The Road to NBFC-Different models for different options: An Interview with Mr.Hemantha Kumar Pamarthy
By Tanwi Kumari | Tanwi Kumari is an MSU Associate. She has worked extensively on legal frameworks of producer companies, as well as human resources policies including implementation of balance score cards and performance pay plans. Hemantha Kumar Pamarthy, the CEO of Hand in Hand Micro Finance Limited, is someone whose personality finds an echo in his profession. He looks upon microfinance as an important tool to curb poverty, in a sustainable way. He has spearheaded Hand in Hand's lending programmes for the less privileged with a degree of compassion, humility, and commitment that is yet to find its match in the industry.

With extensive experience in the area of finance, Pamarthy has gained considerable exposure to microfinance, micro-enterprise development, marketing and accounts. Prior to joining Hand in Hand Micro Finance Ltd., he was Chief Operating Officer at Sarvodaya Nano Finance Ltd. He has also been Associate Vice President at SREI International Finance Ltd. and held managerial positions in Apple Credit Corporation following a decade long association with Godrej Soaps. He has written numerous articles featured in leading magazines such as Frontline and Swagat and also in reputed newspapers such as The Hindu, Deccan Herald, and Andhra Pradesh Times. Over the years he has communicated with thousands of common village folk from across India due to his extraordinary facility with Indian languages. In an interview with the MFI Strategy Unit of the Centre for Micro Finance (CMF), Chennai, he talks about his views on growth of microfinance, specifically the road to a Non-Banking Finance Company (NBFC) and the different models or options of creating an NBFC to make micro-credit and microfinance a sustainable business.

Q: Hand in Hand Microfinance Limited is a registered company on its way to becoming an NBFC and you have been involved in establishing it. The CMF has been associated with you since your challenging stint at SNFL Ltd. Given your wide experience in the field, please throw some light on the key drivers that have resulted in the terrific growth that the microfinance industry in India has witnessed?
A: My association with the CMF has given me a great insight into the microfinance sector and enhanced my knowledge in the area. Indian microfinance industry has experienced very high growth in the last 3–5 years. This is because many MFIs have relatively easy access to debt capital from banks which have to comply with strong regulations by RBI on Priority Sector Lending. As a result, there is imbalance in the debt–equity ratio and equity infusion has become necessary for business growth. This opportunity has in turn attracted the attention of both private equity players as well as social investment funds. This explains the rapid growth of microfinance in India to a large extent.

Q: In what way does this vigorous growth related to the current trend of many societies and trusts rapidly converting to NBFCs?
A: This spate of conversions is basically a part of scaling-up operations. As the outreach and size of operations grows, each firm needs greater access to large fund inflows at affordable rates of interest. Compared to a trust or a society the standing of a limited company is more robust with better corporate governance processes and compliance records. Today, many NGOs, such as societies and trusts, with microfinance programmes are contemplating buying or acquiring existing NBFCs rather than obtaining fresh licenses. This is because they wish to by-pass the careful scrutiny process that RBI subjects new NBFCs to over a period of six months to a year before issuing a fresh license.

Q: What are the pros and cons of starting a new NBFC versus acquiring an old NBFC?
A: The advantage of an NBFC is access to large inflows of funds. But, starting a new NBFC requires resources—both financial as well as specialized manpower. The process involves developing an entirely new establishment from scratch and hence could also be time consuming. Acquiring an existing NBFC means that initial capital requirements are minimized. Those NBFCs which were registered before 1999 needed an initial capital of Rs.25 lakhs only whereas the stipulated equity now is Rs.2 crore. However this could also pave the way for complications right from the name of the organization to the adoption and modification of Memoranda and Articles of Association of the existing NBFC. Resolving these matters could consume a lot of time. Moreover, the ideology mandates, and mission of the old NBFC may be different from the ideological moorings of the acquiring NGO or organization. Aligning divergent positions could be procedurally elaborate and difficult.

