PAPER WRAP-UP: The Role of International Capital Markets in Microfinance, By Brad Swanson

Published by Developing World Markets, 2007, 16 pages, available for viewing here.

This paper explores the entry of commercial investors into the sector of microfinance and the associated evolution of capital markets¹ funding. The potential demand for microfinance is estimated at fifteen times the current market size of USD 17 billion. While more than 75 percent of that amount can be attributed to domestic funding, Swanson speculates that domestic sources are unlikely to remain sustainable for three main reasons: most existing microfinance institutions (MFIs) do not take deposits, due to the cost and complexity of operations; capital markets in most developing countries are thin; and major institutional players, including domestic commercial banks, are typically averse to accepting MFI risk. On the other hand, only USD 4 billion of the market is currently being funded by international sources, leaving over USD 200 billion of demand open to be filled by international capital markets.

The first collateralized debt obligation (CDO) based on microfinance risk was created in 2004 by BlueOrchard, a Swiss company specializing in microfinance investment management and Developing World Markets, a US-based emerging markets fund manager and advisor. The dual aim of this CDO, called BlueOrchard Microfinance Securities I (BOMSI), was to provide long-term funding for MFIs and attract commercial investors with competitive rates. While in BOMSI’s first closing of USD 40 million in July 2004, only four percent of the capital raised came from commercial investors seeking full market returns, that number rose to 41 percent in its second closing of USD 47 million in April 2005. In both offerings, investors purchased seven-year notes with a single repayment of principal at maturity. The proceeds were used to fund MFI loans of the same maturities.

BOMSI marked the beginning of mainstream capital markets investment in microfinance in that it differed from traditional microfinance investment vehicles in the following ways:

It is not a fund. Investors do not rely on a professional manager, but rather come into BOMSI on the basis of their own assessment of credit risk of the underlying MFIs. These investors have a single source of repayment: a static pool of fourteen loans to MFIs.
BOMSI is a limited liability corporation in it will be liquidated when loans pay off, liabilities mature, and it makes final payments to investors. Cashflows from debtors to creditors pass transparently.
Its funding is stratified in five levels of risk: senior, three classes of subordinated, and equity. Cashflow from BOMSI’s loans to MFIs is applied according to a strict order or precedence, with senior investors paid completely first.
Its investors do not hold units in a fund or make loans to BOMSI; rather they purchase securities: bonds and equity interests.

While CDOs are the first and largest feature in microfinance capital markets, some challenges for its future growth include:

the relative scarcity of top-quality of MFIs, which may force CDO arrangers to look to MFIs of lesser size and credit quality as sources of assets (less than 100 out of an estimated 10,000 existing MFIs have qualified for inclusion in a CDO to date)
persuading investors to take risks on smaller and less-established MFIs, either through education or structure enhancements.
the growth of investment funds that currently control more than USD 2 billion of capital

Swanson also explores challenges faced by two other features within the microfinance capital markets: microloan securitizations and commercial equity investments. He concludes that the first is constrained by several factors, namely: short maturities characteristic of microloans, challenges faced by MFIs in constantly originating a sufficient volume of loans, unpredictable performance of the MFI service officer, and lack of regulatory structures in many emerging markets. Similarly, the demand for equity among maturing MFIs remains unmet by the existing handful of private equity funds. Swanson cites the small number of successful exits to date as a major factor in slowing the growth of commercial equity investment in MFIs.

The author does not fail to acknowledge the important role that non-commercial investors play in microfinance investment. Because they often take on risks that commercial investors do not understand or are uncomfortable with, they help leverage their risk capital to the benefit of both parties. In doing so, non-commercial investors significantly speed up MFIs’ access to capital markets. On the other hand, however, Swanson warns that bilateral and multilateral development agencies may be crowding out private sector investors in commercially credible deals by concentrating their funding on the latter’s target investment market: the largest and most successful MFIs.

The study concludes by summarizing some challenges faced by microfinance funding as a whole, and presents some optimistic possibilities. One of the largest constraints to its growth is the illiquidity and instability of many local currencies of developing countries, especially since most MFIs cannot rely on domestic funding. On the international funding market, foreign investors are usually uncomfortable with local currency risk that cannot be hedged. As a result, many MFIs end up borrowing in dollars and euros, and in doing so, passes the risk onto their borrowers in the form of high interest rates. Additional strains on MFI operations are presented by constant adjustments to match volatile exchange rates, as well as high interest rates and fees in the case of borrowing from a local commercial bank that acts as a middle-man for offshore lenders. However, Swanson believes that when local currency markets mature, so will hedging facilities to boost investor confidence.

Another concern for microfinance is the risk of default in the event of global or local recession, since many MFIs have only operated during periods of prosperity. On the other hand, many MFIs have been in operation for ten to twenty years and have successfully weathered significant economic and political instability; this resilience is further supported by research showing that MFIs are inherently less vulnerable to economic shocks and largely uncorrelated to other emerging market assets, both qualities that help reduce portfolio volatility (beta). As previously mentioned, there is also fear that the top tier of MFIs may soon become “overbanked”, forcing investors to turn to lower quality MFIs. However, Swanson qualifies that the underlying robustness of the microfinance business model has also given rise to many smaller, more obscure, but equally credible MFIs. Finally, a fourth concern is the shift of some MFIs away their low-income clients as they move upmarket with their more successful ones. But Swanson believes that most will still focus on microloans while providing higher-level services, in order to continue to breed higher-value customers.

Swanson notes that many of these risks reflect the fact that microfinance has only recently entered capital markets. As investors gain more exposure to this asset, he forsees a proliferation and standardization of financial products and tools, especially since the microfinance business model has already laid a strong foundation for solid growth with a large potential market. Overall, the paper argues that microfinance is attractive for institutional investors seeking diversification, absolute return – and potentially, social rewards.

¹ The author defines “capital markets” as transactions or funds in which all or a major portion of the investment is raised from private sector institutional investors seeking fully risk-adjusted returns.

By Mary Fu

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