Is Commercial Credit for Real?
Commercial Credit and Finance PLC, a listed finance company, growing profits 80% annually over the past six years mystifies critics. After all, combined profits of more than 50 other finance companies have declined three percent annually since 2011, and even banking profits grew at just 7% a year in the six years to 2015.
Commercial Credit growing earnings 35-fold from Rs60 million in 2011 to Rs2 billion in the year ending March 2016 has attracted worry and suspicion that its business is a Ponzi scheme, the collapse of which will have ripple effects on the financial sector. Critics don’t offer evidence to buttress their fears of the implications of the collapse of a large finance company with public deposits topping Rs53 billion by end-December 2016. Their suspicion is piqued by Commercial Credit continuing to report large profits, with few provisions made for dud loans until 2015. In the couple of years since, Commercial Credit’s dud loan provisions increased, but profit growth continued unabated.
Sri Lanka’s finance companies have faced multiple crises over the last three decades. Since 2008, fraud and chilling disregard for governance in many finance companies have eroded trust. Insolvency at one company impacts the credibility of all other finance companies, as depositors start viewing them with suspicion, requiring higher interest rates to retain deposits.
From relative obscurity, by end2015, Commercial Credit accounted for 7.6% of finance company assets and 13% of the industry’s profit by the year ending March 2016. Commercial Credit’s scale now equals that of Central Finance, an industry stalwart, and is equivalent to more than half of People’s Leasing PLC’s asset market share of Rs124 billion by March 2016. Despite bad loan provisions topping Rs5 billion, the firm reported profits of Rs4.2 billion in the 21-month period to December 2016.
Critics are concerned that Commercial Credit’s pace of growth places itself and the financial system at risk. Risks abound for a small finance company transforming at such a rapid pace. Systems are often difficult to scale, and existing ones may be inadequate to manage larger risks. Often, weak processes are identified only after they have led to unrecoverable lending or fraud. Organisation-wide culture, ethics and integrity also often don’t stand-up to quick growth, sometimes with disastrous consequences.
As a result, critics were confounded when, in December 2016, a foreign company paid a premium to acquire a large stake in Commercial Credit. In October that year, directors at Thailand-listed Group Lease – a Japanese-controlled leasing company – proposed to invest $70 million for 29.99% Commercial Credit shares at Rs111 each, double its stock price on the Colombo Stock Exchange. Group Lease shareholders were urged to reject the proposed Commercial Credit acquisition by an independent audit firm appointed to review the transaction.
Despite the adverse recommendation, the Group Lease board’s unstinted backing ensured that the investment took place, which valued Commercial Credit’s stock at four times book value. The valuation was twice as much as investors were willing to pay for finance companies here during a Central Bank-imposed consolidation round in 2014/15.
The Group Lease board justified the price it was willing to pay for Commercial Credit, even telling shareholders that it did not want control of the Sri Lankan finance company, allowing the current management to run the business. At the extraordinary general meeting that December, shareholders overwhelmingly voted ‘buy’.
Rajiv Casie Chitty yawned, forgetting where he was. “Sorry,” he laughs, realising a few seconds later. It was 10am on a Friday morning inside Commercial Credit’s small boardroom crowded by its furniture. It had been a busy week working late nights for Casie Chitty, an accountant and director of Commercial Credit and several other listed firms. He immediately livens up and laughs dismissively at Commercial Credit’s critics.
“We grew fast because we pushed products that gave us better margins, like microfinance and small business loans,” he says smiling, with a hint of matter-of-factness as he shrugs. Commercial Credit is not strictly a microfinance lender. It’s primarily a finance company lending, like all other finance companies, to subprime borrowers. However, 45% of its loan book is microfinance and small businesses to which loans are granted without collateral. Less than three percent of finance company lending is without collateral.
Higher risks in microfinance mean the net interest margins here are the highest. HNB Prime Grameen, which specializes in microfinance, reported an ROE of 61% for 2015/6, twice as much as Commercial Credit that year. Commercial Credit’s 31% return on equity for the year to March 2016 was still more than double the finance company industry average of 12.3% and 16% for banks in 2015. Its financial performance in 2016 wasn’t a blip.
In the six years to 2015, shareholder returns averaged 48% annually. Listed stocks returned just 0.5% annually for this same period. Net interest margins, the equivalent of a company’s operating margin, at 16.4% in 2015/6 is double the finance company industry average and nearly five times the 3.5% average margin of the banking sector.
It’s not clear what margins microfinance and small business lending make, but it’s likely much higher than the reported figure for all loans. Commercial Credit’s high margins are a result of charging high interest rates – ranging from 25-30% per annum – for taking bigger risks, mainly lending up to Rs100,000 without collateral to nearly half a million poor people in Sri Lanka.
