grow. For regulatory, fiscal, structural

and cultural reasons, companies across South Asia struggle to access finance of up to

US$10m. Similarly, microfinance institutions (MFIs) struggle to access debt from the

wholesale marketseven more so following over-indebtedness and suicides amongseveral Indian borrowerswhich impedes innovation of inclusive, pro-poor products in

key sectors, including agriculture, healthcare, clean energy and housing, among others.

The strong conclusion of this Position Paper is that there is an opportunity for an IBFacility, seeded and sponsored by the Asian Development Bank (ADB), to make debt

available to selected companies and financial institutions that are positioned to advance

inclusive business initiatives in scalable and replicable ways. Moreover, ADB is uniquely

positioned to harness internal expertise and bring financing mechanisms to bear which

will enable it to foster interest in, and attract capital to, a modality of investment which

could be genuinely transformative.

In summary, initial due diligence suggests that there is a critical role for a US$100m-US$150m debt facility providing loans of US$1m-US$10m to selected businesses and

financial institutions in India and Sri Lanka that are pursuing strategies to engage with

the poor as consumers, suppliers, producers and distributors.

There is no reason to suppose that, if well managed, a Facility of this nature could notgenerate double-digit returns for investors. Furthermore, if ADB and like-minded

institutions are able to bring innovative instruments to bear, such as credit

enhancements, a liquidity facility and foreign-exchange depreciation mitigation

strategies, returns could be increased significantly.


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1. India

General Observations

1. The Prospects for an Inclusive Business Facility in India

Indias demographic composition and the incidence of poverty, coupled with burgeoningdemand for basic goods and services, make inclusive business interventions not only

timely, but critical. Population pressure and evolving consumption patterns mean that

mass-market solutions are urgently required in healthcare, education, energy,

transportation, water, housing, sanitation and agriculture, among many other sectors.

Given that 53.7% of Indians were living below the poverty line in 2011, according to theMulti-Dimensional Poverty Index developed by the Oxford Poverty and Human

Development Initiative, it could be argued that many investment initiatives will likely (or

necessarily) affect base of the pyramid (BOP) incumbents in some way, either as

consumers, producers, suppliers or employees. With such strong prospects for BOP

engagement at many levels of economic activity, therefore, the question becomes the

modality and conditions of engagement, and whether sustainable improvements in

livelihoods can be achieved as a result.

Initial due diligence as part of the ADB IB initiative suggests that focusing on threespecific modalities of BOP engagement might be particularly effective for the Facility:

incorporating BOP-owned/managed businesses, broadly within the small and medium-

sized enterprise (SME) sector2, into the supply chains of larger companies; improving

access to and quality, affordability, choice and availability of critical goods and services

for the BOP; and engaging the BOP as distributors to reach under-served populations.

There are various reasons for this dual focus articulated below, including the nature of

obstacles to access to finance in India, the type of finance required, the role of the

Indian banking sector, and the strategies and performance of existing non-bank

purveyors of capital, among others.

Four additional conditions in the Indian context make an ADB IB Facility particularlyfortuitous: first, the predominant focus of the banking sector on larger transactions

(with some notable exceptions) due to the perceived lower risk; second, the resulting

dearth of debt finance available to SMEs in the US$1m to US$10m range; third,

regulatory constraints which make the deployment of debt by non-bank financial

companies (NBFCs) very difficult in India; and fourth, the increasing interest among

development finance institutions (DFIs), family offices, high net-worth individuals

(HNWIs) and foundations, among others, in supporting IB strategies.

2It is critical to note that the term SME in the India section of this Position Paper denotes companies

that require up to US$10m of finance(in some cases even more)whether debt or equity. This is insharp contrast to Sri Lanka. The different orders of magnitude must be borne in mind in order for the

conclusions of the document to make sense.


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2. Determining a Strategy for the Facility in India

Faced with Indias vast geography, poverty and urgent demographic challenges, it isimportant for the Facility to develop a focused strategy, recognising the impracticality of

reaching all sectors, states and population segments through one intervention. Similarly,

it must recognise that an attempt to engage with the BOP through all modalitiesi.e., as

employees, consumers, producers, suppliers and distributorsis probably unrealistic

and could adversely affect both the Facilitys financial performance and potential

impact. Furthermore, it should be remembered that the medium of the Facility itself is

investment, and that two of its central objectives are to achieve proof of concept and a

demonstration effect encouraging replication thereafter. For these reasons, elaborated

further below, it is recommended that the Facility focus on business models that engage

the BOP as consumers, suppliers and distributors.

