Lok Capital's Exit from a Microfinance Company

Report: Lasting Impact: The Need for Responsible Exits

Lok Capital (“Lok”) is a private equity fund manager, founded in 2004, that focuses on fostering financial and social inclusion in India.

Background on the Investor

Lok Capital (“Lok”) is a private equity fund manager, founded in 2004, that focuses on fostering financial and social inclusion in India. Lok promotes inclusive growth for underserved populations by investing in enterprises that provide affordable basic services, primarily in financial inclusion, healthcare, and agriculture. It typically works closely with investees to improve their business operations and help them scale to achieve commercial viability. Given Lok’s social mission, it seeks investees who adopt a customer-centric approach that focuses on client protection for low-income individuals. Lok typically also attempts to help investees enhance their impact by developing and tracking social performance policies and metrics.

Lok Capital’s first fund (Lok I, USD 22 million raised in 2006), focused on investments in Indian microfinance institutions. That fund has been fully liquidated. Its second fund (Lok II, USD 64 million raised in 2012) has returned over 100% of invested capital to its limited partners and is set to liquidate in 2020. Lok III has completed a second close at USD 80 million out of a target USD 100 million. Most of Lok’s limited partners are institutional investors, such as pension funds and DFIs.

Lok's Approach to Exits

Lok considers its exit strategy from the early stages of each investment, noting the importance of clearly understanding the interests and long-term goals of a company’s owners or promoters. For example, some promoters may feel a deep sense of ownership in a company, aiming to manage it for a long time or to pass it on to family members; such promoters may not be open to an exit that entails a change in control. Others may wish to sell the company and proceed to start a new business. The promoter has stayed closely involved after most of Lok’s exits, which, Lok’s Managing Director Venky Natarajan explains, helps to maintain a consistent business model and adhere to mission.

Lok also emphasizes the need to remain pragmatic and open to adapting strategy to changing circumstances. If the promoter does not stay involved, Lok tries to ensure a responsible exit by screening potential buyers for mission alignment and strategic fit, as well as for the attractiveness of their financial offers. Lok believes that once a company is ready to scale, it has fulfilled its role as a seed investor. Institutional investors, especially those with significant experience in the sector, are then better equipped to provide the commercial capital and resources needed for scale. Lok seeks buyers that believe in the business proposition and intend to grow the company without drastically altering its core business model. Lok thus seeks to understand potential buyers’ plans to grow the company, screening for risks such as plans for major consolidations that could lead to employee layoffs. 

Lok Capital has completed many exits it has deemed successful in terms of both maintaining mission alignment and achieving attractive financial returns. Most have taken place through strategic sales, secondary sales, or through IPOs. While most of Lok’s exits have successfully ensured mission continuity, for this case, Lok shared an example where the outcome was less than ideal in order to provide a rich opportunity for learning.

Background on the Investment

As part of its first fund, Lok Capital invested approximately USD 1.75 million in 2009 into an Indian microfinance institution for a 24% equity stake in the company. The company provided microloans to low-income customers located primarily in one Indian state. Lok invested with the aim of helping the company refine its processes and operate more efficiently by using technology, for example, such as tablets for field staff. It also intended to help the company expand its offerings to neighboring states over a projected five-year period.

Exit Objectives and Considerations

In 2014—five years after the initial investment and with the end of Lok’s first fund approaching— Lok began to seek an exit. In fact, Lok had begun to seed potential buyers in 2012, hoping to find one that understood the microfinance sector and could provide the necessary growth capital. Though the company was profitable and growing, neither the promoter nor Lok could attract a mission-aligned minority investor, in large part because the company conducted 80% of its business in three Indian states, posing what some potential follow-on investors deemed concentration risk.

Given the timing of the fund’s close, the best available exit option was to sell a majority stake in the company to a strategic buyer: a gold loan company that sought to secure a banking license and saw the microfinance business as complementary to their existing business. Though generally knowledgeable about financial services, the gold loan company had limited expertise in microfinance or with the specific target customer segment, making them a less preferable buyer from an impact perspective. In this example, the strategic acquisition was also less than ideal, since it opened the door to a possible a change in management. Since there were no other investors in the cap table (that is, the promoter owned the rest of the shares), it was relatively easy to manage the exit process.

Results and Lessons Learned

Overall, the investment achieved both Lok’s financial objectives and its impact objectives to improve the company’s processes and grow its operations at a reasonable pace. However, Lok believes the company faces post-sale risks. Natarajan noted specifically that the company’s growing loan sizes and “excessive” growth might indicate less regard for client protection, due in part, he believes, to the change in management after acquisition.

As an alternative to selling the whole company, Lok could have rolled its shares from the first fund over into Lok II. However, Natarajan explained, Lok I’s limited partners preferred to have their capital returned rather than own a stake in the second fund. Another alternative, to extend the life of the fund, would also have inhibited limited partners’ ability to liquidate.

Lok gained valuable experience in this case. Timing was central; a more flexible time horizon would have allowed Lok to hold the company for longer while searching for a more aligned buyer. But the fund had to adhere to its timeline for returning capital. In retrospect, said Natarajan, one viable option could have been to ask shareholders to move their shares to an alternative structure, such as a holding company; the holding company would then have owned the business, allowing it to continue operating while the fund liquidated.

In this case, the drawbacks of a closed-ended fund became evident in light of Lok’s impact objectives. The case also highlights the potential for investors to use creative structures, such as holding companies, in approaching and solving complex situations in ways that are tailored to best fit investees’ needs and long-term impact.

 

Key Details

Investor Description

Private equity fund manager

Mission

To promote inclusive growth for low-income/base-of-pyramid populations in India

Sector

Microfinance

Geography

India

Instrument

Equity

Holding Period

Five years

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