The NBFC- lending (Non-Banking Finance Companies) business is an easy to understand, but difficult to execute business. We explore two aspects of the NBFC lending business in this article:
The capital cycle
The demand cycle
Let me speak about the capital cycle first. The model of NBFCs is pretty simple. They raise money through various sources (banks, institutions, retail investors) and lend it to customers. What they earn in the middle is a spread. For example, if a company can borrow at 8% and lend and 20%, it keeps a spread of 12%. Is a 12% spread realistic? We will come to that later when we speak about Net Interest Margins in another article.
As mentioned earlier, NBFCs borrow money for their lending operations. When the economy is faring well, the NBFC business does much better than others. This outperformance in business is mainly due to the leveraged business model. This superior performance is reflected in the earnings. Outperformance in earnings attracts more investors to these companies. This leads to more equity investments in the form of private placements, follow-on offerings, etc. The debt markets also are very keen to offer money to these companies to participate in the growth story (NBFC is a high-growth sector). The story remains intact as long as the economy is doing well. The moment there are signs of trouble in the economy, fewer investors want to invest in NBFCs. This aversion towards NBFCs keeps growing as the economy worsens. We are going through one such phase after the outbreak of the COVID 19 pandemic.
As the economy recovers from such a crisis, the confidence in NBFCs returns. This confidence peaks along with the economic cycle. This cycle of low and high confidence is called the capital cycle.
To summarise the capital cycle, at its peak, many investors are interested in investing/ lending money to NBFCs. At its trough, NBFCs struggle to raise capital.
The capital cycle discussion will be incomplete without discussing the source of capital for NBFCs. NBFCs borrow mainly from three sources: Retail investors, Banks, and Institutions. Institutional money is volatile in nature and tends to quit when times are tough. As against that, deposits raised from retail investors are pretty stable. Retail investors are highly appreciative of the extra rate of returns that NBFCs offer over banks. Hence, most of them do not really mind staying put with NBFC deposits even in rough times.
The magnitude of stability is in the following order:
Retail investors > Banks > Institutions
You might have guessed it right, the borrowing costs are in the following order:
Institutions < Banks < Retail Investors
As can be seen, NBFCs face a trade-off when raising funds. High stability of retail deposits comes at a higher interest cost. NBFCs that manage to sail through the capital cycle successfully, are likely to have high growth periods in the following decades.
There are many NBFCs in India that have successfully sailed through the capital cycle for many decades. To name a few, Manappuram Finance, Muthoot Finance, Cholamandalam Finance, Sundaram Finance, HDFC Ltd, Mahindra & Mahindra Financial Ltd. The ease with which these companies have raised capital through tough times is also partly due to their parentage. Investors trust NBFCs with strong parents more than standalone entities. A successful track record is also very important in the NBFC business.
As mentioned earlier, the demand cycle depends on the underlying customer base. Let me give a few examples. The NBFC sector can be classified as per the type of lending:
Muthoot Finance is an NBFC having specialized operations in Gold lending. Sundaram Finance and Cholamandalam Finance have commercial vehicle lending as their specialty. Mahindra Finance focuses on rural financing. Muthoot Capital Services focuses on second-hand two-wheeler lending. LIC housing finance, CANFIN Homes are reputed names in the housing finance business. Bajaj Finance has established a niche for itself in the consumer lending space. You see, how various companies are trying to carve out a niche for themselves based on the type of customers, sectors, geographical focus, etc!
NBFCs face demand cycles owing to the cyclical nature of the underlying industries. The automobile sector took a complete u-turn somewhere in 2018. This affected vehicle lenders severely. Many small lenders were compelled to shut shop. Companies like L&T Finance have been underperforming owing to their exposure to the real estate sector. After the COVID crisis, Muthoot Finance, Manappuram Finance are shining bright. Tough economic conditions lead to more borrowing by pledging Gold. This helps the gold loan business.
It is also important to think about competition in a particular space. As a case in point, let us talk about the gold loan business. This business is getting very competitive with many new banks wanting to enter the business. The reason for this competition is understandable. Gold lending is a completely secured business. NBFCs lend much lower amounts than the actual value of gold kept as collateral. This gives a high margin of safety to the gold lending business. Let us analyze a gold lending business from the perspective of a borrower. Normally, anybody who takes a gold loan is in urgent need of funds. To take out that gold loan, a husband has to give a valid justification to his wife, and then she decides whether to pledge her ornaments or not. There is a huge sentimental value attached to gold ornaments (especially in India). The last thing that a sensible man would do is to default on the gold loan! Else, his social reputation might go for a toss or his marriage might be jeopardized. In order to avoid this reputation damage, borrowers are generally particular while selecting the gold lending NBFC. A company like Muthoot Finance has built high brand equity over the last many decades. This trust is in itself a moat for Muthoot Finance or Manappuram Finance.
To conclude, different NBFCs face different demand cycles. Businesses like Bajaj Finance are less susceptible to the demand cycle. Businesses like Cholamandalam Finance have a high dependence on the economic growth. And then there are businesses like Muthoot Finance, which perform much better in recessionary environments.
Let me say this and summarise the above:
NBFCs are companies which borrow money and lend it to different customers. They broadly face 2 cycles: demand cycle and capital cycle. There are times when both the cycles coincide and it leads to a systemic shock. Companies which survive tough times, are likely to do exceedingly well in good times. It is a business of "a survivor takes it all".
Important points to be considered before selecting an NBFC:
Parentage and track record: A strong parentage and track record are important to navigate the capital cycle. Standalone NBFCs are treated like orphans when the economy starts going down.
The Source of funding is important. Companies surviving on institutional money or bank borrowing are more susceptible to the ugly side of the capital cycle. Retail deposits are much safer.
It is preferable to have a company that has established a niche for itself. The lending business is commoditized. It is important to have a distinguishing factor.
Technology is changing the way lending-borrowing used to take place. It is important to have management that can adapt to changing times.
Accounting quality is important in NBFCs, much more than it is in other companies. I will cover this aspect in a separate article.
Thanks for making it to the end. This article is not exhaustive to analyze an NBFC but focuses only on the capital and demand cycles. Hope you enjoyed reading.
All the best!
Disclaimer: This blog is purely for educational purposes. It is not an investment recommendation. Tequity Investing may have a position in some or all of the companies mentioned in the above article. Please do your due diligence before investing.