In this four-part series of Young Turks Master Class, CNBC-TV18 brings you the story of D Lakshmipathy’s Five Star Business Finance, Chennai-based non-banking finance company (NBFC) that specialises in small ticket loans for India’s ‘un-banked’.
Lakshmipathy took over the business in 2002 and Five Star over the years has established a unique underwriting model to assess businesses and extend collateralised loans to them.
With a presence in over 150 locations across South India, serving 40,000 businesses and individuals, Five Star’s assets under management stand at Rs 1,220 crore.
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Interestingly, Five Star’s net non-performing assets (NPA) stand at less than one percent. This NBFC has raised over $150 million to date but its first cheque came from Matrix Partners India back in 2014.
On the final episode, Lakshmipathy is in conversation with Matrix Partner India’s managing director Vikram Vaidyanathan.
Q: Can you tell us a little bit about what was the thinking behind starting Five Star, what is your start-up journey in that sense?
Lakshmipathy: Coming from a non-commerce background, transforming yourself as a banker – it's a journey of full of challenges, but I hail from a business family, driving a business runs in my blood. From my definition, if you are able to master these three things well, then you transform yourself as a good lender. First, you should know whom to lend that is very critical, second, you should know how to lend, third, you should know how to collect it back.
When I joined Five Star in 2002, the company was a high purchase entity, which was lending predominantly to two-wheelers and consumer durables. During that time, the company was in need of capital and a right product to lend.
So, when I saw lending to commercial vehicles, two-wheelers and consumer durables in those days, if you go back early parts of 2000, there was a big banks and big NBFCs, which wanted to come to the retail sector. So, the company like Five Star – like sub Rs 10 crore of asset size, we don’t have any space to move around. So, our margins were squeezed, our pricing was squeezed, especially, we were worried about our asset quality. So in those days, where I started to think about how to turn this company into a higher purchase company to a mortgage company. This is where my entry into Five Star started.
Vaidyanathan: I think he is being very modest. I think it's more like Five Star joined him than him joining Five Star. He came in, he saw this company, which was doing something else and he saw this opportunity, so he invested his own money.
Q: You saw that there was a company with a massive potential and that you thought you perhaps had ideas of how you wanted to grow it and scale it. Can you tell us a little bit about that period of time, what you were able to do with the business, to grow it, what was some of the strategic thinking that you brought to the table.
Lakshmipathy: Mortgage lending was not a great story. I have heard about it 15 years down the line.
Q: It's still not a great story.
Lakshmipathy: I will end up saying that how great it's going to be going forward. So I think, we thought why cannot we get into mortgages. From 2002 to 2007, five years, I just learnt how to master myself as a perfect lender. So, why I am saying is, when we went into mortgage product initially, hundreds of files I have personally visited. I have made an attempt to get into their family members, have a discussion with them, what was their demand, why they need it, I have personally stepped into the business units of hundreds of entrepreneurs, I sat for some time, I looked around what was his talk, what was his business potential, what was the footfalls that he is having it. So 2002 to 2007, I just learnt from a layman to a lender.
From 2007 onwards, we started to focus fully on a mortgage backed lending, then, we also came across who were the guys who were pledging the property and taking their loan from us and then we saw a huge potential in small business firms.
That is the second phase of the growth of the company from a pure play mortgage lenders to a small business lenders. So all in shot, from 2002 to 2013, when we met Matrix Partners, it was a conservative company with a single promoter whose concentration was only to learn how to lend not to build.
Vaidyanathan: There is one thing that is different about his journey versus others that we invest in. He had put his own personal capital and a lot of the family capital, so he thought like a shareholder. He was always thinking about his own personal capital and the debt that he had taken. They had floated a lot of revenue and non-convertible debentures (NCD), but to a lot of people in their own community who they knew personally. So the value of capital and the fact that they had to return that capital and the fact that they had to provide a return to both equity investors and debt equity investors was almost paramount. This sets the stage for some of the conversations that we had, because he was so focused on how to deliver great return for shareholders. That mind-set, we don’t find very often with founders. So, he was almost very ready to say, okay, if I take people’s money, how do I multiply it, how do I give it back to them. I don’t think other people have that mind-set as much.
Q: How did you discover Five Star or how did you arrive at them? I know they keep a very low profile.
Vaidyanathan: For us, small-to-medium enterprise (SME) lending was the space that was a very high interest and we have ended up making multiple investments in that space. Very similar to his thought process that they are very under-served and if you pick the right ‘whom to lend’, then you can make a very profitable segment out of it.
We had looked at many other people, we have had looked at this space and we used to always keep hearing this name Five Star from people. We used to keep hearing it from some of the banks, from other wholesale lenders, who had given money and they had a fantastic reputation as a very high quality low non-performing asset (NPA) book. That is something we were worried about.
It took us a long time firstly to get a meeting, to get in the door and then after that, next couple of meetings on making sure our diligence was done happened very quickly, because we met him, he came into our office and we decided to invest pretty quickly. I think it took almost 9-10 months, almost a year of courtship to finally end up doing that deal.
