Ugro Capital - Opportunity To Invest in a Fintech-like Company Below Book Value

[Sharvan]

Q1 concall Notes

• India has a financial gap of 1.06 crore crores rupees in MSME lending.
• Out of 100 loan applicants, only 30 are approved based on the GRO score.
• The bank aims for a 30% annual loan growth by 2025.
• Off-book loans are expected to increase from 43% to 50%.
• The yield is approximately 17.3%.
• The book value is Rs 145.
• Prime customers are those with turnovers of 50 lakhs to 10 crores, willing to pay 19% for a 3-year unsecured loan.
• The bank has given a 5 crore loan with UGRO X as part of a pilot, with 95 crore pending.
• The target is to achieve 20,000 crore Assets Under Management (AUM) by the end of FY25.
• This year’s AUM is projected to be around 10,000 crore.
• The bank plans to add around 8,000 crore AUM next year.
• The projected GNPA by the end of the year is 1.9%.
• Credit cost covers only on-book loans. Off-book loans are taken care of by the bank, with 80% by the off-book bank and 10% in DA
• The expected tax rate is 29%.
• 20% of AUM does not include GST, where 10% is micro, and 10% is partnership and alliance loans secured by collateral.

[Sidharth_Chandraseka]

I have a question regarding co-lending model. In the illustration shown by UGRO

UGRO has a yield of 14.5% and CoB of 10.5%, so essentially for the 20,000 crores, they will earn 14.5% interest income for their equity contribution(4000 crores) and for the debt component(16000 crore) they earn 4%. So far good. But Why they are including 4% spread from co-lending portion (3200 crores) to their income

[Sharvan]

In the Co-lending Model, the 80% of the loan will go to the co-lenders book,
Here in the 14.5% interest yield the co-lender will only get 10.5% and so the remaining interest of 4%(32000) will go to Ugro capital

[Sidharth_Chandraseka]

Thanks Sharvan for the reply. This is where I am still struggling to understand.

Lets take a example, in regular case(non co-lending) , UGRO borrows money from XYZ bank for 10.5% and lends 14.5%(taken from companies illustration) and pocket the spread. UGRO takes the credit risk of the borrower with 14.5% and XYZ bank takes the credit risk of UGRO with 10.5%

Now if we say a 10 lakh rupee is disbursed with co-lending partner XYZ banks. For 20% of loan UGRO gets 14.5% and for remaining 80% of loan, UGRO gets 4% and XYZ bank gets 10.5%.

Now with this setup, XYZ banks has to factor in the credit risk of the actual borrower, and not the UGRO. In regular lending model XYZ bank earns 10.5% yield with UGRO as their credit risk, in colending also XYZ bank earns same 10.5% yield with much risker MSME borrower. So technically, XYZ banks credit risk increase but their yield is not. Why would a bank agrees to this? What exactly bank is benefitting from this co-lending?

[Vineetjain111]

Bank saves transaction and servicing costs. Ugro does the operational heavy lifting

[Ysr]

lending money is the easy part collecting it is the real deal… UGRO is doing the vetting ,disbursal and collection… colending bank is doing nothing, its just is providing capital from savings account deposits where cost of capital is very low… whatever the bank makes is bonus on the colending book which is short term lending in nature… banks have no ability to efficiently make short term msme loans… they are always lookign for big fish iw lend once and kep collecting interest for many years like home loan or car loan… atlest this is my understanding… any one can correct me if i have got this wrong…

[Sidharth_Chandraseka]

@Vineetjain111 @Ysr Your points are valid if you compare Ugro lending to MSME vs banks lending directly to MSME.

The point I am comparing here is bank lending to UGRO vs bank lending to MSME borrower via colending. As a bank I have two choice, I can lend X amount to UGRO at 10.5% or I can lend the same amount via co-lending and get 10.5%. Interest rate is derivative of the risk of the underlying asset. Probablity of UGRO defaulting is much lower than a MSME borrower.

