Policy landscape affecting First Generation Entrepreneurs in India

Transcription

1 Policy landscape affecting First Generation Entrepreneurs in India December, 2011

2 EXECUTIVE SUMMARY Introduction Challenging for small and startup FGEs to source debt or equity due to concerns with policy design, implementation and eco-system issues Entrepreneurs are a vital catalyst for India s economy. However, many first generation entrepreneurs (FGEs) are unable to take the plunge due to lack of access to finance and a business environment that is difficult to navigate for first-timers. This report provides a review of the specific challenges that FGEs face to start, run and scale their businesses. It then goes on to map out policies and interventions that address and exacerbate these challenges. In most circumstances, we have also provided initial thoughts on the scope for improvement in these policies. Debt Financing Equity Financing Non-financial aspects Next steps Debt is the dominant source of formal capital, accounting for 95% of India s business capital (excluding business own investments). Low supply of institutional funding plagues the Micro and Small enterprise segments, as they are considered too risky to be served by large banking institutions, and too large to benefit from Microfinance, leading to a significant financing gap. Various enabling policies and interventions exist to address financing challenges to FGEs. However, a significant scope for improvement exists in terms of policy design and last-mile implementation issues. There is a need for policies which act as incentives to lenders. India s VC industry does reasonably well in international comparisons. However, the share of early stage deals, vital for FGEs, is low. There is a lack of an enabling ecosystem for FGEs, and high startup risks make investing in this segment riskier for investors. According to investors, India s regulatory framework is inhibiting, changing and ambiguous. This environment compounds the riskiness of investing in Indian enterprises and hampers investments in smaller deals and startups. Over the last decade, the RBI and SEBI have introduced certain measures to ease regulatory bottlenecks, however, there is scope for further development. Heavy paperwork and compliance requirements, and limited enforceability of legal contracts make doing business in India challenging and increase the possibility of failure, especially for FGEs. Limited levels of infrastructure resulting in high transport costs, underdeveloped supply chains, lack of office space, etc. increases costs and makes certain businesses unviable in India. There is scope for the public education system to improve its contribution towards providing employable youth across sectors. Reforms in regulatory procedures to start a business; more government focus on skill development are addressing some of these risks. Nearly 40 government policies and interventions are discussed in this report. The next step is to identify a prioritized list of 4-6 workable policy recommendations that can have a huge positive impact on FGEs. These policies should be feasible for the government to implement. These recommendations will be whetted by experts. After this, we will work with policy makers and other stakeholders to influence policies, government interventions and schemes that encourage First Generation Entrepreneurship in India. 2

3 TABLE OF CONTENTS Table of Contents i. Executive Summary ii. Table of Contents iii. Acronyms and Abbreviations pg. 2 pg. 3 pg Introduction 2. Overview of Financing to FGEs 3. Debt Financing b) Policy Landscape c) International best practices 4. Equity Financing b) Policy Landscape c) International best practices 5. Non-financial Aspects b) Policy Landscape 6. Concluding Thoughts and Next Steps pg. 7 pg. 10 pg. 13 pg. 13 pg. 17 pg. 36 pg. 39 pg. 39 pg. 42 pg. 57 pg. 59 pg. 59 pg. 60 pg. 63 iv. References pg. 65 3

4 ACRONYMS & ABBREVIATIONS Acronyms and Abbreviations (1) Abbreviation Full form Abbreviation Full form ARC Asset Reconstruction Company FEMA Foreign Exchange Management Act BC Business Correspondent FGE First Generation Entrepreneur BF CART CCI CERSAI CGTMSE Business Facilitator Credit Appraisal & Rating Tool Controller of Capital Issue Central Electronic Registry of Securitization Asset Reconstruction and Security Interest of India Credit Guarantee Fund Trust for Micro and Small Enterprises FI FINO FSLRC FVCI FY HR HTIL Financial Institutions Financial Information Network & Operations Financial Sector Legislative Reforms Commission Foreign Venture Capital Investor Fiscal/Financial Year Human Resources Hutchison Telecom International Limited CIBIL CIC CLCSS Credit Information Bureau India Limited Credit Information Company Credit Linked Capital Subsidy Scheme INR IOSCO IPO ISARC Indian Rupee International Organization of Securities Commission Initial Public Offering India SME Asset Reconstruction Company CONFIDI Credit Guarantee Consortium (Italian) IRDA Insurance Regulatory Development Authority CRA Credit Rating Agency IT Information Technology CRISIL Credit Rating Information Services India Limited ITES Information Technology Enabled Services DC Development Commissioner KVIC Khadi and Village Industries Commission DFCF Discounted Free Cash Flow LIS Low Income States DIC District Industries Centre LLP Limited Liability Partnership DMCC Dubai Metal Commodity Centre MFI Microfinance Institution FDI Foreign Direct Investment MGS Mutual Guarantee Societies 4