Q: Why were you reluctant?
Lakshmipathy: For me, capital is no differentiated than a debt. Legally, there is nothing you have to pay them back but morally, I think they are borrowing, they are investing in Five Star. It has go back to them with a decent return, maybe after five-seven years. So, from my thought, all debt capital in any form it comes, I am responsible to give it back to them. They would have met me 18 times for the small quantum. Let us not reveal the quantum now. So, it was a very long discussion between me and Matrix.
Q: What were some of the things – if you can recount for us some of those conversations, what were you trying to convince him on, what were you apprehensive about?
Vaidyanathan: The thing that most founders and investors fight about, we didn’t fight at all, which is valuation. We offered a valuation, which was moderate, he said okay. He said, valuation is yours, now terms are mine and that was okay with us.
That is what we took more and more time and at the time, when we started, we didn’t have a lot of terms to begin with. Over a period of time, as more investors have come, they have got those terms and he has been very gracious enough to give us those terms later.
However, for him to get comfortable that there are terms and investor can potentially exercise, those terms and to get comfortable with the person who is going to be exercising those terms, that is what took him a long time.
Q: This must have been refreshing to a certain extent dealing with an entrepreneur like this, vastly different from entrepreneurs, typically much younger, maybe have some professional experience, building out their first companies enamoured with the unicorn stories?
Vaidyanathan: When you meet a founder like this, it's exciting and it also comes with challenges. So, it's exciting because they are thinking as a shareholder, they are thinking about their own value, they are thinking very long-term and they are not thinking short-term. But we know that there are going to be challenges working with them, trying to figure out how to work with them on faster growth. Those would be the challenges that we were signing up at that point in time.
I would say the thing that excited us the most, when we met the investment was that he was a fantastic lender. He said, it's very important whom to lend, but most of the conversation that we had with him initially was whom not to lend and he was very clear on people that he will not lend to and that usually when you talk to people who are doing the lending business, they say, they can lend to this, they can lend to that, suddenly market size is very big, whereas he would say that I am going to only lend to these people and then I know how to get to these people, I know how to assess them and then I know how to collect from them and he was very focused. That I would say is almost more refreshing than anything else, because you find very few people with that kind of focus.
Q: So in that period of 18 meetings over 9-10 months, what was your biggest learning that something that you have held on to and in negotiations that you have done after that, you had Lakshmipathy’s touch?
Vaidyanathan: Founder always wins is the biggest learning.
Lakshmipathy: Founder has to win in terms, you should win in valuation.
Vaidyanathan: I think the biggest learning for us, when we were doing some of the negotiations is that we learn as much about founders in the negotiation as we do in anything else, because a founder fights on a particular term. I remember he was much focused on the exit term and even till today, he is very focused on the exit term.
You can misinterpret it saying he doesn’t want to give exit, but it's completely the reverse. He is so focused on the fact that he has to give exit that he is fighting on that term the most. So, when you can have a more and more of a discussion around some of these terms, you can discover what is that person thinking and my partner Avnish always says this, that you never make money on terms. You make money on building a large company, but you can lose money on terms, because if things go wrong, you can potentially lose money on terms. We got comfortable that we won’t lose money.
Q: He has made it as his mission to make sure that you make your money. You said just a few minutes back that it was very important for you to recognised very early that the VCs are in a business as well, right, and not a very different business in which you function.
Lakshmipathy: Exactly. They should also know whom to lend, whom to lend from an equity side and when they can get back the money and what are the multiples they can get.
Q: From a strategic point of view, what did you think it was that a venture capital firm like Matrix Partners would bring to the table? What did you recognise as some of their strengths that you could leverage on given your own experience and background?
Lakshmipathy: To be open, I thought that Matrix will help me to grow both personally as well as from my institutional point of view. But once we got the relationship, we had one meeting in Bengaluru, we had a lot of meetings, but one meeting, which was a turning point of Five Star to grow from an entity to an institutional building. So, we both were discussing over a coffee chat that yes, a product has been found, opportunity is big, so why cannot we accelerate our speed. In fact, he recruited my first chief executive officer (CEO), so I shortlisted, I gave it to him. So he recruited.
Q: Do you remember that meeting?
Vaidyanathan: I remember that discussion. So one of the things that was going in my mind at that time is that the company is doing well, it was profitable, it had very high return on assets (ROA) and very low NPAs. But we were growing at a steady rate and to him, growing faster was potentially sacrificing quality and I gave him a lot of data on how other people had grown, how other people have raised money, how can you make sure that we can continue to hold onto our asset quality, while growing fast and if asset quality doesn’t hold up, then we will slow down.
I think the biggest thing that came out at that was going to be team, because it gave him a lot of leverage and gave him freedom to do other things. So he was able to learn and he was able to take on some of the operating duties, where he was able to focus on new, because he focused on new growth and the CEO focused on existing branches and therefore, suddenly the company could grow very fast.
