My opinion on the business outlook for investment research done from India (KPO’s) in light of the current financial crisis

In the short term, there is bound to be pain for the KPO’s as the retrenchment in the western markets for financial services companies leads to cuts in the offshore centers (either captives or contracted outsourcing). But there are some structural shifts that i think will drive long term growth of the KPO sector. These are:

1. Investment banks have usually been “fat-cats” and though the top tier firms have had substantial offshore presence through captives, the layer below (mid-tier and small tier) have not had much much of a global workforce. Now, with the financial crisis hitting hard on consumers and businesses, there is going to be additional scrutiny by investors on the costs and profit margins of the banks (including these investment banks that have become commercial banks now). After the excesses of compensation and greed that has been evident to the market (and the reason for failure), investors are going to demand more austerity. They will not want to pay so much for research. They will also demand more research (productivity), higher quality research (depth and connection with reality) while forcing the banks to keep costs down. This is going force the banks of all sizes to think deeply on the composition of their workforce for the future with greater global component to it. The parting comment here is that we might see the equivalent of the Microsoft business model where there is grassroots adoption of outsourcing across all tiers of banks, not just bulge or large bracket. This will drive the volume and breadth of work.

2. Traditionally we have seen “back-office” outsourcing for KPO. Examples are external financial reporting, fund reconciliation, internal reporting and analytics to support decision making and many other such activities where the primary driver was cost arbitrage (just like Y2K was for IT outsourcing). I think the BIG shift you are going to see is that global sourcing will come into play for front end support now. As an example, my firm SG Analytics is involved in client projects that range from M&A diligence support, analytics support for restructuring business divisions, strategy projects for acquisitions (sector analysis, identifying targets, building business case studies etc). I think this is still the tip of the iceberg. The opportunity (and now the willingness of banks to actually outsource this type of work) will only increase. I would like to hear what other analytics KPO’s are seeing in their markets such as pharma, legal, business analytics and others.

3. Lastly, the pendulum of investments is (and will continue) to shift to wards emerging markets like China, Brazil, Russia, South Africa and India. As more money flows in from institutional investors of all type (HNWI, PE’s, Corporate funds, Sovereign funds etc), you will see the need of quality investment research work being done by local KPO’s in these countries for local investment. The one’s that will be successful are the one’s who will leverage their experience gained serving the global markets to their local markets now.

You can also check blogs written by my colleagues at SG Analytics Blog.

A short history of the recent financial crisis

The roots of the current crisis could be traced back to the slowdown experienced by the US economy in the earlier part of the decade. The US central bank decreased the interest rates to historically low levels to stimulate the slowing economy. Banks flush with excess funds, encouraged people with weaker credit histories to avail mortgage loans to purchase houses. These loans were often with a very low or no initial down-payment, low initial interest rates and higher rates or floating interest rates in the later years. Some of them were even negatively amortizing loans with higher payments scheduled in later years. This led to a rapid growth in the demand for new houses and sharp appreciation in the values of the houses. Taking advantage of these low interest rates and rising property values, US consumers borrowed heavily against their houses, and led a private consumption boom based economic revival.

The banks disbursing the housing loans lowered their due-diligence standards for the loan seekers, as they were not keeping these loans on their own books, and were securitizing them into independent investment vehicles or buying credit default swaps. These helped them in lowering their regulatory capital requirements, and still earn fee based incomes for loan origination, becoming brokers than custodians for these loans. The investment bankers were setting up investment pools, and issuing multiple types of securities against them. These securities were provided with a cushion of investment grade rating by the rating agencies to enable a wider clientele for these securities. These securities were purchased by various pension plans and insurance companies for long term investments. Thus in the process the riskiest assets became the safest assets to own in the market.

In order to earn higher returns, the investment banks themselves became highly leveraged with debt equity ratios reaching 30:1 and capital adequacy dipping to 3%. Any sudden adverse movement in the market could wipe out their entire capital and force them into receivership. Another key factor was the creation and issuance of newer types of derivative products like credit default swaps. These products were priced based on the mathematical models created, than the market forces, leading to imperfect pricing of these products.

With the rise in the interest rates in the US markets in 2006, the weaker home loan borrowers began to delay and default on the monthly payments. Also the borrowing against rising home values became expensive. This put a brake on further appreciation of the home values. This led to home owners reaching their maximum credit limits on their existing homes. The private consumption led boom could no longer sustained by economy due to sharp drop in available credit to consumers and decline in disposable incomes. The housing markets began to decline, leading to increased demand for additional payments and collateral. The weaker borrowers began to default on their payments leading to bargain sales of their homes, further depressing the prices of houses, going into a vicious circle of lowered house prices and further defaults in payments. This rapid default in home loan payments resulted in wiping out of the banks asset base and heavy losses for the mortgage backed securities investors. Further the markets were unable to value the complex derivative products leading to a complete drying up of liquidity for these products. This led to a liquidity crisis for the market players. But it is more a crisis of confidence in counter party that is leading to a crisis of liquidity.

Several iconic financial industry players have been wiped out (Lehman), nationalized (Freddie Mac, AIG), merged (Merrill Lynch), change business model (Goldman Sachs), recapitalized (Citigroup), and restructured (UBS). The sovereign wealth funds and Asian financial institutions which are relatively insulated from credit crisis are likely to cherry pick the assets of the failed and stressed US and European financial institutions, leading to emergence of Asian financial giants. The US economy is likely to enter into low growth or no growth phase with decline in private consumption and restricted availability of credit.