1. BOP as consumers: Facilitating access to key goods and services for under-servedpopulations will provide the Facility with a broad spectrum of investment

opportunities whose commercial thesis is predicated on strengthening BOP

engagement, and where technical assistance (TA) can help in that process.

Investments of this kind can be sub-divided into three themes:

i. Overcoming consumer engagement obstacles: Working with businessesthat have recognised the BOP as a viable, attractive market segment, but

struggle to adapt pricing strategies and revenue models to the cash flow

volatility of lower income groups, or to challenges such as physical

remoteness, absent or limited availability of energy and technology and soon.

ii. Introducing technology: Some businesses that recognise the BOP as anattractive segment are unfamiliar with technology that can facilitate new,

pro-poor engagement models such as remote tele-sales, mobile distribution,

subscription-based purchases, tele-medicine and so on. The Facility will find

opportunities to invest in companies in which the application of technology

could open up new demand segments to be serviced.

iii. Access to finance: Although the regulatory environment makes investing inIndian financial institutions complex, the Facility will have opportunities to

work with NBFCs to develop products that enable the poor to access key

goods and services both in the personal and productive sectors. With regard

to the former, access to clean energy and solar power is a particularly

prominent theme, along with micro-housing. Where the productive sector is

concerned, there are numerous opportunities, including micro-venture

capital, micro-insurance, crop/disaster insurance and input financing.

2.

BOP as suppliers: Engaging the BOP as suppliers is arguably the domain in whichmost progress has been made in the development of IB strategies by larger Indian


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businesses. Most prominently in agriculture, some aggregators have recognised the

tangible and intangible returns on investment that derive from facilitating farmers

access to inputs, information and finance, for example, or from training them in best

practices. Similarly, variations on contract financing models have emerged where

aggregators arrange access to funds which enable poor suppliers to cover the cost of

goods sold, thereby enabling them to be integrated into the supply chains of the

former. This not only fosters loyalty, but also it improves quality and productivity,

and over time, suppliers can outgrow the need for this interim financing mechanism.

3. BOP as distributors: Successes in developing micro-entrepreneurs with localknowledge and networks have been well documented in Latin America, Africa and

India, especially in the area of solar lighting solutions. Where the Facility could have

a particular impact in India, however, is working with traditional financial institutions

and NBFCs to develop financing solutions whilst also helping distributors develop

delivery models that are tailored to vastly-differing states and even regions withinthem. Moreover, the incentive mechanisms which have been key to the effective

design of BOP-led distribution models mean that there is dual engagement of the

poor: as distributors and as employees.

It is suggested that Facility not focus explicitly on BOP as employee investmentopportunities for two reasons. First, companies of the size that require finance which

will enable them to hire significant numbers of poor peoplefor instance, in

manufacturing or retailwould likely have other sources of debt or equity available to

them. Second, other than improving environmental, social and governance (ESG)

practices within large investments of this kind(note that ESG improvements will,

anyway, be required by investors in all Facility portfolio companies)increasing the

quantum and quality of employment opportunities will be an objective common to all

Facility investments.

With regard to investment size, there is a clear, urgent need for debt finance in India inthe US$1m-US$10m range discussed extensively below. This implies a focus on lower

middle market opportunities with strong growth prospects which, to a large extent, have

remained unrealised due to lack of access to finance, above all working capital.

Attempting to deploy capital below the US$1m level in the so-called unorganisedsector would be ill-advised(note, importantly, that in BOP as supplier investments,

some Facility portfolio companies will themselves incorporate this segment in their

supply chains)as would trying to invest significantly larger amounts. This is because

there is fierce competition for larger transactions, requiring a different skill set.


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Access to Finance: Unattended Demand and Supply-side Challenges

3. Access to finance remains a key constraint to inclusive microeconomic growth

Access to financeboth debt and equityremains a fundamental constraint on faster,more broad-based SME growth in India, and it should be noted that the challenge

pertains to companies that require US$10m as much as it does to those that need

US$500,000 or US$1m. In other words, it refers not only to the mom and pop and so-

called unorganised segment, but also to lower-middle market companies, especially in

Indias Low Income States (LISs).