5 ACRONYMS & ABBREVIATIONS Acronyms and Abbreviations (2) Abbreviation Full form Abbreviation Full form MoF Ministry of Finance RBI Reserve Bank of India MSE Micro and Small Enterprises RRB Regional Rural Bank MSME Micro, Small and Medium Enterprises SARFAESI Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act MSMECDP MSME Cluster Development Program SBI State Bank of India MSMEFDP MSME Financing and Development Project SCB Scheduled Commercial Bank MRIP Modified Rural Industries Programme SEBI Securities and Exchange Board of India NBFC NES NGO NKC NMPC NSTEB OBE PE PFRDA PLI POS PSU Non Banking Financial Company North Eastern States Non Governmental Organization National Knowledge Commission National Manufacturing Competitiveness Programme National Science & Technology Entrepreneurship Development Board Off-Balance Sheet Exposure Private Equity Pension Fund Regulatory and Development Authority Primary Lending Institution Point of Sale Public Sector Undertakings SFC SICA SIDBI SIDC SIIC SSI SMERA SVCL TBI UCB USD VC VCF State Financial Corporation Sick Industrial Companies (Special Powers) Act,1985 Small industries Development Bank of India State Industrial Development Corporation SIDBI Innovation and Incubation Centre Small Scale Industries SME Rating Agency SIDBI Venture Capital Limited Technology Business Incubator Urban Cooperative Bank United States Dollar Venture Capital Venture Capital Fund RAM Risk Assessment Model 5

6 TABLE OF CONTENTS Table of Contents i. Executive Summary ii. Table of Contents iii. Acronyms and Abbreviations pg. 2 pg. 3 pg Introduction 2. Overview of Financing to FGEs 3. Debt Financing b) Policy Landscape c) International best practices 4. Equity Financing b) Policy Landscape c) International best practices 5. Non-financial Aspects b) Policy Landscape 6. Concluding Thoughts and Next Steps pg. 7 pg. 10 pg. 13 pg. 13 pg. 17 pg. 36 pg. 39 pg. 39 pg. 42 pg. 57 pg. 59 pg. 59 pg. 60 pg. 63 iv. References pg. 65 6

7 INTRODUCTION First generation entrepreneurs are a vital catalyst for the economy; important to ensure conducive policies are in place to support them About this report: How policies affect India s first generation entrepreneurs Entrepreneurs are a vital catalyst for India s economy. However, many first generation entrepreneurs (FGEs) are unable to take the plunge due to lack of access to finance and a business environment that is difficult to navigate for first-timers. In this report, we analyse the specific challenges that FGEs face and map these challenges to the various policies and interventions by the Government of India. Many policies seek to address the difficulties faced by FGEs but often have room for improvement. For example, the Ministry of Micro, Small and Medium Enterprises (MSME) introduced a Credit Guarantee Scheme to enable entrepreneurs to access debt without collateral. Considering lack of collateral is a major impediment in raising debt for FGEs, this scheme had a huge potential for impact. However, this guarantee is accompanied by various clauses which limit it s attractiveness amongst banks to lend using this guarantee. One such requirement is to declare a loan as a non-performing asset (NPA) before claiming a refund. Since most banks wish to bring down the number of NPAs, this clause reduces the attractiveness of lending under this guarantee, making it not altogether different from collateralbased lending. This could be an example of a well-meaning policy not having the desired impact due to design issues. There is also scope for improvement in the on-ground implementation of various well-meaning policies or interventions. For example, various State Governments have set up incubators to provide office and equipment facilities for first-time entrepreneurs. The effectiveness of this intervention, aimed at creating a strong ecosystem support for FGEs, is limited in places because the government-run incubation offices may not be functioning properly. Therefore, while an incubation centre has been allocated, in practice, there is a need to utilise this facility more efficiently. Finally there is a need to review certain policies, as they sometimes contribute to exacerbating existing challenges faced by FGEs. Consider one last example: foreign equity investors in India cannot issue a loan to an entity they have already invested in. The government places this restriction because it wants to guard the ability of foreign capital to provide loans (which has implications on monetary policy and inflation). However, this has the unintended effect of preventing investors from supporting FGEs they are associated with by, say, issuing a short-term loan. Limitations such as these compound the existing risks of doing business in India and make investors more risk-averse, especially towards FGEs. This report provides a baseline of all such policies and interventions that affect the ability of FGEs to start, run and scale their businesses. In most circumstances, we have also provided initial thoughts on the scope for improvement in these policies. In the future, we will be streamlining the findings in this report into a specific and prioritized list of workable policy recommendations for the government. The final aim is to go beyond the report and support policy makers in making India s business landscape more attractive for FGEs. 7

8 INTRODUCTION Features of this report Scope The topic of policies affecting FGEs in India is broad. Therefore, to get traction on key issues, we have defined the scope of this report as follows: While all aspects of doing business in India is covered, the report will especially focus on access to finance for FGEs. This is because financing is a major hurdle for most FGEs; further, most non-financial issues affect access to finance as well. Most policies in India that affect the functioning of FGEs do not refer to FGEs specifically as a target base. Therefore, for debt, we focus on government policies directed to MSMEs. For equity, we look at government policies affecting seed and early stage enterprises. The rationale for these choices are explained on page 11. We cover FGEs in all sectors. However, we do not cover sectoral policies, such as, say, a subsidy for clean energy businesses. We focus on Central level policies and look at the State level only if relevant. Definitions Most terms and concepts used in this report are explained as and when they come up. The following three terms, however, are used extensively throughout the report and hence defined here: First generation entrepreneurs: all entrepreneurs whose parents did not run businesses. The basic premise is simply that FGEs do not have an existing ecosystem to support them and find it harder to run businesses and raise capital compared to second generation entrepreneurs. 1 Policy: All Acts and Regulations authored by Central Ministries or autonomous Government bodies, such as the Reserve Bank of India. Interventions: Government schemes and actions where resources of the exchequer are expended beyond administrative purposes. For example, a State Venture Capital Fund or Credit Guarantee Scheme. 1 Source: National Knowledge Commission, 2008, Entrepreneurship Research Methodology We used the following four methods to complete the research for this report: Review of government policy documents and policy drafts as available on the internet. Secondary research on challenges and government policies & interventions affecting FGEs. Interviews of investors, lenders and FGEs. Existing Intellecap knowledgebase, where available. Structure of report The rest of this report is as follows. Chapter 2 sets the context by providing a brief overview of the debt and equity financing landscape in India. This overview provides the broad contours of debt and equity financing for businesses and compares them vis-à-vis each other. Chapter 3 delves into the challenges that FGEs face while trying to access debt capital and how various policies and government interventions are addressing or exacerbating these challenges. The last section of this chapter lays out in detail each of these policies, their impact or benefits and what, if any, is the scope for improvement. Chapter 4 follows a similar pattern for equity financing. Chapter 5 covers the non-financial challenges of running a business in India, especially for FGEs. As in the previous two chapters, policies that are interfacing with these challenges are detailed therein. Chapter 6 concludes with a final assessment of the report s findings and delineates next steps in the direction of making policy recommendations and influencing policies in this arena. 8