@Ysr

whatever the bank makes is bonus on the colending book which is short term lending in nature

Banks take hell of a credit risk while doing a co-lending transaction. As a co-lending partner, bank has to bear 100% credit risk of the 80% portion of the loan

Credit risk is the most important factor that defines the interest rate of the loan. Why would a banks settles with same RoI when credit risk goes up and service costs of both type(again, to Ugro vs to MSME via colending) is the same and are very small compared to loan size.

[Ysr]

splitting loans to mutiple parties is inheritely less risky… imagine the MSME lender like UGRO diverts all the money to related parties and runs a bogus loan book…? who is to stop that ? lending directly to UGRO or any other large entity is basically concentration risk and many banks have suffered due to few large accounts going bust… with colending bank can still recover the loan if if UGRO goes bankrupt…

[Akash_Padhiyar]

There are multiple benefits to bank such as:

To reach a wider range of borrowers:

Co-lending can help banks reach a wider range of borrowers, including those who may not qualify for a loan from a bank on their own. This is because Ugro Capital may have a different lending criteria than banks, and can lend to businesses that may not have the same financial records or assets as larger businesses.

To share expertise:

Co-lending can allow banks to share their expertise with other lenders. This can be helpful for both banks and borrowers, as it can lead to better lending decisions and more successful businesses. On other side Banks may find that Ugro has good business model in term of selecting customers and in term of collection efficiency when it comes MSME. NBFCs can be more efficient in smaller concentrated areas comparing to big banks.

To comply with regulations:

In some cases, banks may be required to co-lend with other organizations in order to comply with regulations. For example, the Small Business Administration (SBA) requires banks to co-lend with SBA-approved lenders in order to qualify for SBA loans.

Overall, co-lending can be a beneficial arrangement for both banks and borrowers. It can help banks reduce risk, reach a wider range of borrowers, share expertise, and comply with regulations.

[Midhunjoe]

Part of the reason could be that ,banks also need to do priority sector lending as a requirement by RBI. Co-lending helps nationalized banks achieve their priority lending targets . MSME sector is a priority sector next only to agriculture. This arrangement helps banks to ride on the acquisition expertise of lenders like Ugro and meet these targets without diluting margins.

[rks00]

Sid,

In the Pic you attached of the “sample illustration”, They are assuming a 1 lakh crore Book. Line 1 (Loan Amount). I think you are tying this to their guidance of 20,000 crore and that’s why the numbers don’t make sense.

Basically the entire point of the sample illustration is only and only to show how the co-lending model helps boost the return ratio’s, RoA & RoE. To illustrate this point they took random numbers like 1,00,000 cr as the AUM. This is NOT to be juxtaposed with their FY25 guidance of 20,000 cr AUM guidance.

So in the sample illustration - Since 80% of the 1 Lakh Cr Aum is “off Book” and they earn a 4% spread on that, 4% of 80,000 is 3,200 cr. Additionally in the “On book” portfolio as you correctly stated, they earn a 14.5% interest income on that. So 14.5% of 20,000 = 2,900 cr. That’s shown as interest income (Line 3) in the illustration screen shot you posted.

The Math is correct. Hopefully this helps

As to how this is a win win for the banks & UGRO -

The banks are not setup operationally to service so many (relatively small a/c size)customers & the cost to do so is prohibitively high.

Banks are not setup to underwrite credit for those that don’t have an organized money trail of income and expenses.

Banks get to acquire and onboard new customers (those that the bank co-lends to)

Banks have priority sector lending targets that Ugro helps them achieve.

The risk weightage for the banks on their B/S for “Priority sector lending” is lower, that’s why the banks are indifferent about the perceived higher risk co-lending vs lending to Ugro at the same 10.5% in your example.

[Sidharth_Chandraseka]

Thanks everyone for the reply.

@rks00

I think you are tying this to their guidance of 20,000 crore and that’s why the numbers don’t make sense.

