We did not grow until we perfected the business model: Five Star Finance Chairman

In an exclusive interview with Moneycontrol’s M. Sriram, Lakshmipathy and K Rangarajan, CEO of Five Star Finance opened up like never before, about their growth strategy, cautious expansion, reacting to the pandemic. The interview was edited for clarity.

So, tell us about the origins of Five Star Finance.

So, Five Star was started in 1984 by V. K. Ranganathan, my father-in-law. I joined Five Star in 2002 after my marriage. I'm a Computer Science Engineer from Madras University. So, I joined Five Star since it was a father-in-law run institution.

I joined for two reasons. One- Five Star wanted a good business model. It was lending in the consumer durables and two wheelers space, which was very tough in the early 2000s because big banks and NBFCs entered this space and smaller players like Five Star were squeezed.

It also needed equity, which I brought in. So, when I came into Five Star, I looked at the existing business model which was not working right. So, we were thinking what next we can do?

Back then, loan against property was not as well regarded as it is today. We were finally looking into that. So, we changed direction from a high purchase lender to a mortgage lender.

We really started 17 years down the line (from 1984). Our Chennai branch was very successful, and we expanded in Tamil Nadu. That was even more successful and we moved away from Tamil Nadu. Today we have 262 branches in 8 states.

See, we didn't grow until we knew that the business model was perfect. And look at our background -- when we started 17 years down the line, we didn't grow 100 percent or 50 percent on the first day. We just grew 10-20 percent for the first five years. We saw the cycles. During both ups and downs how does the customer behave? What kind of effect is it having on the collection strength? If a customer turns bad, what is our end recovery process?

We learnt these parameters over a period of time. The first ten years, our growth was very subdued but we kept learning things. So, after 10 years, we thought yes, we have found a good business model with good profitability and very good asset quality, low NPAs. Then we thought, okay let’s scale this.

When did you take this call?

Around 2012 or so is when we started to build up our team, bring our equity and start growing fast. In the last four years we have grown 100 percent year-on-year (YoY). What is happening today is that the lenders and companies who come now into this field don't have this time to learn.

So in those 10 years, give me some examples of what you learnt. What were your mistakes?

Yeah, I learned a lot. I joined as a computer science engineer who knows nothing about lending. My first NBFC experience is Five Star. So, I have to learn more than what Ranga (current CEO) learned in Five Star very shortly, because for me, what is an NBFC, who is my customer, how do I see my customer, everything is from scratch.

A few things were very, very clear. One- we don't want to get into an unsecured product. And, we want to lend it to a customer who is not being seen as potential customers by bigger NBFCs and banks. So that we have enough time to learn about it, instead of doing it in a hurry. I would see at least 2,000-3,000 files of borrowers personally. I have sat with the customers’ family in the living room, I have sat in their shops to find out how the things work for them,

We made small mistakes here and there. Initially, we did not bring in a wife as a co-applicant. Then we thought of a spouse as a very strong supporter for our lender, so we brought in the spouse. So, these are small learnings. We didn't want to get into the rural market. So, we were completely semi-urban and fast-growing markets. We don't have a cluster-based approach. Those were the learnings. And we were purely into the service industry. We didn't get into industrial or MSME manufacturing, and went into services instead.

Right. What is your customer profile like?

Bulk of the customers that we finance do some kind of a cash and carry business. So typically, when you walk across a market, all the guys that you see, who are owning a shop, they're all our potential customers.55-60 percent of our portfolio is shopkeepers. 20 percent are self-employed- say plumbers, masons, electricians, and the likes... And another 20 percent are either cash salary or wage earners, working in factories or casual laborers.

D Lakshmipathy, Chairman, and K Rangarajan, CEO of Five Star Finance

These shops you are financing, what is their average turnover?

In all our applications, every adult member of the family is a compulsory applicant and a co-applicant. The entire family comes in collectively. And, they come together for the loan, and hence it is a family decision. The family’s cash flow will be anywhere between Rs 25,000 to 40,000 a month.

Why do you consider collective income? The loan is technically for the business, so is collective income like a guarantee?

See, 100 percent of our loans are collateralized, typically by self-occupied residential properties. Our conviction is that this is a very important and major decision. The decision should not be taken by any single person. The family comes together because it is a huge thing for them to mortgage their home and take a loan. It also helps filter out people who will take loans for a frivolous purpose.