The literature on access to finance in India is extensive, and this Position Paper does notset out to summarise it. However, the following key dimensions of the access to finance

problem should be highlighted in the context of the Facility:

Supply-side bottlenecks: Although Indian banks are obliged to lend a certainpercentage of assets to priority sectors including micro- small and medium-sized

enterprises (MSMEs) and agriculture, they do so largely under duress.

Moreover, with few exceptions, they approach the SME sector with a corporate

lens and erect insurmountable barriers to finance in the form of unrealistic

collateral requirements, submission of at least three years detailed financials

and long, bureaucratic form-filling exercises. Banks urgently require training in

appraisal, monitoring and evaluation SME loans. Currently, they gravitate

towards the M segment because it is more familiar and viewed as less risky.

Where public sector involvement is concerned, significant debt finance is

theoretically available to Indian SMEs through the Small Industries Development

Bank of India (SIBDI). Moreover, guarantees and credit enhancements are also,

theoretically, available. In practice, however, many potential borrowers lack of

awareness of SIDBI products, combined with labyrinthine bureaucracy make the

debt almost impossible to access. Worse still, the application process is so

cumbersome and time consuming that banks administering the SIDBI funds

increase loan prices accordingly. The result is that what was intended as a

concessional product ends up being prohibitively expensive.

At a more general level, lending has been constricted by the absorption of vast

amounts of credit in the infrastructure and real estate sectors during the boom,

much of which was for projects requiring government approval which has since

been delayed indefinitely or withheld. Banking sector assets have been depleted

through this over-exposure.

Demand-side constraints: In consequence, SME growth is hindered as ownersoften resort to taking personal loans at monthly interest rates of 2%-5% to try to


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inject working capital into their businesses. Further pressures on SMEs result

from the following factors, among others:

The frequent mismatch between loan terms and supplier and customerpayment terms if SMEs do manage to access formal finance;

An inability to invest in research and development and technologies thatwould improve efficiencies;

The absence of information technology (IT) and managementinformation systems (MIS) that would enable improved supply chain and

inventory management;

An inability to develop effective marketing strategies resulting in limitedvisibility to vendors and customers; and

Failure to attract fresh talent.

4. Breaking the deadlock: making debt available to SMEs

The demand for debt in India clearly far outstrips supply across sectors, company sizesand geography, and it is the strong conclusion of the due diligence exercise that the

Facility should focus on providing debt rather than equity (see below). More specifically,

the Facility should take three aspects of the problem with access to debt into

consideration, including affordability, security and tenor of debt:

i. Affordability: Demand for working capital from Indian SMEs is fuelled as muchby the lack of affordability of debt from formal financial institutions as scarcity.

Affordability, it should be noted, refers not just to loan price, but also to

repayment terms, which often fail to accommodate revenue seasonality and

cash flow volatility. The Facility must therefore ensure that it provides debt at

affordable rates and that it accommodates the volatilities highlighted above.

ii. Security: Few SMEs are able to meet banks rigid collateral requirements.Providing security and personal guarantees can be a struggle, and traditional

sources of collateral such as land often fail to provide anywhere near the

amount of coverage needed. Training in cash flow-based lending must be

provided to intermediaries administering Facility funds, otherwise collateralconstraints will once again prevent many companies from accessing them.

iii. Loan tenor: When SMEs do manage to access debt from formal sources, thetenor is often inappropriate. Many businesses require what are effectively

working capital facilities which are both long term (if not open-ended) and take

into account fluctuations in monthly revenues. To the extent that the Facility can

incorporate patience and flexibility into the tenor of its loans, the contribution


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that it will make to the financing landscape and, critically, the demonstration

effect it will have on other financial institutions will be significantly enhanced.3

5. The Facilitys modality of finance: debt versus equity

Whilst many Indian companies struggle to access finance of all kinds, there are severalcompelling reasons why the Facility should avoid providing equity:

Unfamiliarity with equity: Not only do many businesses in the Facilitys targetsize range have opaque ownership structures and informal or non-existent

governance arrangements, few owners are open to dilution. This is even more

prominently the case in LISs and remote areas. Additionally, the absence of the

repayment discipline of debt, which is immediate, can foster an approach to

equity as free money, especially among family-owned and less sophisticated

businesses.

