Behind the Headlines: Surging Private Investment in Microfinance - An interview with CGAP microfinance expert Xavier Reille

June 15, 2007    

It's no surprise that big new investments in microfinance are making the news. After all, the idea that helping poor people is good business has caught on in a big way.

The Economist has certainly taken an interest - it recently featured two articles on the changing landscape of investment in microfinance. The articles critiqued the way this investment field is shaping up (i.e., donors need to move on to riskier pastures)1 and warned of the obstacles to commercializing microcredit (again, donors need to move on to riskier pastures).2

Specific deals are drawing attention, too. Sequoia Capital, an influential private equity fund, recently invested US$11.5 million in India's SKS Microfinance. This made such a big splash that it not only gained coverage in a variety of local papers, it captured the attention of business news giant CNBC,3 while the controversial initial public offering of Mexico's Compartamos reached the pages of Business Week.4

CGAP recently conducted a survey to quantify the growth of foreign capital investment in microfinance. We sat down with the author of the survey, CGAP microfinance expert Xavier Reille, to get the details behind the headlines.

1. What factors account for the recent surge in foreign capital investment in microfinance?

There are really two forces at work here. The first is the demand of microfinance institutions (MFIs). Leading MFIs are growing very quickly, sometimes doubling their portfolios every year. These MFIs are hungry for capital and are actively chasing foreign and domestic investors.

The second force is the growing interest of socially responsible investors (SRIs), both in Europe and in the United States. Microfinance is perfect for this type of investment. It provides returns close to money market levels with low historical risk, and, at the same time, it has shown that it can make a big difference in the lives of the poor. Private retail investors attracted to microfinance drive this SRI demand.

We at CGAP have been surprised by the current surge of private investment in microfinance. Our recent survey of the 70+ microfinance investment vehicles (MIVs) intermediating funds between foreign investors and MFIs yielded impressive results. In 2006 alone, MIVs disbursed over US$1 billion to MFIs.5 This is clear evidence of how the microfinance industry is changing. While microfinance used to be heavily funded by public donors, now private investors--and notably SRIs-- play a preeminent role.

2. Investors are enthusiastic - but what are the challenges?

There are several challenges. The first is transparency. Transparency on MFIs' financial performance is arguably quite good. More then 950 MFIs are listed on the MIX and roughly 400 microfinance ratings were conducted in 2006 alone.

However, the investor side is much more opaque. It's very hard to compare the performance of MIVs. Different MIVs have different investment objectives and financial instruments. They have diverse legal structures, regulatory frameworks, and accounting practices. And because there is no common reporting framework, investors find it difficult to assess and compare the performance of fund managers. CGAP has been working with industry players, fund managers, regulators, and investors to come up with reporting guidelines for MIVs. These will be published later this year.

The second challenge is improving credit evaluation tools. Very few microfinance securities have been rated on credit risks, but this situation is starting to change as mainstream rating agencies, such as Standard and Poor's and Fitch, increasingly engage in microfinance. For example, Standard and Poor's recently rated BlueOrchard Loans for Development (BOLD II), a collateral loan obligation put together by BlueOrchard and Morgan Stanley.6 But microfinance is a young industry and lacks historical data and analysis on default history and payment incidents. Credit evaluation tools and risk management techniques will have to improve over time.

The third challenge is to expand the pool of investable MFIs. Today, there are too many investors chasing too few MFIs. With only 400-450 investable MFIs and the majority of demand for capital coming from Latin America and Eastern Europe and Central Asia, international financial institutions (IFIs) and donors are still needed to extend the outreach of microfinance by helping create new MFIs in underserved markets.

3. How do you see this increased investment playing out over the long term? Should MFIs rely on foreign investment, or ultimately aim to raise capital in domestic markets? Or both?

Foreign investments are, and will remain, an important source of funding for MFIs. In many developing countries, there is no deep domestic market and MFIs are not authorized to offer savings services, for example. Foreign capital is sometimes the only option.

But foreign capital comes at a cost. Most foreign investments are made in hard currency debt - 70 percent of IFI debt is in hard currency according to the recent CGAP survey - that can be expensive for MFIs. Such investment can also be volatile in case of economic shock or social crisis.

Although foreign capital has an important role to play, the end game is to integrate MFIs into the local financial market: to intermediate savings, source loans from commercial banks, tap the debt market through bond issues, and for the most successful ones, become listed on the local stock exchange.

4. Most microfinance investments to date have been fixed-income and private equity placements. Is the field moving toward more complex financial transactions?

Over the last few years, we have seen increasingly complex financial transactions. Through those, a range of routes into commercial investment in microfinance have emerged. MFIs like Mexico's Compartamos or Mibanco in Peru have issued bonds with credit enhancements from IFIs. Compartamos conducted an initial public offering in April 2007. Sophisticated collateral debt obligations (CDOs) securitizing a pool of loans to leading MFIs have been organized in partnership with major investment banks. Three international CDOs were issued for a total of US$180 million in 2006. Some large MFIs (such as BRAC in Bangladesh and Procredit Bulgaria) have also securitized their portfolios on the domestic market. Structuring techniques that divide debt into different risk/reward layers are particularly interesting because they can bring together a mix of investors - including public investors, SRIs, and institutional investors - with different risk appetites. These complex financial transactions demonstrate the growing integration of microfinance into the financial market.

5. What are the roles and comparative advantages of private and public investors in this rapidly changing landscape? Are IFIs crowding out commercial investors?

There has been much debate and controversy in the industry on the question of whether public investors are crowding out private investors.7 On closer inspection, the issue is not so much public funding versus private funding, but subsidized versus commercial capital. Ultimately, both public and private funding are needed to advance microfinance and scale-up this young sector. They should work together to help create new MFIs in underserved markets, to leverage public subsidy to attract commercial capital, and to develop financial instruments to link MFIs with the capital market.

However, the real question is: What is the role of subsidy in a transforming industry? Where should subsidies be allocated? And in what form? Some MIVs are ready to take on more risk than some IFIs because they are funded by investors with a very strong social orientation. There is an urgent need to better define the roles and comparative advantages of public and private investors in this rapidly changing environment and to determine who should be bearing the greater risk tolerance.

MFIs are double bottom line institutions.8 The real opportunity for microfinance is to tap the huge and growing SRI market.

1 "Time to Take the Credit," The Economist, March 15, 2007.

2 "Small Loans and Big Ambitions," The Economist, March 15, 2007.

3 "Sequoia Invests $11.5 Million in Microfinance Fund," CNBC, March 29, 2007.

4 "Microfinance Draws Mega Players," Business Week, July 9, 2007. Please also refer to this issue's lead article: Banco Compartamos: Interest Rates, Profits, and an Initial Public Offering

5 Building Financial Systems for the Poor: MIVs and IFI Investment examined

6 BOLD II is a collateralized loan obligation that repackages and securitizes a pool of loans to 20 leading MFIs in 13 emerging markets.

7 To view recent discussion, refer to the Microfinance Gateway Debate Blog, IFIs: Crowding Out or Crowding In?

8 Double bottom line" institutions have a developmental or social objective in addition to a financial objective.