IFMR CAPITAL CONNECTING MICROFINANCE INSTITUTIONS TO CAPITAL MARKETS

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1 Introduction to Securitisation for MFIs IFMR CAPITAL CONNECTING MICROFINANCE INSTITUTIONS TO CAPITAL MARKETS

2 About IFMR Capital IFMR Capital is a non-banking finance company based in Chennai, whose mission is to provide efficient and reliable access to capital for institutions that impact low-income households. IFMR Capital is one of several different companies under the IFMR Trust ( banner, promoted with the overarching goal of ensuring that every individual and every enterprise in India has complete access to financial services. One of IFMR Capital s core verticals is microfinance, with a focus on connecting microfinance institutions (MFIs) with debt capital markets through securitisation transactions, innovative structuring, investor product development, and market making in the securities we underwrite or guarantee. Working closely with each of our clients, we aim to deliver the optimal debt solution for them at each stage of their growth. We act not only as a structurer and arranger for our clients, but also as an investor in each transaction we structure. By linking our own success to that of our clients, we ensure that we will perform an in-depth assessment of an MFI s quality and that our growth will be a direct result of our ability to deliver lasting value for our clients. The fact that we have a financial stake in each of our transactions also enables other investors to place a high degree of confidence in the quality of institutions we work with. Investors and Market Development Our experienced investor relations team based in Mumbai maintains strong relationships with India s largest debt investors including banks, mutual funds, and insurance companies. This allows us to understand the specific requirements of the market, as well as to educate investors about microfinance and each of the high quality institutions with whom we partner. We are also establishing open information and trading platforms that bring greater transparency and standardization to the nascent micro-loan backed securities market. Through the establishment of robust market infrastructure and investor education, our clients will be able to avail the immense benefits of continual access to capital markets for years to come. IFMR Capital s Offering to MFIs Investor Relations Investor education, product design aligned with market demand, placing securities with investors Debt funding to facilitate access to capital markets Partnerships with rating agencies Platforms allowing for increased transparency and liquidity in microloan backed securities Credit and structuring expertise Team The IFMR Capital team possesses decades of experience gained from working with domestic banks, international investment banks, rating agencies, MFIs, private equity funds, derivatives exchanges, and top legal firms. We have a diversity of backgrounds but share a deep commitment to bring the benefits of financial innovation to institutions that impact low-income households. IFMR CAPITAL 1

3 An Introduction to Securitisation for MFIs Securitisation typically involves the conversion of assets that have predictable future cash flows (such as a pool of micro-loans) into standardized, tradable securities. Summary of Securitisation Process The MFI originates a portfolio of loans and IFMR Capital performs due diligence on the MFI. A Special Purpose Vehicle (SPV) is created. This bankruptcy-remote entity is set-up as a private Trust. A portfolio of loans is selected to be sold by the MFI to the SPV. A rating agency will perform due diligence of the MFI and evaluation of the loan portfolio. Credit enhancement may be provided by the originating MFI (first loss default guarantee, cash collateral) and by other investors including IFMR Capital (second loss deficiency guarantee), to achieve the desired rating of the issuance. The SPV issues securities to investors and the MFI receives funds when the portfolio is sold. CRISIL s View In contrast to the slowdown witnessed in other retail asset segments, microfinance loan disbursements have maintained strong growth and robust asset performance. Access to capital markets through securitisation can be a key growth enabler for microfinance, and can accelerate the social benefits arising from it. While the initial transactions have banks as investors, CRISIL believes that availability of more public data on the performance of microfinance loans will enable MFIs to tap the capital markets in the coming years. Indian Securitisation Market Review, MFI Sale of Portfolio SPV Rated Securities INVESTORS (Banks, Mutual, Insurance Companies, IFMR Capital) A significant difference between a securitisation and a traditional loan portfolio sale or assignment is that by having the portfolio rated and converted into standardized securities, a new universe of investors that have an appetite for rated assets are able to invest in microfinance. Rated securities are also much more liquid than plain-vanilla term loans or micro-loan portfolios purchased under assignment, as securities can be traded more easily. The first formal securitisation of assets in India took place in 1991, when Citibank securitised a pool from its auto loan portfolio, rated by CRISIL, and placed the paper with GIC Mutual Fund. At the end of March 2009, the Indian securitisation market totaled Rs. 523 billion and is comprised mostly of securities backed by auto loans, two-wheeler loans, mortgages, credit card loans, and various other assets originated primarily by NBFCs, corporates, and banks. IFMR Capital is now actively working to develop the market for securities backed by micro-loans as a new Asset-Backed Securities (ABS) market in the country. Characteristics that make micro-loan portfolios attractive for securitisation include their very high granularity of loans, superior asset quality, low prepayment risk, and diversification benefit for investors given the low correlation with other asset classes. IFMR CAPITAL 2