9 TABLE OF CONTENTS Table of Contents i. Executive Summary ii. Table of Contents iii. Acronyms and Abbreviations pg. 2 pg. 3 pg Introduction 2. Overview of Financing to FGEs 3. Debt Financing b) Policy Landscape c) International best practices 4. Equity Financing b) Policy Landscape c) International best practices 5. Non-financial Aspects b) Policy Landscape 6. Concluding Thoughts and Next Steps pg. 7 pg. 10 pg. 13 pg. 13 pg. 17 pg. 36 pg. 39 pg. 39 pg. 42 pg. 57 pg. 59 pg. 59 pg. 60 pg. 63 iv. References pg. 65 9

10 FINANCE OVERVIEW Debt and equity are complementary sources of finance for FGEs; currently in India, debt is the dominant source of capital Overview of debt financing to the MSME sector in India Debt is dominant capital source for businesses The main categories of suppliers of debt capital include Scheduled Commercial Banks (comprising public sector, private sector and foreign banks), Government institutions such as Urban Cooperative Banks, State Financial Corporations and Non-Banking Financial Companies. Public sector banks are the largest suppliers of institutional finance to MSMEs. Products offered through institutional finance cater to a variety of requirements ranging from short term to long term credit needs, and include fund based products (e.g. cash credit, overdraft, etc.) and non-fund based products (e.g. letter of credit, bank guarantee, etc.). There is a skew towards fund based products, and short term working capital loans in particular. While branch banking continues to be the main delivery channel to cater to these enterprises, branchless banking initiatives via business correspondents, mobile phones, etc., have emerged recently Debt vs. equity to Indian enterprises (INR bn) Overview of equity financing to seed and early stage FGEs in India Equity investors provide risk capital to enterprises in hope for commensurately high returns. While there is a high variability, investors typically expect to exit their investments within 3 to 7 years. Since investors seek potential for high growth (to accrue high returns), only certain type of enterprises get access to such capital. In India, early and growth stage investments have focussed on Information Technology (IT) and IT Enabled Services (ITES). For FGEs, there are two formal sources of equity infusion: a) high net worth individuals called angel investors, who provide seed and early stage funding, and b) Venture Capital Funds (VCFs), which provide equity for early and growth stage enterprises. FGEs can get equity infusion by agreeing to dilute ownership of the company with the investor. The specific structure of each transaction, however, has many variations and can include a combination of instruments like preferred stock, convertible debt, mezzanine debt, etc FY FY FY FY Gross credit to industry Total VC/PE investments Notes: VC/PE investments, usually expressed in USD, were INR 45 to 1 USD. The term 'industry' includes small, medium and large enterprises. Sources: Credit data: Handbook on Statistics on Indian Economy , Reserve Bank of India. Equity data: India Private Equity Report 2011, Bain Capital, Inc. Debt accounts for over 95% of India s business capital needs, excluding business own investments. Even when equity investments peaked in 2007, it only accounted for 8% of total business capital in India. The above graph includes large and late stage enterprises; therefore, share of equity capital to FGEs is likely to be smaller. The dwindling share of equity capital during was a result of dwindling foreign capital owing to the economic crisis. 10

