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

This 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 or the governments they represent. ADB does not guarantee the accuracy of the data and information provided in this report.

Table of Contents
Section Introductory Remarks 1. India 2. Sri Lanka 3. Key Additional Considerations Page Number
3 4 16 20

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 environmental challenges 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 companies with 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 among several 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 IB Facility, 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$100mUS$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 not generate 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. 3

1.

India

General Observations
1. The Prospects for an Inclusive Business Facility in India Indias demographic composition and the incidence of poverty, coupled with burgeoning demand 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 the Multi-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 three specific modalities of BOP engagement might be particularly effective for the Facility: incorporating BOP-owned/managed businesses, broadly within the small and mediumsized 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 particularly fortuitous: 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.

It 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 in sharp 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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Determining a Strategy for the Facility in India Faced with Indias vast geography, poverty and urgent demographic challenges, it is important 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-served populations 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 businesses that 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 so on. Introducing technology: Some businesses that recognise the BOP as an attractive 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. Access to finance: Although the regulatory environment makes investing in Indian 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.

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2. BOP as suppliers: Engaging the BOP as suppliers is arguably the domain in which most progress has been made in the development of IB strategies by larger Indian 5

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 local knowledge 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 within them. 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 investment opportunities 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 in the 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 unorganised sector 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.

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 socalled 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 not set 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 certain percentage 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 owners often resort to taking personal loans at monthly interest rates of 2%-5% to try to

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 customer payment terms if SMEs do manage to access formal finance; An inability to invest in research and development and technologies that would improve efficiencies; The absence of information technology (IT) and management information systems (MIS) that would enable improved supply chain and inventory management; An inability to develop effective marketing strategies resulting in limited visibility 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 sizes and 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 much by 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. 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 collateral constraints will once again prevent many companies from accessing them. Loan tenor: When SMEs do manage to access debt from formal sources, the tenor 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 several compelling reasons why the Facility should avoid providing equity: Unfamiliarity with equity: Not only do many businesses in the Facilitys target size 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 significant correction 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 large transactions (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 ability of 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 2004-2007 vintage 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.

The 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 that might 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.

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 generally attributed 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 that manage 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 is relationship 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 its willingness 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 is favourable. 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 various microfinance institutions (MFIs) in Andhra Pradeshover-indebtedness leading,

Note 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 is recent, 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 social enterprises, 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, combined with 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$1mUS$10m debt transactions.5 Furthermore, given the relative costliness of bank finance in India, and the difficulty of accessing 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).

Note 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 and objectives 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 several reasons. 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.

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Sectors: If the above-suggested orientation for the Facility is acceptedtargeting the BOP as consumers, suppliers and distributorsseveral target sectors naturally stand out, including: i. Agriculture: With a particular focus on value capture and value addition through 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). Access to finance: Working with selected NBFCs and MFIs on new product development, including crop insurance, disaster insurance, micro-health insurance, micro-venture capital, access to clean energy and so on (see footnote 4 above, however). Access to finance opportunities could also be 12

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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. Housing: Affordable housing for the poor, although initially launched by some 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. Education: With a focus on last mile solutions, i.e., focusing on costreduction and hence affordability of vocational, primary and remedial education (note that investment in K-12 is restricted by the Indian government). Healthcare: Owing to poor quality and a general mistrust of public healthcare, 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.

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Innovation: There are three areas in which, if innovative, the ADB Facility could make an enormous contribution to the financing of IB initiatives in India. a. Incorporation of a liquidity facility: Especially post-crisis, investors react negatively 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 recognise Indian rating agencies methodologies and rating scales. Not only do investors have concerns about the ability of the former to assess the creditworthiness 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: Given the considerable depreciation of the Indian rupee in 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 capital markets 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: US$150,000,000 DFIs, foundations, HNWIs, local and international banks 1-3 depending on due diligence 7 years 4 years 36 months 14-18% per annum US$5 million 2% per annum 20% above a hurdle rate of 8%

ADB IB Debt Facility Investors Fund managers Facility life Investment period Lending term Target return Minimum commitment Management fee Carried interest

If a key objective of the Facility is not only to enhance awareness of inclusive business as a tool for achieving social outcomes and producing attractive returns, but also to attract private-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. 14

It is suggested, therefore, that ADB adopt an agnostic approach on this issue and, at the appropriate 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 restrict engagement 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 in conjunction with the Facility (see below for a discussion of technical assistance).

