Know a microfinance fund: reading the Dignity Fund LP model

Dignity Fund LP belonged to a category of vehicle that appeared as microfinance moved from donor funding to investment: a limited partnership that raised money from private investors and on-lent it to microfinance institutions in developing countries. Whatever became of any individual fund, the structure is worth being able to read, because it is still the standard container for private capital entering the sector.

Start with the legal shape

A limited partnership has a general partner who manages and is liable, and limited partners who contribute capital and are not. That arrangement tells you several things at once. The manager's income comes from a management fee on committed capital plus a share of profit above a threshold, which rewards raising and deploying money as much as choosing well. The investors are few, wealthy or institutional, and cannot withdraw at will — the fund has a fixed life, after which it must be wound up or extended.

The fixed life matters more in microfinance than in most asset classes. A fund with a term of several years is lending to institutions whose own growth horizon is a decade or more, which creates pressure to exit at a moment dictated by the partnership agreement rather than by the borrower's condition.

Then ask what it actually holds

Most microfinance funds hold debt, not equity: senior unsecured loans to microfinance institutions, typically with maturities of one to three years. The credit risk is therefore institutional, not the risk of any individual borrower — a fund does not lose money because a market trader failed, it loses money because an institution's portfolio deteriorated, its funding dried up or its regulator intervened.

Equity funds are a different business, with longer horizons, board seats and returns that depend on eventually selling a stake to someone else. Mixing the two in one vehicle rarely works well, and a fund's documents should make clear which it is.

Currency is where the returns are decided

This is the question that separates informed investors from hopeful ones. A fund raising dollars and lending dollars to an institution whose borrowers repay in local currency has not avoided currency risk; it has moved the risk to the institution, which will absorb a devaluation with its own capital. A fund lending in local currency carries the risk itself and must hedge, which costs a large part of the yield in exactly the markets where returns look highest.

Any fund that reports attractive returns without explaining its currency policy has explained nothing. The same applies to sovereign and transfer risk: money can be lent into a country and then find it cannot leave.

The questions that settle whether a fund is worth studying

Four are sufficient for a first pass. What is the target return, and is it presented gross or net of fees and hedging? What is the concentration by country and by institution, since a handful of large exposures is common and rarely disclosed prominently? What happens in a workout — does the manager have the standing to restructure a loan to a systemically important lender? And who bears the first loss, given that some vehicles carry a junior tranche funded by a donor precisely so that private investors do not?

The last question is the one that most often changes an investor's understanding of the risk they are taking. A fund with a subordinated public tranche is a partly subsidised investment, which is not a criticism — it is a structure that exists because it works — but it should be visible in the reading.