Hive of microfinance activity attracts serious attention

Jul 2007
United Kingdom, July, 02 2007 - Investment banks and institutional fund managers are being persuaded to take microfinance institutions seriously as they show better returns than some other emerging market investment vehicles and prove their stability in the face of external shocks.

The lives of Bolivian street vendors and Cambodian rice farmers are worlds apart from those of Wall Street practitioners, but these days Wall Street bankers and investors and impoverished entrepreneurs in developing countries are at least developing a structural link through the capital markets.

In the past few months alone, conferences addressing the link between microfinance and the capital markets have been held in Chicago and New York. The fact that Muhammad Yunus won the 2006 Nobel Peace Prize for his pioneering work in microfinance at Grameen Bank in Bangladesh also helped to focus attention on the industry.

Now institutional fund managers and investment banks are getting serious about supporting microfinance institutions (MFIs) that lend to these entrepreneurs. A market that was long a preserve of specialist microfinance funds making bilateral loans has not only embraced structured debt products, such as collateralised debt obligations (CDOs) and microloan securitisations, but now institutional equity offerings as well.

Some of these are being co-ordinated by the biggest bulge bracket investment banks. In April, Mexico’s Banco Compartamos, the microfinance lender, which has been licensed as a bank by the Mexican government since June 2006, did a $466m initial public offering (IPO). It was the world’s first IPO in the microfinance industry, with 80% going to the US market, predominantly institutional investors, and the rest being sold in Mexico. Credit Suisse co-ordinated the sale.

And in May, Morgan Stanley and microfinance asset manager BlueOrchard Finance announced the launch of a $108m collateralised loan obligation (CLO) offering in dollars, euros and sterling, called BOLD 2, which will fund 21 MFIs in Azerbaijan, Bosnia, Cambodia, Colombia, Georgia, Ghana, Kenya, Mongolia, Montenegro, Nicaragua, Peru, Russia and Serbia. The CLO will be sold in five tranches rated from AA to BBB, with a $50m unrated portion.

The efforts have a clear social impact on the lives of the end recipients. A loan of just $100 to a microentrepreneur could be enough cash to kick-start a tiny business: to buy a cart from which to sell vegetables, perhaps, or even a second-hand car to transport vegetables from a market where they can be bought at wholesale prices.

Asset class potential

But institutional investors cannot honour their fiduciary duties to clients through social returns. The question of how far microfinance can be considered a serious asset class for the institutional market lies in what the financial returns are and how much capacity and liquidity can be generated in this infant market.

Developing World Markets, a US-based investment bank and fund manager focused on microfinance, has launched several deals aimed at the institutional market. Last September, it advised on the largest ever equity private placement in microfinance: a $43m investment by TIAA-CREF in ProCredit Holding, a global microfinance holding company. Brad Swanson, partner at the bank, says that although the social impact of the bank’s projects are a selling point, it has to show comparable rates of return to similar structures in more established asset classes to make it through a fund manager’s investment committee.

“The social value is a door you go through to meet with institutions, but once you’re there, it’s all about risk and return and they will compare you rigorously with other assets,” he says.

Mr Swanson cites the example of the bank’s rated, multi-tranche CDOs, such as the $60m Microfinance Securities XXB launched in June 2006 funding 30 MFIs and rated by MicroRate. “Investors can choose a risk and return level that they’re comfortable with. The senior notes pay mid to high single digits. At the bottom of the pyramid, if you’re taking an equity-type risk, then the returns are comparable to equity pieces in CDOs in other asset classes.”

But in some cases, investors can find better returns in microfinance than in other emerging market investment vehicles. As Roger Frank, managing director of Developing World Markets, puts it: “If you look at the JPMorgan Emerging Markets Bond Index, some of our projects are paying rates that are comparable with or even slightly better than that.”

The risk factor

They may be happy with the returns, but institutional investors are still not 100% comfortable with the risks. That is why Developing World Markets sponsored a working paper put out last year by the Stern School of Business at New York University. The paper, Can Microfinance Reduce Portfolio Volatility?, identified six key factors affecting the performance of MFIs and commercial banks in emerging markets, their percentage change of net operating income, return on equity, profit margin, percentage change in total assets, percentage change in loan portfolio and portfolio at risk. The annualised results from 1998 to 2004 were then compared to global market indicators over that period and also to the domestic economic performance in the country where each institution was located.