11 Equity Debt FINANCE OVERVIEW Insights on financing by size, stage, sector & geography; analysis of which FGEs to focus on in terms of debt and equity capital By Size By Stage By Sector/ Geography FGE Focus Information asymmetry, dearth of credit history, high transaction costs and susceptibility to shocks constrain supply of finance to micro enterprises, making them the most difficult segment for banks. Medium enterprises are considered more equipped to absorb external shocks, and are better served than other segments. Micro enterprises mainly use fundbased products, where as mature small and medium enterprises also utilize non-fund based products. Early-stage enterprises in the MSME sector face challenges with respect to access to institutional finance. Reliance of traditional banks and financial institutions (FIs) on established track records, as one of the key parameters for issuing loans, constrains supply to earlystage enterprises. According to a survey conducted by the National Knowledge Commission (NKC), FGEs believe that access to early stage finance from banks is very difficult at the startup stage, and is relatively easier at the growth stage. Working capital contributes to a large extent of debt demand as manufacturing enterprises face high trade credit requirements and enterprises in the service sector are labor intensive. Knowledge based service enterprises due to intangibility of operations and limited collateral face challenges in accessing debt finance. Penetration of institutional finance in North Eastern States (NES) and Low Income States (LIS) 1 in India is restricted due to low levels of industrialization, infrastructure, high cost of operations and an unstable political environment. From this analysis, it is clear that the most under-served FGEs are micro & small in size and tend to be in early stages of their businesses. For this report, we look at FGEs by size and focus on access to debt for micro & small FGEs. This also corresponds to most government policies and interventions in this space. The average deal size in early and seed stage deals in India is USD 3 million (INR 15 crores) from 2006 to In the US, this average is almost half at USD 1.7 million in PPP terms. 2 This indicates that VCFs in India are not supporting smaller FGEs compared to their American counterparts. While data on angel investments are not available, qualitative information suggests that there are far lesser angel investments in India as well. Only around 15% of equity deals are for seed & early-stage businesses. Growth-stage deals (companies with an established business model and team and are looking to expand) account for around 20% of all equity deals. Over 60% of equity deals are for late stage and private investments in public equity (PIPE) because investors consider them safer. These have little bearing on FGEs. Equity investors predominantly target energy, real estate, financial services and telecom to invest in. These are large and relatively safe sectors. Among smaller deals, IT & ITES dominate, accounting for around 20% of deals from Of all VC backed firms in India, 50-60% are based out of Bangalore and Mumbai. Around 98% of the firms are concentrated in 6 Indian cities, though operations extend to smaller cities and urban India as well. 1 LIS includes Bihar, Uttar Pradesh, Rajasthan, Chhattisgarh, Jharkhand, Madhya Pradesh & Orissa and NES includes Sikkim, Assam, Meghalaya, Arunachal Pradesh, Tripura, Nagaland, Manipur, Mizoram 2 In exchange rate terms, this is USD 5 million. In Purchasing Power Parity (PPP) terms, USD 1 is approximately equal to INR 16, or approximately one-third of the exchange rate. Source: India Private Equity Report 2011, Bain Capital, Inc.; Stanford Business School conference on venture capital in India; Primary interviews In terms of equity, the most under-served FGEs are those in seed and early stage businesses. Therefore, we focus on policies affecting such enterprises. We also look at policies affecting FGEs that are looking for smaller deals. 11

12 TABLE OF CONTENTS Table of Contents i. Executive Summary ii. Table of Contents iii. Acronyms and Abbreviations pg. 2 pg. 3 pg Introduction 2. Overview of Financing to FGEs 3. Debt Financing b) Policy Landscape c) International best practices 4. Equity Financing b) Policy Landscape c) International best practices 5. Non-financial Aspects b) Policy Landscape 6. Concluding Thoughts and Next Steps pg. 7 pg. 10 pg. 13 pg. 13 pg. 17 pg. 36 pg. 39 pg. 39 pg. 42 pg. 57 pg. 59 pg. 59 pg. 60 pg. 63 iv. References pg

13 DEBT FINANCE CHALLENGES Overview of Micro, Small and Medium Enterprises; MSMEs contribute significantly to the Indian economy, but face significant funding shortages To provide context for analyzing policies related to debt to MSMEs, here we describe important features of this sector Overview of MSME sector by initial investment; size, sector and other features Definition of MSMEs in terms of initial investment (INR) Manufacturing sector > 5 and 10 Crores > 25 Lakhs and 5 Crores 25 Lakhs Services sector > 2 and 5 Crores > 10 Lakhs and 2 Crores 10 Lakhs Landscape of MSME sector (In terms of enterprises) Medium Small Micro 0.21% Informal sector 4.7% 95% Source: MSME Development Act 2006, 4 th All India MSME Census ( ), MSME Annual Report 2010 Size: The number of enterprises in the MSME sector in India amounted to 26.1 million units as per the 4 th MSME Census ( ) with the Micro segment accounting for 95% of units in the sector. Registration: 24.5 million enterprises in the MSME sector are unregistered enterprises, amounting to nearly 94% of total enterprises in the sector. Sector: The Services sector dominates over the Manufacturing sector amongst MSMEs, with ~71% of enterprises engaged in the Service sector. Type of organization: Close to 95% of enterprises in the MSME sector are Proprietorships, followed by Partnership form of organization. State-wise distribution: more than 55% of units are in 6 states: Maharashtra, Tamil Nadu, Andhra Pradesh, Karnataka, Uttar Pradesh and West Bengal. The MSME sector has consistently registered a higher growth rate than the rest of the Industrial sector Share of Manufacturing output (in terms of value): 45% Contribution to GDP: 8% Share of total exports (In terms of value): 40% Contribution to employment: 60 million Source: 4 th All India MSME Census ( ), MSME Annual Report,