Unrealistic valuation expectations: Although there has been a significantcorrection in the market since early 2011 and many large private equity funds

are either under water or may, at best, return capital to investors, business

owners valuation expectations remain unrealistic. This is particularly the case in

the SME sector, where owners lack a thorough understanding of the drivers of

excessive valuations in the mid-to-late 2000s.

Absence of transactional infrastructure: With the exception of largetransactions (US$20m and above) undertaken by large private equity houses,

India does not have the intermediaries, knowledge or transactional

infrastructure that facilitate equity deals. This becomes an even more significant

obstacle in transactions and is more acute in remote areas and LISs.

Inability to accompany equity with debt: Under current regulations, the abilityof funds to deploy debt alongside equity is limited, cumbersome and expensive.

Although the regulations can be circumvented (to a degree) by using mezzanine

structures such as convertible debt and preference shares, it is rumoured that

SIDBI may close such loopholes. Given that it is usually more working capital that

companies appropriate for Facility funding lack (and are positioned/structured

to absorb) rather than equity, debt is the more logical modality than equity.

In addition, the performance of private equity funds, especially those of 2004-2007vintage years, is trending towards mediocre at best to disastrous at worst. Entry prices

were justified by inflating growth assumptions, and a mutually-reinforcing vicious circle

developed whereby owners came to expect exaggerated valuations and funds failed to

attract investors unless they promised commensurate returns.

3The question naturally arises whether loans on such terms would distort the market. However, given

that most banks focus on larger commercial opportunities, the opportunity cost of the distortion thatmight transpire is outweighed by the demonstration effect the Facility could have in alerting banks to

the viability and, ultimately, profitability of financing the missing middle.


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By contrast, the advantages of debt are significant, including; Risk profile: The discipline of immediate and regular repayments, which

provides insight into businesses cash flow positions, coupled with the exit

realisation inherent in debt significantly reduces the risk profile of a Facility.

Return profile: This need not, however, imply that the higher returns generallyattributed to equity must be foregone (and they are certainly not being achieved

at present!). Indeed, significant upside generated from sales multiples are not

likely,4 but medium and long-term debt at annual interest rates of 16%-18%

would be highly competitive and attractive to many target companies.

Moreover, the ability to return cash to investors frequently, whilst recycling

proceeds from interest payments, will help to counteract the impact of currency

depreciation on the Facility.

Need for working capital: Even larger, more sophisticated companies thatmanage to secure equity investment from private equity funds or other sources

still need access to working capital, and indeed often end up using the equity in

this way, which is very costly and inefficient in the long run.

Opportunity to stimulate complementary lending: Banking in India isrelationship based, particularly at the SME level. Relationships are especially

important in LISs and remote areas (when there is access to formal financial

institutions). As highlighted above, given that many business owners have to

take out personal loans to fund working capital requirements, the Facility should

help to mobilise complementary lending from banks that take comfort from itswillingness to lend to sponsors they already know (but may have rejected for

business loans) from personal banking relationships. The presence of the Facility

should, therefore, act as a catalyst for breaking down such barriers between

personal and commercial lending, and strategic use of TA funds could be critical

in this regard (see below).

Proposed Focus and Structure of the ADB IB Facility for India

6. Inclusive business: where access to finance and impact intersect

The conclusion of initial due diligence in India is that the timing for an IB debt Facility isfavourable. In fact, it is arguably urgent owing to several features of the Indian financing

landscapesome long-standing, some more recentwhich are exacerbating the impact

of financial exclusion. These include:

Turmoil in the microfinance sector: Following the scandals in variousmicrofinance institutions (MFIs) in Andhra Pradeshover-indebtedness leading,

4Note that it may be possible to deploy mezzanine structures in some cases to capture upside for

investors, however, this should not be relied upon as regulatory arrangements are subject to change.


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in some cases, to suicidesmicrofinance has, to some extent, become a dirty

word in India. The relevance of this to the Facility is that, although most MFIs

had been focused on aggressive growth of their loan books, a few were focused

on the development of new, inclusive products and mobile payment methods

especially targeting women and the illiterate. Innovation has since all but ceased

due to MFIs difficulty in accessing debt from the wholesale markets and

because of restrictive new legislation introduced by the Reserve Bank of India

(RBI, the central bank). In addition to forcing many micro-entrepreneurs to seek

finance from money lenders, pawn shops and gold tradersdepending on their

proximity to innovative MFIs, they might have been able to access small

business loansMFIs are struggling to upscale with and for their clients

because of nervousness in the sector. It should be noted that, particularly in

agriculture, this was a significant source of finance (again, depending on

location) for some BOP suppliers and producers.

