When we started our fund management practice back in 2015, it came as a natural extension to the wholesale lending business at Northern Arc Capital. Our twin objective at the time was to create a platform that a) helps tap into newer investor classes unfamiliar with our target segments/those that prefer FOF strategies, thereby increasing the pool of commercial impact capital available and b) providing differentiated and long term debt funding to the NBFCs within our target sectors. Five years on, 9 funds and many more in the pipeline, INR 2,000+ crore of assets under management and 100+ investors, it’s been quite a satisfying journey so far. Applying a bottom up approach – each of our funds has been carefully curated to align with investor and potential portfolio company expectations taking into consideration tenor, sectors and return as against the likely risk, across categories of AIFs. This approach helped tap into many new investor segments earlier untapped through the wholesale route including insurance companies, HNIs and family offices both domestic and offshore – with our latest fund that announced a first close of US$ 23 million in March of this year, designed specifically for international investors. All of our funds have exhibited a stellar performance over the years exceeding the target return communication, with consistent and timely pay-outs to senior investors despite stress events. Besides creating a niche as one the few debt impact fund managers in India, we are also among the very few close ended debt funds to have completed an entire cycle from deployment to full redemption to investors over a span of three and a half years.

02. Traditionally Northern Arc has always focussed on raising funds domestically. Your last fund was the first international fund raise. Why did you decide to reach out to international investors this time

With a mandate to enable broad based access to capital to the financially under-served, tapping into international investor capital especially those without direct India strategies, has been in the works for a while. India is a complex geography to navigate, and more so for investors without the wherewithal to set up a practice in India or develop deep understanding of sectors or conduct diligences on sectors or in dealing with regulatory and operational hurdles. The fund management route through fully managed offshore and onshore structures enables ease of investing into India, achieving the desired impact without having to deal with these issues. The potential pool of international capital available that could be routed into impact sectors in India on the debt front is immense and as a community as well we’ve only touched the surface. With many new funds and ideas already in the pipeline, we hope to make significant strides over the next few years in accessing fresh routes of capital into the impact investing space in India.

03. Do you see a change in outlook towards the Indian debt market amongst LPs/ international impact investors over the past decade?

India’s visibility in the international arena across areas of politics and finance has increased many-fold over the last decade. A clear indication on the financial side is the steady growth and depth of FII flows into equity markets. In addition to equity inflows, the last few years has also seen high participation by international investors in a relatively liquid government securities market. With growing confidence in the Indian markets, the benefits of a developed ecosystem has also translated into an increase in investments in the impact investing space; with a reliance on niche category fund managers like us in addition to direct investing. A direct indicative of this change is an increase in debt funding to impact focussed NBFCs over the years. While earlier such funding was limited to relatively larger NBFCs in the microfinance space, a gradual shift has been observed, with higher acceptability today of smaller NBFCs across sectors. More LPs/impact investors are also starting to look out for onshore fund managers/partners with a granular understanding of the sectors for channelling investments.

Today, India has the perfect mix of a robust securities market infrastructure, attractive absolute interest rates and an exciting landscape of business models targeting impact sectors of agriculture, financial inclusion, education and renewable energy. When you combine these aspects with tech based delivery models, India makes a compelling case for international investors/LPs for ‘profit with purpose’ investing.

04. How differently do international LPs approach debt focussed GPs like you? (debt focus vis-à-vis equity focussed funds)?

While there is a growing interest in debt funds in the impact space over the last few years, we continue to form a lower fraction of the overall pie of impact investing in India. In comparison to domestic LPs, most international LPs view debt funds from the same lens of an equity investment - with regard to the discharge of fiduciary responsibilities, incentive alignment, governance and investor protection. With international pass through structures setup overseas also taking on the features of equity, the convergence of debt and equity in evaluation is far more. Therefore, the primary difference in evaluating debt and equity is from an underlying portfolio construct perspective. Given the inherent differences, debt being a fixed tenor and return instrument as compared to equity, a different set of metrics are used towards assessing risks and corresponding return expectations.

In addition, hedging mechanism and post hedge returns to international LPs is also a major consideration for debt focused GPs like us. High hedge costs have been a key deterrent for attracting long term international debt capital into India. India has a need for increased forex flows in order to meet balance of payment and improving economic growth. While equity has traditionally met this requirement, the listed space is reaching the upper limits of foreign ownership caps. Additionally, sovereign debt purchases have been volatile in nature. An out of the box solution could be for the central bank to operate as a market maker for specific long only capital using the backstop of foreign reserves to lower hedge costs. This can potentially unleash an avalanche of rate seeking money the country needs to spur the economy, especially in the absence of risk averse domestic capital.

II. Impact of Covid-19 and the subsequent lockdown

05. How are you seeing the impact of the pandemic on asset quality in the sector and more specifically on your portfolio?

The pandemic is expected to severely impact India’s GDP in the current financial year. A potential swing in GDP from +5% to -5% could result in an INR 20 trillion+ impact at a macro level. At present, India’s gross savings are at 30% of GDP, of which household savings are at approximately INR 20 trillion. While this cushion is expected to absorb some extent of shock, a depletion in savings will constrain demand in the near future. In the absence of a government demand stimulus, income capacity of companies and individuals will fall, further constraining their ability to spend and repay debts.

