By Jindal Haria

India Ratings and Research (Ind-Ra) has assigned Northern Arc Capital Limited (NAC) a Long Term Issuer Rating of ‘IND A+’. The Outlook is Stable. The instrument-wise rating action is as follows:

Instrument Type

Date of issuance

Coupon Rate

Maturity Date

Size of Issue (million)

Rating/Outlook

Rating Action

Non-convertible debentures (NCDs)*#

-

-

-

INR5,000

IND A+/Stable

Assigned


    *Interchangeable with the company’s bank loans.

    #Yet to be issued 

KEY RATING DRIVERS

Niche Competitive Strengths and Experience: NAC may be credited for creating a market over the past eight years for fund-raising (debt capital markets and securitisation) by non-banking financial institutions (NBFCs) that have medium scale of operations and have shown a moderate ability to raise funds. It offers various platforms to NBFCs, including a substantial proportion in the lower investment and sub investment grades, covering sectors such as microfinance, commercial vehicle finance, small business lending, consumer finance, agri value chain finance, affordable housing finance, etc, to raise funds. Likewise, NAC offers investors opportunities to invest in varied risk-adjusted return-yielding avenues across diverse asset classes, while the company itself may invest in the subordinate tranches. NAC has demonstrated expertise across securitisation, on-balance sheet lending, alternate investment platform, guarantee structures and other risk sharing mechanisms and continues to launch new products. It witnessed transaction volumes of INR120 billion-150 billion annually during FY16-FY18 and about INR51.2 billion in 1HFY19. NAC has also diversified into partnering with non-NBFCs and is attempting to scale up gradually. It also ventured into the direct origination vertical, by providing business correspondent channels for selected borrower-partners. At end-September 2018, its assets under management (AUM) stood at INR38.5 billion (across balance sheet and off-balance sheet exposures).

 

NAC’s strength stems from its in-house and cultivated talent. Its ability to retain the top management is key to its business prospects. The current senior management team has significant experience with NAC. The team had seen some exits in early FY18, but NAC has subsequently attracted talent from the financial industry.

 

Adequate Capitalisation for Current Scale of Operations: The Tier 1 of NAC, which stood at 17.41% at end-September 2018, has remained at almost similar levels over during FY16-FY18. It was aided by capital infusion of about INR2.12 billion since FY17. NAC’s internal accruals, which had been in the range of 15-20% in the normal course of business, dropped to 14%-15% in FY17 and FY18, primarily on account of the credit costs on subordinate tranche investments in the securitisation of microfinance portfolios. The risk weighted assets of NAC also include its off-balance sheet exposures. The agency expects NAC to maintain higher capital levels than peer-rated NBFCs on account of concentrated exposures (across platforms), given the semi-wholesale nature of the business and the moderate credit profile of its borrowers.

 

High-but-Declining Sectoral Concentration; Moderate Borrower Profile: The share of microfinance (across all platforms) in NAC’s origination volumes was 51% in 1HFY19 (FY18: 41%; FY15: 67%; FY14: 84%). Meanwhile, the share of small business loans and commercial vehicles increased to about 40% in 1HFY19 (FY15: 17%). The concentration of microfinance exposes NAC to sectoral risks; the tranched investments in microfinance may offer some credit protection, but under default, the loss given defaults could be substantially higher for NAC than those for senior investors. Over FY17 and FY18, several such investments of NAC defaulted because of demonetisation-related challenges in the microfinance sector and it witnessed credit costs of about INR0.6 billion. However, its balance sheet lending had some support from the borrowers’ balance sheets. In the past few months though, NBFCs and other corporates, especially those rated ‘A’ and below, have been facing challenges with respect to fund-raising; this could exert stress on NAC’s borrowers. Early delinquencies in NAC’s portfolio would be key monitorables. 

 

Liquidity Position Moderate Compared to Peers: NAC maintains a minimum of three months of net servicing requirements as balance sheet liquidity in addition to two months of planned disbursements in the form of unutilised limits or bank lines. In the agency’s opinion, NAC’s on-balance sheet liquidity should be higher than that of similar rated NBFCs, given its moderate but relatively concentrated borrower profile. It has unutilised cash credit lines of about INR1 billion and has sanctioned, but unutilised, lines of about INR2.9 billion. This could be adequate to cover its repayment obligations till March 2019. Over the next three months, NAC may need incremental bank lines to the extent of additional disbursements planned (over and above current book size) and ALM gaps beyond March 2019. At end-September 2018, NAC’s ALM gap stood at about 13% of total inflows; it declined to 4% in December 2018 in line with the funding gaps seen in the past. In case NAC is unable to roll over its INR2.1 billion outstanding commercial paper (CP) borrowings (against peak CP outstanding of INR5.45 billion in FY19 till date), it would need to replace the same by long-term borrowings over the next three months. Ind-Ra expects NAC to be able to manage its ALM and have sufficient liquidity to meet repayment and committed business obligations. It has on-boarded some foreign banks as lenders in a material manner since 2HFY18. 

