In this article, I will highlight the problems with current metrics used to assess companies’ ability and willingness to repay loans, and the inaccessibility of finance for most social enterprises. This leads into why we provide uncollateralised loans and why we chose to look at a different set of criteria when we lend to Social Enterprises.
Problem 1: Inability of social enterprises to access capital
In the business of lending, the conventional wisdom as a lender is to protect our capital and gain the highest yield from that capital. Hence, lenders are generally risk-averse. At risk of oversimplifying things, most financial institutions usually require all or a combination of the following:
3. 3-year fortress balance sheet & financial statements
Even with all 3 conditions above fulfilled, borrowing is by no means guranteed – especially in countries where capital is scarce and opportunities to deploy capital is plenty.
For most social enterprises trying to raise capital, they rarely have any one of the 3 conditions above, let alone all 3. While a rare few might fulfil all 3 conditions above, their businesses are typically not profitable or large enough to warrant the effort of issuing a loan for most financial institutions. What this unfortunately means is that social enterprises generally have no access to capital from traditional lenders such as banks.
Problem 2: Lack of reliability of current metrics to assess a company’s ability and willingness to repay
There is a problem with current metrics used to assess SEs’ ability and willingness to repay by current lenders. To understand this, we have to think about the purpose of gathering evidence about each SE. Gathering evidence could take two forms – direct and indirect. As my professor once wrote, “If I want to know if a watermelon is tasty, I can gather evidence about its tastiness directly by biting into it. However, though we might be tempted, we cannot gather evidence directly when buying a watermelon at the grocery store. Thus, we gather evidence concerning the watermelon’s tastiness in a different way: we smell it. If it gives off the right aroma, we have indirect evidence of its tastiness. We thus have two tests for watermelon tastiness: the direct taste test and indirect smell test.”
The crucial difference between direct and indirect tests is that indirect tests leave a gap between what is measured by the test and what the test is supposed to tell. For example, in the case of the watermelon test, the fruit seller could have sprayed all her watermelons with watermelon perfume, making all the watermelons smell nice. These newly sprayed watermelons thereby pass the indirect smell test but passing this test obviously does not mean the watermelons are actually tasty!
Similarly, we have the same indirect/direct testing in the lending space:
Unfortunately, for lenders, it is impossible to perform a direct test in the lending space. You cannot tell a borrower’s ability to repay until the actual repayment date with true and accurate financial information. Neither can you tell a lender’s willingness to repay unless you can somehow look into the borrower’s brains to see their thoughts. Instead, you have the proxies tested by traditional financial institutions as indirect tests for a borrower’s ability and willingness to repay.
Despite the rather stringent conditions imposed by financial institutions in India, there is a rather high Non-Performing Loan (NPL) Rate. India ranks 5th out of 39 major world economies plagued by bad loans. This rose from 7.5% in 2016 to 9.3% in 2017, doubling over the past 4 years to a total of $148 billion in mid-2017. This is a clear sign that the current indirect tests being employed are not effective in directly testing companies’ willingness and ability to repay. The major reasons for this are outlined below:
Our solution for social enterprises:
At givfunds, we recognised problems (1) with reliability of traditionally used indirect tests and (2) inability of social enterprises to gain access to loans, and realised a different set of criteria had to be created to indirectly assess a social enterprises’ ability and willingness to repay. This is a gap in the market which few were solving. While not monetarily profitable, debt provided to these social enterprises would have a multi-fold impact on society with the growth of these social enterprises. Hence, we analysed how we could flip the traditional model of lending to cater better to social enterprises. Our learnings resulted in a different set of indirect tests which was catered towards lending to Social Enterprises at scale, as shown below:
You could read more about how this ensures a low NPL rate in our article on how we ensure repayment.