The financial sector is a mirror of the stress in the real economy. Hence the impact of Covid-19 on consumption focussed sectors such as passenger mobility and discretionary spend (entertainment, dining out, travel etc.) is expected to be significant. This in turn will translate to a significant impact on the balance sheets of these companies, impacting both shareholders (lower profits) and lenders (higher credit costs).

Northern Arc’s target segment however focus on financial inclusion largely in rural India, with most businesses financed being set up to deal in essential services. For example, the microfinance sector has over 73% of its portfolio in rural districts with over 57% of borrowers engaged in agri and agri allied activities. Hence, the overlap with some of the most affected segments is much lower for our portfolio companies. Our portfolio companies are additionally well capitalised to withstand any earnings impact. The recent monetary and fiscal initiatives have added significantly to the liquidity buffer of our companies and helped tide over the negative impact of Covid-19. In addition, what has helped in course correction adding resilience to non-bank lenders amidst the current pandemic were the recent crisis events of demonetisation and IL&FS default. Hence, while the year will be one to forget from an earnings and shareholder returns perspective, we do not expect any solvency risks for our portfolio entities.

06. What in your opinion will change for Northern Arc and other impact investors in the aftermath of the Covid-19 crisis?

Covid-19 has upended the status quo and brought about changes which will last well beyond the pandemic. One positive effect has been the huge acceleration in digital adoption necessitated by social distancing. Digital channels will be the primary focus for companies which are re-examining every facet of their business to succeed in a post Covid world. Digital is democratising access and blurring lines (today, parents have access to their children’s online classrooms) while bringing in a new level of cost efficiency (AI/ML can bridge the cost of processing an INR 5,000 vs INR 5 crore loan) thereby spawning new business models. It will be an exciting time for impact investors to deploy growth capital to back businesses which utilise these digital rails to reach maximum beneficiaries. From an investor perspective, increased comfort with video conferencing has resulted in far more acceptability of virtual diligences and quicker decision making. We are also seeing higher levels of engagement by investors at an investment level with an increase in data sharing and clear alignment with impact metrics and focus on outcomes.

A willingness to partner for directed credit is already evident and Northern Arc is the preferred partner for three such initiatives at advanced stages of launch.

III. Regulatory Climate

07. Leaving Covid-19 aside, what is your opinion on the current regulatory climate with respect to debt financing in the for-profit impact industry?

Debt financing should be looked at through the lens of both instrument suitability as well as access. A company today can access debt via the securities and loan markets. Tradability is the biggest USP of securities. However, tapping this instrument comes with additional costs, compliances and involvement of third party agencies (rating, trustee, exchange etc.) which could prove to be cumbersome. The bilateral loan market is a much easier proposition and better suited to early stage companies. Access to providers of capital via the loan market however is restrictive, and mostly limited to banks and NBFCs. India has a financial system where large companies borrow directly from the bond market and smaller companies meet their financing needs through bank credit. This has created a gap where providers of capital via pooled structures such as AIFs that cannot lend via loans are able to address only a limited set of deserving companies, especially in the non-financial services segment. Further, while loans are entirely under the purview of the RBI, securities fall under the regulatory ambit of RBI (loan market) and SEBI (securities market), adding to increased complexities in compliance for smaller companies. While the capital market regulator should be commended for the robustness of pooled capital structures such as AIFs, there is much more that needs to be done from an instrument and access perspective, through a unified approach by both regulators.

Another theme that has gained traction globally is that a ‘one size fits all’ approach stifles innovation. Customization is essential to enable wider access. A regulatory sandbox which green lights small scale ideas/experiments such as in blended finance instruments/structures is necessary to broad base access between providers and consumers of capital.

IV. Organisation Plans

08. What is the medium term plan for Northern Arc Investments Management? Will the focus of being an exclusive debt impact investor continue ?

Well over a decade ago, Northern Arc identified a significant gap in access to finance for individuals/corporates across the country and created a profitable business model in addressing it. The approach has always been in identifying a need and using structured finance to solve it. The funds business takes a platform approach to structure solutions for both investors and investees, with a secondary consideration on the type and form of capital, a by-product of the former.

For investee companies, we have enabled finance via a range of instruments spanning short term commercial paper, long term senior debt, tier II capital and including hybrid capital. These are structured into unique investment solutions, each fund suitable to a different segment such as insurance companies, HNIs, foundations, financial institutions and offshore investors. While Investing is our main business, many investors rely on our expertise to deliver the best risk/return proposition. For example, our latest fund offering is rated AA+ for capital protection while targeting high double digit returns.

Today, we manage funds across all three AIF categories, with tenors spanning from 1 month to 10 years and an experienced investment team with a demonstrated track record across all funds. The gap we identified at our inception still exists, and while our near term focus is debt, we remain committed to structure investment solutions in hybrid, grant or equity – wherever an unmet need emerges.