People don’t like companies making excessive profits particularly from high interest rates without realising the necessity. High interest is not evil. It helps lenders recover the cost of reaching out to people often in rural areas that banks and other finance companies largely ignore. “It’s a costly business to be in. Micro lending is intensely human resources driven. You need to invest in the right people who can nurture and keep up with micro borrowers and SMEs because you have to go to them for collections,” Casie Chitty says. Investing in processes to ensure timely collection, minimum errors and fraud is another challenge.
Micro lending is a tricky business. Several micro finance projects in India, Pakistan and Nicaragua have failed because of rising delinquencies, forcing lenders to seize pots and pans belonging to borrowers to recover loans. There is evidence to show that’s lenders investing resources to engage and nurture borrowers leads to double bottomlines, higher shareholder returns and people moving out of poverty. Poor people have a better track record of repaying loans: Under one percent of HNB Prime Grameen’s loan book is bad. Commercial Credit had similar loan default rates, averaging 1% each year until 2015; but delinquencies rose to 5.6% by 2016 partly on account of floods and later drought impacting livelihoods. “We grew too fast and are now facing the consequences,” Casie Chitty admits. “We’re cleaning up the loan book now.”
Fast business growth is exciting: Owners and managers are thrilled watching their beliefs and hardwork transform into tangible results, high returns delight investors, and customers benefit from improved access to better goods and services, as when a company scales the business, new jobs are created and suppliers get more orders; the quality of life is improving for many people, and they want it to last.
Growing fast can be risky. Firms becoming bigger and more complex can lose sight of their core business, pursuit of topline revenue can send costs soaring out of control, timely collection of receivables becomes challenging, recruiting the right people to fill critical new roles is difficult, and the quality of goods and services tends to drop. Fast growth is particularly risky for companies in the business of lending other people’s money; and since the 2008 global financial crisis, regulators everywhere from Europe to India have regularly warned banks and other financial firms against growing too fast.
A decent rate at which to grow a financial business is subjective, but outliers growing profits faster than everybody else tend to attract worry. During the year ending March 2016 and the nine months to end-December 2016, Commercial Credit has provided Rs5 billion in profits as provision for bad debts. This is a prudential requirement and does not mean loans up to this value have actually gone bad. “We’ve provided up to 10% of our loan book,” Casie Chitty says, adding that the firm is about done cleaning up.
Despite these provisions, Commercial Credit still made Rs4.3 billion in profits during this period, confounding critics. Despite micro finance assets nearly halving to 21% of total loans in 2016, the business contributed 32% to topline revenue. The company also has a loan product for small businesses, lending up to Rs500,000 without collateral. Collections are done daily. These loans make up 13% of the loan book, generating 6% of revenue. “Both are very profitable, but we need to grow them cautiously because recovery of bad loans is too costly,” Casie Chitty says. “We learnt from our mistakes and are now investing more on training, which is crucial for the success of microfinance going forward,” the Commercial Credit director says.
For a micro and small business lending to work, firms must invest in people to market its loan products, closely monitor how borrowers are investing their money and ensure timely collection. Scaling the business becomes challenging, because finding enough people willing to always be on the move is difficult. Even mutual fund management firms and insurance companies in Sri Lanka are struggling to recruit sales people because most recruits expect desk jobs. Commercial Credit found an interesting solution to this problem: Love.
“We are successful because we are deliberately building a culture around love and integrity. We are passionate about uplifting the lives of others through simple acts of love,” says Casie Chitty. By instilling the values of service to a greater cause — uplifting the lives of the poor — the company hopes frontline staff will be galvanised to perform better.
Since 2015, ‘Seven Habits of Highly Effective people’, the international bestseller by Stephen Covey, has become Commercial Credit’s bible. “Nearly 60% of our training is based on this book and it is at the heart of what we want this company to be,” Casie Chitty says. The first three habits deal with self-mastery: Being proactive, beginning a task with the end in mind, and developing personal vision and leadership. The second three habits deal with relationships: Having genuine feelings and caring for others, understanding them, and teamwork. The seventh is the pursuit of a lifestyle of physical and mental renewal through exercise, prayer and reading that keeps reinforcing the first six habits.
Nearly 2,000 frontline staff are entrusted with building long-term relationships with micro borrowers. This requires genuine care and trust. “Monitoring is crucial, because if borrowers spend their loan on consumption, repayments will take a hit and eat into our books. We help them understand what it means to invest in a business,” he says. Commercial Credit’s 350,000 micro borrowers belong to 20,000 groups of between 15 and 20 people meeting at a public place, a community center, the village temple or a school at least once a month. Here, Commercial Credit staff conduct training on basic business and finance skills.