14 DEBT FINANCE CHALLENGES A large number of enterprises in the MSME sector face severe challenges with respect to funding from Institutional sources Only 4-5 % MSMEs are covered by Institutional funding, given that approximately 95 % of villages are not covered by banks. There is, therefore, a need to bridge this gap through enabling policies. - Dr. K C Chakrabarty, Deputy Governor, RBI (May, 2010) Sources of Finance to MSME units (No. of units) 2% Snapshot of Outstanding credit to MSEs in India from Institutional sources (INR crore) 250,000 Scheduled Commercial Banks 5% 200,000 No Finance/Self Finance Finance through Institutional Sources 150, ,000 50,000 93% Finance through Non- Institutional Sources 0 Public Sector Banks Private Sector Banks Foreign Banks Government Institutions Source: 4 th All India MSME Census ( ). Close to 95% of enterprises in the MSME sector do not have access to finance from Institutional sources Heavy dependence of MSMEs on personal savings and Noninstitutional sources such as borrowing from friends and family, money lenders etc. owing to limited supply of institutional finance Propensity amongst Banks/ Financial Institutions (FIs) to undertake lending decisions based on availability of collateral and established track record High risk perception of enterprises in the MSME sector, and high transaction costs involved in serving these enterprises often deters certain Banks / FIs from lending to the sector FY 2008 FY Notes: Government institutions comprise Urban Cooperative Banks (UCBs), Regional Rural Banks (RRBs), State Financial Corporations (SFCs), State Industrial Development Corporations (SIDCs) and SIDBI (Direct Credit to MSE) NBFCs excluded from graph due to unavailability of official data regarding NBFC financing to the sector 2. Sources: RBI Annual Report , Report on trends and progress of Banking in India , MSME Annual Report, 2010, SIDBI MSME Database, 2010 Scheduled Commercial Banks are the key sources of institutional financing for the sector, with ~88% of outstanding credit to the MSE sector in FY 2009 contributed by Public sector banks, Private sector banks and Foreign banks together Public sector banks account for a clear majority (~75% of outstanding SCB credit to MSE sector) when compared to Private sector and Foreign banks Credit outstanding to the MSE sector from SCBs grew increased to INR 364, 012 crores in , with Public sector banks continuing to outpace Private sector banks and Foreign banks with a y-o-y growth of ~45% (over ) Debt is the predominant source of capital for businesses. However, given a low penetration of institutional debt to MSMEs, there is a pressing need to strengthen the role of Banks and Financial institutions in providing institutional finance to enterprises in this sector. 14

15 DEBT FINANCE CHALLENGES Players in the Debt landscape operate at varying risk segments, leading to a significant financing gap, especially for the MSE sector Suppliers of Debt finance operate at various parts of the spectrum. However, differing risk appetites limit the supply of finance to the MSME sector, which is generally perceived as risky by Banks and Financial Institutions DEBT FINANCE SUPPLIER Scheduled Commercial Banks Largely unserved by Institutional finance Public Sector Banks Private sector Banks & Foreign Banks Scheduled Commercial Banks are down streaming operations to serve the MSME sector Public sector banks are the leading suppliers of debt capital to the MSME sector on account of their wide branch footprint, with State Bank of India leading bank financing in the sector As Private sector banks and Foreign banks are largely present in urban areas, they have limited outreach in the MSME sector NBFCs MFIs Niche NBFCs Large NBFCs The NBFC segment comprises of large NBFCs that serve Medium and Large enterprises and niche NBFCs that serve the Micro and Small enterprise segment MFIs are also up-scaling their operations beyond the Informal sector to cater to the Micro enterprise segments Government Institutions Informal sector Source: Intellecap Analysis; Primary Interviews UCBs, SFCs, SIDCs, RRBs etc. Micro Small TYPE OF ENTERPRISE Medium Large Government institutions such Urban Cooperative Banks (UCBs), State Financial Corporations (SFCs), State Industrial Development Corporations (SIDCs), Regional Rural Banks (RRBs) etc. have been instrumental in serving the MSME sector due to greater access to entrepreneur information and an extensive network However, a large number of these institutions have been displaying signs of weakness, highlighting the need for measures to improve governance, financial health, reduce Non-Performing Assets (NPAs) etc. Low supply of institutional funding plagues the Micro and Small Enterprise segments, as they are considered too risky to be served by large banking institutions, and too large to benefit from Microfinance, leading to a significant financing gap. 15

16 TABLE OF CONTENTS Table of Contents i. Executive Summary ii. Table of Contents iii. Acronyms and Abbreviations pg. 2 pg. 3 pg Introduction 2. Overview of Financing to FGEs 3. Debt Financing b) Policy Landscape c) International best practices 4. Equity Financing b) Policy Landscape c) International best practices 5. Non-financial Aspects b) Policy Landscape 6. Concluding Thoughts and Next Steps pg. 7 pg. 10 pg. 13 pg. 13 pg. 17 pg. 36 pg. 39 pg. 39 pg. 42 pg. 57 pg. 59 pg. 59 pg. 60 pg. 63 iv. References pg

17 DEBT FINANCE POLICIES Regulatory framework guiding lending practices in India and Government Committees on issues of commercial debt financing RBI is the main regulator of debt capital; rules and regulations initiated by various Central Government Ministries Lead Actor 1 Acts; Regulations; Policy Documents Reserve Bank of India (RBI) RBI Guidelines for Banks; RBI Guidelines for Priority Sector Lending, RBI Guidelines on Business Correspondents and Business Facilitators (2006) Ministry of MSME MSME Development Act 2006, Package for Promotion of Micro and Small Enterprises (2007) Ministry of Finance Ministry of Consumer Affairs, Food & Distribution Ministry of Corporate Affairs Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act 2002 Department of Financial Services: Credit Information Companies (Regulation) Act (2005) Policy Package for Stepping up Credit to Small and Medium Enterprises (2005) Warehousing (Development and Regulation) Act (2007) Limited Liability Partnerships Act 2008 Provincial Insolvency Act 1920 (Covers Proprietorships and Partnerships) Various steering committees instituted by the Government provide policy recommendations on key issues Lead Actor Recommendatory Reports Prime Minister s Office Report of the Prime Minister s Task Force on MSME (2010) Four Step process for raising debt capital in India Committees / Working Groups instituted by various Government institutions Report of the Committee on Comprehensive Regulation of Credit Rating Agencies (2009) Report of Working Group on Rehabilitation of Sick SMEs (2008) Report of the In-house Working Group on Asset Securitization (1999) Report of Working Group to review the Credit Guarantee Scheme of the CGTMSE (2010) Report of the Working Group on the Issues and Concerns in the NBFC Sector (2011) 1 The Acts listed under the various ministries (in green) affect most the Ministry indicated here, but also has ramifications on other Government institutions. 17

