Rating Rationale

Strengths
* Healthy capitalisation metrics supported by regular capital raising
Varthana has healthy capitalisation, supported by regular capital raising. Between 2013 and 2018, the company raised about Rs 340 crore through various funding rounds with the last one being in March 2018 for Rs 200 crores. The networth of Varthana is comfortable at Rs 403 crores as on March 31, 2020 with adjusted gearing stood at 2.0 times.. The gearing over the last 4 years has not exceeded 2 times as on audited balance sheet date. The company is also expected to follow a conservative leverage philosophy over the next two years. Over the longer term, the steady-stage gearing is not expected to cross 5 times.

The tier-1 and total capital ratio of the company was 36.35% and 36.80% respectively as on March 31, 2020. CRISIL believes that Varthana is adequately capitalised and any additional proposed capital infusion would further enhance the company's ability to absorb any asset side risks in the medium term.

* Significant experience of the promoters in the school finance industry
Varthana is involved in financing of affordable private schools which is a niche segment of operations. The founders of Varthana, Steve Hardgrave and Brajesh Mishra have significant experience in this asset class due to their previous association in similar line of business. The key personnel in top management have been associated with the financial industry at various levels including collections, backend operations, credit and legal and have extensive experience in running the finance business.

Given their significant experience, the management of Varthana has been able to put in place elaborate credit policy, prudent loan monitoring process and provisioning policy given the nature of the loans. The management is also focused on building good governance systems. It has an experienced Board with three independent directors and has appointed reputed auditors.

The company's assets under management (AUM) stood at Rs 1,104 crore as on March 31, 2020. CRISIL believes that the experience of the promoters and management will stand Varthana in good stead as it scales up its portfolio over the medium term.

* Healthy operational profitability
Varthana has a healthy pre-provisioning operational profitability (PPOP) marked by high gross spreads and moderate operating costs. Since it operates in a niche segment of school financing and at lower ticket sizes (more than 80% of loan book is of less than Rs 3 crore), it does not face significant competition from Banks or other NBFCs. Consequently, average yield on the loan book is 19%. With leverage being low, Varthana's total income margin net-off interest expenses (as a % of average total managed assets; ATMA) is strong at over 10% over last two years.

The company follows a hub and spoke model for ground level operations and is present in 14 States. The company's operating costs were moderate at around 4.5% of ATMA during fiscal 2018 and fiscal 2019. However, during fiscal 2020, the operating costs increased and reached 5.7% of ATMA. This coincided with a stagnation in the portfolio due to a combination of NBFC sector specific issues and manifestation of asset quality challenges during fiscal 2020. Nevertheless, due to the high gross spreads, the overall PPOP has remained healthy at 4.8 to 6% of ATMA over last two fiscals. This will help the company manage potential increase in provisioning or write-offs in case of flare up of delinquencies.

Weakness
* Elevated asset quality metrics due to slippages of large ticket loans in fiscal 2020
Varthana's asset quality metrics historically have been low with GNPA ratios below 2.0% till fiscal 2019. In fiscal 2020, there was a sharp spike in GNPA to 7.2% as on March 31, 2020. CRISIL understands that the increase in GNPA was due to a combination of factors which include economic slowdown, key-man risk in a few large accounts and diversion of funds by borrowers. However, excluding the top 4 large accounts of more than Rs 3 crore, the GNPA is expected to be at 5.8%. Furthermore, most of the large NPA accounts have been provided for by the company and management expects recovery from most of these accounts. The provisioning cover was 42% for ECL stage-3 accounts as on March 31, 2020.

Varthana has increased collections effort in the last quarter of fiscal 2020 through enforcement of SARFAESI wherever possible and also by engaging in the discussion with the management of the delinquent accounts to bring in either strategic investor or to change management. CRISIL further understands that these efforts have resulted in a few delinquent accounts become performing thereby resulting in reduction of GNPA ratio to 6.9% as on June 30, 2020.

The overall collection efficiency has been on an improving trend over last three months but remains below pre-pandemic levels. CRISIL understands that the collections of the company are expected to stabilise as the schools re-open. However, any further slippages in the asset book thereby increasing the GNPA level beyond the current level would remain a key monitorable and a rating sensitivity factor.

* High credit costs impacting earnings
The earnings of the company was constrained in fiscal 2020 by increase in the provisioning cost primarily because of the slippages in the asset quality in the last 2 quarters of fiscal 2020. This was despite the healthy pre-provisioning profitability. Varthana recorded a profit after tax (PAT) of Rs 15 crore for fiscal 2020 and a return on managed assets (ROMA) of 1.3% for fiscal 2020 against a PAT of Rs 36 crore and ROMA of 3.4% for fiscal 2019.

Varthana has conservative provisioning policy which has resulted in higher provisioning expense. The company provides 100% provisioning for secured loans at 360+ days-past-due (dpd) and at 180+ dpd for unsecured loans. Based on the management's assessment on the likely timeline of recovery, the provided exposures are written-off. The company's aggregate credit costs (provisioning and write-offs) was at Rs 34 crore during fiscal 2020 of which Rs 11 crore was for loan write-offs. This included additional Covid-19 specific provision of Rs 6.5 crore. The above factors have resulted in lower profit levels. However, the company has healthy PPOP and hence CRISIL expects that PPOP would provide sufficient cushion for the company to absorb existing asset side shocks. Furthermore, CRISIL understands that most of the large NPA accounts have been provided for by the company and a recovery from these accounts is expected to improve the earnings profile. However, any further pressure on the asset quality, thereby affecting the earnings profile will remain a key rating sensitivity factor.

* Ability to diversify funding profile
Varthana's resource profile comprises of NCDs, ECBs and loans from NBFCs. These comprise of 76% of overall borrowings. The share of bank funding is low at 19%. Additionally, over the last one year, the company has primarily relied on securitisation and ECB as the mode of fund raising. The relatively low incremental funding from banks over the past few quarters makes it necessary for Varthana to make inroads in the traditional bank funding route. The funding environment for NBFCs remains confidence sensitive and there are impending worries of impact of the pandemic on asset quality for entire financial sector. Consequently, the ability of the company to raise funds on a continued basis and at optimal costs will remain a key monitorable.

Liquidity - Adequate
The company as a policy, with regard to the current circumstances of Covid-19, decided to maintain cash and liquid investments equivalent to 3 months of gross repayments and expenses. In normal circumstances, Varthana would maintain positive cumulative mismatch up to 3 months and have clear visibility for six months in terms of funding. The liquidity cover of the company was 1.7 times for 3 months of repayments as on July 31, 2020. The overall liquidity position (cash, liquid investments and unutilised working capital lines) of the company was Rs 148 crore as on July 31, 2020. As per CRISIL's analysis of ALM as on June 30, 2020, there are no negative cumulative mismatches in upto 12 months bucket.

Rating Sensitivity Factors
Upward factors
* Improvement in profitability with RoMA above 2.5% on a sustained basis
* Sustainability of GNPA below 4% over the medium term
* Increase in scale of operations while maintaining operational costs and improving earnings.

Downward factors
* Continued shortfall in collections, thereby impacting asset quality and credit costs
* Increase in steady state gearing above 4 times in the medium term
* Profitability metrics remaining subdued with RoMA at below 1%
* Increase in GNPA beyond current levels.