If we leave it to a single person, here is what could happen. Say the breadwinner of the family is a gambler. And he just wants to mortgage his house because he has run into debts or whatever. There is no check on him, right. The house belongs to him, he can actually mortgage it. But we are not in the business of repossessing a house, selling it later and then recovering our loan. We are in the business of actually lending it, where the collateral axe is a very strong moral persuasion and repayment is via cash flows. So we make the whole family come in.

This asset is so important for them in their life, they’re not going to come for artificially higher ticket sizes. They are only going to come to you exactly for what they need. And they only want to come to you for the loan where they are confident that they can service it easily.

That makes sense. You're also known for a conservative collection strategy. How do you implement that? Because some fintechs and lenders have got into trouble over aggressive collection tactics. How do you take care of that?

It starts right from the sourcing. We don't actually have a separate collections team itself. So, the guy who sources the file is also responsible for collections. That brings a strong sense of ownership right from the beginning. You're not having incentives in a wrong way that somebody sources a file and somebody else collects the file. We’re one of the very few NBFCs of our scale which doesn’t have a dedicated collection person at all. It makes sure that people stay disciplined in the process.

See, we have also dealt with this customer segment (SMEs) for 35 years. Products may have changed, but the customer focus never changed. We know how they behave, how their cash flows behave, when to be flexible, and when to be rigid. We have seen at least six business cycles with these customers.

For example, we are okay with delays but not with defaults. So the customers also know that Five Star is not going to pressurize them if they got delayed by a few days.

I think what has surprised us and others is that we have not repossessed a single property so far. So, we don't do aggressive collection practices. Most of our practices are making sure that we're educating the customers, making sure that we are staying with them, through those delays, and making sure that you're working with them to discipline them. Then they're back on track.

That’s interesting. Can you take me through what the last one year was like? When the pandemic hit India, lending and especially SME lending was one of the worst hit areas. How did you deal with all that?

Firstly, we were blessed that the majority of our customers are small shop owners and bulk of them also were doing essential service. So, it's not that people really have zero income. Cash flows were hit, but it did not come down to zero. Second, our ticket sales are very small so our average ticket size for a loan is 3 lakh – 3.5 lakhs; so an EMI of Rs 7,000-7,500.

So, it’s not really a huge burden especially when you are taking the entire family's income for that cash flow. It’s not a single person’s income. Thirdly- the first wave at least was restricted to the big cities, while our presence is from Tier 3 to 6 cities. 95 percent of our branches are actually between Tier 3 and Tier 6 cities. These cities were not that affected. The current second wave though, I’m not sure yet.

We have a very strong presence on the ground and we have more than 4,000 people on the phone. So we could actually reach out to these customers, we could speak to them. The pure focus was even during the moratorium period never miss the relationship with the customer, stay in touch with them, understand what's happening in his life.

Even if he's not able to pay a full EMI, let him pay part EMI. If he’s not able to pay part EMI, let him pay 1000 rupees. I think it's important to keep the relationship alive and make sure that some flows are coming. We also said please take the moratorium only if you really need to. If you think your cash flows are sufficient enough for you to service a moratorium, you're better off paying it rather than holding it and then paying it with an additional burden towards the end.

I think in the peak of lockdown in April last year, our collections were at 52 percent, while most others were at 20-30 percent collections. And by June we reached 90 percent collection. And at 99 point something in September. In the unsecured situation, customers also tend to get carried away by what the other people do. In secured lending, customers know they have collateral, which has been pledged. It is important for their family. They are a lot more self-disciplined than the unsecured lot.

That makes sense. And what about disbursements? Did you have to stop disbursements for a couple of months? How did that happen from April onwards?

From the end of March we stopped disbursements. We wanted to see how this is going to pan out. And we were very clear in our minds that first, the collection should come back and then we will slowly start disbursing.

Collections picked up from June, so we started disbursing in July. We did it in a phased manner, where those branches with a good collection track record got to start first. It was October, by the time the last few branches got permission to disburse. We were careful. But as we speak, this month we should be disbursing the most we have ever done so far.

And as you have recovered and grown, what was the rationale for raising money now? You’re profitable and have money in the bank so I’m guessing you don’t strictly need the money?