Q: Can individuals or associations of people come together to register an NBFC? What are the statutory compliances in this context? Can you tell us about such an instance within the sector?
A: An NBFC is essentially a registered company and as such requires a minimum number of shareholders. One individual cannot make a company. But, yes, an NBFC can be formed by a group/association of people who can pool money to raise Rs.2 crore and then get registered as an NBFC.

Q: Clearly, MFIs can come in many avatars. What are the legal forms of MFIs that are prevailing?
A: An MFI can be formed in three main ways. One option is to form a Trust or a Society which also may be an NGO set up with non-profit objectives. The mandate of this entity is to reach out to the poor to the extent possible. If the scale is large, the next option is to form a company under Section 25 of the Companies Act, 1956, but this option is constrained by the fact that no dividend can be paid to the investors. This limits large capital infusion into the organization, because huge investments naturally come only with huge expectations of commensurate returns. Scaling-up does pose a problem in this regard. However, where operations are very large both in terms of geographic spread, as well as in terms of outreach, establishing a private limited company or a public limited firm as an NBFC may be advisable. NBFCs can attract equity infusion through investments from a group of individuals and/or investment institutions. However, a private limited company which cannot have more than fifty shareholders can access only a limited amount of capital.

Q: Are equity investments possible only in NBFCs? What are the capital requirements of forming an NBFC?
A: Yes, investments can be made only in NBFCs because profit can be shared with investors only through this legal framework. Presently, to form an NBFC one should obtain a Certificate of Incorporation (registered under Companies Act 1956) from the Registrar of Companies (ROC). As I mentioned earlier, a minimum net owned fund (shareholder equity) of at least Rs.2 crore is stipulated. Later, business commencement permission is also required.

Q: In your experience what are the other means of raising equity for an NBFC? Are there any regulations to be followed to raise equity from the capital market?
A: If an NBFC has sound processes and systems it may also raise equity from the capital market. It can issue shares and raise equity from the public through an Initial Public Offer (IPO). However all IPOs will be subject to regulation from the Securities and Exchange Board of India.

Q: What are the other ways of raising equity such that the MFI is able to generate profits without diluting its social goal of greater financial inclusion? Can members of Self Help Groups (SHGs) become equity holders? If yes, what are the challenges?
A: Within the alternate arrangement for forming an NBFC–MFI by raising equity from the members of SHGs, the SHG members become shareholders and stakeholders of the organization. The major problem faced in this case is that the NBFC has to incur high costs in terms of both time as well as finances in order to communicate financial and/or non financial disclosures to all its shareholders. Given that the surplus after expenses in an NBFC-MFI is normally rather marginal, this is a serious challenge. We do have such models in the country. One organization from Andhra Pradesh has successfully demonstrated it.

Q: Can you tell us about the MBT (Mutual Benefit Trust) model and its challenges? We have learnt that SHG members can become equity holders in the NBFC through the MBT model.
A: An MBT is a federation of several SHGs which comprise both the shareholders as well as the equity providers for the NBFC. This method results in community ownership. However, it requires unrelenting patience and time to set up such a system.

Q: What regulations must foreign individuals or institutions comply with in order to invest in NBFCs? How much time does it take to get clearance from authorities or regulators?
A: Repayment rates in the microfinance sector are usually high and hence it is very attractive to investors both domestic and foreign. As far as I know, for foreign entities to make equity investments into MFIs they need to obtain clearance from the Foreign Institution Investment Board (FIIB). This process generally takes several months.

Q: Given the influx of funds into the microfinance market today what operating model, in your opinion, should an MFI adopt in order to break even quickly, churn out profits and grow fast?
A: MFIs should first contemplate why the growth is necessary. Is it required to show the world its competence? Normally any organization registered and formed as an NBFC–MFI has a strong social cause as well as a robust business model. Such being the case, growth should come as a natural consequence rather than by design. In other words, prospects for profitability should not be the sole consideration when one decides an operating model. However, to answer your question specifically, to scale up operations the ‘NBFC–MFIs way’ would be better. Following either the Grameen model or SHG model or a hybrid of both, could prove successful. Between the two, the Grameen model has been observed to break even faster.