Q: What was some of the things that went through your head as you tried to give up certain amount of control, because for this person to come in and make meaningful his responsibility in Five Star, you would have to give up a lot of what you were doing?
Lakshmipathy: I think once you have right product with you, if you want to grow the product, you should bring in the right team. Earlier as you rightly said, I was handling the business, credit, operations, so all three integral parts of lending. However, today if you see, Five Star, we have ten department heads who have come from all banking space. Everyone has the freedom to move around. At the same time, as a promoter, I have to monitor them. If responsibility not given, then you cannot expect the company to grow.
Vaidyanathan: One of the things I have to appreciate is that lot of people with his background, we often here that they will build a team and they will professionalise but very few people end up doing it.
Q: Nurturing those teams, growing those teams, right?
Vaidyanathan: He took his time. It was not like he immediately invested and immediately decided he is going to do all this, but he took his time and once he made a decision, then it's a 100 percent decision. So, as soon as he made this decision, then he went hundred percent and then he built this entire team out, the CEO, CFO and now like he said, it's a bunch of department heads that have come in.
Q: Talking about the business itself, can you give us little bit of insight into what to your mind is your biggest differentiator from other NBFCs, other lenders that are in the market today?
Lakshmipathy: What differentiates Five Star from competitors are is that first we patiently learned the sector. For last seven years, I went to the families of customers, sat with them in the business units, saw how business runs. So you have to be very patient in first cycle. Once you think you have learnt it, well you are able to lend them well, you are able to collect them well, then you can accelerate the speed.
People who have jumping now, they want to accelerate the speed at first instance and that is where the issues may come up as we go forward.
Q: Perhaps pressure from investors to show quick growth, large book size, but perhaps patchy asset quality?
Vaidyanathan: I think that is the case and that is what made the partnership work, because he had set expectations lower than valuations. It gave him room to grow at the pace that he wanted to and then, once we started doing larger rounds with future round investors, we had to grow faster. So we made the choice to grow first, then take on more capital.
But the other thing that really differentiates Five Star is Lakshmipathy and the team and ethos of the team. Until recently, he still travels 20 days in the field. Only six months back someone else has had the authority to open a branch and we are now close to 150 branches. Since he does not let anyone drive, it meant he would go to all these branches across these four states and see the branch physically, know what is happening at the ground level and very few people actually do that.
Lakshmipathy: What you talk, you have to walk. What you say in a budget - what will be the growth story, if you are closer to that, then I don’t there is any questions or hardships you will be facing within the board.
Q: But how do you stay so disciplined, because there are external shocks in the business that doesn’t led you walk the talk sometime?
Lakshmipathy: So if you take last three years, almost 12 quarters have gone and in all these quarters, we have not missed a single quarter. Even in demonetisation quarter, we never missed our target and neither during Goods and Services Tax (GST) episode. Since we know our field very well, these are not the external shocks – we have good asset quality even in that quarter.
If you stick with what you say and what you say really comes out of what you have learned from the market, then there will be hardly any misses.
Vaidyanathan: The other thing we learnt and we observe as a pattern in all of our successful companies they never miss plan. Lakshmipathy and the team never put forth a plan that they don’t know how to hit. And if they revise a plan, it has always been upwards and never downwards.
In times, be it demonetisation, GST etc. they are always the first to inform the board. So even before the board members have thought about the problem, there will be a very quick email or WhatsApp that says that this is the problem, this is what has happened and this is how we are thinking about some of the choices. Just having that advanced communication and over a period of time, you as a board member also relax, because you know the founders are on top of it.
Q: Talking about the future, you have done recently a 100 million round. You have brought in TPG as you new partner to your growth story. Tell us what you expect to do with this large quantum of raise that you have had and how you plan to scale up Five Star?
Lakshmipathy: A global player like TPG, who want to partner with Five Star itself tells you how big the opportunity is for the company. With the new capital coming in, we want to exercise our growth beyond south. So, we have just opened a few branches in Maharashtra and Madhya Pradesh – what we typically call as learning branch. We will learn vital things from the market from these two states and once our thoughts are right, we will grow the way we did in south India. Be it organic or inorganic, this capital will help Five Star to position ourselves as a key player or leader in this small finance segment.
Q: After Matrix joining you as their first partner – first venture capital into your company – what did you subsequently start looking for in venture capital and therefore, what should all young entrepreneurs, whether they are first time business owners, just out of college looking to do a startup and raise money or mature professionals, who are starting a business – what should they be looking for in their venture capitalist (VC)?
Lakshmipathy: They should not look for the valuation, they have to look for the right partners. So don’t get the first partner wrong that may change your aspiration drastically. Choose the first partner right. Take your time, do not give importance to the valuation, but give importance to the relationship. End of the day, paper doesn’t matter, people matter.
What I have learned from Five Star with venture capitalist like Matrix is always talk what you can do and do not overestimate yourself. Play it cool, do what you can deliver and do it rightly. Those are the important things for a first time entrepreneur who deals with VCs.
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