Two things mainly. One, we clearly have a plan to go public and get listed in the foreseeable future. So, we want to make sure that we are absolutely capitalized and well aligned. You want to do one round before the IPO from a capital efficiency perspective. And this was that round. Second is that Morgan (Stanley PE) one of our early investors who invested in 2016 wanted an exit. While they were looking for an exit, we didn't want to have two separate processes running- for primary and secondary. So this round is a large secondary with a small primar.

It was largely the same. No big difference.

Do you have an IPO timeline, say in 18-24 months? And does it help that markets are hot right now?

What makes an IPO interesting is that we started this (business) two decades ago and have built it very carefully and successfully. The last four years before COVID, we grew 100 percent every year. Generally a company grows this fast and then if COVID hits, you will know the true colour of the assets right? You can’t hide anything right?

Now, the true colour is that we are one of the best in underwriting. We have created a niche for ourselves, and want to be a specialist small business lender who will be listing. IPO also has the benefit of making us more visible; your rating goes up, your liability is being taken care of. Obviously we are not a deposit taking NBFCs, our liability has to come from banks and NBFCs. So once our visibility goes up in the IPO, our liabilities will also be much easier. So, that is the thought about an IPO in the next 12 to 18 months.

Five Star’s leadership background is also interesting. A lot of the team- your COO, CHRO, Head of Treasury, Ranga himself, and others are from the Sri Sathya Sai Institute of Higher Learning (Andhra Pradesh). And a lot of you are from Chennai. How does that affect company culture?

Yes, I should clarify, I am not from Sathya Sai. So, I said I'm an engineer from Madras University. Right. Most of my leadership team management team are from Sathya Sai. And Ranga is from there but he was the first professional to join Five Star in 2015 Most team members already knew him. It is good to have a community with similar characteristics who understands company culture. You're right, maybe two-thirds of our management team is from Sathya Sai.

So, when all this happened in 2015, the company was also just starting to build out. We had very ambitious plans and wanted to recruit the best talent. But, the normal professional is not going to join you at that stage because people will not leave their high-flying careers to join a company that early, So the first set of people who joined were people whom we knew from long long back. They trusted my and Mr. Pathy’s judgement to come to this company.

These people took a plunge not because of the company’s growth, but because there was somebody whom they could trust and stay with. So nothing like going back to your own batchmates whom you know for 15-20 years. They are accomplished professionals in their own right.

Did you look for anything else, while hiring?

Mr. Pathy was very clear that he didn't want people from other NBFC and banks to join, because he said they're going to come with so many preconceived notions about what is good and not good in an NBFC, and the process of actually making them unlearn is more difficult than the process of teaching someone entirely new.

So none of us have an NBFC background. He was very clear that I can teach you what an NBFC is, I can teach you the business model. We were very, very focused on culture and fitment, and character. Everything else was secondary.

That makes sense. For the last one year, a lot of people in the lending industry have been talking about the account aggregator framework. In terms of data collection is supposed to be the next big thing. Do you think it helps you? What is your stance?

No, I think it will help people with a little (social or income) higher strata than what we are targeting at this stage. People who have digital footprints and people who have credit footprints in the country. Our customers don’t have that. So, we are watching out in terms of how it’s going to really evolve. It's definitely a useful initiative that RBI has come out with.

What is your plan now for the next year or so? What sort of scale are you looking at?

I think we have grown fairly steeply pre-pandemic. The good part is that COVID has convinced not just us, but the whole world that our underwriting was good. Because the biggest mistakes that most NBFCs do is that in their aggression to grow, sometimes credit quality is compromised. Even in the mother of all stresses, it's great that we're still sitting with them on 1.3 percent gross NPA (Non Performing Assets). So that gives us tremendous confidence in the business model the way we underwrite.

We understand the South very well. We are present in all four southern states, we still believe there's a lot of opportunity to penetrate deeper in there. That will be our stronghold. We have no aspirations to overnight become a pan-India company, I think we will take it very, very slowly and in stages, and the South will continue to be a stronghold for the foreseeable future.

That said, I don't think we are really going to run behind a number target, but we will definitely be growing at a healthy CAGR. I don't want to reveal any number targets now.. But the opportunity is big. Without compromising on the underwriting or the asset quality, I think we will always be conservative in the way that we take things from here. But, we have all the ingredients for growth. I think we will definitely grow much faster than what the industry average is. But I don't think it’s going to be running behind a specific number.

So in FY21, we will be a bit above 1000 crores of revenue. So Rs 1500 next year is not unachievable.