Debt funds are a relatively new phenomenon: The emergence of debt funds isrecent, and is being led by two formidable players in international finance: KKR

and a breakaway team from Citibank. Unsurprisingly, they are seeking to raise

large funds that will be focusing on substantial transactions. Whilst other fund

managers may follow suit, there is no evidence to suggest that there will be a

focus on lower middle market companiesi.e., deals of below US$20mlet

alone SMEs as more traditionally defined.

The start-up space is relatively robust: In contrast, seed capital, even for socialenterprises, has remained relatively robust in India, although admittedly it is

more difficult to access in LISs and remote areas. There is little indication that

there has been a significant decline in the availability of such finance in the wake

of the international economic slowdown and financial crisis of 2008-2011.

In essence, therefore, the orientation of equity towards large transactions, combinedwith the relative accessibility of venture capital and the limited availability of innovative,

inclusive financial products from MFIs that had been venturing down this path, creates a

compelling role for the Facility to focus on the unattended segment of broadly US$1m-

US$10m debt transactions.

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Furthermore, given the relative costliness of bank finance in India, and the difficulty ofaccessing it post-crisis, many companies that require amounts in excess of US$10m are

able to fund their needs through substantial cash accruals. Focusing on such companies

would likely be a distraction, as there would be no compelling reason for them to pursue

Facility financing (unless, of course, they needed to complement equity with debt

financing that they were unable to source).

5Note that the Facility would also have opportunities to lend to MFIs to support innovation of new,

inclusive products. It would be important, however, to ensure that such activities did not replicate,overlap or confuse activities associated with the US$400m line of credit that ADB has extended to

SIDBI.


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7. Suggested parameters for the ADB IB Facility in India

With the above discussion in mind, this section proposes some parameters andobjectives for the IB Facility in India, and attempts to highlight areas where it could

make a highly significant contribution through innovation and flexibility:

i. Geography: An exclusive LIS focus is neither necessary nor prudent for severalreasons. First, the quality of deal flow in LISs is generally poor. Second, with the

exception of Pragati, there are few competent fund managers focussed on LISs.

Third, in order to achieve a balanced portfolio from a risk perspective, it is advisable

to combine an opportunistic effort to reach LISs and remote areas with transactions

in other states. Recommendation: If the Facility is apportioned among several

managers, a significant allocation to Pragati (subject, of course, to full due diligence)

would be an effective strategy for ensuring LIS coverage.

The issue of geography should also be considered from the perspective of rural and

urban settings. Given the raid, unplanned, widespread urbanisation throughout

India, urban and peri-urban poverty have become as urgent as rural poverty. This

suggests that a focus on basic infrastructurewater, sanitation, housingin

secondary and tertiary cities could be as impactful as a rural focus per se.

ii. Sectors: If the above-suggested orientation for the Facility is acceptedtargetingthe BOP as consumers, suppliers and distributorsseveral target sectors naturally

stand out, including:

i. Agriculture: With a particular focus on value capture and value additionthrough supply chain development. For example, bringing technology and

TA to bear to introduce or improve pre-cooling, dehydration, resin and

enzyme extraction, steam sterilisation and so on. Some large aggregators

have attractive growth prospects and steady cash flows reflecting steady

contracts, but struggle to fulfil orders because SMEs in the supply chain

cannot access finance to boost capacity. Another area within agriculture

which has a disproportionate impact on the BOP is infrastructure, such as

food chain and cold chain strengthing (or introduction where absent).

ii. Access to finance: Working with selected NBFCs and MFIs on new productdevelopment, including crop insurance, disaster insurance, micro-health

insurance, micro-venture capital, access to clean energy and so on (seefootnote 4 above, however). Access to finance opportunities could also be


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pursued by lending to SME financing companies that provide finance of

$500-$15,000 to SMEs. The opportunity in such companies would be to help

them to enhance credit and risk analysis, and to support development of

new products that assist them in retaining and growing with their clients.

iii. Distribution: Distribution of solutions that are vital to, and affordable for,the poor, such as solar lighting, clean cooking solutions, clean water,

sanitation, secondary and tertiary irrigation, and so on. (Note the dual BOP

engagement here: BOP as distributors (i.e., employees, in a sense) and the

impact on end-users.