In Indian context the bull market in stocks which started in 2003, reaching its peak valuation in January in 2008 (PE of 28) has come to more modest levels now. The Indian real estate is also expected to decline in next 12 to 18 months, becoming more affordable. The prices of food commodities, metal commodities, energy (crude oil) has declined from their peaks, and will result in lower inflation, in turn lower interest rates in future. This is expected to revival in the manufacturing sector. The Indian stand on tight regulation of the financial sector and gradual introduction of reforms has been vindicated again by the credit crisis.

Non Banking Financial Companies in India (NBFC): A perspective

Non Banking Financial Companies or NBFC in India are registered companies conducting business activities similar to regular banks. Their banking operations include making loans and advances available to consumers and businesses, acquisition of marketable securities, leasing of hard assets like automobiles, hire-purchase and insurance business.

Though they are similar to banks, they differ in a couple of ways. NBFC’s cannot accept demand deposits (deposits that can be withdrawn at immediate notice), they cannot issue checks to customers and the deposits with them are not insured by the DICGC (the India equivalent of FDIC in the US system). Either the RBI (Reserve Bank of India) or the SEBI (Securities and Exchange Board of India) or both regulate NBFC’s.

Though the NBFC’s have been around for a long time, they have recently gained popularity amongst institutional investors, since they facilitate access to credit for semi-rural and rural India where the reach of traditional banks has traditionally been poor.

NBFC’s have also had a major impact in developing small business in rural India through local presence and strong customer relationships. Usually the loan officers in such NBFC’s know the end customer or have a strong “informal” understanding of the credibility of the borrower and are able to structure their loans appropriately.

With the next wave of growth in India expected to come from the semi-rural and rural sector, the unique access of NBFC’s to these sector puts them in a great position to benefit from this growth. As evidence of their attractiveness, Goldman Sachs bought a 20% stake in Sriram Credit for 75 mUSD in Q1 2008. Credit Suisse is planning to take a majority stake in Bokdia Marketing and Finance (as reported in May 2008). Foreign Institutional Investors (“FII”) are also setting up their own NBFC’s in India to offer corporate banking and private banking operations. As an example, Societe Generale got approval for its NBFC launch in the country in October 2007. The French financial services group plans to strengthen its brand in India though NBFC’s.

There are three categories of NBFC’s,

a. Asset Financing Companies (“AFC”)

b. Loan Companies (“LC”)

c. Investment Companies (“IC”)

In my current post, I will focus on two NBFC sectors of Microfinance and Infrastructure finance which fall under the category of AFC and LC. In a future post, I will focus on consumer finance with specific focus on the automobile sector.

Microfinance Sector (very attractive)

There is a huge need for credit in the rural sector in India. Roughly 245 million people need 52 bUSD of microfinance credit. This includes small and marginal farmers, landless laborers, micro entrepreneurs in the rural and semi-urban areas. NBFC’s constitute almost 66% of the microfinance (MF) sector. The customer base covered by microfinance is expected to reach 49 million people by 2012 growing at a CAGR of 43% with an expected loan portfolio of 6 bUSD. (Source: Recent report on microfinance by Intellecap, a research firm specializing in microfinance).

The key growth drivers in the microfinance sector are:

a. Need for broader suite of products: Products such as investment products, insurance products, retirement planning can be offered to the customer base

b. Regional diversification: The NBFC’s in this space are mostly concentrated in South India. I expect this to grow in other regions.

c. Market consolidation and entry of FII: The smaller NBFC’s will get acquired and large FII’s (such as Fullerton) will come in and build franchising models to accelerate the quality and penetration of MF in rural areas.

On the flip side, there are some constraints in the microfinance sector such as lack of regulatory rules which are still evolving, lack of standardization, ability to attract quality human resources and an industry attitude that it is still a social enterprise versus for profit professional enterprises.

Lastly, in terms of recent investment activity, SKS microfinance (37.3 mUSD), Share Microfin (27.5 mUSD) and Spandana (12 mUSD) were financed in the last year. Additional NBFC’s such as Bandhan, Cashpor and Grameen Koota are looking actively for investments.

Infrastructure Finance Sector (very attractive)

During the economic boom of the 1990’s, the Govt. implemented many policies for infrastructure development with focus on roads, telecommunications, ports, and power. Special purpose vehicles (“SPV”) were formed to facilitate the credit demands of various projects. A majority of these were setup as NBFC’s. The Govt. also implemented public private partnerships (“PPP”).

As a perspective, during the period 1990-2006, 233 PPP projects were completed with total investment of 69 bUSD. The PPP investments grew from 0.6 bUSD in 1991 to 17.1 bUSD by 2006 representing a CAGR of 25%.

During the period 2007-2017 the levels of investment is expected to further accelerate fueled by the economic growth and the need to catchup on infrastructure to facilitate this growth. During this period investment of roughly 1500 bUSD (Source: Govt. website, World Bank and E&Y report) would be needed on power, roads and telecommunications.

The Govt. is setting up favorable policies to attract at least 50% of this investment from the private sector. The private NBFC’s are expected to become a major investment vehicle to funnel the private investment into the growing infrastructure sector in India.

SG Analytics an investment research firm based in India which i work for does sector research work on emerging markets such as India and China.