PAPER WRAP-UP: Foreign Capital Investment in Microfinance: Balancing Social and Financial Returns by Xavier Reille and Sarah Forster

A Consultative Group to Assist the Poor (CGAP) publication, this 24-page study discusses the boom of private investments in microfinance. Along with an overview of current players, the authors highlight the latest trends and issues in debt and equity financing. The full-version of the paper is available here.

Foreign capital investment has more than tripled to USD 4 billion between 2004 and 2006. The most notable change aside from the growth is the entry of private investors. However, these investors are not purely commercial investors but ones with a social orientation. The authors believe that this new investment stream is beneficial for microfinance institutions (MFIs), as they will need broader capital markets to fund growth and reach an increasing number of financially-excluded poor.

The first major player in microfinance is development finance institutions (DFIs), private investment arms of government institutions. They account for over half of microfinance’s total foreign investment, doubling since 2004 to USD 2.5 billion in 2006. While DFIs gave MFIs funding at the beginning before profitability was proven, there are concerns about them exiting the commercially viable markets. Some have even accused them of crowding out private investors through lower interest rates and more flexible returns.

The second player is individual investors, both retail and high net worth investors. Retail investing expansion has been made possible by new online marketplaces like Kiva and MicroPlace. Finally, institutional investor entered first through international banks and their philanthropic departments. These banks introduced MFIs to mainstream financing techniques such as local currency financing, and lent nearly USD 550 million in 2006.

About half of microfinance investments are channeled through specialized intermediaries known as microfinance investment vehicles (MIVs). With over 80 MIVs in operation, investment levels reached USD 2 billion in 2006 with over USD 3 billion in assets under management. The study surveyed 40 MIVs, placing them into 6 categories to compare results of their performance. The survey’s results can be found on page 7.

According to the paper, debt investment has turned into a buyers market. The leading MFIs have an abundant supply of credit, with the majority concentrated in the largest 150 MFIs. Debt accounts for 78 percent of all MIV investment, and foreign investors lent USD 1 billion in 2006. Thus leading MFIs can drive hard bargains and make lender compete. The study quotes a Bosnian MFI manager stating “There is a lot of competition among foreign lenders to provide us capital. This means we’re in a position to negotiate hard with investors and ask for lower interest rates.”

Another trend is higher long-term debt to total capital ratio (gearing). This could limit further borrowing due to adequate capital limits and prudential financial management. Moreover, 85 percent of debt is financed in hard currency, as hedging is difficult and costly. The fall in loan pricing, the rise in gearing, and currency risks will make risk-adjust returns less attractive. The authors even believe that that debt market in some areas is overheated and pricing does not reflect country or credit risks.

In response, investors are developing hedging instruments to loan in local currency. In addition, they are providing larger and longer loan terms which help MFIs grow. The average MIV, fixed-income transaction size grew by 30 percent in one year. However this adds to the concentration of investments into the largest, most sophisticated MFIs. That is not to say MIVs and DFIs are not trying to move down market. However, their absorption capacity is limited, and 300 medium-sized MFIs have only 11 percent of all MFI assets according to the MIX, a microfinance information clearinghouse.

Equity investments have lagged behind fixed income and have been confined mostly to socially motivated, public investors. While the current lack of competition, high growth rates, and double digit returns make MFIs attractive, there are still several challenges. The limit of MFIs capable of hosting shareholder investments, the lack of standards and valuation benchmarks, the lack of a secondary market, and the limited exit options have depressed equity pricing until 2006.

However, the market is changing quickly. A Council of Microfinance Equity Funds survey counted 222 regulated commercial and shareholder-owned MFIs, up 22 percent from 2004. This plus landmark IPOs has helped push up valuations; private placement deals reached 1.5-3 times book value, nearing the 2-3 multiple of emerging market banks. Also, IPOs provided the first real exits in the microfinance market, enticing some private equity (PE) funds to invest with expectations of future IPOs. However, equity investments have been limited to deep markets such as India and Latin America.

Some mainstream, purely commercial investors have entered the market, albeit on a small scale. MFI directors will need to understand the differences, consequences, and trade-offs of this financing option. For instance, PE investments often have higher, faster return expectations, which require a focus on business profitability. This leads to questions of whether MFIs can uphold their social mission that’s made microfinance so successful.

Overall, these private-sector investments will do more than contribute capital. Private investments should improve governance capacity and the much-needed skills of growing and managing businesses. In addition, socially responsible investors will demand better information on social and financial performance. This will allow for the most effective allocation of funding and best achieve the goal of sustainable financial services for all.

Xavier Reille is CGAP’s lead microfinance specialist. He is also Chairman of the MIX, founder of microfinance portal Microfinance Gateway, and director of a G8 initiative to scale up microfinance in the Arab world. Sarah Forster is the director of Geoeconomics, an independent consultancy. Her work in microfinance has focused on Bosnia and Afghanistan, and she is Director of Development for Big Issue Invest, a provider of finance to high-performing social enterprises.

by Jennifer Lee

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