There's Nothing Small About Microfinance

by Amy Sulzman
J.P. Morgan Investment Analytics & Consulting
amy.l.sulzman@jpmorgan.com

Investors are always on the lookout for investment vehicles that can both diversify their portfolios and provide consistent positive returns. Those who favor socially responsible investment strategies are increasingly looking to microfinance initiatives as a means of attaining such results. Though this market is still in its developmental stages, many institutional clients are considering microfinance institutions (MFIs) and microfinance investment vehicles (MIVs) as a means of diversifying their holdings. These investments seem to have a very low correlation with other asset classes and many have performed well in even the most volatile of markets.

Micro-What?

In third world countries, there is a greater disparity between the number of people who want to work and the number of jobs available. Oftentimes, poor people are forced to either work for themselves or starve. Since they lack collateral, banks are unwilling to loan to them, so the poor may turn to lenders of last resort to fund their businesses, frequently paying more in interest than the revenue their businesses actually produce. These endeavors barely result in enough money to put food on the table for their families, let alone allowing the business owner to make a profit.

Microfinance was developed to address these harsh realities. It is often referred to as “banking for the poor.” By providing very small loans (normally less than $200) to poverty-stricken individuals, microfinance initiatives allow borrowers to start or expand small, self-sufficient businesses. With the micro-loans they are given, people are able to purchase inventory and supplies that they can quickly transform into sustainable businesses. As their businesses grow, impoverished individuals slowly climb out of poverty, improving their living conditions, providing better nutrition for their families, and often reaching levels of education they never thought possible.

The MFIs that provide the loans also support the borrowers through various means such as educating them about savings accounts and insurance, providing entrepreneurial and life skills classes, and providing advice on anything from nutrition to childhood education. Repayments are often collected at weekly meetings that gather all of the borrowers in one locale. By bringing all of the borrowers together, MFIs create support groups in which the borrowers can share their stories of both successes and failures. By sharing their problems with one another, the borrowers help each other, allowing them to learn and grow as individuals and as a community.

While the MFIs can charge high interest rates ranging from 18 to 60 percent, their rates are low in comparison to the 120 to 300 percent the borrowers would normally pay their local moneylenders¹. As a result, the repayment rate on micro-loans is between 95 and 98 percent, a number that exceeds the repayment rates on student loans and credit card debts in the United States¹. Under most lending strategies, the loans are re-paid within 6 months to a year, at which time another loan can be granted if the borrower so chooses. The high interest rates that MFIs charge are a result of the costs they face to provide their services. Funding and operating costs for these operations are high because unregulated MFIs are not allowed to access savings or public deposits to fund their operations. Additionally, many borrowers live in rural areas that are not easily reached. According to Anna Kanze, an investment analyst at one of the leading private equity microfinance investors, Grassroots Capital, “The delivery costs of microfinance (i.e., the cost of reaching the ‘unreached’) can be quite high. Even for efficient MFIs, operating expenses can be in the range of 10- 12% of gross loan portfolio.” In order to cover these costs, MFIs charge higher interest rates.

Show Me the Money!

As one of the founders of microfinance, Muhammad Yunus, was once quoted, “This is not charity. This is business: business with a social objective, which is to help people get out of poverty.” MFIs often begin as small non-governmental organizations (NGOs) that have a focus on credit as a small scope of their activity. Over time, these NGOs become more and more commercialized, transitioning into non-bank financial institutions, and eventually developing into regulated banks. According to a survey conducted by the Consultative Group to Assist the Poor (CGAP), as of 2006, there were 57.9 million borrowers being serviced through MFIs². Per Exhibit 1, there are now over 350 foundations funding these MFIs, with investors ranging from development finance institutions, individual investors, institutional investors, to endowments and foundations. The main funding instruments used are debt, equity, loan guarantees, and grants, with debt being the most widely used instrument³.

Some of these investors are including microfinance vehicles in their portfolios as part of socially responsible investing initiatives, while others see microfinance as a means of diversification. Dutch healthcare pension fund PGGM has contributed $200 million, and the U.S.’s TIAACREF has contributed approximately $100 million to the microfinance sector⁴. One of Europe’s largest pension funds, ABP, has invested about $215 million in microfinance debt and private equity holdings, and recently committed an additional $30 million to a microfinance private equity fund⁵. ABP uses microfinance as a means of diversifying their private equity holdings.

While microfinance helps impoverished people raise themselves up out of destitution, it can be a sound investment when implemented correctly. MFIs have access to funding from philanthropic foundations that is not experienced in most other asset classes. Investors commit to the MFIs in the name of the MFI’s mission, and not just for financial gain. In tough times, these investors are much less likely to flee their investments in MFIs. This is one of the factors that make microfinance investments fairly uncorrelated to other asset classes.

Investors in microfinance have a few options from which to choose when considering MIVs. MIVs can be classified into two main categories: microfinance funds and microfinance structured instruments. As of December 2008, there were 104 active microfinance investment funds with total estimated assets under management of $6.5 billion⁶. They range from commercial investment funds and registered mutual funds to blended value funds. These funds often provide returns comparable to money-market funds. Structured microfinance debt instruments, however, are gaining steam, with eight CDOs currently investing in leading microfinance institutions⁷.

