"The best of SMEs get credit at interest rates which are at least around 175-200 basis points higher than those of blue chip large corporates" J.S. Gujral (left), Director, and Sanjiv Narayan, MD/ SGS Tekniks

A petrochemical engineer by education and entrepreneur by choice, Nagesh Basarkar, 33, is a happy man. Core Energy Systems Pvt. Ltd, an enterprise set up by him in 1999 with a capital of Rs 40 lakh, is growing and growing fast. In less than six months of 2006-07, it has clocked Rs 10 crore in revenues. The tiny enterprise's journey has been well worth the trouble. But once in a while, Basarkar still gets to sample the constraints that bind a small business. In January this year, for instance, four banks-including private and public sector banks-turned down his request for a loan. Core, which provides turnkey solutions for capital equipment projects, had won an order worth Rs 6.2 crore from one of the top government-backed research organisations. With impeccable execution credentials, Basarkar felt the new order would be his ticket to realising his dreams: A turnover of Rs 100 crore by 2010.

What was the problem? A hefty collateral as a pre-requisite for the loan. And the collateral size? The usual 20 per cent of the order-or a whopping Rs 1.24 crore in Core's case. "At the rate we were growing, no way could we have put up so much money," says Basarkar. Core has doubled its turnover in 2005-06 to Rs 4 crore. The inland letter of credit from his client meant little for the bankers. A new generation private banker told Basarkar that the nervousness stemmed from the huge size of the order, given Core's puny turnover of Rs 2.2 crore. "They did not doubt my technical capabilities of delivering on the project. The bankers probably expect small enterprises to grow at only 20-25 per cent and no more," he says. Basarkar's case, though representative of the chicken-and-egg situation that most small and medium enterprise (SME) promoters get into, did not end in the manner it usually does for most SMEs. He did manage to find the funds.

Lucky him. A study of 32,000 SMEs and 2,500 large corporates by rating agency, crisil, shows that SMEs have lower access to bank funding. SMEs have a significantly low median gearing (that is, debt as a percentage of shareholders' equity) of 0.34 times as against 0.73 times for the large corporates, according to CRISIL. "The difference was even more evident when promoter loans are considered quasi-equity," says D. Thyagarajan, Director, CRISIL SME Ratings.

Insistence on collateral, personal guarantees and other such credit enhancements spring from the historically high non-performing assets in the SME sector. Heightening the caution levels are the poor information flow about the sector and its informal business practices. "Traditionally, such companies have been very opaque about their disclosures to banks," says Vijay Chandok, General Manager, ICICI Bank.

Consequently, the higher risk perception gets factored into the cost of funds and the time taken for disbursement. Sometimes the due diligence by banks takes as long as three to four months. "The best of SMEs get credit at interest rates which are at least around 175-200 basis points higher than those of blue chip large corporates," says Sanjiv Narayan of Gurgaon-based SGS Tekniks, which manufactures industrial electronics at its plants in Gurgaon and Baddi. Narayan points out that even aggressive private sector and foreign banks are of no help. "They are willing to lend but only at bigger ticket sizes," he says.

Other channels of organised finance, whether it is private equity and venture firms or institutions such as Small Industries Development Bank of India (SIDBI), are constrained by the same factors. According to SIDBI Chairman N. Balasubramanian, the smaller units are the most distressed ones. He splits the SME universe into four categories on the basis of turnover and their access to finance (see The SME Segmentation). As the enterprises increase in size and scale, they become more sophisticated in their business processes. "The smallest category typically has just one to two people running the enterprise, so there is limited manpower and little understanding of funding requirements," he says. Manish Gupta, Managing Director of advisory firm IndusView Advisors, agrees. "A lot of SMEs do not maintain good books, and then there is the management structure-typically family-run with no second rung in place," he says.

Kunwer Sachdev, a first generation entrepreneur who heads Su-Kam Power Systems Ltd and now has Reliance Energy India Power Fund and Temasek Holdings as private equity investors, explains the start-up issues. "In the early stages, accounting or finance-related issues are often the last priority for the entrepreneur as he is focussed on just growth in sales. Private equity investors or banks on the other hand need assurance of safety of their investment." Moreover, in pursuit of their goal of high returns, VCs have a preference for scalable ventures-untried or untested ventures; or ventures which are highly technology oriented, difficult to replicate or have entry barriers for others.

