Solar Financing in India - Part 2

Giving Loans

“A bank is a place that will lend you money if you can prove that you don’t need it”

- Bob Hope

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Lenders make money by giving out loans and charging interest and fees on those loans. The more loans you give (let’s call that amount the “loan book”), the more interest income and fees you can charge on it – This explains why I get three calls each day asking “Sir, kya aapko personal loan ki requirement hai?” (Do you need a personal loan?). 

Giving money is easy, getting it back is hard. Banks know it. Anyone who has lent money knows it, which is the reason banks are extremely thoughtful of the “who, what, where, how, why” of the lending business.

In a way, lending is a noble business because in an ideal world, providing credit (money) to buy things, is a great way to promote spending, increase affordability, grow the economy and advance the nation. However, this comes with a huge responsibility, the money that you are loaning has been borrowed from someone else, and to them, you hold fiduciary responsibility. In banks, some of this money comes from public deposits hence lending is a heavily regulated business because you are the custodian of someone else’s capital. Therefore high governance standards and strong processes are enforced. This sense of responsibility is also the reason why lenders like certainty.

When you know your money will be back, you are safe. Anything entrepreneurial, innovative, too cool, or too good to be true is seen with suspicion. There is another set of lenders that take some additional risks, focus on specific opportunities and work together with banks to become a part of the ecosystem and those are the Non-Banking Financial Companies (NBFCs). They use technology, sector-specific expertise, geography-specific expertise to provide a huge boost to the overall lending market. They often act as feeders to the banks for loans. Regardless of who you are as a lender, the key questions are similar:

• Who is your customer and how do you get to them i.e. How do you originate loans?

• How do ensure that borrowers will pay you back i.e. what is your ‘underwriting’ criteria?

• How do you manage the competition?

Before we get into how you get to your customers, it’s important to know who your customers are and why they need your service.

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Why need a solar loan?

Depending on where you are located in India, a rooftop solar plant will pay for itself in 3 to 7 years. Many factors play into this thumb rule calculation, these are just averages. The fact remains that for a majority of our population retail solar is a 'good to have' and not a necessity. The status quo is power from the DISCOM and while solar can save you lots of money, it's not a necessity. Try selling something that’s not a necessity – it’s a tough one.

Furthermore, for most, the upfront investment is a high ticket payout hence even those who are interested, think twice. A 3 to 7 year payback is not great for instant gratification but if a loan product can be structured in a way that it pays for itself – the numbers seem to make sense. We are now at a position in most parts of the country, where the equated monthly installments (EMI) on solar is usually lower than the savings generated from solar.

For Residential customers, it’s a ‘good to have’ rather than a necessity. My friends and family have been extremely supportive of my ventures but very few asked for solar for their homes. If it doesn’t make economic sense, it’s a hard sell for solar, let alone financing. In the residential segment, the folks who think of solar are the ones who already have the means to afford it hence maybe not need the financing. One has to spend some time learning about the customer persona. For segmentation, one has to find a homeowner (not a tenant), with adequate roof space, and a large enough electricity bill to nullify through solar.

Large metros tend to have apartments/condominiums. Pro tip: The lesser the number of decision-makers – the easier will be your sales experience. Apartment complexes are hard to convert because the sales cycles are very long. I can potentially find some good work as a stand-up comedian if I shared with you the conversations I have had with certain management committees of cooperative housing societies (CHS) and residential welfare associations (RWA). Apartments also tend to avoid loans because of the risk and finger-pointing that could come with such discussions.

SMEs are an interesting segment. There are many industries where power as a % of the total cost is significant and they also tend to have rooftop space. These tend to be family-run businesses hence meeting the promoter and his family is usually easy, the decision-makers are few. SMEs also operate in semi-urban clusters – These industrial clusters can be of a single industry or multiple industries. Promoters also have astute knowledge on how to make their money work for them. They are some of the sharpest people I have met. They know a rupee invested in their capital expenditure of their own business would yield a higher return than funding a new asset like solar.

Across segments there is awareness but you may end up educating the customer and still lose to your competitor on price. Identifying the maturity of the buyer and that too one, that’s inclined towards a loan is critical.

If you are considering solar financing – I request you to ask one question to yourself Can you find “a large enough, consistent, good quality loan book in a certain geography”? 

Let us try to break this down:

• Large enough – The world of lending works on big numbers. The bigger your loan book, the more attractive you get to mature lenders for refinancing. I will discuss more of this in part 3 but to share this idea in simple numbers:

1. Assuming you close 1000 residential loans of 5KW each in one year. That 5 MW would be approximately 20 Cr. of loan book (5 MW x Rs. 55/Wp x 70% debt) – In the world of solar, executing those many projects is commendable but in the world of lending – those are not exciting numbers for refinancing a new untested asset class.

2. Similarly, 1000 SMEs of 100 KW is 100 MW or 200 Cr. of loan book – now the numbers are large but executing 1000 SME loans is challenging – You must have a very strong last mile connect with the EPCs to originate for your loan book.

• Consistent – You would want your loan book to consistently grow over time i.e. every year you should be able to achieve higher loan disbursements than the year before. Given the scaling challenges, you must ask yourself if that is possible for your preferred geographies and industries.

• Good quality – Giving money is easy, getting it back is hard. More on this in the section called underwriting below. Customers that are good quality borrowers i.e. have demonstrated a history of paying back loans or have the ability to do so, will have lots of options for lenders – why should they come to you?