As Exhibit 2 depicts, MFIs have produced positive returns even in more volatile markets⁸. According to the World Bank, funds have enjoyed average annual returns of 6.3% for investing in the debt of microfinance institutions and 12.5% for investing in their equity⁹. Over the past 5 years, microfinance investments have carried similar or lower risk levels and volatilities than other asset classes, while still producing higher annualized returns. When most asset classes were suffering record lows at the end of 2008, microfinance funds returned positive numbers. In fact, assets of the top-ten microfinance investment funds grew by 32% in 2008, sporting high and relatively stable returns in such turbulent markets¹⁰.

Exhibit 1: Who is Funding Microfinance?

Exhibit 2: Historical Microfinance Fund Performance
 

 

	Symbiotics Microfinance Index	Merrill 3-Mo. US T-Bills Index	Barclays US Aggregate Index	HFRI FOF Composite Index	EMBI+ Index	S&P 500 Index
Cumulative Returns -  5 Yr.	24.33%	14.36%	26.91%	15.48%	47.89%	16.23%
Annualized Returns - 5 Yr.	4.45%	2.72%	4.88%	2.92%	8.14%	3.05%
Standard Deviation - 5 Yr.	0.16%	0.17%	1.06%	1.94%	2.88%	4.71%

Source: RIMES, Bloomberg.
The Symbiotics Microfinance Index tracks 6 microfinance funds: ResponsAbility Global Microfinance Fund B Cap, Dexia Micro-Credit Fd SicavBlueOrchard Debt USD Cap, Finethic Microfinance SCA SICAR USD, ResponsAbility Microfinance Leaders Fund, EMF Microfinance Fund AGmvK, Class T (since March 2009), Dual Return Fund Vision Microfinance USD Cap (up to and including February 2009).

What’s the Catch?

While these numbers may seem attractive, it is important to note that not all microfinance investments are created equal. Most MFIs are planned to help impoverished people while simultaneously sustaining a profitable business. However, there are instances where for-profit strategies are trumping the needs of the individuals. When profits become the main target, microfinance investments may not function as they are intended to, and negative outcomes can result. For example, MFIs may target markets in which they believe will be most profitable, rather than spreading their services more evenly. By prioritizing markets with greater economic activity and higher population densities, they increase their likelihood of overlapping with other MFIs¹¹. In such situations, borrowers have the option of being loaned money from multiple MFIs at the same time, sometimes taking on loans they will be unable to pay back. As a result, certain areas are becoming over-saturated with loans and borrowers are becoming over-leveraged, and thus unable to pay back their loans or use their loans efficiently.

Focusing on particular markets also leads to greater competition among the MFIs, causing them to both take larger risks to secure new clients, and expand their product offerings without adequate controls being put in place to manage them. Rapid growth forces MFIs to hire a large amount of staff over a relatively short period of time. The newly acquired staff members are not always adequately trained, and may make loans that are riskier than their better-trained counterparts. Staff incentivesmay also be implemented to gain an advantage against other MFIs, leading to staff members taking on short-term gains at the expense of long-term, more meaningful loan relationships. Group meetings with the borrowers and one-on-one interactionsmay decrease, thus degrading the customer service relationship that is often so integral to these types of investments. All of these factorsmay place the microfinance institutions at a higher risk for defaults.

As an investor, there are currently very few tools to track how well the microfinance investments are doing. MFI reporting practices are still catching up to international capital markets standards. The diversity and lack of transparency of the various investment vehicles, as well as the still misunderstood performance standards, make it very difficult to truly assess and compare the performance of microfinance investments. Groups like the Microfinance Information eXchange post rankings on microfinance institutions, such as those depicted in Exhibit 3, that consider transparency, efficiency, and outreach statistics. Benchmarking MFIs against each other is one of the few analytical aids that are currently developed for these types of investments.

Tools such as the CGAP Microfinance Investment Vehicles Disclosure Guidelines¹², as well as social ratings developed by M-CRIL, MicroFinanza, Planet Rating, and MicroRate, are being utilized to mitigate the lack of disclosure for these investments. Until these guidelines and benchmarks are adopted by additional microfinance institutions, there will be little for investors to benchmark against. Consideration of the investment guidelines that microfinance investments presently follow is also prudent. Expenses may be relatively high on microfinance investments – up to 2.5% of the investor’s annual assets¹³ – while liquidity may be low, comparable to that of hedge funds or limited partnerships.

Exhibit 3: Top 10 Leading Microfinance Institutions (view larger)

Source: Microfinance Information Exchange (MIX). "2009 MIX Global 100: Ranking of Microfinance Institutions." January 2010. www.themix.org/sites/default/files/2009 MIX Global 100 Composite.pdf

Is It Worth It?

Overall, microfinance vehicles are worth analyzing and, may be appropriate for some institutional portfolios. Though the asset class may still pose some challenges, many large pension plans have begun investing in developing microfinance institutions. By diversifying with MFIs, investors may be able to reap both the ethical rewards of socially responsible investing and the monetary rewards of steady returns.

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