4 Benifits of Rated Securitisation for MFIs Diversified sources of funding Through a rated securitisation, MFIs are able to open up multiple new avenues to seek funding. Mutual funds are the largest investors in the securitisation market and have over Rs. 800 billion dedicated to invest in Fixed Maturity Plans - a category for which micro-loan backed securities qualify. There is a perpetual demand from these plans for short term securities (maturity under 1-year) and therefore there is an excellent fit with the short duration of most micro-loans. While many banks have historically provided unrated funding to MFIs, the upcoming enforcement of Basel II regulation will incentivize banks to invest a greater portion of their funds into rated assets. Given that a rated micro-loan securitisation simultaneously qualifies as a Priority Sector Lending asset and also carries a lower risk-weight than an unrated portfolio purchase or loan, banks will likely have a strong appetite for such securities going forward. Insurance companies, private wealth managers, and NBFCs are other investor groups that participate in the asset backed securities market, from which MFIs can potentially access funding via rated securitisations. These investors have a variety of risk-return preferences and therefore efficient structuring can be used to match a particular security s maturity, rating, and yield to meet a given investor s demand. By expanding their funding sources to a variety of institutional investors as mentioned here, MFIs can better manage their liquidity and access more regular funding throughout the year, as opposed to the current trend of lumpy inflows towards year-end when banks are looking to meet their priority sector lending requirements. As institutions build their track record and access the securitisation markets time and again, they will also build their own reputation with investors and rating agencies, thus enhancing their own standing in the market. Lower cost of financing The presence of different types of investors in the market will also serve to increase the liquidity of micro-loan backed securities and also lead to a secular reduction of cost of funding for MFIs over time as the asset class matures. The average yield on P1+ or AAA equivalent rated assets vary from 6% - 7% today, and therefore, securities backed by micro-loan assets with a similar rating can eventually be priced at similar rates with appropriate risk premium. By accessing the securitisation markets multiple times throughout the year, an MFI can significantly reduce its overall cost of funding. Capital release Once an MFI sells an existing loan portfolio to an SPV to be securitised, this effectively frees up its equity and provides immediate liquidity to invest in its growth. This means that an MFI is able to increase its client base and overall outreach in a shorter period of time, without raising additional equity. MFI Securitisation Case: Equitas Micro Finance In March 2009, IFMR Capital and Equitas Micro Finance India Pvt Ltd concluded the first-ever rated securitisation of a micro-loan pool in India. The transaction involved the securitisation of a loan pool of Rs. 160 million originated by Equitas, a leading MFI with operations in the southern state of Tamil Nadu. The transaction was structured and arranged by IFMR Capital, and the loan pool was purchased from the originator by a bankruptcy-remote Special Purpose Vehicle (SPV) created specifically for this transaction. The SPV then issued pass through certificates (PTCs), thus allowing the cash flows from the loan pool to be transferred to the investors through the SPV. The transaction has two tranches of securities and received the following rating from CRISIL: AA for the Senior Notes and BBB for the Subordinated Notes. The rating process involved a comprehensive due diligence conducted by CRISIL covering the MFI s performance and quality of the loan pool, the structure of the transaction, the extent of first and second loss protection, legal aspects of the transaction etc. The IFMR CAPITAL 3

5 loan pool was thus securitised into the AA rated Senior Notes (equal to 80% of issue size, i.e. Rs 125 million), which were subscribed to by Yes Bank, and BBB rated subordinated notes (equal to 20% of issue size, i.e. Rs 31 million), which were purchased by IFMR Capital. Equitas provided cash collateral equal to 11.7% of the issue size. The senior note investor is therefore provided protection to an extent of 31.7% of the issue size, in the form of the cash collateral from Equitas and the BBB rated notes, which are fully subordinated to the senior notes, subscribed to by IFMR Capital. The extent of protection increases as the portfolio runs down. IFMR Capital structured this securitisation also keeping in mind the learnings from the sub-prime crisis. The fallout from the sub-prime mortgage market in the U.S. showed that, when all risks are passed on to end investors, loan originators and financial intermediaries have no incentive to perform the requisite due diligence at the time of originating and buying portfolios of loans. The first-loss risk that Equitas bears is to ensure that the originating MFI maintains high quality of origination and servicing. The second loss piece, in the form of subordinate notes, provided by IFMR Capital ensures that it has an incentive to conduct robust pre-purchase due diligence to ascertain that the originating institution is of high quality. Each party in the transaction thus takes risks that it is best equipped to handle and the structure ensures that the incentives of all parties are aligned. Rating Agency Crisil Equitas Micro Finance Rs.160 MM Portfolio of microfinance loans SPV Assigns and maintains rating for the portfolio Rs.160 MM Securities with periodic principal and intereset payments AA Senior Notes 80% Fully subscribed by Yes Bank BBB Junior Notes 20% Fully subscribed by IFMR Capital Cash Collateral 11.7% First loss by Equitas IFMR CAPITAL 4

6 Proposed Multi-Originator Securitisation IFMR Capital is working to structure a securitisation of micro-loans from multiple MFIs (i.e. originators). The key advantage of a multi-originator securitisation over a single originator transaction would be that investors are provided with greater diversity across geographies and across MFIs, thus reducing idiosyncratic risk as well as servicer risk. The multi-originator securitisation will be targeted at mutual fund investors specifically, as the door-to-door maturity of the portfolio would be 12 months and have an average duration of 6-8 months. IFMR Capital s interactions with mutual funds have shown that they are keenly interested in this retail asset class. The structure enables smaller MFIs to access a new class of investors since their portfolios can be pooled to reach a more significant deal size. In the multi-originator structure, the cash collateral will be proportional to each MFI s portfolio and the cash collateral put in by one MFI will not be utilised in case of default on any other MFI s portfolio. However, the Junior Notes will be common for the entire pool. Portfolio Criteria - Top branch concentration <5% - Top state concentration <20% - Top district concentration <15% Seasoning - Min 2-3 months Credit enhancement 4-5 MFIs with Geographical diversification Senior note - Cash collateral by the MFI - Junior note subscribed by IFMR Capital/Banks Portfolio of microfinance loans Rating Agency SPV Assigns and maintains rating for the portfolio Securities with periodic principal and intereset payments P1 + Senior Notes Subscribed by mutual funds BBB/P1 Junior Notes Subscribed by IFMR Capital/Banks Junior note - Cash collateral by MFIs Cash Collateral First loss by MFIs IFMR CAPITAL 5

7 IFMR CAPITAL 1, Cenotaph Road Teynampet Chennai India capital@ifmr.co.in