The Indian financial services sector is buzzing with activity as private equity investors, both global and domestic, pour substantial funds into the market. Financial sponsors have made a flurry of substantial investments in the sector, including Warburg Pincus' acquisition of Shriram Housing Finance, Advent and Multiples PE’s investment in Svatantra Microfin, EQT and ChrysCapital's acquisition of a majority stake in HDFC Credila, Mubadala and Avendus' investment in Avanse Financial Services, and TPG’s acquisition of Poonawala Housing Finance.
What’s driving the surge?
Various factors have cumulatively boosted investments in the sector. The quest for scale, a proven track record of strong financial returns, enhanced synergies, and a focus on financial inclusion have all played pivotal roles. The sector's agility in adopting technology and reaching last-mile consumers has positioned the NBFC sector as the third-largest globally, trailing only the United States and the United Kingdom.
The government has also been proactively liberalising investment policy in the sector. The liberalisation of investment by private equity funds in Indian insurance companies has been followed by the Securities Exchange Board of India (SEBI) specifically permitting financial sponsors to become sponsors of Asset Management Companies (AMCs), which means that private equity funds can now contribute even more than 40% of the net worth of an AMC.
Furthermore, even the global anti-money laundering watchdog, the Financial Action Task Force (FATF), has removed the United Arab Emirates and Cayman Islands from its grey list, giving financial sponsors the headspace to structure their investments through these jurisdictions as well.
Key considerations for PE investments
While considering investment in the sector, private equity investors must consider the following critical factors:
Funding mix: Structuring of investment instruments is critical due to regulatory requirements on leverage ratios and capital adequacy norms. For instance, NBFCs must ensure that Tier II capital does not exceed Tier I Capital (wherein Tier II capital includes preference shares not compulsorily convertible and hybrid debt instruments such as compulsorily convertible debentures and Tier I capital includes equity shares and compulsorily convertible preference shares). This effectively means that funding the financial services entities by way of debt or hybrid instruments has its limitations.
Exposure norms: The investments received by financial institutions can be used to lend or invest onwards. However, most financial institutions have to comply with credit concentration norms to ensure that funds of financial institutions are not concentrated (by way of investment or lending) in one particular entity of a group.
Restriction on multiple competing financial services entities: While there is no specific written restriction in law on having multiple financial entities (including NBFCs) within the same group carrying out competing businesses, the regulators do not view such structures favourably. For instance, the RBI may restrict a group or PE fund from having significant influence (which includes having more than a 20% stake) in more than one NBFC of the same category carrying competing business.
Regulatory approval: Specific regulatory approval is typically required for a change of control and for exceeding the thresholds prescribed by the relevant regulator. For example, in the case of banks, the acquisition of 5% or more of paid-up share capital or voting rights requires prior approval from the RBI, and in the case of NBFCs, change of 26% or more shareholding requires prior approval from the RBI. It is pertinent to note that in the case of banks, the obligation to obtain this approval is that of the acquirer, while in the case of NBFCs, the obligation is of the NBFC. Such approvals are typically procured between four and six months of filing the application.
Key compliance check: The regulators have been taking a cautious but progressive approach to ensure the financial system is strengthened. The RBI has recently taken stringent actions against non-compliances that were not adequately rectified even after notification of such breach, especially non-compliances relating to anti-money laundering, know-your-customer and interest rates. The RBI has taken several regulatory measures by imposing penalties and even directing cessation of business.
The road ahead
The financial sector has emerged as one of the fastest-growing industries in the country, leading the charge in adopting innovative technologies to enhance financial inclusion. With the increasing integration of artificial intelligence and significant investments in upgrading tech solutions by financial services entities, the sector is poised for even greater activity, returns and investments.
Vidushi Gupta is Partner at law firm Khaitan & Co. The views expressed are personal.