18 DEBT FINANCE POLICIES Information asymmetry, risk of doing business & high transaction costs are key concerns for banks when lending to MSMEs Banks / Financial Institutions rely to a great extent on availability of adequate collateral and an established track record to evaluate credit worthiness of firms; conditions largely unmet by firms in the sector This leads to MSMEs availing of non-institutional sources of finance as they may not have the required collateral or track record Concerns/ challenges faced by Banks/ Financial Institutions when lending to the MSME sector stem from the following reasons: Lending to MSMEs is RISKIER Lending to MSMEs is COSTLIER Limited Financial Transparency High Information Asymmetry Low levels of Financial Literacy Vulnerability of Business operations High mortality of units and weak creditors rights High transaction costs Limited outreach High risk perception of MSMEs and limited risk appetite of banks/ financial institutions at times due to internal policies which encourage cautious lending impact credit flow Lack of suitable financial information & an inadequate information infrastructure leads to information asymmetry between lenders and enterprises in the MSME sector. Limited information on the enterprise inhibits access to finance, as banks consider accounting systems and financial records of these firms to be inadequate in many cases Insufficient information with respect to collateral, and lack of relevant credit history information leads to challenges in risk assessment and recovery on loan defaults Entrepreneurs in this sector usually have limited information on financial sources, products and services available., and limited skills with respect to the same Weak financial strength of enterprises on account of vulnerability to demand and market shocks, shortage of working capital and rising NPAs contribute to lenders concerns High turnaround time of processing MSME loan applications due to limited information regarding the credit history of enterprises. High transaction costs involved (cost of sourcing, acquisition and servicing) in serving this sector often adversely affect lenders inclination to lend Limited outreach of commercial banking institutions and lack of tailored products to cater to needs of this sector, contribute to higher transaction costs 18

19 DEBT FINANCE POLICIES Mapping policies and interventions to the various financing challenges Challenge Faced Enabling Policies Enabling Interventions Concerns/ challenges faced by Banks/ Financial Institutions when lending to the MSME sector: Need to increase Supply of Capital Lending to MSMEs is RISKIER Lending to MSMEs is COSTLIER Limited Financial Transparency High Information Asymmetry Low levels of Financial Literacy Vulnerability of Business operations High mortality rate and weak creditors rights High transaction costs Limited outreach 1. Sector specific act defining MSMEs: MSME Development Act (2006) 2. Inclusion of Credit to MSEs in Priority Sector Lending Guidelines (RBI) 3. Promotional Programmes/ Policy Packages: o PM s Task Force on MSMEs (2010) o Package for Promotion of Micro and Small Enterprises (2007) o Policy Package for Stepping up Credit to Small and Medium Enterprises (2005) 7. Facilitating Asset recovery and reconstruction: SARFAESI Act (2002) 9. Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE) to enable collateral free loans 10. Instituting a new form of collateral: Warehousing (Development and Regulation) Act (2007) 11. Establishment of Credit bureaus: Credit Information Cos. (Regulation) Act (2005) 15. Institution of Branchless banking initiatives: RBI Guidelines on Business Correspondents & Business Facilitators (2006) 4. Schemes/ Programmes by Ministry of MSME to promote MSME sector. Overview of schemes implemented through: o Office of Development Commissioner (MSME) o National Small Industries Corporation 5. SIDBI: Financing & Non-Financing initiatives 6. Other enabling institutions: SFCs, UCBs & District Industries Centre (DIC) Infrastructure support to mitigate Information asymmetry and risk: 8. Asset Re-construction Company (ARC) 12. Credit Bureaus (E.g. CIBIL) 13. Collateral Registry (E.g. Central Registry maintained by CERSAI ) 14. Credit Rating Agencies (E.g. SMERA, CRISIL, ICRA etc.) and Performance & Credit Rating Scheme (NSIC) 16. Cluster Development Programmes to leverage economies of scale (Financing & Non-Financing aspects) Constraining Regulations / Policies 17. Archaic Bankruptcy laws for Proprietorships and Partnerships (Provincial Insolvency Act 1920) 18. Inadequate legal & regulatory framework for alternative forms of working capital finance such as Factoring/ Securitization of receivables 19. Regulations constraining on-lending to NBFCs (other than MFIs categorized as NBFCs) limit their access to debt finance from banks (Exclusion from Priority Sector Lending guidelines) 19