Growth Moderated on account of Externalities:
NAC grew its balance sheet and its business prospects on the back of growth in the microfinance segment from FY11 to FY16. Notable sectoral diversification to other segments has been visible since FY15. Many of its key microfinance borrowers became large institutions in themselves over time and their dependence on NAC’s balance sheet has reduced, while NAC continues to work with them on placements. To maintain its pace of growth, NAC had to on-board more entities in earlier stages of evolution across multiple segments. In addition, demonetisation impacted collections in the microfinance sector and some of NAC’s transactions defaulted. The microfinance segment slowed down in FY17 and most of FY18; as a result, the volumes of transactions enabled by NAC did not grow substantially over the same period. Overall, the volumes fell 18% yoy in FY18 (FY17: up 11% yoy), mainly because MFI volumes decreased about 42% yoy (down 6% yoy), though this was partially offset by growth in other segments (FY18: 16%, FY17: 51%). Based on the run-rate, the company expects the volumes to exhibit material growth in FY19 on the back of both non-microfinance and microfinance segments, with the impact of demonetisation wearing off. NAC has also ventured into other financial segments, to direct origination (partnering with its existing relationships) and has gained sectoral expertise; all of this cumulatively could help NAC capitalise on growth opportunities as and when they arise. 

Profitability
Subject to Sectoral Risks, Especially from Microfinance: NAC’s business model results in high yield loans as well as fee income that is proportional to its volumes. The fee income as a proportion of its volumes increased to about 0.7% in FY18 (FY16: about 0.4%), largely driven by the contribution of Northern Arc Investment Management’s (NAC subsidiary) alternate investment platform, which has an AUM of about INR11 billion as of 9MFY19. This particular platform has the ability to continue to provide fee and investor diversification. The average yield on its loans and investment portfolio has remained at about 13% since FY16. Ind-Ra does not expect any material decline in the fee income profile and yields in the short-medium term as the company now has a diversified book that covers multiple asset classes. 

NAC has witnessed credit costs of 1% and 1.5% in YTD FY19 and FY18, respectively, mainly due to intense stress on some transactions post demonetisation. These costs were at negligible levels in the pre-demonetisation period. Ind-Ra does not expect the credit costs to sustain at these elevated levels, especially in a normal business scenario. However, its exposure to microfinance would continue to weigh on its credit costs as the segment is subject to more idiosyncratic, systemic and event risks than other segments. As NAC diversifies further, the potential impact of these risks would decline, but they would continue to exist. 


RATING SENSITIVITIES

Positive: A substantial capital raise in line with its growth plans, growth in scale of operations, further diversification in the sectoral mix along with growth in overall volumes, continued diversification of its funding profile, led by a higher proportion of long-term funding and lower sectoral concentration, while maintaining asset quality could lead to a positive rating action. 

Negative:
The inability to maintain adequate funding for contingencies and business, significant lowering of capital buffers from current levels, high levels of short-term borrowings that could impact the ALM of the company, and any asset quality shocks, which could  result in the weakening of profitability and capital buffers, could lead to a rating downgrade.

 


COMPANY PROFILE

Northern Arc Capital Limited is a Chennai-based NBFC promoted by Dvara Trust. It had an AUM of about INR38.5 billion at end-September 2018.


FINANCIAL SUMMARY

 

Particulars

FY18

FY17

Total assets (INR million)

35,970.6

29,273.5

Total equity (INR million)

6,112.7

4,856.8

Net profit (INR million)

862.5

637.7

Return on average assets (%)

2.6

2.2

Equity/assets (%)

17

16.6

Capital adequacy ratio (%)

17.2

16.9

Source: Company annual report, Ind-Ra analysis

 

 

 



COMPLEXITY LEVEL OF INSTRUMENTS

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Analyst Names

  • Primary Analyst

    Jindal Haria

    Associate Director
    India Ratings and Research Pvt Ltd Wockhardt Towers, 4th floor, West Wing Plot C-2, G Block. Bandra Kurla Complex Bandra (East), Mumbai 400051
    +91 22 40001750

    Media Relation

    Namita Sharma

    Manager – Corporate Communication
    +91 22 40356121