• Certain geography - Often EPCs would say there is a lot of demand for loans in a certain region but we do a market outreach, we notice only a few loan files will come through from each region. Getting 50 loans from 2 locations is much better than 5 loans from 20 locations. Find deep ponds to fish – shallow ponds will tire you out. After taking many buses, trains, flights, you will realise what’s the point of all this if you are not making enough spread (as a lender) / margin (as an EPC). Spreading yourself too thin will increase transaction costs for servicing the project/loan.

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Structuring the product

A loan product has typical features – I will purposely not get into specific numbers because then the arguments can be endless – the intent of writing this is to have the founder appreciate what works and what doesn’t for each of these metrics. It is for them to chose the right balance.

• Interest Rate - Customers are very sensitive to the actual interest rate % number. Solar is not a need-based product so there is no hurry per se. The more the collateral that’s offered the lower is the interest rate. In my experience, the customer can pay a high-interest rate loan for a need-based product but when it comes to a non-critical product, they will be sensitive. Lending unfortunately is a business where the interest rate is the first number customers ask – so be aware of the economics.

• Processing Fees - One can charge a nominal fee for the processing fee but to hope that you will make your IRR pop because of this - may not be a sound strategy. The intent of this fee could be to fund your loan processing costs, or a part of the customer acquisition cost but rest assured the customer will negotiate. The savings you are promising are delayed gratification but the processing fee is charged upfront.

• Subvention Fees - Typically, a 0% loan means the lender doesn’t make interest income from the end customer but from a ‘subvention fee’ charged to the EPC or other stakeholders in the supply chain. Retail solar doesn’t enjoy margins as high as consumer durables or electronics where you can get a large enough subvention fee to optically reduce the interest rate and make a faster sale. If EPCs do that consistently, ask them how are they being able to share so much of their margin with you – unless they have magical procurement strategies, the quality of the equipment would be the one being compromised. Such an EPC business may not be around for too long.

• Tenor - A very short loan tenor means EMI far higher than the solar savings – if you can convince a customer, super! but you must remember that your loan book will churn as fast, so you will need find new loans to keep the book to the same size. A very long tenor means you are exposed to the long tail equipment risk and borrower risk. Equipment Risk - I cannot stress enough the importance of long-term reliability of the solar equipment. We promise our customers 25 years but have we seen a single cycle yet? Retail purchase is driven by brands but the equipment seldom goes through any reliability test. Furthermore, the companies might themselves change their business, who will service the warranties? As I write this, I am reading that LG Electronics plans to exit the solar module business. Borrower risk – Apartment complex committees change. SMEs go through business cycles – if your SME is in a cyclical industry then there is more risk. If the business is slow, factories are not running on full capacities – their willingness to repay may change.

• Collateral - This is usually a dampener for any solar loan conversation. SMEs typically have already pledged their factories to the banks. For residential, the loan amount is too small to discuss collateral.

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Underwriting

In a lending company, the magic sits with the underwriting team also known as the credit team. Once the sales team hands over the file to credit, the latter decides whether to give you a loan or not. Saying yes too often can create bad loans. Saying no too often is easy – I have met folks who are so biased and strong about their views that they shoot a discussion down even before it begins.

The best I have met – hear you out and then go to meet the customer. In about 15-20 mins of a discussion, they make a guesstimate whether they should approve the loan or not. We can discuss fancy credit underwriting engines – excel sheets, AI, ML based models but when it comes to a long-term loan like solar, the best I have met operate in a similar way – they ask a set of questions, pick up on cues and have a strong gut feeling. Then they see the financials to confirm their judgement. It’s a sight to watch – mastery at work. 

Being wealthy doesn’t mean the borrower will pay you back. Conversely, having limited resources doesn’t mean the borrower has no intention to pay. Good credit teams have sound judgement but meeting each borrower in person takes time.

SMEs are seen as a risky asset class but in reality, the promoters have pledged all their primary assets (home, factory, office) to the bank. They may seem risky if you apply conventional metrics but if you meet them, you will notice they are heavily invested in their business – hence broadly their intention is in the right place. Even then, they are bad cases. Such is life but reducing the probability of those cases will eventually define the strength of your financing company.

If you are considering starting a solar financing company – speak to an open-minded, experienced senior credit manager who knows nothing about solar. You will be enriched at the end of the conversation.

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Competition

The lending ecosystem in India is vast with many NBFCs, private and public sector banks. Many of the challenges mentioned in the first two parts of this essay can easily be mitigated by the sheer scale of their operations. Banks have vast branch networks, offer competitive interest rates, can raise capital is much better rates than an NBFC. Further, solar falls under priority sector lending, one can top-up solar on a home loan as a potential home improvement loan, and finally there are concessionary lines from development finance institutions, yet, rooftop solar has not quite caught the public imagination like electric vehicles. I would urge founders to ask why?

Some of the answers can be found by observing bankers – not only at the senior level but also at the branch level – how do they think about lending? What drives them and what worries them? These questions will provide insights that are critical before you start your solar financing journey. Having said that, the large part of the lending that has gone into the rooftop solar segment still happens to be from PSU banks.

One consideration is that, if there was an answer to “a large enough, consistent, good quality loan book in a certain geography”, then banks would have already addressed this opportunity - think of the progress we have made in Large C&I and open access over the years.

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In Part 3, we will discuss liabilities - fundraising for debt and equity. Many of the solar industry founders have a corporate finance background (Investment Banking, M&A, Private Equity) hence they understand loan products, company analysis, etc. very well but … it requires someone to understand core banking to appreciate how critical a driver is raising liabilities … and it’s a never-ending process. After all, money is the raw material in the lending business.