20 DEBT POLICY ENABLERS Enactment of a sector-specific law and inclusion of credit to MSEs as Priority Sector Lending were significant steps for the sector 1 All debt-related policies are marked using the same numbers on page 19, the policy overview page Sector-specific Act governing promotion and development of sector: MSME Development Act (2006) 2 Inclusion of Micro & Small Enterprises in Priority Sector Lending guidelines Policy Overview Impact / Benefit Scope for improvement The MSME Development Act came into force from October 2, Classified units in the Micro, Small and Medium category, based on total investment in plant and machinery for manufacturing units and equipment for service units Facilitated formation of the National Board of MSME - an apex, statutory, advisory body to advise the Government on issues relating to the MSME sector Imposed penalties for delayed payments by large companies to Micro & Small enterprises Made provisions for development of future policies such as a procurement preference policy and exit policy As per RBI mandates, Priority Sector Lending targets are 40% of Adjusted Net Bank Credit (ANBC) or Off-Balance Sheet Exposure (OBE) (whichever is higher ), for domestic commercial banks while it is 32% for foreign banks Lending to the Micro & Small enterprise sector is considered in computing performance of domestic commercial banks under the overall PSL target, while foreign banks have sub-targets of 10% of ANBC or OBE (whichever is higher). Clear legal definition of units that fall under the MSME sector Expansion of plant and machinery limits and recognizing that investments in service units may be smaller. Facilitated formulation and execution of schemes and funds for promotion and development of the sector Provisions for penalties on late payments aim to encourage smoother cash flow to micro/ small units Simplification of registration processes Proposed procurement policy to guide purchase of supplies and Exit policy to regulate liquidation of sick units Guidance from National Board in policy formulation and programme execution Aims to address the shortage of funds in the MSE sector, by targeting bank lending to this sector To ensure allocation of sufficient financing to MSEs, RBI has accepted the following recommendations by PMs Task Force on MSMEs (2010): o Year-on-year credit growth of 20% to MSEs o Micro segment to account for 60% of annual outlay to MSE sector o Target of 15% growth per annum in number of micro enterprise accounts in commercial banks Stronger enforcement of policies such as penalties for delayed payments are required to ensure a continuous stream of working capital Need to introduce policies mentioned in the Act, such as the Procurement preference policy and Exit policy Scope to include special provisions for promotion of women entrepreneurs in procurement policies etc. Tendency amongst Financial Institutions to use annual sales for definition of units, leading to inconsistency with government mandates at times Scope to fix a sub-sector target within the overall priority sector ceiling (40%), as MSEs have to compete with Housing, Education etc. for the residual 12% after sub-targets fixed for agriculture and weaker sections at18% and 10% respectively While current regulations focus on large commercial banks serving MSMEs, there is a need to recognize that smaller financial institutions such as NBFCs, can complement the services of large commercial banks Source: Micro, Small & Medium Enterprises Development Act, 2006; Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); Entrepreneurship Development in the Micro Small and Medium Enterprise Sector in India - A Report by Shamika Ravi, Indian School of Business (July 2009); RBI Master Circular - Lending to Priority Sector (July 1, 2011); 20

21 DEBT POLICY ENABLERS The Government has undertaken efforts to provide stimulus to MSME financing and capacity building via policies and packages 3 Government support through Policies/ Promotional Packages Overview of intervention 1. Prime Minister's Task Force on MSME (2010): Set up to evaluate the issues raised by various MSME associations and develop an action plan to address the issues of the sector Final report submitted on January 30, 2010, with recommendations on issues relating to credit, taxation, marketing, labor, exit policy, infrastructure/ technology/skill development and packages for North East, Jammu & Kashmir etc. 2. Package for Promotion of Micro and Small Enterprises (2007): Consists of various proposals/schemes to support MSMEs with respect to credit, fiscal matters, clusterbased development, infrastructure, technology and marketing Package also focuses on capacity building of MSME associations and support to women entrepreneurs through guarantee covers, financial assistance etc. 3. Policy Package for Stepping up Credit to Small and Medium Enterprises (2005): Package was introduced aiming to double the credit flow to the sector within five years Measures to increase the quantum of credit include directives for banks to attain a minimum 20% yearon-year growth in credit to the MSME sector and provide credit cover on an average to at least 5 new MSMEs at each of their semi-urban/urban branches annually Impact / Benefit Stipulations in the Report of the PMs Task Force on MSMEs with respect to the following are likely to facilitate credit flow to MSMEs: o Strict adherence by banks to 20% year-on-year growth for MSE lending with 60% allotment for Micro sector o Creation of a fund with SIDBI called Special Fund for Micro Enterprises using shortfall against MSE credit targets for commercial banks The Task Force also indicates introduction of a Public Procurement Policy with a target of at least 20% of annual purchase volume from MSEs for government departments and PSUs, need to re-engineer and strengthen the District Industries Centers (DIC) to facilitate promotion and capacity-building of MSMEs etc. In addition to bank targets for lending, measures in the Policy package for stepping up credit include the need for banks to follow a transparent rating system to determine cost of credit, adoption of a cluster based approach for SME financing etc. Implementation closely monitored by RBI and Government, facilitating accountability and adoption Scope for improvement Issues in implementation, long turn around time etc. often limit effectiveness of such support. E.g. Introduction of Public Procurement Policy mentioned in the PMs Task Force Report on MSMEs (Target of >20% of annual purchases from MSEs) has seen limited progress Need for formulation of concrete plans of action and/or fund allocations in order to ensure effective execution of indicated measures, in line with urgency of requirement In addition, there is scope for increased private participation for implementation of various government schemes Source: business.gov.in; Report of Prime Minister s Task Force on MSME (GoI) January 2010; Package for Promotion of Micro and Small Enterprises (Ministry of Small Scale Industries & Agro & Rural Industries) February 2007; Policy Package for Stepping up Credit to Small and Medium Enterprises (Announcements made by Union Finance Minister) August 2005; 21