iv. Housing: Affordable housing for the poor, although initially launched bysome companies such as Mahindra as a corporate social responsibility (CSR)

initiative, has proven to be profitable in parts of India whilst, of course,

being desperately required.

v. Education: With a focus on last mile solutions, i.e., focusing on cost-reduction and hence affordability of vocational, primary and remedial

education (note that investment in K-12 is restricted by the Indian

government).

vi. Healthcare: Owing to poor quality and a general mistrust of publichealthcare, there is a tradition of paying for private care, even among lower

income groups in India. This makes investments in healthcare delivery and

last mile solutions more viable.

iii. Innovation: There are three areas in which, if innovative, the ADB Facility couldmake an enormous contribution to the financing of IB initiatives in India.

a. Incorporation of a liquidity facility: Especially post-crisis, investors reactnegatively to lock-ups or gate provisions, and tend to prefer funds which

provide redemption facilities (at least quarterly) at the prevailing net asset

value (NAV). Given the mismatch between the tenor and liquidity of assets

and liabilities, illiquid instruments are difficult to sell down in order to meet

redemptions. Recommendation: A liquidity facility (LF), provided by a

counter-party with an AAA rating such as ADB, could be used to meet

redemptions to the extent that asset sales are infeasible at any given time.

All or part of ADBs commitment would remain un-drawn to meet liquidity

requirements to fund draw-downs or redemptions. In case of drawdowns,

they would happen at NAV. Meanwhile, the un-drawn portion of the LF

would generate returns for ADB on an un-funded basis on the committed

portion of the Facility. Further upside would be available to ADB by capturing

the bid-offer spread in case of redemptions.


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b. Credit enhancement: Foreign investors neither understand nor recogniseIndian rating agencies methodologies and rating scales. Not only do

investors have concerns about the ability of the former to assess the credit-

worthiness of investee companies, but they are also worried about Indias

debt rating as a sovereign. Recommendation: Providing protection on

principal commitments (at the portfolio level, not the individual credit level)

could mitigate such concerns of private-sector investors that might

otherwise not participate in the Facility.

c. Currency hedging: Giventhe considerable depreciation of the Indian rupeein 2012, many private-sector investors prefer to hold their investments in

hard currency, and may even be willing to forego upside in order to

minimise currency exposure. Furthermore, the Indian rupee has become

extremely expensive to hedge, and is rarely available beyond a one-year

time horizon. Recommendation: Leverage the expertise of ADBs capitalmarkets department to provide the operating currency to those investors

who may otherwise not participatei.e., non-DFIsin a cost-effective

manner at the Facility level.

In summary the table below provides sample terms for an ADB IB Facility in India:ADB IB Debt Facility US$150,000,000

Investors DFIs, foundations, HNWIs, local and international banks

Fund managers 1-3 depending on due diligence

Facility life 7 years

Investment period 4 years

Lending term 36 months

Target return 14-18% per annum

Minimum commitment US$5 million

Management fee 2% per annum

Carried interest 20% above a hurdle rate of 8%

If a key objective of the Facility is not only to enhance awareness of inclusive business asa tool for achieving social outcomes andproducing attractive returns, but also to attractprivate-sector players into the space, then the incorporation of the innovations listed

above, combined with the attractive returns that could be generated, would enable ADB

to make a critical contribution and to move the market.

Depending on due diligence, the Facility could either be administered by one manager,or divided among several. There are advantages and disadvantages to both approaches.

Working with a single manager simplifies logistics and communications and would

enable ADB to develop a very close working relationship through which it could get a

very granular sense of lessons learned. Disadvantages of this approach would include

single-manager exposure risk.


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It is suggested, therefore, that ADB adopt an agnostic approach on this issue and, at theappropriate time, evaluate all potential managers (of which there are not many) on their

merits. If there is a positive relationship between the ability to cover multiple sectors

and geographies and deploying capital with several managers, then it probably makes

sense to work with several.

Regarding time to market, there is significant pressure on many DFIs to restrictengagement with India to LISs or activities which will have a clear impact on the poor.

For this reason, a Facility which explicitly targets inclusive business as a means of

achieving pro-poor outcomes is extremely timely and would likely be well received by

various DFIs, notably CDC, Proparco, Sifem, DEG and FMO.

Strategic use of TA has also already proven to be of interest to various donors inconjunction with the Facility (see below for a discussion of technical assistance).