@rks00 No, I am not taking about management guidance. I purely talk about the illustration

@rks00

The Math is correct. Hopefully this helps

I did not say math is wrong. The point I raised initially is why they are including 3200 cr. spread of the bank’s portion as their income. How you can claim the interest portion of someone else’s money

To elaborate more on this, I was going over the RBI guidelines for the co-lending.

If you see the attached pic which I took from the RBI website and also what I heard in Indiabulls concall, co-lending interest rate is the blended rate of both bank and NBFC. The main motive of this approach is to lower the cost of credit. But as per the illustration stated by UGRO, in both cases(Co-lending and regular mode of lending) they are charging 14.5%. The ultimate borrower does not have any benefit from this.

if I go by the logic which RBI mentioned, interest rate of co-lended loan should be 11.3%

I understand companies has some leeway to change the structure of this transaction, but if you read the last two lines of the attached pic, it is clearly mentioned that the benefit of low cost funds of banks should be passed on to the ultimate borrower. As per the illustration, this is not happening and borrower is charged at same rate.

And if you think from other perspective, Co-lending is much like two parties(nbfc and bank) is coming together to lend money to borrower. How one party(NBFC) claims the interest component on the other party’s proportion of the loan(Bank). In securitization this is possible, since loans are securitized at a lower rate and the excess spread can be considered for loss provision and any excess will be passed back to originator. In co-lending, NBFC has nothing do with the 80% of banks contribution, no risk sharing, no loss enhancement. In indiabulls, management mentioned same, two parties have their own interest rate and borrower is charged with blended rate and NBFC get 100% processing fee charged to borrower and they also charge bank some percentage every year as a servicing fee.

I understand the benefits, parties involved and roles in co-lending. But I in here I am trying to understand only the technicality on how this is structured

Disclosure: Neither owning nor tracking. Neither bullish or bearish. Just found this illustration in presentation, so trying to understand the co-lending, as my other portfolio companies do some co-lending

[gaurav_srivastava1]

They have clearly stated that their margin is 14.5-9 i.e 5.5 in many their concall, and this would ne misleading if their margin is 2.2 … Also banks are getting their spread 8- wacc then how is it the nbfc would get less then their ideal spread, either bank would also be charging less than 9 percent and reducing their spread … And that i am not very sure they would be willing to do neither the nbfc would except for indiabulls who i always feared …

[gaurav_srivastava1]

My simple funda form big gain investing is rising roe with rising profit… If roe is going to increase from 4 to 18 percent and pat from 60 cr to 450 cr from 2023 to 2025 , the price is going to sky rocket , i have already gain near 45 percent and hoping for 400 percent more in next 2 years. It started as 20 percent of my portfolio in april and has become 30 percent now
…

[Sidharth_Chandraseka]

@gaurav_srivastava1

this would ne misleading if their margin is 2.2 … Also banks are getting their spread 8- wacc then how is it the nbfc would get less then their ideal spread, either bank would also be charging less than 9 percent and reducing their spread

Are you referring this spread number from the table I added?

@Sidharth_Chandraseka

if I go by the logic which RBI mentioned, interest rate of co-lended loan should be 11.3%

[rks00]

Sid,

My bad, I did not understand your question previously. I think i understand it now.

Anyways, to answer your question - There is no blended rate in the UGRO example. Ugro charges the end customer the entire 14.5% (pays an interest expense of 10.5%) and therefore pockets the 4% spread. That’s how they get the 3,200 cr as well (4% of 80,000). They are not claiming any part of the banks interest income. The bank’s interest income is 8,400 cr (10.5% of 80,000 cr) shown as interest expense in the UGRO illustration (post above)

The screenshot you attached is from the RBI circular dated 2018.