And, where will growth come from? Horizontally or vertically?

So, one of the things that we have always kept very seriously now in mind, is that we are not going to grow by giving more money to the same set of customers. That's the easiest way to grow. But the rest are the most dangerous way to grow. And we have seen multiple examples of overexposure or being over leveraged by a set of customers.

Since inception, the focus has been increasing the number of customers. And in between the last six years we would have grown our average customer base from about 7,000 to 1,80,000 customers now. So we want to add customers. We are not going to go behind higher ticket sizes. So, the growth has to come either from penetrating our existing geographies, wherein we will put more branches, more feet on street, more officers to go and source those files. Or expanding into adjacent geographies. I will go from Karnataka to South of Maharashtra for example.

Right. Why are you expanding this way? It seems very cautious. Is it because business has behaved differently even in adjacent regions?

No, I think for you to get your model right, it's not just about randomly going into some geographies and starting sourcing files. You have to get your credit right, operations right, legal right, get your collections right, people right. So one way we think is that no branch should be beyond 100-150 kilometers from any other branch.

So when you are expanding from Karnataka, suddenly you can put new branches in North Maharashtra, where you have no presence. From a monitoring perspective, are you going to recreate the entire operations and legal just to service two branches in North Maharashtra?

It doesn't make sense that way. Right? I think as you move contiguously, it gives you the benefit of scale, it also gives you the benefit of the infrastructure that you've already created. It helps you observe and get things right. And then move beyond another 100-150 kilometers from there, rather than being in isolated pockets.

It's interesting you say that, because a basic assumption would be that small business owners or small shopkeepers would largely be the same across the country. So, you could argue that if you have succeeded in two or three states that the model is replicable in the other states?

It is, it is. But the customer is only one end of your equation, right? The other is your own people. Now, how do you make sure that your people have the right flexibility?

Your assumption is 50 percent right. In a good time, yes, the tea shop owner in Chennai behaves the same way in Bombay, behaves the same way in Bangalore. But, in bad times, Chennai tea shop owners behave better than the tea shop owners in Bangalore. Why? That's the culture.

That is how the people were grown in these areas. So, in good times, I can open one branch in Rajasthan and one branch in West Bengal. But, in bad times, you will see all the three customers behave differently. That is the culture of North versus South, West versus East.

See, currently, we don't want to get into fully digital lending. Right. We want digital to be a part of our three main operations- business, underwriting, collections. So, we want technology to support these three operations rather than technology being the forefront of these three.

Give me an example of how technology can support rather than being on the forefront?

Today, there is not much data available publicly about how these customers behave. We are building our own internal database in terms of what our history has been in terms of how these customers have behaved. When they have paid on time, when they have not paid on time? It’s their entire ultimate data pool that we are creating, because we are sitting on good data of these set of customers.

That's the first logical step for me to get into any of those things in terms of predictive analytics. Like Mr. Pathy said, I don't think the end objective suddenly becomes that you just give a loan online in 24 hours. But, how do you use technology in a more practical way which augments your underwriting capacity?

Qualitative feedback is important. Because qualitative analytics is not available otherwise. How do you know about selling habits of people? How do you know about political affiliations? How do you know what their living style is? We observe and lend. But with every passing year, we also have access to a lot of similar customers that we have financed in the past.

So, we want to use tech from this perspective to see how we can reach more customers.

So in addition to your branch base model, would you also consider lending via an app? That doesn't mean you lend in 24 hours, but it’s an alternate mechanism. Somebody doesn't need to come to you physically.

Exactly. See, that's not a problem at all, as long as it is just another channel for our customer to reach us. Our decision is not based on that. Why should it be restricted, let them come via app, website, anything. That's okay. But as long as it's just another channel for us, we decide based on our assessment, whether to go ahead with lending or not.

Lastly, are you also slower to lend digitally because digital lending so far hasn't shown a sustainable business model in India yet?

I won’t comment on that, but I think digital lending generally focuses on short-term loans and small ticket lending. They do not get into any type of collateral based lending. We are absolutely on the other end of the spectrum on all the three parameters. We don't do short term lending.

Most of these loans are either for his business or towards an asset creation or some significant economic event in the family. So you have to take great care from an underwriting perspective, rather than just going by a few metrics that you could have based on its cash flows or bank balances or credit scores.