The study’s conclusions, although tentative, suggests that MFIs are less correlated than emerging market commercial banks are to the equity indices and far less correlated than emerging market commercial banks to domestic macro conditions. This supports what has been suggested for some time, namely that because borrowers from MFIs operate in the informal sector, they are less affected by shocks to the formal economy. After all, many MFIs report historical repayment levels of 97% or more on the loans that they advance.

“Over most of the emerging markets’ economic disasters of the past two decades, we found that despite deteriorations in the macroeconomic conditions, these MFIs actually did okay, because their clients’ businesses are just dealing with some of the most basic human needs,” says Mr Frank.

New securities

Aside from advances in quantifying the risks, new securities that are structured to suit the risk appetite of institutional investors are being developed. The involvement of the mainstream rating agencies, as well as specialist rating agencies such as MicroRate, for example, is facilitating that and giving the industry a much-needed boost in size, liquidity and transparency. While Morgan Stanley launched its first unrated microfinance CLO last year, its new one, BOLD 2, will be the first in the industry to be rated publically by the non-specialist rating agencies, with some tranches achieving an AA rating from Standard & Poor’s.

And the scale of institutional offerings is also increasing. Vikram Gandhi, managing director and global head of the financial institutions group at Credit Suisse in New York, says that the size of the Compartamos IPO and the strength of institutional demand shows that it is possible to find liquidity in microfinance securities. “The Compartamos IPO demonstrated that MFIs are capable of delivering long-term growth and supporting liquidity on an institutional scale,” he says.

The offering was 13 times oversubscribed, priced at $40 per share, at the top end of the indicated range, and traded up 32% on the first day of trading. Institutional investors took 84% of it, with nearly 50% of the overall allocation going to the US and 29% to European investors. BOLD 2, the Blue Orchard and Morgan Stanley deal, was also sold to institutional investors with no prior knowledge of the microfinance industry.

The hope is that eventually the wider microfinance market will appeal to even more institutional investors, thereby giving liquidity a much needed boast as well as increasing the potential of MFIs to lend locally. After all, there is scope for more lending by MFIs. The number of microcredit customers is increasing 34% a year on average, yet only 4% of the potential end market has been captured so far, according to MicroCredit Summit.

Size matters

The biggest problem is that, for all the progress that has been made in expanding the commercial microfinance industry, it is still a tiny market. Banco Compartamos is rather unusual in that it has a $275m loan portfolio and an excellent track record in profitability and growth. It is also rated by Standard & Poor’s and Fitch.

Yet only the top tier MFIs globally that are profitable and have the longest track records can absorb commercial capital. The earlier stage MFIs rely on grants. As a result, the top tier of the market, and particularly the top 50 MFIs globally, is already getting crowded with commercial microfinance funds looking for somewhere to invest their cash.

That is a problem for institutional investors who want to scale up investments. State Street has committed more than $4.5m to two global microfinance funds in the past few years. Nevertheless, as Brian Koeller, one of State Street’s senior portfolio manager focused on CDOs, pointed out at a recent microfinance conference hosted by MFI support organisation Accion International: “The problem is that you need credible vehicles to put your cash into. Certainly institutional investors want the portfolio diversification, but the allocations you can make are still very small.”

Mr Frank agrees: “You can’t just throw unlimited capital into it and so a lot of the major financial institutions are not geared up to deal with this.”


Further down the track, MFIs need long-term equity capital to enable them to build sustainable businesses and apply for bank licences, such as Mexico’s Compartamos. But a lot of work needs to be done to pull more MFIs up to this stage. Mr Swanson believes that having more commercial investment capital available will help the evolution of MFIs, from reducing the marginal cost of capital to improving corporate governance and disclosure.

“We speak to many MFIs that are using commercial capital for the first time,” says Mr Swanson. “There’s certainly a different level of discipline in the capital markets, so we spend time with MFIs, walking them through and explaining it. But capital market participation could also simply give more confidence to local entrepreneurs that the capital will be there as they build their businesses.”

That will take time to filter through but, paradoxically, the more that MFIs attract more sophisticated international funding – or, as the NYU working paper concludes, move into commercial lending as their clients accumulate wealth and begin to resemble their commercial banking counterparts – the sooner portfolio diversification advantages that they offer to institutional investors will disappear.

“As there’s more liquidity and institutional investors are able to express a view more easily, we will see more macro trends impinging on investors’ decisions,” says Mr Swanson. “But as MFIs do more commercial lending, the question arises: will that change the nature of their business and also make their returns more correlated to macro economic conditions in that particular country?”

The funding of microfinance through the capital markets presents as many questions as there are answers. But for now, at least, the two are getting a little more accustomed to each other.

Source : The Banker

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