“The whole market is undervalued!” Casie Chitty says laughing. When Thai finance company Group Lease paid Rs111 a share for 30% of Commercial Credit in December 2016, critics couldn’t comprehend what happened. A share was trading at half that price at the time, falling further to Rs48.1 by the fourth week of February 2017. Perceptions that this was a Ponzi scam solidified.
“What Group Lease paid for Commercial Credit is not too high at all. It’s what? Ten times earnings? That’s not high. They studied our books and they understood the potential. We’re a good fit,” he says.
Commercial Credit may have its skeptics, but Group Lease seems to understand its business, even willing to pay four times book value for it. During the finance sector consolidation phase in 2014/15, investors were unwilling to pay anything more than two times book value. Even Commercial Credit acquired 96% shares of listed finance company Trade Finance and Investments for Rs1.55 billion at slightly less than twice its book value.
Group Lease, a $17 million revenue company, specialises in motorcycle leasing in Thailand, operating a digital platform for payments and insurance. The company, which has operations in Cambodia and Indonesia, is a unit of Japanese firm Wedge Holdings Co ($82 million revenue in 2016), managing several businesses in digital finance and publications, entertainment, hotels, rubber, nutrition, and portfolio management across Southeast Asia.
Group Lease directors told its shareholders that the Commercial Credit investment was critical to the company’s expansion strategy in Southeast Asia. Global audit firm PricewaterhouseCoopers did the financial due diligence, proposing a valuation between Rs83 and Rs114 per share. Negotiations settled on Rs111 and announced to both markets here and Thailand in October 2016.
Grant Thorton Services, a global accounting firm, was appointed as Independent Financial Advisor (IFA) by the board to advise shareholders about the viability of the deal. In a November 2016 report to Group Lease shareholders, Grant Thorton asked shareholders to scuttle the deal when it came up for approval at an EGM scheduled for that December. It said the Rs111 price was ‘significantly’ and ‘remarkably’ overvalued compared to its own valuations ranging from Rs70 to Rs74 a share.
It also gave several reasons why Commercial Credit was a risky investment: cracks in its microfinance business model were appearing, as were evidence of a fraud, accounting errors and lax supervisory controls. Neither Grant Thorton nor Commercial Credit’s annual reports detail what the fraud is about. “There tends to be fraud at the front end at collections, so we’ve had to tighten processes and introduce online payment systems,” Casie Chity says.
The Group Lease board stood firm on its decision to invest in Commercial Credit. The problems identified by Grant Thorton were being dealt with and the board argued that the share price factored Sri Lanka’s and Commercial Credit’s growth prospects. “We’re investing in a profitable, dynamic and well-established company in Sri Lanka. Commercial Credit is well organised and well managed,” the board told shareholders in a letter filed with the Thai stock exchange.
The IFA warned shareholders that Group Lease would not be able to recover the investment soon enough and exiting early would force it to sell its shares at a sharp discount. The directors rebuffed this claim. “This is not a near-term investment, but rather a part of Group Lease’s long-term strategy to be a leading finance company in Asia, gaining valuable microfinance expertise (from Commercial Credit), which we can transfer to our current markets,” it said, adding that it had no reason to believe it would have to divest. “We are willing to leave the control and management with the current team, as they have demonstrated their ability to grow the company,” the board told shareholders.
At the subsequent EGM on December 6, 2016, nearly 98% of shareholders raised their hands in favour of the transaction, and Group Lease became the second-largest shareholder of Commercial Credit.
Commercial Credit also disposed 28% shares held in BG Myanmar Microfinance Co to Group Lease for Rs326 million, realising a Rs273 million profit. “It was a small operation with zero bad loans,” Casie Chitty says. “We couldn’t grow the business because regulations prevented us from taking out funds to lend there.”
“We grew too fast, but we’ve learned from the experience,” Casie Chitty says. The company is planning to expand the less-risky leasing business instead. “Demand is growing for cars, motorbikes and three-wheelers, and this is where the opportunity is.”
Making leasing its core business couldn’t come at a worst time, with the government imposing tough limits on leasing and interest rates picking up from 2017, but returns from micro lending will continue to support the company’s earnings. Also, with 60% of its loans maturing within a year — micro and small business lending tenures are typically 12 months — Commercial Credit is able to quickly adjust its margins. This also gives Commercial Credit a competitive edge in an already overcrowded market. “Most companies heavily exposed to leasing will find their business getting killed,” Casie Chitty says. “But we will have the flexibility to grow.”
Commercial Credit’s margins are forecasted to grow from 17% in the year to March 2017 to 21% in three years, according to the company’s new investor Group Lease, who has factored Commercial Credit’s intended halving of loan growth to 15% by 2021. It also forecasts that bad loans will halve to 1.4% from 3% during this period.