To my understanding & I could be wrong, There is a new circular - RBI circular / 2020-21/63 FIDD.CO. Plan.BC.No.8/04.09.01/2020-21 dated 05.11.2020. In which there is no mention or requirement for a blended rate. It simply states, “The ultimate borrower will be charged whatever interest rate agreed by both lenders” Screenshot below. There is no mandate on a blended rate depending on % of loan contribution.

Even theoretically, the Blended rate idea does not make much sense to me.
Any bank lending to UGRO, will price risk differently when lending to UGRO vs lending to a Micro SME(end consumer that UGRO lends to). The idea that they should use the UGRO lending rate and blend that (in proportion of loan contribution) while lending to the end Micro SME customer doesn’t make much sense, as the end consumer is way more risky than UGRO is, and therefore needs to be priced accordingly.

Hope this helps

https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11991&Mode=0

[gaurav_srivastava1]

That what i thought , blended rate means a regulatory business where your upside are capped by regulation … Companies like at ntpc , powergrid cant charge more than 14.5 of roe on invested capital to keep cost minimum , hence those are bad businesses…

[Soumyadeep_Majumdar]

It’s been over two years since this post and I have largely been a silent observer (apologies for that). In the meanwhile, my position size in Ugro has ballooned close to ~20% of my portfolio (~100% gains), which I guessed would be a good time to lay out the pointers behind my increased conviction on Ugro Capital and why I continue to hold.

An inaction is also an action and needs equal amount of hard work, conviction and persistence

First and foremost, the deal breaker - Management Quality. Historically, we have seen various concerns raised around the Religare issue (addressed this couple of years back), high fees paid to Board members (addressed beautifully by Mr.Nath in the annual AGM earlier this year) and some key personnel transitions (CEO,CFO transitions). However, despite these minor events, I believe the management of Ugro Cap has been fairly receptive and addressed most of the queries with valid reasoning.
Additionally, there have been good additions to the team, both to the board via:

1. Tabassum Inamdar (Ex-MD and Co-head of India Research team, Goldman Sachs)

   and to the core team via:

2. Om Sharma (Ex-CDO, AU Small Finance Bank , ISB and BCG alum )

I have been a long proponent of the idea that in India, one of the key factors for Financial institution failures has been less to do with the underlying credit risk but more to do with the lack of adequate corporate governance. It was very interesting to see this commentary in the conference call.

Second, the bet on co-lending model and the execution capability has been on-point with a steady growth in off-book AUM

Yes, the risk around seasoning of the loans still exists as nicely articulated in the latest credit report and one needs to keep a close watch on the GNPA/NNPA levels and movement across the buckets, specifically in some of the sub-sectors.

This can be an interesting play, however needs to be monitored. As called out by Mr. Nath in an interview, they are still working on finalizing a few processes before opening the floodgates.

The recent concall also threw interesting light on the Gro Score 3.0 model and the process followed. (thanks @nirvana_laha and @Chins for asking a great set of questions)

Finally, we have seen some publicly-acclaimed investors join in on the journey as well which I guess can be taken as a positive.

Overall, I believe one needs to wait, watch and track the seasoning and impact on asset quality as the cycle turns which will be an interesting exercise in itself.

[learning]

There is nothing unique or special that any company can do for that matter to arrive at individual credit score, its a wide spread practice which any bank or financial institution does, these guys seems to be marketing it as if they have found something new or something which others are not aware of.

[njain1983]

The only thing unique/special/moat in this business can be the credit scoring model and their risk management. Jury is still out on that and we will only know the verdict in few years, specially after a down turn. The one thing going for Ugro is the massive and ever increasing TAM as MSME’s are (gradually) realizing that there is benefit in formalization rather than staying informal and saving taxes. As OCEN, ONDC etc matures there will be many more MSME’s will opt for formalization and look for credit. My belief is that lending firms which can keep the Risk in control, will reap huge benefits is the MSME lending space. An investor can wait for the definitive verdict to be out in few years or can invest now with a close eye on whether the Management is walking the talk and get out if they are not.

Disc: Invested