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2.

Sri Lanka

General Observations
1. Overview of the Current Financing Landscape The salient feature of the Sri Lankan economy in the context of the Facility is that approximately 91% of its 18,000 firms are SMEs, according to World Bank data. Since the global economic slowdown and financial crisis, SMEs have suffered disproportionately in terms of access to finance, for two reasons. First, commercial lending rates soared to 2530% in 2008-2009; and second, banks re-directed their lending activity to larger, safer corporate clients. Worse still, the non-performing loan (NPL) ratios of some Sri Lankan banks peaked at 10% (some data indicate they may have reached 12.5% in some cases), augmenting aversion to lend to the sector. With borrowing requirements of larger firms likely to accelerate as the economic recovery gains momentum and credit constriction slowly eases, capital will be directed to large companies rather than SMEs. Indeed, the World Bank estimates that un-met credit demand between 2010 and 2012 could be as high as US$1.5bn in the country. With banks constrained by the global credit crunch and reticent with uncertainty, lending volumes have fallen significantly, and demand for government securities has sky-rocketed. Meanwhile, there have been on-going efforts to persuade commercial banks to downscale to supply credit to SMEs, however, it appears that associations of risk with the segment are so strong that very significant credit enhancements would be required in order to persuade them to divert even a small fraction of resources in this direction. The flight to treasury bills and all but the largest corporate clients is a trend that will abate at a glacial pace, and there is little reason to suppose that banks nervousness about the relative informality of the SME sector will subside soon.

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Opportunities for the IB Facility Given the inimical view of banks on smaller businesses in Sri Lanka, opportunities for the IB Facility lie in the SME space, and arguably should be approached from two routes: provision of debt finance of up to US$2m to lower-middle market companies that themselves have established linkages into the supply chain; and provision of finance to MFIs with the specific objective of developing inclusive financial products: i. SME lending: Unlike India, there is little equity culture in Sri Lanka and, with the exception of Aureos Capital, which is focussed on much larger transactions (US$10m and above), there is no dedicated private equity fund in the country 16

(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 echelons of 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 smallscale finance in the countrybroadly speaking, loans of US$10,000US$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 in Sri 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 smallholder farmers for:

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Insurance products, covering disease (crop and livestock), and natural 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 flexible repayment terms (i.e., not monthly), removing the asymmetry between harvests and payment schedules.

b. Value-chain clustering and reverse investment: LOLC Microcredit, for example, 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 developing new 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 to illness, 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 smallscale 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 microhousing loans, whereby clients with strong track records of multiple loans with the MFI are able to borrow up to US$10,000 to construct small homes. The MFIs have recognised an opportunity to leverage longstanding 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 Sri Lanka, apportioned in the following way:

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i.

Loans to MFIs for product development: Progress on integrating the poor further 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 range of 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 Lanka multilateral 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. Development of service provision models: Whilst a company may recognise an opportunity 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 other geographies, notably Africa, can be brought to bear through TA in order to replicate best practices. Training of local bank staff: Banks incentivise staff to mitigate risk and minimise losses. 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

ii.

iii.

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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 need technology upgrades covering many areas, including: Accounting systems, management information systems and financial controls; Procurement and inventory management; Supply-chain tracking and management; In agriculture, clean energy production (small biogas, for example), cooling, storage, transportation; 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. 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.

v.

vi.

Many 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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