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(note that one fund sponsored by LR Global, is attempting to raise US$30m for

US$1m-US$5m equity deals and is approaching a first close). Transactions above

US$2-US$4m are difficult to come by, and business owners are hesitant to open

their ownership structures to external shareholders. As highlighted above on the

lending side there is, conversely, a chronic shortage of debt available to SMEs.

Even when banks are willing engage with SME clientsand this assumes that

they have well-prepared financials, suitable governance structures, sufficient

collateral and a strong operating historyit is generally not below interest rates

of 20% or more. Furthermore, bank capacity for assessing opportunities in the

SME segment is weak, and varies significantly between branches and regions

(beyond Western Province and the greater Colombo area, it drops off

vertiginously). Thus, few banks are equipped to recognise attractive commercial

opportunities in the SME segment and reject potential clients outright.

There is therefore a critical gap to be filled with debt, both in the upper echelonsof the SME space, and in the transitional space between the largest loan sizes

that MFIs can provide and more traditional small-scale banking. It is important

to clarify the implications of this for the Facility: because of the dearth of small-

scale finance in the countrybroadly speaking, loans of US$10,000-

US$250,000many small business-owners take out multiple loans from MFIs

but use them for so-called income generating activities. So the opportunity for

the Facility becomes a two-pronged strategy: addressing both the absence of

small-scale finance and facilitating innovation in the microfinance sector (see

below) in order to help foster a continuum of finance for SMEs.

ii. Promoting innovation in MFIs: Microfinance has a long, established history inSri Lanka and emerged from the non-governmental organisation (NGO) and

donor-driven model of the 1980s and 1990s. Largely focused on the group

lending model, geographical coverage of microfinance is impressively high and is

being extended to areas that were impenetrable during the civil war. That

microfinance is a priority for the government is evidenced by legislation pending

in parliament which, from 2013, will enable MFIs to take deposits, mobilise

savings and will facilitate the creation of a credit bureau by forcing all

microfinance practitioners to register with a central authority. (This particular

development will be key to reducing the incidence of multiple loans).

This background is critical because the new legislation will pave the way for

much-needed innovation in microfinance, and it is in this domain that the

Facility can play a vital role. More specifically, there are 5 sub-sectors which

urgently require the development of inclusive, pro-poor financial products that

the Facility can support:

a. Agriculture: There is burgeoning demand among subsistence and small-holder farmers for:


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Insurance products, covering disease (crop and livestock), andnatural disasters such as floods and drought;

Access to inputs, such as seeds, pesticides, insecticides,herbicides, fertilizer and so on; and

So-called cultivation loans, which allow farmers flexiblerepayment terms (i.e., not monthly), removing the asymmetry

between harvests and payment schedules.

b. Value-chain clustering and reverse investment: LOLC Microcredit, forexample, has developed an innovative co-operative investment product,

whereby it takes a stake in a farming co-operative and provides finance

to farmers for purchasing inputs. A pool of permanent working capital is

created, whilst TA funding supports the administration of the entity.

Farmer incomes increase as the co-operative, with the support of LOLC,

cuts out middlemen by establishing fair-trade contracts and developingnew export opportunities. The scheme has been successfully piloted

with 800 cinnamon farmers, and requires significant additional capital.

c. Micro-health insurance: The vulnerability of household livelihoods toillness, especially in the agriculture sector, is extreme. There is scope to

introduce products that have proven very successful in Sub-Saharan

Africa which apply new modelling techniques to at-risk groups. The

result is a win-win for communities and MFIs, where effective yet

profitable coverage is provided.

d. Small-scale renewable energy: One MFI has experimented with small-scale biogas projects, whereby 25 families pool animal and crop waste

to create clean energy for cooking needs. A fertiliser by-product is also

produced. The MFI provides the finance for design and implementation,

resulting in a sustainable energy solution and attractive return on

investment.

e. Micro-housing: Some MFIs have been experimenting with micro-housing loans, whereby clients with strong track records of multipleloans with the MFI are able to borrow up to US$10,000 to construct

small homes. The MFIs have recognised an opportunity to leverage long-

standing client relationships, and need additional capital to expand the

programme.

