Behind the Headlines: How Are Equity Investments in Microfinance Valued? An interview with CGAP expert Xavier Reille

February 15, 2009    

Equity investments in microfinance have received plenty of attention in the media – even as recently as November 2008, with headlines like SKS Microfinance Raises $75 Million (Rs. 366 Crore) The World’s Largest Private Equity Investment In Microfinance and Ujjivan Raises $19.6 million (Indian Rupees 940 million) of Equity Capital. But just what criteria are investors using to make their decisions?

CGAP recently collaborated with JP Morgan to establish valuation benchmarks for the very first time. We asked CGAP expert Xavier Reille what’s happening in the equity investment market, and what recommendations they came up with for microfinance investors, analysts, and managers.

1. Just how much equity investment in microfinance is actually happening?

Well, equity investment in microfinance is still a small market niche, but it’s growing quickly. Right now there are 24 specialized microfinance equity funds with assets under management totaling US$1.5 billion. Institutional investors seem to be interested as well. As part of their socially responsible investment strategies, leading pension funds, like TIAA CREF in the United States and ABP in Europe, have made microfinance equity allocations of over US$100 million, and others are watching the market. Venture capital companies, like Sequoia, and a few large private equity funds, like Legatum, are testing the waters with small equity investments in microfinance institutions (MFIs), and we could see some initial public offerings (IPOs) in some emerging markets, like India.

On the other hand, there’s still really only a small number of investable MFIs, and there’s no secondary market for microfinance equity, so primary issuances are limited. Right now, most transactions are in the form of private placements. So far, there have been only two pure microfinance IPOs (Compartamos in Mexico and Equity Bank in Kenya), and with the current turmoil in the market, it’s unlikely we’ll see new ones any time soon.

2. So, while interest in microfinance equity investments is strong, the actual microfinance equity market is still very young. What are the obstacles to growing this market?

The lack of information on microfinance valuation is a major challenge. Investors and MFIs need reliable and accessible market references to improve equity pricing. However, until now, little research has been done on microfinance equity valuation because it has been hard to access private data – hence the collaboration with JP Morgan.

3. In establishing these new valuation benchmarks, what did CGAP and JP Morgan find?

Our analysis was based on two datasets: a sample of 144 private equity transactions gathered by CGAP through a strictly confidential survey – the biggest gathering of this kind of data to date – and data on 10 publicly listed financial institutions that serve poor and low-income consumer lenders.

We found that private equity valuations for MFIs have ranged widely. Over the past four years, historical median valuations in our private sample have varied between 1.3x and 1.9x historical book, and between 7.2x and 7.9x historical earnings. The broad range of these indicators could signal a lack of market consensus on MFI valuation.

We also saw that publicly listed low-income finance institutions (LIFIs) have outperformed their country indices by a very large margin – 240 percent – since the creation of the index in 2003. Since the Lehman bankruptcy in September 2008, our Low-Income Finance Index has also outperformed the Global MSCI financials by 8 percent, despite investors’ more conservative investment strategy. As a result, these institutions now trade slightly higher than traditional banks (1.7x 08 book for LIFIs) versus 1.5x for emerging banks as of January 2009. Microfinance seems to command a premium.

4. Based on the findings, should investors value MFIs the same way they value traditional banks?

No. We’ve identified five ways that MFIs differ from traditional banks – and which suggest that MFIs require a slightly different valuation approach: a double bottom line that emphasizes social as well as financial returns; excellent asset quality; high net interest margins; high operating costs; and longer term funding provided by developmental investors. But in the end, the analysis should be done on a case by case basis, as MFIs represent a very diverse group of institutions.

5. So, what was the biggest surprise finding from the survey?

We had two major suprises come out of the private transaction survey. The first was that in India, MFIs are trading on average at six times book value. This is more than three times the world wide average. We think such high valuation can be explained by the srong perfromance of Indian MFIs; the large Indian market and prospects fro IPOs aren’t enough to justify such high valuation. The interest of a dozen of larger private equity funds such as Seqouia and Legatum active in the Indian markets and all shopping for micorfinance equity have also probably driven valuation up in this market.

We were also surprised by relatively high level of valuation (1.6 times book) in Africa, despite the poor earnings records of African MFIs in our samples (negative return on equity). Again, these results might be influenced by the supply side: there’s strong demand for microfinance equity deals in Africa from social and public investors.

6. What are the main drivers of valuation?

Our analysis showed that the main drivers are transaction value and net income growth. But there are eight other factors that we consider very important: (1) the type of buyer and its possible social motivation; (2) the country of the MFI; (3) the legal status of the MFI, especially if it’s a fully regulated bank; (4) operating efficiency; (5) leverage; (6) reliance on retail deposits; (7) asset quality; and (8) profitability (as measured by return on equity).

7. How does the financial crisis factor in?

MFIs will definitely be affected by the financial crisis. We expect that liquidity shortages, currency dislocations, and the global recession will all affect MFIs and their clients to varying degrees – and in ways that will be more evident during 2009. Higher costs of funding due to tighter credit and to weaker emerging markets currencies relative to dollar-denominated loans are a big concern in the short term. Then we anticipate slower growth and lower earnings power in the medium term.

MFIs might have to look for funding from domestic public agencies and development finance institutions (DFIs) as they lose commercial funding. We think MFIs will need to concentrate on asset and liability management; credit standards will be critical to maintaining high asset quality. The crisis will also put pressure on valuations. We don’t expect to see any new listings in the short term. We expect multiples of private transactions will drop in 2009 from a median of 1.9x in 2008.

But overall, the microfinance sector appears fundamentally sound. The larger institutions, with diversified funding sources, like retail deposits, will best withstand economic and financial contraction. Valuations may change, but strong fundamentals and the commitment of DFIs and private investors should strengthen pricing going forward. MFIs with a solid funding base and strong asset quality might even emerge stronger from the crisis, and valuations should be back on track by 2010. Overall, we think the long-term outlook for equity investment in microfinance is good.