"At the rate we were growing, no way could we have put up so much money (a collateral of Rs 1.24 crore against a bank loan of Rs 6.2 crore)" Nagesh Basarkar CMD/Core Energy Systems

The other big issue in India is that of reaching out to this granular pool of SMEs stretching across multiple industries. "Since it is a diffused set that is being targeted, accessing SMEs in a cost-efficient manner is a difficult task," says Gupta. With demand far outstripping supply, Balasubramanian readily owns that "the needs of the smaller outfits could not be addressed appropriately, even by SIDBI". SIDBI was formed in 1990 as a development finance institution for the sector.

Slowing down progress is the fact that there is no published or syndicated information available on Indian SMEs, unlike some of the other developed nations. Left with limited options for organised finance, SME promoters often rely on their own sources of funding such as high cost credit card loans or approach NBFCs or unorganised money lenders. Such funds come at a premium and affect the firm's efficiencies and competitiveness. And the SMEs continue in the vicious cycle of small size and inadequate finance.

Government Push

Stunted SME growth costs the nation, since small enterprises are what drive the economy. Aware that the small sector contributes nearly 40 per cent to the industrial output of the country and is the largest source of employment after agriculture, the government is planning to put in place a comprehensive legislation by October this year (see The Big Invisible on page 100). The intent is to push for doubling the flow of credit to this sector from Rs 67,000 crore in 2004-05 to Rs 1,35,000 crore by 2009-10.

Meanwhile, asymmetry of information is being tackled on two fronts. Beginning May this year, Credit Information Bureau (India) Ltd (CIBIL) has started compiling credit histories of enterprises. It has begun with a database of 600,000, of which nearly 95 per cent are SMEs. "The total targeted database could be over 1 million," says CIBIL Chairman S. Santhanakrishnan.

"In the early stages, finance-related issues are often the last priority for the entrepreneur" Kunwer Sachdev CEO/Su-Kam Power Systems

In the interim, banks are also becoming more flexible in their assessment procedures. Bankers, as seen in Core Energy's case, have traditionally looked at financial ratios and have lent against the security of fixed assets. Now, however, banks are formulating alternate strategies. For example, ICICI Bank, which has chased SME clients quite aggressively, looks at surrogates like supply chain linkages and cash flows to evaluate the credit worthiness of the SME entities. It has also developed a proprietary scorecard-based model to process credit information faster. And the result is that the SME strategic business unit contributes 11 per cent to the bank's total fee income. This points to the inherent bankability of the sector as a whole.

Credit rating by independent agencies is yet another way to fill information gaps. Last year, SIDBI teamed up with Dun & Bradstreet and CIBIL to set up the SME Rating Agency (SMERA). CRISIL too began its SME ratings business last year with Su-Kam and has rated some 400 firms already. SMERA has also tied up with 16 banks, 12 of which have linked their lending terms to the rating obtained. "With a credit rating, 50 basis points could be shaved off from the interest rates," says SGS' Narayan.

However, it is early days yet and the concept has yet to catch on. "SMEs often fear that since their financials do not reflect the correct picture, they may not get a good rating and the same could boomerang via reduced lending," says SMERA CEO, Rajesh Dubey. But as the good stories get around, the rationale for transparency will gain ground and it could well lead to a significant change in the operating environment. "This would reduce the turnaround time for SME loans, as well as promote risk-related lending," says Santhanakrishnan of CIBIL. "Currently, the good SMEs are cross-subsidising the bad ones with high rates for all," he says.

More Solutions

"Traditionally, small enterprises have been very opaque about their disclosures to banks" Vijay Chandok General Manager/ICICI Bank

Apart from legislation, other measures such as Credit Guarantee Fund Trust for Small Industries (CGTSI) and the creation of the Indonext platform (a Bombay Stock Exchange-backed market for raising debt and equity for small businesses) augur well. Fiscal measures such as simplification of disclosure requirements could also help. "The disclosure requirements and accounting methodology for recognising income as applicable to large firms, is neither desirable nor feasible," says SMERA's Dubey.

SIDBI's Balasubramanian believes that instead of relying on government machinery alone, private sector potential should be tapped in targeting the smaller-sized firms. "For credit demands up to Rs 5 lakh or so, local experts need to be encouraged. They could serve as the link between local entrepreneurs and the banks and could mentor the entrepreneurs on quality, technology and finance issues," he says.

SME-oriented venture funds such as SBIC (Small Business Investment Company) programme of us Small Business Administration can fill the gap in private equity for SMEs. But ultimately as ICICI Bank's Chandok says, "Efficient business models would attract capital at competitive rates and natural competition amongst financiers will drive prices down. In such a context, the onus of getting cheaper finance to a large extent rests with the SMEs themselves."

The goods news: The more progressive small entrepreneurs already get the message.