3. Recommendations for the IB Facility in Sri Lanka

It is recommended that approximately US$20m of the IB Facility be deployed in SriLanka, apportioned in the following way:


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i. Loans to MFIs for product development: Progress on integrating the poorfurther into supply chains in inclusive ways that enable them to both capture

greater value and increase incomes depends on two developments. First,

engaging with aggregators and influencing their procurement policies and

willingness to engage with suppliers. And second, developing financial products

that help the poor to improve yields and increase output whilst enhancing their

resilience to exogenous shocks.

The MFIs interviewed during due diligence emphasized the need for technical

assistance funding and infusion of expertise from other markets in the

development of inclusive products. They specifically highlighted the importance

of gaining access to some of the risk assessment and modelling techniques that

have proven effective in agricultural insurance and micro-health products in

Sub-Saharan Africa.

ii. Debt finance for SMEs:There is a dearth of debt available for SMEs in the rangeof US$50,000 to US$2m. There are several intermediaries which the Facility

could consider to administer loans to SMEs, whilst supporting them in the areas

of credit analysis and risk assessment, cash flow-based lending and so on. By the

same token, the Facility could opt to work with one or several commercial

banks, were there a genuine commitment to developing expertise in SME

lending in the long term.


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3. Key Additional Considerations

The Importance of Technical Assistance

1. The need for multi-dimensional engagement: finance plus technical assistance

All constituents interviewed as part of the due diligence exercise in India and Sri Lankamultilateral development institutions, DFIs, commercial banks, donors, fund managers

NGOsemphasized the importance of providing technical assistance alongside finance if

meaningful progress is to be made in solidifying the inclusive business concept in the

region.

There are several areas or themes which would be crucial for TA to cover:i. Engagement with aggregators: In the BOP as suppliers model, awareness

needs to be built among aggregators in several areas. First, some still struggle to

distinguish between CSR and inclusive business strategies. In other words, the

long-term value of developing supply chains by engaging with producers with

expertise and/or finance is still not widely recognised. Second, few aggregators

have expertise in working with local financial institutions to encourage them to

provide products to their suppliers that would ease production bottlenecks.

ii. Development of service provision models: Whilst a company may recognise anopportunity to provide goods and services to BOP populations in ways that

enhance access and affordability, they may struggle to develop effective

implementation models to do so. In both India and Sri Lanka, companies struggle

to understand sales, distribution and consumption patterns and need assistance

with developing outreach and market development models. Similarly, the

development of risk-sensitive products and modalities of engagement with poor

and remote distributors and suppliers require training. In many relevant

sectorshealthcare, agriculture, education, for exampleinteresting

breakthroughs and important failures and lessons learned from othergeographies, notably Africa, can be brought to bear through TA in order to

replicate best practices.

iii. Training of local bank staff: Banks incentivise staff to mitigate risk and minimiselosses. This risk aversion underlies their reticence to engage with the SME

sector. TA would be critical to train partner financial institutions in credit

appraisal, cash flow-based lending and, more generally, the ability to identify

diamonds in the rough i.e., SMEs which, despite poorly prepared financials,

ad hoc or absent governance arrangements and loose financial controls, would


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clearly thrive and become solid clients were they given access to finance and TA

to address such weaknesses;

iv. Technology upgrading: SMEs in both India and Sri Lanka of all sizes needtechnology upgrades covering many areas, including:

Accounting systems, management information systems and financialcontrols;

Procurement and inventory management; Supply-chain tracking and management; In agriculture, clean energy production (small biogas, for example),

cooling, storage, transportation;

v. Training: In numerous areas, including: Management capacity and corporate governance; Human resource management, retention, training and incentivisation; Financial controls and accounting; Fiscal management and effective tax planning; Stakeholder engagement: producers, consumers, suppliers, local,

provincial/state government and so on; and

Export development, marketing and new market penetration.vi. Investor-readiness or investibility: Although the use of TA to prepare

companies for investment is controversial6, it might be used to work with

companies considered and initially rejected by the Facility, but which have a

strong chance of securing finance if they meet certain key targets and

milestones. For example, a fund manager might advise a company that,

provided proper corporate governance arrangements are implementeda

board of directors with three external directors, for examplethey will qualify

for a loan. TA could then be used for training on board composition and

effectiveness, and could even be structured as a re-payable grant once the

target becomes a portfolio company.

6Many donors have concerns around free rides and sponsors with take the money and run

attitudes. Additional concerns include the effectiveness of the so-called machine gun approach,whereby TA is sprayed at many potential investees in the hope that some prove worthy of

investment.

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