Group Lease wasn’t the first foreign investor to discover Commercial Credit. US-based private equity firm Creation Investments, specialising in microfinance and financial services companies lending to poor communities, invested Rs1 billion to acquire a Commercial Credit stake in 2014.
Commercial Credit was incorporated as a licensed finance company in 1982 in Kandy with 22 branches by 2008. That year, BG Investments, a private company controlled by Roshan Egodage, acquired a controlling interest in Commercial Credit. Four years to 2011, topline net interest income averaged Rs119 million annually, listing on the Colombo Stock Exchange by way of introduction.
Egodage announced a strategic plan to grow the business, including increasing the share price 10 times in three years to Rs280. He couldn’t achieve the share price he wanted, but Egodage grew annual average revenue by more than 18 times to Rs2.2 billion over 2011-14. Chairman of Creation Investments Patrick Fisher saw an opportunity. The investment firm believes in maximising financial and social impact returns.
Delighting investors is important to attract enough funds to areas considered too risky by conventional lending institutions, and social impact is achieved by ‘investing, not giving’, and empowering people to escape poverty. According to its website, the firm manages over $4 billion in several investment funds, with exposure to small banks and micro lenders from Albania and Russia in Europe, Peru and Mexico in Latin America, and India and Indonesia in Asia.
In March 2014, Creation Investments acquired 28.67% in Commercial Credit via a private placement for 48 million shares priced at Rs21 each, becoming the second-largest shareholder. Fisher got a boardroom seat. Two years later, Commercial Credit has doubled its annual earnings to Rs9.6 billion, serving a million Sri Lankans with micro and small business loans. The book value of the company, which grew eight-fold from 2011 to Rs3.3 billion at end-March 2014, more than doubled to Rs8 billion two years later in 2016. A little more than two years after investing in Commercial Credit, Fisher got a chance to reward the investors backing his funds. Group Lease’s acquisition of Commercial Credit included 22% held by Creation Investment. At Rs111 per share, Fisher made a tidy profit of five times the 2014 investment.
If Commercial Credit is running a Ponzi scam, someone ought to have noticed. But what confronts everybody is a company that’s figured out the business of lending to the poor. Every year, the Central Bank inspects the books of registered finance companies—it has a separate unit with a very long name, ‘Supervision of Non-Bank Financial Institutions Department’. It’s unlikely that Commercial Credit’s off-the-charts growth in net interest income, lending, deposits and profits escaped the Central Bank for six years. Commercial Credit’s books have been dissected by Thailand-listed Group Lease, probably its Japanese parent, and three global audit firms including Ernst and Young (its external auditor), a credit rating agency, banks and shareholders.
“We now want to double our book value in three years to Rs20 billion,” Casie Chitty says. Three things will take the company there: One, recalibrating the loan book to include less-risky lending assets; two, reducing its dependence on more costly public deposits to finance its loan book from over 85% to 70% by issuing debentures; and three, Group Lease Thailand’s plans to build synergies with Commercial Credit around three growth areas. First, it plans to leverage Commercial Credit’s microfinance know-how to benefit its other entities in ASEAN, including in Laos, Cambodia and Indonesia, and plans to share its digital finance business platform with Commercial Credit’s operations in Sri Lanka.
This should immediately benefit Commercial Credit, who is planning to expand leasing in a crowded market.
“To compete and grow in leasing, the challenge is how to differentiate ourselves,” Casie Chitty says. The answer lies in service delivery. Commercial Credit needs to approve loans faster without compromising on due diligence and make it convenient for customers to service those loans. “We want to improve the efficiency of processes as far as possible and be ahead of the curve,” he says.
The second area is around microfinance and commercial banking. “Commercial Credit is looking to expand in other industries such as banking and life insurance, which could be another synergy for Group Lease in the coming years,” the Group Lease board told its shareholders. Also, Commercial Credit operating a successful finance business here with 122 branches possessed the know-how and skills Group Lease can transmit into developing banking and microfinance services for Cambodia, Myanmar, Laos and Vietnam, emerging economies with underdeveloped banking systems and pent-up demand.
The third area is in insurance. In 2015, Commercial Credit’s main shareholder Rohan Egodage’s BG Investments and Patrick Fisher’s Creation Investments incorporated an insurance company called Capital Life Assurance, yet to commence operations. However, the biggest investments will be in its people.
“Qualities like love and integrity tend to feed innovation and synergies, and distill an open culture that encourages learning and a flat hierarchy,” Casie Chitty says. Love is mentioned 73 times in Commercial Credit’s annual report for the year ending March 2016, unprecedented for any financial institution perhaps. “We probably haven’t done enough in terms of training, but we are passionate about the culture we want for ourselves.”