ZestMoney, the fintech lending start-up that had to shut operations in 2023, had been struggling for a while. Its founders Lizzie Chapman, Priya Sharma and Ashish Anantharaman resigned in May, leaving the company with the investors and a new management.
While the company had been in talks with digital payments company PhonePe for an acquisition, that too fell through. There were reports that this was because the business’s due diligence did not meet expected standards.
Before the company could tackle the blow of the failed acquisition talks, Aditya Birla Finance, one of the major lending partners of ZestMoney decided to cut its partnership with ZestMoney citing the RBI’s move on increasing risk weight on consumer loans. According to reports, the company's existing venture capital investors have been struggling for a while to find buyers in the market.
Amid regulatory changes by the Reserve Bank of India (RBI) for the digital lending sector and a funding crunch, the buy now pay later (BNPL) had to shut shop. The central bank has also been warning against unsecured lending and has taken steps to ensure the unbridled increase in such loans does not become a crisis.
There has, exclusive of RBI’s concerns, been a cautionary reduction of investment in the digital lending sector in India because of various factors such as the lack of capital adequacy and the high risk of defaults. Investors said they have been maintaining a low profile and want authorities to come up with better regulations for it.
Harshvardhan Lunia, Chairman of the Fintech Convergence Council (FCC), Founder and CEO, Lendingkart Technologies, told The Core, “Experienced investors now try to get a complete understanding of the company before investing. In the last few years, a lot of people have jumped into investing in India and many of them don’t know what horizons to keep for investments. One now invests more in people/ founders. Even if the sector is not doing good, the expertise of the founder could help get better returns on investment. So the investors’ trust is more on the founders.”
A report by market intelligence platform Tracxn found that the Indian fintech sector saw a 63% drop in funding last year. The sector also saw only one company, InCred, emerge as a unicorn. This was in comparison to five unicorns in the sector the year before.
What’s In Your Books?
The RBI's increasing risk weightage on unsecured lending and its repeated words of caution have affected sentiments among investors. But they’re now also worried about capital adequacy in the digital lending sector and how the companies run their businesses. BNPL companies are considered the most vulnerable because of the number of defaults.
“For several lending start-ups, there is a greater examination of their books and their abilities to compete with encumbrances that the market may insert. Investors are now sensitive of the potential of the target market, pricing strategies these companies have, and their strength in building a liability franchise,” said Siddarth M Pai, an investor and founding partner at 3one4 Capital, a venture capital (VC) firm.
The reduction of funding in the sector was prompted in 2021 when the RBI came up with the Working Group Report on Digital Lending. The report suggested treating BNPL models as balance sheet lending or BSL. In balance sheet lending or BSL for a monetary loan, the original lender retains the debt throughout the life cycle of the loan. So, if the borrower defaults completely or partially, debt gets piled up on the lenders’ book and thereby the risk on the lenders surges with low capital available to the lenders.
“In case, defaults start happening, the recourse that will be available to lenders due to the unsecured nature of the product will be very limited. RBI wants to ensure that the finance institutions have more capital to absorb any future loss. This has not only affected BNPL but the entire lending ecosystem as a whole. The industry is widely expecting a few more regulations on BNPL and such subjects. Investors have become a lot more discerning when it comes to governance and regulations,” added Pai.
The fact that there is a crunch in capital flow has also created a sense of uncertainty in the minds of investors. Investors believe that investing in a sector that is regulation-sensitive is not a preferred choice as the sector may underperform with every regulatory change and the probability of generating better returns gets minimised.
“We can’t invest in something which is regulation sensitive. Digital lenders need to figure out how they can get the capital and raise a lot of capital to support themselves. One needs to have a really large fund to pump in that kind of money,” said Naganand Doraswamy, managing partner and Founder at Ideaspring Capital, a venture capital firm.
Evergreening Of Stressed Loans
Last month the RBI clamped down on the evergreening of loans in the banking and non-banking financial company sector through alternative investment funds. Evergreening of a loan means issuing new loans or providing additional credit to borrowers struggling to repay existing debt. It is a process by which financial institutions try to hide stressed loans because once classified as such, they have to provide for losses, which reduces profit.
“In case of loan evergreening if a borrower defaults, the lender can show that as a treasury loss with AIF investments as NCDs and not an NPA (non-performing asset). Earlier, the Securities and Exchange Board of India (SEBI) issued a consultation paper released on May 2023, wherein they proposed that AIFs no longer sell schemes that allow this through what is known as a ‘preferential distribution (PD) model'. The idea is to make things transparent and let the investors know what are the risks involved in this company before investment and accordingly, they can invest. But the investors should be well aware of the risks involved,” said Venkatakrishnan Srinivasan, founder of Rockfort Fincap LLP, a financial advisory firm.
Previously, the Working Group has recommended measures to prevent regulatory arbitrage/misuse of the PD model in AIFs such as the evergreening of non-performing assets by regulated lenders and safeguards to address the aforesaid misuse/concerns.
SEBI has also proposed through a consultation paper in November 2023 to amend the regulatory framework for a category of Special Situation Funds so that the SSFs can acquire stressed loans
“There are a few players who are into evergreening but the guidelines will be applicable to the whole industry. This will stifle the fintechs (into lending business) to receive debenture debt loans and receive money from banks. Over the period of next few weeks, if there is clarity, the investors' sentiment might change,” said Ashish Fafadia, Investment Partner at Blume Ventures.
What Is The Way Forward?
Industry experts believe that the only way to turn around investor sentiment is to build sustainable lending business models with slow gradual growth rather than focusing on aggressive growth.
“Finally, all the investors putting in money look for returns either through the sale of the companies or through IPO. PayTm was a torch bearer and they went for an IPO, but they managed a below-average performance. When a torch bearer goes through this kind cycle plus we also haven’t seen many fintechs doing exceptionally well in terms of getting listed, fintechs may choose not to focus on IPO at the moment. We will have to wait for 12-24 months to see if fintech is going for an IPO and if investors can make money out of that,” said Lunia.
Sustainable growth models and licences from regulatory bodies could also help attract better investment in the sector.
“Few years ago, fintechs players were mostly unregulated bodies and not under the purview of the RBI. But it has changed over the years. VCs now want to invest more on regulated and licensed entities so to keep up with the investors’ sentiments, it is better for the digital lenders to keep themselves licensed properly from regulatory bodies,” said Mukesh Bubna, founder, Monexo, a digital lending platform.
Fintech companies also need to focus on steady growth in particular geographies with good repayment capacity building. “Investors' sentiment is more of a wait-and-watch mindset. There have been constant regulatory changes happening now. The investors want to focus on companies that have the ability to navigate through the regulatory changes, keeping a balance with both credit quality and profitability,” said Anil Pinapala, CEO and founder at FlexPay by Vivifi, a fintech lender.