22 DEBT POLICY ENABLERS Schemes to promote and develop the MSME sector have been formulated and executed through varied implementation agencies Overview of intervention Impact / Benefit Scope for improvement 4 Ministry of MSME & Implementing Partners: Programmes & Schemes 1. Ministry of Micro, Small & Medium Enterprises: Nodal Ministry for development of policies/ Programmes/ schemes to promote and advance the MSME sector, execution and co-ordination Supported by the Office of Development Commissioner (MSME), National Small Industries Corporation (NSIC), Khadi and Village Industries Commission (KVIC) and Coir Board 2. Schemes operated by DC (MSME): Credit Linked Capital Subsidy Scheme (CLCSS) for technology upgrades: Aims at facilitating technology upgrades by providing15% capital subsidy to MSEs on institutional finance availed by them National Manufacturing Competitiveness Programme (NMCP): Aims to improve competitiveness of MSMEs across value chain of the sector and involves 10 components. NMCP includes programmes such as setting up of new tool rooms, product and process quality improvement, cost reduction etc. Other schemes include a scheme for capacity building (to strengthen MSE database), MSE-CDP (Cluster Development), CGTMSE etc. 3. NSIC: Public Sector enterprise set up to provide technical, financial and marketing assistance to MSMEs Undertakes schemes related to raw material procurement, product marketing, credit rating and technology support such as the Marketing Assistance Scheme, Performance and Credit Rating Scheme etc. Establishment of a distinct Ministry for the MSME sector facilitates the formulation and implementation of targeted policies/ programmes/ schemes aiming to increase the competitiveness of MSMEs and facilitate credit flow to the sector, amongst other advantages Setting up of a Call Center of the Ministry Udyami Helpline, contributes to improving the financial literacy of FGEs by providing a single point facility for information on formalities for setting up an enterprise, obtaining bank loans, subsidies etc. The DC (MSME) functions as an apex body supporting Government in developing and implementing policies and programmes for the sector, and provides assistance in varied areas such as marketing, technology, entrepreneurial development etc. Schemes implemented by NSIC assist MSMEs in raw material procurement and marketing of products (through consortia and tender marketing, single point registration for government purchase, credit support for procurement etc.), and contribute to enhancing the competitiveness and marketability of their products The Strategic Action Plan of Ministry of Micro, Small and Medium Enterprises, notes that a key challenge is multiplicity of programs/ schemes undertaken by various departments/ ministries for the same target group. This duplication with respect to design, implementation and communication often leads to confusion Need for effective coordination between various stakeholders, with synchronization of communication strategies In addition, there is a need for greater involvement of the private sector in scheme execution and improved awareness building initiatives Source: msme.gov.in;nsic.co.in; business.gov.in; Strategic Action Plan of Ministry of MSME 22

23 DEBT POLICY ENABLERS As the apex institution for promotion, financing and development of the MSME sector, SIDBI has a prominent role to play 5 Small Industries Development Bank of India (SIDBI): Financing & Non- Financing support Overview of intervention Principal Financial Institution for promotion, financing and development of MSME sector and co-ordination of related activities of organizations Financial support is provided through Direct lending, Refinance to eligible Primary Lending Institutions (PLIs) such as Banks, State Financial Corporations (SFCs), State Industrial Development Corporations (SIDCs) etc. and financial assistance through loans, grants, equity/ quasi-equity to NGOs / MFIs for on-lending to MSMEs SIDBI funding schemes relate to composite loans, financing marketing activities, equipment finance etc. In addition to finance, SIDBI has undertaken various initiatives with respect to non-credit requirements such as equity capital, credit rating, credit guarantee, technology up gradation etc. SIDBI is the implementing agency of the MSME Financing and Development Project (MSMEFDP), a multi activity, multi-agency project on financing and development of MSMEs through provision of financing and non-financing services, and development of an enabling eco-system. The project components include: o Credit facility from World Bank & KfW Germany used for extending credit to existing and new MSMEs o Risk Sharing Facility (Piloted through CGTMSE) o Technical Assistance by DFID UK, KfW and GtZ Germany covering capacity building of banks / financial institutions and borrowers, addressing policy and regulatory issues, promotion of market oriented business development services etc. SIDBI s Modified Rural Industries Programme (MRIP) aims at stimulating viable rural enterprise through facilitating availability of business development services Source: Report on Entrepreneurship in India, National Knowledge Commission, Government of India (2008); business.gov.in; SIDBI; Business Standard Impact / Benefit Provides financial support through Direct lending and Refinance, along with Development & Support services. Facilitates development of an enabling eco-system by varied initiatives: o Establishment of an Asset management company managing Venture Capital funds: SIDBI Venture Capital Limited o Credit guarantee support to collateral free loans: CGTMSE o MSME specific credit rating agency for transparent and comprehensive risk profiling: SME Rating Agency of India (SMERA) o Establishment of India s first MSME focused Asset Reconstruction Company for quicker resolution of NPAs: India SME Asset Reconstruction Company (ISARC) SIDBI has also undertaken efforts to promote Microfinance across India to cater to enterprises which do not have access to institutional finance The MSMEFDP aims to make MSME financing an attractive and viable option for banks/ financial institutions in India, and caters to financing and nonfinancing needs of MSMEs MRIP caters to MSE needs relating to financial & non-financial services such as market linkages, technology etc. Scope for improvement The Report of the PMs Task Force on MSMEs (2010) recommended the institution of measures to enhance resource support to SIDBI and to make available cheaper resources for on-lending at low interest rates to the sector There is also scope for SIDBI to encourage private players to set up Venture Capital Funds catering to the sector 23