Funding Sme – The Challenges And Risk Within - Alternative financing sources - Part - 7

MSME FUNDING - Alternative
financing sources
Part 7
Funding Sme – The Challenges And Risk
Within

Alternative financing sources
Securitization of Trade Credit: Trade credit is an important source of financing
for MSMEs, as they sell on credit to their large customers and then wait for
long periods for payment. If these receivables (trade credit) could be packaged
as a securitized asset, which would essentially be a commercial paper with the
credit rating of the large firm, it could help MSMEs reduce their investment in
working capital and their need for finance significantly. The credit worthiness
of a typical MSME would also improve, qualifying it for greater bank funding.
Though the securitization process which is similar to factoring, could be more
cost-effective than bank funding, factoring, and letters of credit.

Securitization of MSME Credit: Likewise, MSME credit could be packaged in
the form of loan pools or securitized assets and sold to investors interested in
such an asset class. The MSME loans which had very nominal share of 2 per
cent in securitization during 2010-11 have emerged as one of the key loan
categories to be securitized accounting for almost 11 per cent of total assets
securitized in the asset backed security (ABS) pool during 2011-12, indicating
growing investor and issuer interest in this asset class.

If institutions utilize their expertise to systematically build this asset class
backed by a strong underwriting framework and market it to a larger investor
franchise then such transactions would enable small business lenders to
access capital markets at a reasonable cost and boost funding to MSMEs.
Securitization helps in creating a secondary market for MSME loans in India
and if properly applied this technique can become a replicable tool that can
enhance access to finance for MSMEs. The new guidelines for securitization
of standard assets issued by Reserve Bank of India in July 2012 are also
expected to go a long way in the creation of a true securitization market in
India as they have incorporated several safeguards to enhance the quality of
pass through certificates issued in a securitization transaction.

Factoring to Tackle Delayed Realization
of Receivables:
Considerable delay in settlement of dues/payment of bills by the large-scale
buyers to the MSMEs units adversely affects the recycling of funds and
business operation of MSME units. Further, timely payments from customers
will help MSMEs in reducing their working capital requirements leading to
lower interest costs, improved profitability and a positive impact on the long-
term health and sustainability of India’s MSME sector. A study of 5000 MSMEs
by CRISIL shows that high quantum of receivables is an endemic problem
across industry/ sectors and geographies in the MSME space.

of Receivables:
Smaller MSMEs, perhaps due to their lower bargaining power, are in an
unfavourable position with weaker receivable positions. CRISIL estimates that
timely payments from large customers will help MSMEs reduce interest costs,
and improve profitability by around 15 per cent and have a positive impact on
the long-term health and sustainability of India's MSME sector. It is,
therefore, critical that small enterprises receive payments on a timely basis
from customers or alternatively they are able to raise liquidity against their
receivables.

of Receivables:
The above problem of delayed realization of receivables can be institutionally
tackled by factoring which provides liquidity to MSMEs against their
receivables and can be an alternative source of working capital. Factoring is a
flexible alternative to traditional forms of funding. When a client makes a
sale, delivers the product or service and generates an invoice, the factor buys
the right to collect on that invoice and releases funds, usually 80-90 per cent
of the invoice value to the client.

of Receivables:
Factoring as a financial services product is superior to the conventional bank
finance in terms of it being an easy and fast method of turning accounts
receivables into cash, offering funding up to 90 per cent of the invoice value,
not restrained by geographical limits, non requirement of collateral security,
offering value-added services in the form of sales ledger administration,
collection and credit protection, credit screening-cum-credit monitoring and
early detection and warning of customer service problems.

of Receivables:
Across the world, factoring is a preferred route of accessing working capital
for MSMEs and even larger organizations. Some banks and financial
institutions in India have already launched factoring services for MSMEs. As a
result of this procedure, MSMEs attain liquidity against their receivables from
customers and is regarded as a cash management tool. Factoring would also
help improve MSME financing and is a major step towards fullfledged
securitization. The Indian factoring market is currently pegged at around Rs.
25000 crore. Factoring as a service is seeing significant demand from MSMEs
in line with global trends.

Angel Funds / Venture Capital Funds:
Venture/ Risk capital is often a more appropriate financing instrument for
high-growth potential and start-up MSMEs. However,
the ability of MSMEs (especially those involving innovations and new
technologies) to access alternative sources of capital like angel funds/risk
capital needs to be enhanced considerably. Although the sector commonly
uses traditional debt, this type of financing is often not accessible for fast
growth and start-up firms. During their initial phase, firms need finance to
study, assess and develop an initial concept (seed phase) or for product
development and initial marketing (start up phase).

At this stage, firms may be in the process of being set up or may exist, but
have yet to sell their product or service commercially. High-growth firms
usually develop an idea, concept or product that requires an incubation
period before generating revenues and profits.

An enterprise basically looks for venture capital to provide them with the
financing they need to expand or break into new markets and grow faster.
Further, Government of India, in terms of the recommendations of the PM’s
Task Force on MSMEs, is already looking at removing the fiscal/regulatory
impediments to the use of such funds by the sector. Venture/ Risk capital
funding is ideal for newly emerging ventures like bio-tech, food processing, IT,
pharmaceutical and other knowledge based sectors. Creation of venture
capital funds to meet the equity requirements of these units in the initial
phase of their working in the knowledge sector including BPO, KPO, Life
sciences, on-line business, technology-enabled design and manufacturing as
well as in emerging areas of nanotechnology and environmental technology
would go a long way to help such industries.

Angel investors are investors who
typically invest their own funds,
unlike venture capitalists, who
manage the pooled money of
others in a professionally-
managed fund are increasingly
becoming another alternative
source of funding for MSMEs in
India.

Private Equity Funding: Private Equity (PE) investment provides another
source of raising capital for MSMEs. PE funds have been investing in Indian
firms since 1990s. These financial enterprises are typically focused on funding
a company early, adding value to them and making an exit at a later stage.
They are stable sources of capital and tend to have an investment horizon of
3-5 years looking at a multiple return on their investment. PE investors not
only bring capital but also expertise and experience and expertise from
established businesses and from the global markets. They expose their
portfolio companies to best in class practices and work extensively to see that
they are implemented into the organizations that they are funding

They also work extensively with their portfolio companies and encourage
management to undertake operational improvements in case of any strategic
opportunities such as mergers, acquisitions and joint ventures. The Planning
Commission recently released a preliminary approach paper regarding its
12th five-year plan (2012-2017). A key focus area in the plan is to promote
equity investment in MSMEs by constituting a Working Group devoted to the
concept.

Owing to the high valuations at
which the investments were
made in 2007 and 2008, a
number of portfolio investments
of PE funds are currently not ‘in
the money’ and with the relative
fall in Indian rupee, exits have
been becoming even less
attractive.

For CY2013, SMEs attracted US$1.25bn which is 3% down when compared
with US$ 1.3 bn in CY2012, however the number of deals have increased by
26% to 222 deals. Private equity investments in India's MSME sector fell to
US$151 million in January-February 2013, implying a decline of 51 per cent
compared to similar period last year.

In the last four years, 2011 was the best year for the sector, attracting
US$1,478 million in PE flows across 188 deals, compared to US$1,246 million
across 159 deals in 2010 and US$642 million across 103 deals in 2009. In
2012, the sector attracted investments totalling US$1,184 million across 151
deals - a fall of 19 per cent over 2011.

Mezzanine Financing: Business owners need finance in order to invest but
they want to retain control of their business and not give up valuable equity.
For MSMEs the financing options are limited and private equity investors are
usually interested in larger companies, while business angel investors are
more active in start-ups. Furthermore, conventional bank lending is often not
available for projects that could be classified as speculative. That’s where
mezzanine finance comes in. Mezzanine finance is a fairly well-known type of
funding, which sits between traditional bank debt and equity and it is exactly
what many MSMEs need.

Mezzanine debt refers to hybrid financial instruments that possess
characteristics of both debt and equity. It lies somewhere in the midst of debt
and equity on the riskreturn spectrum. In the hierarchy of creditors,
mezzanine debt is subordinate to senior debt but ranks higher than equity.
Mezzanine debt is also called subordinated debt or second mortgage.
Commensurate with their subjugated position in the claim over the assets of
a corporation which is tantamount to the assumption of relatively higher
risks, mezzanine financers typically demand a higher rate of return as
compared to debt providers but lower than that required by equity investors.
Mezzanine finance typically is a structured debt-like instrument, earning high
yields, through a combination of cash coupon and terminal yield and/or
equity-linked components, such as warrants and optionally convertibles.

Although the position of mezzanine finance lies along the continuum
between traditional debt and equity, the exact extent of its commonality with
either is nebulous at best. This is because mezzanine debt instruments are
primarily of the over-the counter (OTC) type, i.e., they are privately
negotiated contracts between private parties.

Mezzanine financing can be a very effective tool in aiding sales development
and creating jobs, but a common question is how it impacts the internal
structure of a business? This is the major issue between MSMEs and equity
investors.

THANK YOU
Email: jyoti.gadia@resurgentindia.com Call Us: +91 124 4754550
www.resurgentindia.com
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within/

Funding Sme – The Challenges And Risk Within - Alternative financing sources - Part - 7

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Funding Sme – The Challenges And Risk Within - Alternative financing sources - Part - 7