In this article, we answer the question of how we ensure our borrowers repay our loans and why we expect a low Non-Performing Loan (NPL) or default rate. This question is commonly asked, especially since our loans are uncollateralised and lent to small organisations with little history. In the context of India which has traditionally high default rates, this lending seemed extremely risky. Ironically, this same question was asked over the last 40 years to the Nobel Peace Laureate, Muhammad Yunus.
To understand ensuring repayment rates, it is essential to understand the business of lending. In lending, there are always two questions to answer about the borrower. These are the borrower’s (1) willingness and (2) ability to repay.
In this previous article, we shared the problems with traditional borrowers’ metrics to evaluate both. This is largely due to the mismatch between the indirect tests used by traditional borrowers and the direct test (willingness and ability to repay). Additionally, their indirect tests also often act as “sticks” rather than “carrots” for borrowers, making it difficult to build goodwill with borrowers. For example, when a borrower misses or is late for a payment, stringent steps will be taken by lenders to collect this payment – often in the forms of threats on their collateral or worse.
Evaluating borrower’s willingness and ability to repay
At Givfunds, we believe that there should be a different method to evaluate a borrower’s willingness and ability to repay. These are our learnings:
Willingness to repay
In many South Asian countries, this is the more difficult question to answer of the two. Because we provide multiple loans across long periods, our first loan is often the riskiest because of the difficulty in evaluating a social entrepreneurs’ willingness to repay. Every subsequent loan builds on the existing relationship we have with the social enterprise and hence their willingness to repay. To de-risk ourselves for these loans, we have used 3 main strategies:
We work with social enterprise aggregators to identify social enterprises with positive cashflow and proven business models. More information about how working with these social enterprise aggregators help us lower risk by allowing us to tap into a pipeline of good quality social enterprises can be found here.
b) Due Diligence Processes (PDCs, referrals etc.)
With over 10 years of lending experience on our team, we have a robust due diligence and loan management process that ensure low NPLs. You could read more about both processes here.
c) Working Capital Loans: Smaller ticket sizes and shorter loan lengths
While we expect each social enterprise relationship to last as long as 5 to 15 years, our first loan is given as a small and short working capital loan between 3-6 months and $1,000 - $5,000 USD. Together, loans made for the first time would eventually make up a small percentage of our portfolio (less than 5%).
Assume we take a conservative average social enterprise relationship length of 5 years, and ticket size of $10,000 (our average ticket size for subsequent loans is exponentially higher, ranging from $3,000 to $50,000). As for the first loan, we assume a rather aggressive average loan length of 6 months with a ticket size of $5,000.
Despite the conservative assumptions, first loans only make up 5% of the overall portfolio in this example.
Ability to repay
For the current businesses we evaluate, it is relatively easy to evaluate their ability to repay with their finances and an understanding of their cash cycles. In fact, cash flow cycles are a much better indicator of a social enterprise’s ability to repay than other metrics. While there might still be defaults, we estimate a default rate due to lack of ability to repay at a low 1-3%. In some cases, such as with cooperatives, we work with our partner social enterprise aggregators to act as guarantors to the loans as well.
Recourse methods: What we do when a default occurs
We believe that recourse methods when a default happens could be improved to better support social enterprises in changing lives. For example, there is a huge difference between a purposeful defaulter and one who might be having a tough month or two in business. Running a business is difficult, let alone running a social enterprise. Black swan events happen often where social enterprises have the willingness to repay, but not the ability. How we treat both cases should be different – much like Grameen Bank does.
When they have no ability to repay due to freak business events, most funders throw more dirt into the hole, instead of giving a hand to help them out of it. In these cases, we try to understand the difficulties faced by borrowers. This helps us understand how we could relieve or ease the social enterprise back into profitability – whether through restructuring the loans, lowering repayment rates, or even issuing new loans if a strong case could be made. This practice is adopted from the measures taken by Grameen Bank.
This does not mean we are easy on purposeful defaulters. In the case of purposeful defaults, we would pursue legal action against defaulters.
In summary, we use the following indirect tests to test for a social enterprise’s willingness to repay: