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Fueling the Growth of MicrofinanceThe Role of Private Equity:

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In our cover story, Anurag Agrawal, Senior Vice President, Investment Banking, Intellecap, breaks down the science of microfinance valuation, and reveals why Indian MFIs have continued to attract increasing amounts of capital during the global financial crisis, and have done so at a significant premium over their global peers.

Regular FeaturesNews Board 8

Commentary 10The Case for Private Equity InvestmentJustin Wilmott

global viewpoints 18

Resources 46Recommended Readings and Calendar of Events

Trends 48Indicators on Equity Investment and Microfinance

Survey 50Microfinance and Equity Investment: Risk and Return Perceptions

Books 52Book Review and Book Excerpt

last Word 54The Curious Case of Co-Investments in MicrofinanceMegha Jindal

Interview The Truth about Private Equity and Microfinance 15Sumir Chadha: Sequoia Capital

Bold Valuation? 17Paresh Patel, CEO of Sandstone, responds

How To How to Win an Investor in 12 Steps 22 An MFI’s Guide to Raising Private Equity Investment Manju Mary George

mergers & acquisitions The Next Frontier: Is M&A a Feasible Strategy for Expansion? 24 Vineet Rai

legal Private Equity in Microfinance: Some Legal 26(and Some Non-Legal) Perspectives Howard J. Finkelstein

Investors Do DFI or Not to DFI? 30André Laude

The Time is Right for US Institutional Investors 32Susan Salerno and Clara Lipson

ResearchMicrofinance Investment Vehicles: Best Practices 35and Lessons Learned Bhakti Mirchandani and Howard Finkelstein

PerspectiveInto the Mainstream: How Commercial Investing Brings 37Clarity to the Sector Michael Chu

Risk/Reward Liability Planning: How Can Investors and MFIs Navigate 39Funding Options and Devise Strategy? Sonia Mukhi

Maximizing Microinsurance Investment Returns: 41A Closer Look at Microinsurance and Private EquityAlex Bernhardt

events Taking the Pulse of an Emerging Investment 44

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The Driving Factor for mFI valuations in India:an Insider’s Perspective

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Corrections: Microfinance Insights Vol. 12, May/June Issue While we spend a lot of time trying to ensure the accuracy of our publication, a few errors escaped our

attention in the last issue.In several of our articles, we either omitted the footnotes, or presented them incorrectly. Please see updated versions of the following articles online at www.microfinanceinsights.com. “A Double Bottom Line Vision for the Future” by Nigel Bigger and Jennifer Meehan; “The Proof is in the People: Impacting Women through Relationships and Trust,” Ela Bhatt; “Opening the Black Box: How the Poor Use Credit in India,” Alexandra Kobishyn; “Mortar and Mortgage: Low Income Housing Solutions for Urban India,” Affordable Housing Team, Monitor Group; “Altruism Reloaded:

Seeking Work with Impact,” Sarika Bansal.

We incorrectly described our author Thomas Dichter. His career in development spans over 45 years (not 35), and while he occasionally writes for the CATO Institute, he is not employed by them.

Search by author online for access to each corrected piece.

InvestmentBalancing Social and Financial

CritiqueIt’s No Magic Bullet

GenderThe Women’s Empowerment Myth

IndexSocial Impact Tools

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Dear Reader,

For this issue, we sat down with two mainstream venture capital investors, Sequoia Capital and Sandstone Capital, who have taken ownership stakes in one of the fastest growing microfinance institutions in India, to understand their views on this sector. During our conversations, I was surprised to hear phrases like, “we want to dominate” the sector, and “we want to be the sector killer.” These are not words one would expect to hear in the lexicon of microfinance, a sector born out of the desire to help the poor by giving them access to capital. In fact, I’m tempted to label that language domineering, and perhaps even, exploitative.

But, on second thought, perhaps it’s just economics, plain and simple. To think that microfinance is still a purely social industry would be like the

proverbial ostrich burying its head in sand.When asked about their financial versus social priorities, both investors told me

flat out: this investment was purely financially motivated. Microfinance has been usurped by people who view it as an economic opportunity. Money talks! Financial inclusion is a pleasant byproduct.

While the entire sector is not driven by private equity financing, the large Tier I microfinance institutions (MFIs) are. And, it is these, arguably, more professional MFIs that give the sector its shape and determine its direction. SKS Microfinance in India has become a behemoth; it will be the largest MFI in the world in two years, and will likely serve 8 million people by then. This was not fuelled by grant funding. The launch pad that is private equity has made this possible.

From many vantage points, the presence of private investors in microfinance is positive. Becoming more competitive improves business; like any business in a capitalist free-market society, competition pushes companies to be the best they can be. Economic incentives eradicate inefficiencies, support the development of organizational infrastructure, optimize resource allocation, and enable MFIs to reach more borrowers.

But–and this is a big but–does reaching more borrowers mean that they are living better lives? When a mobile telephone company gets 10,000 new subscribers, does that make it a better company?

There is a linear relationship between the amount of capital and the number of people an MFI can reach. The danger is that people equate reach and rising numbers with the notion that people’s lives are improving and that they are ultimately moving out of poverty. As we demonstrated in our last issue, focused on Social Impact, merely giving a poor person a loan does not change his or her life. We must be careful not to confuse the concept of reach with poverty alleviation.

For-profit microfinance is here to stay, and it is without a doubt the best way to optimally grow the sector, which is why we dedicated our issue to the subject. As you’ll see, many of our writers and commentators in this issue are “bullish” on the idea. However, not everyone agrees. That disagreement is healthy; it will make sector players more cautious, and more accountable for their actions. Let’s remember, you can’t throw money at the poor and hope to change their lives. Private equity and other sources of funding have an important role to play. But collectively we are all responsible to make sure the industry grows in the right direction.

Enjoy the issue, Lindsay ClintonManaging Editor

Managing EditorLindsay Clinton

Editorial TeamAparajita Agrawal, Ranjit Koshi, Asako Matsukawa, Vibha Mehta

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vol. 7, july 2008

From the Editor

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Is Bigger Really Better?


NeWs BOardUS$180,000 for Global PartnershipsJune 26, 2009 - Global Partnerships, a Seattle based microfinance organization, has received a grant of US$180,000 from M.J. Murdock Charitable Trust of Vancouver to manage its loan funds, which have attracted more than US$45m in capital since 2006. The grant will primarily be used to hire a director of investment operations and will allow the organization to better manage its three investment funds and improve its overall management. CBK License for Nine Microlenders to Accept DepositsJune 25, 2009 - Faulu Kenya Limited has received a license from the Central Bank of Kenya (CBK) to accept deposits. At least nine more microlenders are expected to receive similar licenses by this year end. Faulu is one of the nine companies that have submitted formal applications to become deposit-taking institutions. The license was granted in accordance to the Microfinance Act that came into effect in May 2008 to promote a culture of savings in Kenya.

Congressional Gold Medal for YunusJune 25, 2009 - Two bills have been introduced in the US Senate and the House of Representatives to award the Congressional Gold Medal, the highest award conferred by the US Congress, to Dr Muhammad Yunus. So far only a few international personalities, including the Dalai Lama, have been bestowed with this award.

Microfinance Association for the UKJune 24, 2009 - The Microfinance Association, a global professional body that will cater to the needs of microfinance practitioners, has been established in the United Kingdom. Membership is open to all microfinance practitioners worldwide and the members of the association will be offered an information center, a career advice center, and a knowledge management center.

LeapFrog Raises US$44m for World’s First Microinsurance Fund June 19, 2009 - LeapFrog Financial Inclusion Fund, the world’s first investment fund focused on microinsurance, has announced that it has raised US$44m. The capital has been raised from a range of public and private investors around the world, including the European Investment Bank, FMO, Omidyar Network, Triodos-Doen, Hivos-Triodos Fund, ACCION International, Calvert Large Cap Growth Fund, Felipe Medina, and the LeapFrog team.

SKS to Raise US$104m through DebtJune 17, 2009 - SKS Microfinance, the largest microfinance player in India, is planning to raise US$104m through a mix of debt products to fund loan demands of its customers. A non-convertible debenture is issued for a fixed maturity, normally a year, and cannot be converted into equity.

SAP and PlaNet Finance Join Forces to Create Sustainable Business Models June 17, 2009 - SAP has made a commitment to provide financial, software and technical assistance to PlaNet Finance. To improve the microfinance sector, PlaNet Finance and SAP will together target three main areas: technology development for the field, development of software solutions for

MFIs and deployment of SAP technology for PlaNet Finance’s corporate initiatives.

ADB Unveils Energy Program June 17, 2009 - ADB has launched a program to provide access to modern energy to an additional 100 million people in the Asia-Pacific region by 2015. The Energy for All Partnership will support an initial phase of six working groups on domestic biogas, solar lanterns, liquid petroleum gas, financing for energy services, and energy enterprise development.

Grama Vidiyal Raises the First Equity Investment in India in 2009June 16, 2009 - Grama Vidiyal Microfinance Private Ltd (GVMFL) has announced the successful completion of the second round of equity infusion worth US$4.25m. The MFI intends to use the newly acquired fund to support its expansion plans over the next year and meet the enhanced capital adequacy norms set by the Reserve Bank of India. The investment in GVMFL came from MicroVest’s newly launched equity fund, MicroVest II, which invests with Tier I microfinance institutions. Unitus Capital (UC) acted as financial advisor to GVMFL.

New Payment System for CREDOJune 16, 2009 - CREDO has launched a new type of payment system for clients that allows them to make loan payments free

Photo: Ian Britton


NeWs BOardof charge via ‘PayBox,’ a newly designed payment system located in shops, streets and villages. Besides increased convenience, the new system also brings significant time and cost savings for CREDO, as well as increased cash flow and efficiency of its operations. This newly adapted method of payment is already in use in Georgia with people using these machines to pay mobile phone bills, Internet and utility expenses.

Three Rural Banks Receive MABS’s Eagle AwardsJune 15, 2009 - Three rural banks were honored with the Eagle awards, given by the USAID-funded Microenterprise Access to Banking Services Program (MABS) of the Rural Bankers Association of the Philippines. The rating measures a bank’s microfinance performance on five parameters—efficiency, asset quality, growth, liability structure and earnings. Those awarded included GM Bank, Rural Bank of Santo Tomas and Rural Bank of Oroquieta.

Agile Financial Technologies to Acquire Theme Technology’s Microfinance ProductsJune 10, 2009 - Agile Financial Technologies has entered into a contract with Theme Technologies that will allow it to acquire Theme’s microfinance, microcredit and credit management product range, in an earn-out mechanism (a mechanism wherein part of the acquisition cost is linked to future performance of the acquired entity and paid over a period by the acquirer) over three years. The products are compliant with CGAP standards and will be rebranded and launched as Agilis Universal Microfinance.

Grameen-Jameel Joins Hands with Aga Khan AgencyJune 9, 2009 - Grameen-Jameel has announced that it has facilitated a multi-million dollar credit facility for the First Microfinance Institution (FMFI) Syria, part of the Aga Khan Agency for Microfinance, to improve the lives of 2,700 underprivileged Syrians through credit, deposits and other financial services. Under the financing scheme, Grameen-Jameel has issued a guarantee to support US$2.7m in local currency financing. Although this is

Grameen-Jameel’s first deal in Syria, the company has closed around US$20m in partial credit guarantee transactions to date.

Standard Chartered to Lend US$500m to MicrolendersJune 4, 2009 - Standard Chartered is on track to lend US$500m to microlenders to help the industry survive the financial crisis. A majority of microfinance institutions said they had faced liquidity constraints over the last six months in a survey conducted by the Consultative Group to Assist the Poor (CGAP) in March. Standard Chartered has steered a clearer path through the financial crisis than most competitors and the bank says its decision to lend to MFIs is a commercial one rather than purely an issue of social responsibility.

Pakistan State Bank Creates Microfinance Credit Guarantee FacilityJune 1, 2009 - State Bank of Pakistan has designed a microfinance credit guarantee facility in order to channel funds to microfinance. It is expected to enable banks/DFIs to play a leading role in easing credit constraints of MFBs/MFls in their efforts to maximize outreach by extending credit facilities to them.

IADB to Support Small Scale MFIs in Latin AmericaMay 31, 2009 - Inter-American Development Bank (IADB) will support a project to assist small-scale MFIs in Latin America and the Caribbean in obtaining credit risk ratings and performance assessments. The new project will give priority to MFIs with loan portfolios between US$1m and US$15m, with average loans not exceeding US$3,000. The project will also encourage regulators, rating agencies and microlenders to exchange information, best practices and lessons learned from their experiences with microfinance regulation and rating.

Share to Raise US$50m EquityMay 28, 2009 - Share Microfinance is raising equity funding of US$50m. IFC is looking to invest in the firm with other investors. In 2007, Share had diluted more than 51%

stake to Legatum Ventures for US$25m. It also raised US$2m from Aavishkaar-Goodwell. The US$50m fundraising would be one of the biggest transactions in Indian microfinance after SKS Microfinance’s US$75m deal in November last year.

Cambodian Non Performing Loan (NPL) Rate Rises Again May 18, 2009 - Cambodia’s high risk rating has led to international lenders increasing interest rates to the country’s MFIs, which are in turn being passed on to the borrower, causing increased default rates. The rate of microfinance non performing loans (NPLs) has increased to 2.5% in the first four months of 2009, compared with less than 1% for the same period last year.

Finance Unlimited Establishes New Micro-Lending CompanyMay 15, 2009 - Citadel Capital, the leading private equity firm in the MENA region, controlling investments of more than US$8.3bn, has announced its entry into the microfinance sector with the establishment of a new Portfolio Company, Tanmeyah. The investment in Tanmeyah will be made through Finance Unlimited, the firm’s platform company for investments in the regional financial services sector. Tanmeyah will help thousands of small business owners and low-to-middle income entrepreneurs gain access to loans and financial services that would otherwise be unavailable to them.

Equity Funds worth US$50m for Nigeria and GhanaMay 11, 2009 - Alitheia Capital, Nigeria; Goodwell Investments, The Netherlands; and JCS Investments, Ghana together have launched a US$50m fund focused on developing microfinance banks and entrepreneurial MFIs on a social and commercially viable basis. The geographic focus is Nigeria and Ghana. n


cOmmeNtary

The Case for Private Equity Investment

“Quite simply, there is nowhere near enough grant capital available to meet the funding requirements of the world’s mi-crofinance institutions (MFIs) as they continue to scale.”

Much has been accomplished since the early days of modern microfinance

when NGOs and organizations such as Grameen Bank started lending to industrious, but poor, communities in Bangladesh. The sector now touches well over 100 million people worldwide and boasts a total loan portfolio in excess of US$40bn. Although significant growth was originally catalyzed by grant-led initiatives, such scale would likely not have been possible without the participation of commercial capital. In fact, with billions of individuals still lacking access to basic financial services, representing an estimated demand of US$300bn in loans, the future role of commercial capital will be even more critical. The reality is that it

is impossible for microfinance to achieve its full potential without the participation of private equity and debt investment. Quite simply, there is nowhere near enough grant capital available to meet the funding requirements of the world’s microfinance institutions (MFIs) as they continue to scale.

A role for grant capital in microfinance, however, still exists. Indeed, there are many

initiatives that simply fail to offer much potential for a commercial return, but are still critical to the continued development of the sector. These include programs for conducting social impact analysis or the development of microfinance products for “ultra-poor” clientele. In this respect, both commercial and grant capital can work hand-in-hand as the sector continues to evolve and bring more of the world’s poor into the formal economy.

Private equity in microfinance is mostly invested in the form of early stage start-up or growth capital. This type of investing is very different from the large-cap private equity techniques employed in the devel-oped world, where investee companies are often over-leveraged and streamlined in

although the microfinance sector cut its teeth on grant-led funding, much of the astounding growth and reach we have seen over the past 2-3 years in the sector has been achieved through outside investment from private equity players. This new velocity for the sector has been received with mixed reaction from more traditional microfinance leaders and practitioners. It’s too much growth, too fast, they say. are they right to be concerned? or should they see value in reaching more poor people in a shorter span of time? justin Wilmott, vice President at legatum ven-tures, shares his perspective.

Wilmott finds that it is impossible for microfinance to achieve its full potential without the participation of private equity. Are MFIs ready to fly far and fast? Photo: Steven DePolo


cOmmeNtary

Justin Willmott is a Vice President with Legatum Ventures, based in Dubai. Legatum Ventures has invested over US$60m of private equity to support the microfinance sector globally since 2007, and continues to be an active supporter of the sector as it develops towards reaching its full potential.

the pursuit of a short-term exit and return on capital. In contrast, private equity in microfinance often serves to strengthen balance sheets, not to weaken them, and the greater corporate governance require-ments of such investors inevitably results in stronger organizations. An increasing flow of this type of capital will not only al-low the sector to scale, but will also lead to greater accountability and transparency.

As an emerging sector within the global financial services landscape, microfinance stands to substantially benefit from the increased participation of private equity investors. Through the provision of risk capital, such investors will actively support new business models and lending methodologies. With this in mind, consider the interesting parallel of the positive role played by private equity in other emerging sectors, where it has often resulted in the financing of hundreds of innovative young companies. Not only have these companies generated attractive returns on equity, but many have also contributed considerable social value by improving productivity, health, and access to information, not to mention the many new employment opportunities they have brought to the market. Examples include technology, telecommunications, biotechnology and, most recently, clean technology, all sectors that would not have achieved the same level of success without the risk capital, strategic support and commercial networks that private equity investors provide.

While the volume of private equity in-vested in microfinance to date has barely scratched the surface of the sector’s re-quirements, there are already a number of examples of the positive role that this

capital has played. In India, a series of no-table investments has provided the foun-dation for increased outreach, greater geographic diversity, the introduction of new products and improved mechanisms to attract and retain high quality talent. Over the past two years, the five largest MFIs in the country have been the benefi-ciaries of approximately US$180m in pri-vate equity investment, which has helped them to grow their combined active client bases from 2.2 million to over 4.7 million, a compound annual growth rate of 45%. Four of these organizations are now serv-ing well over a million active clients each. Furthermore, numerous new business models have been launched as a direct re-sult of investor support. Of particular note are the branchless banking technologies currently enabling millions of previously unbanked individuals to efficiently access deposit accounts, government disbursals, insurance products, and even secure pay-ment platforms.

Despite the positive impacts of such in-vestments, some still criticize private eq-uity backed MFIs for their rapid growth rates. This is potentially a valid concern, but prudent investors will always seek to temper such growth with conservativism, since a default-ridden loan portfolio is of limited value no matter how large it is. This ensures that the interests of private capi-tal are aligned with those of the recipients of MFI credit – both parties benefit from growing a quality loan portfolio, promot-ing greater operational efficiencies and technological sophistication, and ultimate-ly from accessing public capital markets. These benefits all serve to lower the oper-ating costs of the MFI, therefore resulting in a lower cost of capital and more efficient service for the end client.

As we reflect on the evolution of the microfinance sector from its origins in 19th century Germany,1 and its subsequent

development in South Asia, it is clear that an increasing participation of private capital has already stimulated greater competition amongst for-profit MFIs. This will ultimately lead to lower interest rates, a higher quality of service, and a greater diversity of products. Further private equity investment will be a key factor in enabling the sector to reach the billions of unserved clients who still live outside the formal financial system. It will also help more MFIs take a number of important steps towards better serving this market in securing banking licenses (enabling cheaper funding through deposits and a much needed saving tool for their clients), attracting world class talent and accessing cheaper capital markets. As we have seen, private equity and grant capital are far from being mutually exclusive and can actually co-exist. Grants have already realized many valuable developments, and in the future it is likely that this type of capital will also address many more important issues such as the measurement

of microfinance’s social impact, the best way to serve the poorest of the poor, how to increase financial literacy, and how best to deliver complementary services like healthcare and education. Each of these is very valuable, not only for the clients concerned but also for society at large, strengthening the sector overall and thereby complementing the ongoing efforts of private equity investors. n

Raiffeisen Banks were founded in 1846 in rural Germany and are early examples of microfinance institutions. Many of them are still in operation today, functioning as 1. co-operatives or savings banks.

“…private equity in microfinance often serves to strengthen balance sheets, not to weaken them, and the greater corporate governance requirements of such investors inevitably results in stronger organizations.”

“Over the past two years, the five largest MFIs in India have been the beneficiaries of ap-proximately US$180m in private equity investment, which has helped them to grow their com-bined active client bases from 2.2 million to over 4.7 million, a compound annual growth rate of 45%.”


cOver stOry

A recent study on Microfinance Equity Valuations conducted jointly by CGAP

and JP Morgan confirms that India is a clear outlier when it comes to valuations in microfinance. According to this study, globally the median price to book value (P/BV) multiples over the past four years ranged between 1.3x and 1.9x for historic P/BV. Some of the earlier transactions took place closer to a BV multiple of 1. For Asia this number is significantly higher at 2.4. India remains an outlier even within Asia. While most MFI transactions in India are reported to have taken place in the range of 3-4 BV multiple, some of the recent transactions have taken place upwards of 4 and in some cases even

5 times BV multiple. This article attempts to examine, in the Indian context, what is driving the valuations of these institutions.

We have about 200 million households

in India. Ninety five percent of them with an annual household income of less than INR100,000, and technically one could treat that as the total addressable market for microfinance. However, if one took a more conservative approach of using a loan to income ratio of 1:5 and a loan size of US$200 (most of the mature Indian MFIs and particularly the urban-focused institutions are approaching average loan per client of INR10,000), then we are looking at annual income per household below US$1000 (INR50,000 p.a.) assuming payback of about one year. Such households will form roughly 80% of the Indian population. If you exclude the ultra-poor, you’re talking about 60% of the

microfinance today is a well established asset class and one of the hottest sectors for equity investments globally. In India alone, during the last couple of years, the microfinance sector has seen more than 20 equity investment transactions aggregating over uS$200m. In spite of a worldwide recession, not only have these Indian mFIs continued to attract increasing amounts of capital, but have done so at a significant premium over their global peers. anurag agrawal, Senior vice President, Investment Banking, Intellecap, has facilitated numerous private equity investments for several of the leading microfinance institutions in India. He shares his insights.

“Intellecap’s Inverting the Pyramid Report 2008 estimates the size of this market to be as high as US$50bn. This translates into a business opportunity where some of the early movers have not only demonstrated the ability to scale profitably, but also have a huge potential to scale in the future.”

The Driving Factor for MFI Valuations in IndiaAn Insider’s Perspective

Despite a global market in recession, microfinance valuations in India soared last fall. Is the excitement warranted? Photo: Michael Sutto


households or about 120 million families. Based on the current outreach figures of

approximately 15 million, we are roughly at about 12.5% penetration. This holds true with the assumption that a)per family gets a loan an b) a borrower borrows from a single MFI. Since it is a well known fact that this is not the case in practice, the actual penetration level on the ground is likely to be far lower, most likely less than 10%. This is in spite of the phenomenal growth already recorded by Indian MFIs. Their outstanding portfolio is reported to have grown at an impressive Compound Annual Growth Rate (CAGR) of approximately 80% between 2003 and 2008 and had already crossed the US$1.5bn mark by March 2008. These Indian MFIs not only have a track record of demonstrating sustained high growth rates but have also maintained such growth along with robust profitability. Intellecap’s Inverting the Pyramid Report 2008 estimates the size of this market to be as high as US$50bn. This translates into a business opportunity where some of the early movers have not only demonstrated the ability to scale profitably, but also have a huge potential to scale in the future. Add to this, the relatively superior quality of management, efficiency metrics of Indian MFIs, and continued availability of larger sums of on-lending from banks to leverage equity capital and thereby consistently generate Return on Equity (ROE) in the range of 20-30% for the investors, and it is not difficult to see why Indian MFIs are prime targets of investors globally.

Changing Profile of MFI Investors and Valuation MetricsThe market potential of microfinance in India has certainly caught the attention of the investor community. The early equity investors in MFIs were mostly Development Finance Institutions (DFIs) who were seeking a double bottom line return on their investment. These institutions, even though they had very large funds (running into billions of dollars) for investment at their disposal, by their very nature, they were fairly conservative to their approach to valuation and mostly relied on Book Value (BV) multiples. Over time, a number of Microfinance Investment Vehicles (MIVs), many of them funded by these DFIs, came up with an explicit focus to fund the growth of MFIs. It is reported that there are more than 100 MIVs in existence managing funds ranging from US$10-100m. India, due to its very large market size, growth potential and developmental impact, is one of the primary areas of focus for a large number of these MIVs. Even though most of MIVs are debt focused, due to the regulatory restrictions in India, these foreign MIVs are exclusively doing equity transactions in India and competing head-on with the DFIs in this space.

The managers of some of these MIVs also brought with them a fresh approach to valuations of MFIs as compared to the more traditional DFIs. In India particularly, most of the MFIs were originally structured as non-profit organizations, even though these MFIs had acquired reasonable size in terms of clients and portfolio. At the time of conversion into a regulated Non Banking Financial Company (NBFC), which is the predominant legal form for carrying out microfinance operations in India today, they did not have the book value size or the profitability to command commensurate multiples based valuation based on net worth or profitability. These MIV managers recognizing the growth potential of these institutions were able to make some smart early stage investments in some of the largest MFIs in India in the last four years by taking a more flexible approach to valuation using forward-looking techniques such as Discounted Cash Flow (DCF) and Client multiples-based valuations. These investments based on future growth potential and profitability projections took place at considerably higher multiples of book value and profits. These early investments became new benchmarks for fresh investments into MFIs in India.

Even though the MIVs set new valuation benchmarks, with their average investment size in the range of US$2-3m, they did not have sufficient capital to meet the ever growing needs of some of the larger MFIs, many of whom were growing consistently at

“Clearly as things stand today, there are definitely more investors and more capital on the buy side than the number of quality deals that can attract sizable private equity capital.”

cOver stOry

17.67

14.60

11.15

12.62

13.44 12.78

9.29

8.82

10.28 8.30

7.25 7.69

9.41

3.30 2.49

1.67 1.67 1.78 1.69 1.32 1.25 1.46 1.30 1.13 1.20 1.47

-

2

4

6

8

10

12

14

16

18

20

Apr-08 May-08 Jun-08 Jul-08 Aug-08 Sep-08 Oct-08 Nov-08 Dec-08 Jan-09 Mar-09 Apr-09

Ratio

Val

ues

Intellecap Banking Index

P/E

P/B


more than 100% year on year. However, by now the microfinance sector had caught the attention of the mainstream private equity investors. Early private equity investors in India such as Sequoia (see our Interview with Sumir Chadha, Sequoia on page 15), Legatum and JM Financial have clearly demonstrated the huge return potential of these MFIs. These institutions have shown tremendous resilience in spite of a global financial crisis which has made the sector even more attractive from a portfolio diversification point of view. Some of the larger funds end up competing with one another for investments, particularly in some of the larger MFIs. Clearly as things stand today, there are definitely more investors and more capital on the buy side than the number of quality deals that can attract sizable private equity capital. This demand-supply mismatch by itself is an important factor that is driving up valuations particularly for the “marquee deals” with one of the larger established players.

Now that there are sufficient benchmarks available for comparison, the valuation

techniques used for these private equity transactions seems to have come full circle. Private equity investors prefer to use the more traditional Earnings and Book Value multiples that they use for valuing other sectors. The typical pre-money historical Earnings multiples range from 10-15 times for a reasonably mature (profitable), mid-sized MFI. In such a heated investment climate, the private equity investors are getting cautious about going over-board with fancy book value multiples. The risk is multiplied for every successive investor who is investing a larger pool of capital at a higher price.

The Indian microfinance sector has yet to see any significant exit or IPO. In other markets where one has seen a listing of MFIs, significant correction has taken place in the valuation of these MFIs and they are trading well below their listing price. To provide an Indian context, we created an artificial Index of 10 of the leading private and public sector banks in India (based on market capitalization) and tracked their book value and earnings multiples over a period of one year ending March 31, 2009. The average historical Price to Earnings and Price to Book Value ratio in this period for this banking index was 11.35 and 1.70 respectively. The median figures were slightly lower at 11.15 and 1.52 respectively. The range of Book Value multiples during this period varied between a high of 3.4X and a low of 0.97X and for Price Earnings the range

was between 18.23X and 6.22X. This period saw the maximum volatility in the Indian Capital Markets from a period or irrational exuberance to a time of deep recession for the financial services sector. We expect that, given the high volatility in this period, the capital markets have tested its extremes and the long term average multiples for the financial services sector in India are likely to be within this range.

Even though the microfinance sector as a whole has outperformed its peers in the financial sector, even in India, we expect that as these institutions mature and become more aligned with the mainstream financial sector their valuations and multiples will mimic the behavior of some of the larger financial institutions. One can therefore expect some rationalization of valuation metrics used for Indian MFIs in the medium to long term but in the short term we expect them to continue to trade at a significant premium to their global peers, and for good reason. n

Anurag Agrawal is a Senior Vice President at Intellecap and leads the investment advisory practice of the firm with specific focus on assisting early stage multiple bottom-line enterprises access growth capital in the form of equity investments. He has been involved with carrying out valuations for most of the leading microfinance institutions in India and has also assisted many of these MFIs in their fund raising efforts.

“Even though the microfinance sector as a whole has outperformed its peers in the financial sector, even in India, we expect that as these institutions mature and become more aligned with the mainstream financial sector, their valuations and multiples will mimic the behavior of some of the larger financial institutions.”

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As on 31 Mar '09 In INR Millions

Banking Index - Constituents

Market Cap Weightage

Axis Bank 148,969 6.65%

Bank of Baroda 85,366 3.81%

Bank of India 115,223 5.14%

Canara Bank 67,937 3.03%

HDFC Bank 414,063 18.47%

ICICI Bank 370,344 16.52%

IDBI Bank 32,903 1.47%

Kotak Mahindra Bank 97,548 4.35%

Oriental Bank of Commerce 27,584 1.23%

Punjab National Bank 129,731 5.79%

State Bank of India 677,481 30.23%

Union Bank of India 74,177 3.31%

Total 2,241,324 100.00%

“Even though most MIVs are debt focused, due to the regulatory restrictions in India, these foreign MIVs are exclusively doing equity transactions in India and competing head-on with the DFIs in this space.”


Microfinance Insights (Insights): Just five years ago, SKS was an NGO. SKS is now India’s largest MFI. How do you think these inflows of capital have changed SKS?Sumir Chadha: One of the things I love about Vikram [Akula, the founder of SKS Microfinance] is that he’s always been a man with a large vision: solving the poverty problem in India. The only way to solve it is to have tremendous scale. And scale requires massive equity infusions. Without it, unfortunately, it’s not scaleable. The sad reality is, if you want to hit 150 million people in this country, you need to raise a lot of money, and you have to have a management team that is highly professional, highly driven. So, SKS had two choices: one choice was to remain small and nonprofit, but frankly not very impactful, or try to really change the country and adopt a lot of the best practices from business.

Insights: There are several investors—mainstream and not so mainstream—with a stake in SKS. Unitus. Sandstone. SVB. Kismet. How do you handle the changing priorities of different investors? How does the board manage each investor’s expectations? Since no one has the majority stake how do you find balance?Chadha: There is this outside perception that there is a conflict among the board. But there really isn’t. If you were to attend one of our board meetings, I can tell you I am just as concerned about service quality as a social investor. There really hasn’t been this big social versus profit debate. In practice it has been a non-issue.

Insights: In terms of Sequoia’s perspective on things regarding financial versus social priorities and returns, would you say it’s 50-

50, 60-40, 70-30? How would you weigh each of those priorities?Chadha: Sequoia doesn’t have a social bucket. Let me explain. What’s interesting about us is that virtually all our investors are not-for-profits. So we are in the fortunate position of choosing the clients that we work for (meaning our investors). Interestingly, a lot of the social investors are for-profit investors.

Insights: Usually, an MFI promoter is not permitted to exit. And, yet, I’ve been told that Vikram has sold his stake. What is your position on this?Chadha: Vikram has sold a small stake in the company. We typically do that in many of our companies. I know in the social sector people frown upon making money. We don’t think it’s a crime. We think it’s okay to make money, we don’t think it’s anything we have to hide or be embarrassed about. It is ok to do good by doing well.

GROWTH, VALUES, RATESInsights: You have said you want SKS to “dominate” the industry. But that word has some negative connotations, when we’re talking about a social sector. There’s talk of SKS poaching a lot of clients from other MFIs. What is your take on that?Chadha: I think it’s very positive. Why should a poor woman have to suffer because it’s a social sector, and you can’t compete for her attention? If SKS does a better job for that poor woman, that poor woman must benefit. If we charge a lower interest rate, or provide better customer service, I personally think that’s a good thing. There should be competition for the poor woman’s interests. With SKS a tiny part of the growth has come from taking other people’s clients – perhaps five percent. Ninety

five percent of the growth has come from going into new areas where no one has been offering microfinance services. That makes it so exciting.

Insights: SKS has been growing at astronomical rates: in FY 2007-08, it grew at a rate of 200%. At what rate of growth would you say, “Beyond this, it’s too risky.”Chadha: Well, we are slowing down the growth rate. This year the growth is going to come down to slightly above a 100%. The growth rate is slowing down with scale. There are high risks to rapid growth.

Unfortunately, I don’t think that if we grow, others can grow at that scale, because SKS is about 25-30% of the market share in the industry, and that share is growing. One of the challenges is that if we want to solve the poverty problem and slow the growth rate, it does have a negative consequence in terms of the whole industry’s growth. So there is a strong social feeling in the pressure to grow.

One of the tensions is that we want to make sure that the service quality to clients remains very high, and that we keep following our processes, and our systems. I think what the company has done very nicely last year is to make huge investments in IT systems. There has been a huge emphasis on training. What I find impressive is that if we were to go and visit a center meeting in Bihar versus a center meeting in Andhra Pradesh – the center meetings run exactly the same way. What that standardization allows you to do is not dissimilar to what Henry Ford did with the Model T, and created a car industry in the U.S. This standardization allows you to produce a lot more and a lot faster.

The Truth about Private Equity and MicrofinanceInterview: Sumir Chadha, Managing Director, Sequoia Capital Indiaone of the first “mainstream” investors to take the plunge into microfinance was Sequoia Capital. Its entry was one of the first indications that microfinance could be seen as purely profit-driven investment. Better known for its venture capital investments into google, yahoo, youTube and apple Computer, Sequoia invested uS$11.5m into SKS microfinance, based in Hyderabad, India, in 2007. Since then the company has made an additional investment into ujjivan, an urban microfinance institution based in Bangalore, India. microfinance Insights sat down with Sumir Chadha, managing Director with Sequoia Capital India, to learn about the motivations of the company with regards to microfinance, and the innerworkings of SKS.

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EXITSInsights: Exit prospects are limited these days. In the current economic environment, MFIs that were planning to IPO have had put those plans on the back burner. What are the most favorable exit options now? Chadha: I think we are contemplating an IPO for SKS sometime next year, so that will provide an exit. But one thing that we have learned at Sequoia is that we tend to, by nature, be long term shareholders. We are in no hurry to exit. Especially when you see a very special company like SKS where, frankly, I will hold my personal shares for a long, long time. The reason we are contemplating an IPO is primarily because of Vikram’s vision to solve the poverty problem in India. Through an IPO we can go out and raise over a US$100m in new equity. Hopefully that will lead us to 30-40 million members and help us scale this, and solve the problem. To do it we need a lot more capital, and public markets offer us the ability to raise even more money.

Insights: So 2010 is the IPO?Chadha: That’s what we’re contemplating. Nothing is done till it’s done, but we’re thinking about that.

VALUATIONSInsights: At the Risk Roundtable held by Intellecap in Mumbai in January, about 15 mainstream investors attended, all expressing interest in making a microfinance investment. One of their main concerns: the high valuation paid by Sandstone last fall: US$400m. Why did Sandstone pay such a high valuation? How does that change things for the overall investing environment?Chadha: I think Sandstone got a very good deal. My personal thought is that Sandstone will make a lot of money on the last investment round. We don’t disclose the multiples– but by traditional multiples, clearly they were high for the last SKS round. We faced the same issue. When we did the Series B investment in SKS in March 2007, we became the largest shareholder in the company. We invested US$6m as part of a US$11m round, led by Sequoia. People in microfinance were shocked. They said we were overpaying for the company. What we told people is that when a company is growing at 200% a year, it forgives a lot of sins. One way to think about it is if you pay X, every

year your price is dropping by two thirds, just because the profits are growing so fast, and so what appears high may not be so high if you’re willing to take a 3 or 4 year view.

I think generally microfinance valuations are overheated. I think the challenge is that many investors wanted to get into SKS and they couldn’t. Frankly, the effect is that everyone is trying to get into the next company. I don’t want this to sound the wrong way, but not every company in microfinance is an SKS. Part of the problem has been that there are a lot of companies that have raised money at undeserved valuations in the industry.

Insights: As the goal of growing an MFI is to bring in more customers, more clients---is there a certain value per client?Chadha: There is definitely value placed on clients. The problem with all those metrics once you are doing a late-stage round – like the last round of SKS, because then you have a real book value, you have real earnings. You have 2 million clients; you have a scale with which you can have real numbers. In the very early stage where we invest because the denominator so small, we find those numbers meaningless.

What we tend to look at more is quality of management team, quality of vision, size of the market opportunity, how big do we think we can be in 4-5 years, and almost always [we take] a minority stake. We prefer minority stakes because we want the entrepreneur and the management to be big beneficiaries of the company as well.

We’ve found that in the early stages, valuation doesn’t matter that much. Whether you invest US$5m or US$10m, US$15m, it tends to be less important. What matters more to us is ownership; we start as a small shareholder and then keep upping. We have found that by the time a company exits, the shareholder that makes more money is the largest shareholder, and it has very little to do with the valuation you paid if you came in early. So we tend to be far more focused on ownership and far less focused on valuations.

Initially the valuations caused shock in a lot of people. But I think today they are shocked they didn’t invest in that valuation.

Insights: What do you have to say to critics who claim that private equity investors like

Sequoia, cause over-commercialization, and “mission drift”?Chadha: I think it happens. I agree with the critics. I think it’s very investor-specific. I’m sure that there are key investors that cause mission drift. I don’t think every PE investor and every social investor are the same. I know that in the case of SKS and Ujjivan it has not happened. But the other thing I want to point out is that these things are very tricky. As I mentioned, a lot of social investors are for-profit. There is a lot of grey in the world. It’s not all black and white.

Insights: Do you think PE investors in microfinance are dwindling now? Chadha: I think it’s definitely gone through a bubble. And I think this sort of market correction has definitely thrown some cold water on it. I know a lot of MFIs in India had high valuation expectations after the last SKS round, I also know many of them have not been able to raise money. You are seeing that imbalance, because unfortunately SKS creates expectations in this industry that not everyone can meet.

Today, when I talk to a lot of PE investors I hear there’s a big gap. Microfinance companies come and say they want to raise money at 6x book value. And the PE investor says, “I’ll give you money but I’ll give it to you 2x book.” So there’s a big gap in the market which is why you see deals not happening. I won’t name names, but if I look at the top five guys in microfinance in India, after SKS, I think four of them are fundraising for eight months and none of them have closed.

There’s this big valuation gap. Everybody wants the SKS valuation, but doesn’t have the SKS performance. And the key investors want to invest, but not at those prices, especially after the financial crisis, people are far more careful.

Microfinance is a very capital-intensive business, so they will have to keep raising capital for these companies. So at some time these lines are going to cross. I’m seeing a lot of microfinance companies dampen their expectations. I see investors being more willing to come in. But clearly this has gotten way overheated. There’s been too much excitement and I think it’s like many sectors where the leader will look great, but it’s not really clear if everyone else will from a finance perspective.

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If you’re in a number seven in the industry, maybe there’s no IPO or an exit. I think there’s a lot of “me too” investing at this stage.

Insights: Do you see SKS or Ujjivan making any acquisitions in the near future?Chadha: I think it’s a possibility. Both companies, and I don’t want to speak for them,

are open to it. What’s interesting is that the organic growth rates are so high today that if you look at just the number of new clients that SKS adds in a month is the size of a mid-size MFI. Part of the reality is that in 30 days we can grow our way into that, so why even do an acquisition? Because doing an acquisition involves a lot of work, a lot of effort a lot of

management integration risk. If the industry growth rate slows down you might see more consolidation. But today there isn’t too much pressure on it because of the high growth rates. And also there is a lot of egoism in this industry. n

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Bold Valuation?Paresh Patel, Sandstone, respondsIn late 2008, Sandstone Capital led the largest private equity investment in microfinance, into SKS. In the aftermath, many “mainstream” private equity investors speculated that Sandstone paid too high a valuation. lindsay Clinton, managing editor, spoke with Paresh Patel, Ceo of Sandstone, about the rationale behind the valuation.

Insights: While many private equity investors are interested in the sector, many have expressed concern about the high valuation you paid last fall. A lot of investors thought that it was bold. In hindsight, do you think the valuation was right? Patel: We could have paid a significantly higher price and we still would have made 35%+ IRRs. In fact we recently received an offer for investment from a globally recognized investor at twice the price we paid. It is still early, but we are extremely satisfied with the investment thus far and operating performance has exceeded expectations.

I think the question people had was that we did the deal in the middle of the financial crisis. I think that if that’s your question, as an investor, then you haven’t done your work, and you don’t understand the sector or the business. To us, it’s not a bold investment, microfinance is largely unaffected by the global recession and credit crisis. It’s a very logical investment: microfinance is a nascent but enormous market and SKS is the market leader in terms of depth of team, size, scope, corporate governance, financial results and balance sheet strength.

Insights: There are various methods of valuation: Price/Book value, Earnings multiple, Cash Flow analysis. Is there a certain value per client? Patel: That’s one way of looking at it. Some people look at cable companies or wireless companies at EV per subscriber. It’s possible. That said, I don’t think microfinance investments are difficult to justify based on traditional metrics.

The major debate is whether you value these companies on Price to Book (P/B) or Price to Earnings (P/E). We prefer P/E, but certainly the P/B comps from the early days of HDFC, Axis Bank, Compartamos, etc… were extremely high given the early stage in their lifecycles. This sector should be valued similarly. Typically in financial services, institutions are not rewarded with high P/Bs, because to grow, you need to grow your equity, and in growing your equity quickly, there’s a lot of dilution (and possibly loan losses).

But the opportunity in microfinance is slightly different. And this also a more nuanced reason of why we’re attracted to microfinance. Despite industry-low lending rates, SKS can generate very healthy ROEs, and because of priority sector norms in India, it can sell many loans off balance sheet. Together these mean that the sustainable rate of growth is significantly higher than other financial services companies in India today.

If I look at one of the major banks, from 2003 to 2009, its market cap grew over 500%. It’s earnings per share were up only by 70%. Think about that as a shareholder. How much value was really created? The bank financed growth not through high ROEs, but consistently large equity dilutions meant to build scale rather than shareholder value. The market cap goes up, but the existing shareholders aren’t benefiting. Microfinance can avoid that. One misconception about microfinance is that huge growth is accompanied with significant equity dilution. You can run these businesses at sustainable rates of growth 40-60% without dilution due to the ROEs and off-balance sheet financing.

Microfinance also benefits from superior credit quality through multiple cycles. In traditional consumer finance or commercial banking gross NPLs will range from 1-5%. In microfinance our experience has been 0.2-3%.

What else is different? A branch network built around consistent and fair processes creates better relationships with borrowers than other rural brands. SKS has been selling a wide variety of products and services through the channel, generating significant fee income.

If you look at these arguments in totality it becomes clear that Price/Book as a metric is not as instructive: (a) microfinance has a different financial model, (b) the industry is early in its lifecycle and (c) above all the industry can be a distribution channel for other products and services. Given these points, DCF and Price to Earnings seem to be more valuable for the next 4-5 years as growth ramps and the distribution channel is utilized n


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Banking on the Future: Pension Fund Seeks Socially Responsible InvestmentTIAA-CREF is a U.S-based pension giant that has been helping millions of people to and through retirement since 1918. In response to client requests for more socially responsible investment opportunities, TIAA-CREF launched the US$100m Global Microfinance Investment Program (GMIP). The first microfinance institution to benefit was ProCredit Holding AG, in which the GMIP invested US$43m. We reached out to TIAA-CREF’s Managing Director of Social and Community Investing, Scott Budde to learn more about their views on private equity in microfinance.

Global Viewpoints

ProfileScott Budde,Managing Director, Social and Community Investing Department, TIAA-CREFNew York, NY, USA

TIAA-CREF has great belief in microfinance as an asset class. But what, in your opinion is distinct about the sector?Microfinance is one of relatively few investment options that can provide both competitive returns (relative to the risk) and positive social impact in emerging markets. In addition, from a social perspective, microfinance has broad support across the political spectrum which certainly helps.

What are the top three factors TIAA-CREF considers when investing in an MFI?With the exception of ProCredit Holding (which is a holding company), I don’t think it is likely we would invest directly in MFI equity or debt due to the difficulties of direct investing of relatively small amounts of capital. Our Microfinance Investing Vehicle (MIV) criteria, however, would include a wide range of objective and subjective factors.

How would you address industry critics who say that commercialization simply leads to a “mission drift”? I think preserving the mission of an MFI is central to ensuring successful

commercialization. Conversely, I see commercialization as often central to creating an efficient and expanding mission. Thus, from both a social & financial perspective, we wouldn’t want an MFI to drift from its mission.

From an investment perspective, this combination of mission and commercialization is a big plus. In the current environment, even with some turmoil in microfinance, the sector is resulting in a more sustainable business model and more stable returns to investors.

Finally, I should mention that I believe commercialization is necessary for microfinance to expand its mission and footprint. There simply is not enough philanthropic capital to support the growth rates seen in microfinance around the world. Fortunately, commercial capital is available to support this growth though it will require at least reasonable commercial returns for investors.

The GMIP, through which TIAA-CREF invests, is based on the double bottom line philosophy. As an insider, do you see the proportion of such investors increasing significantly in the next few years? How important is the double bottom line philosophy to your customers/clients? We certainly see growing interest in a wide range of double bottom line strategies including other Socially Responsible Investment (SRI) strategies such as social screening and shareholder engagement. Growth in the actual money is a little more

difficult to predict because there are many more constraints (such as regulatory issues around developing new products). For TIAA-CREF’s 3.4 million investors, after financial return – which ranks number one as the most important factor for our clients – social, environmental and governance factors rank a high second.

As an investor, what changes do you think the microfinance industry needs to undertake in order to attract more investors? I think the industry would be well-served by clearly defining itself as one that strives to achieve both competitive financial returns and positive social impact. Currently the industry sends a wide range of messages to investors and the public promoting itself as anything from philanthropy to a legitimate commercial business with a mission. This is a very confusing message for investors.

I should, however, add that I realize there may be certain microfinance markets or segments that require a philanthropic approach or Technical Assistance (TA) funds to achieve success. I strongly support these initiatives but the problem is that they are often not clearly distinguished from investment options and this adds to the confusion. Also, these funds are very scarce and should really be directed to areas of microfinance that cannot attract commercial capital.


Managing Money…and Investor Expectations: A Fund Manager’s TakeIn India, the rapid growth of the microfinance sector has brought in a number of private equity players. A hot-bed for microfinance, the country sees several microfinance deals every quarter. In such an environment, it takes a skilled fund manager to negotiate the interests of the investor and the investee. To find out more about this angle, we spoke with Aditya Bhandari of Aavishkaar India Micro Venture Capital Fund, a venture fund based out of India, that promotes development, through investment, in rural and semi-urban India.

Through the Looking Glass: An MFI’s PerspectiveThe recent years have been boom-years for the economies of Eastern Europe, riding on the entry of several countries in to the European Union, and boosting oil revenues in the Caspian Sea economies. This has provided opportunities for growth for MFIs as well. However, the region has not seen private equity deals to the extent of those in other regions. Investment in the sector is dominated by DFIs and IFIs. The slow pace of regulation in these new democracies is also a factor in the slow growth of investment. Vase Dadilev, Executive Director of Horizonti Microfinance in Macedonia, shares his thoughts on investing in the region.

ProfileVase Dadilev,Executive Director, Horizonti MicrofinanceSkopje, Macedonia

There has been little private equity involvement within the microfinance space in the Eastern Europe region. Why do you think this is so?First of all, I believe there is a lack of sufficient knowledge and information about the equity investments and what challenges they may pose to the MFI management, board and donors. Another reason is the legal environment for microfinance in Eastern Europe. As per my knowledge in the Balkans most of the MFIs operate as NGOs whose structure does not allow

equity investment.

How do you think private equity can change the way microfinance operates in Macedonia?It could bring more professionalism in MFI operations and build internal capacities in terms of staff development, innovations, new technologies and strengthening the sector’s reputation. MFIs will become more competitive in the market, reach more clients and introduce new products.

As an executive at a microfinance institution, what are your two biggest concerns when it comes to private equity in microfinance? Firstly, the prevention of the MFI’s “mission.” How will private equity investment affect the

balance between achieving the social and financial performance? And my second concern is the investor’s expectations on the return on investment.

Can you elaborate on the danger and prevention of “mission drift”? Many equity investors put financial results as a priority over the social ones. Of course, there are social investors with intentions to invest in microfinance because of the MFI’s social performance. But also do not forget that there are MFIs that faced “mission drift” because of management and board decisions. This creates a challenge for social investors to identify an MFI with a strong management commitment to the mission and achievement of social goals.

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ProfileAditya BhandariAavishkaar India Micro Venture Capital FundChennai, India

As a microfinance fund manager, you come across many investment-worthy MFIs. What are the top 3 deciding factors you consider while evaluating an MFI prior to investment?To select one of many MFIs is not an easy task. The top 3 parameters that we look at are a) senior and middle management team and their ability to take the MFI to the next level b) existing geography of operation vis-à-vis intended areas of operation c) quality of the existing scale/operation of business which can include

portfolio quality, MIS, processes, and so on.

While raising money for microfinance investment, what are the challenges you most often face from potential investors? What are their biggest concerns?One such challenge is to match different LPs’ (limited partner) appetites with respect to the scale of operations. For example while a few might look at large, mature MFIs, others are interested in start-ups. Matching all this in one fund is not impossible, but is a bit challenging.

Some in the industry often talk about the mismatch in expectations between investors and MFIs. From your experience working with both sides, what is the one thing that an investor and an MFI can do to ensure their

expectations are at par?The investors should strike a balance between social and commercial – this will help in keeping the MFI model stable and sustainable. The MFIs should start projecting a far more achievable target which means moderating the expectation on valuation. They should also share the vision of building a strong second line of management.

Finally, what is your prediction for private equity inflow given the current economic scenario?Institutional money is there in the market ready for deployment and will continue to be available. The recent changes in the global market scenario will only boost the sentiment further.


Does It Pay to Do Good, and to Do It Well? Yes, but first…

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Look before you leap, the saying goes. And that’s exactly what several venture capitalists are doing these days. While several VCs have invested in the Indian microfinance sector, there remains a large number looking at microfinance with a mixture of curiosity and excitement. Careful not to get scalded by a hot sector, several of these investors are maintaining a cautious distance – waiting for the most opportune moment to invest. Lightspeed Ventures – a multinational VC firm with investments in China, India, Israel and the U.S—is one of them. We spoke to Bejul Somaia, Managing Director, Lightspeed Ventures, India for his take on the Indian microfinance sector, as an outsider.

ProfileBejul SomaiaManaging Director, Lightspeed VenturesNew Delhi, India

As an organization not currently invested in microfinance, what would you say are the top two reasons you would consider investing in microfinance at some point?The first reason is that we see a very large opportunity to deliver financial services to the financially excluded population, given the absolute number of households this segment represents and their potential credit requirements. The success of some of the larger MFIs provides a window into the size of the opportunity and the fact that a scalable business model exists. The second is the philosophy of ‘doing well by doing good.’ There are not many opportunities that one gets to build businesses of this scale that have the potential to generate 25%+ return on equity (ROE) and have a social benefit as well.

Having identified two reasons to invest, what are your two biggest concerns? One concern is that although microfinance has been around for a while, in some ways it is still nascent. The hyper growth that characterizes the industry today has really happened only in the last 2-3 years. and this raises questions around sustainability, quality of the portfolio and other associated risks. It is inevitable that shortcuts will be taken to accommodate such rapid growth and therefore questions must be asked about what those shortcuts are and how will they manifest themselves over time. Questions such as “can you really have

that kind of growth and have a super high quality portfolio?”, “can you grow that quickly and appropriately monitor internal fraud?” and “can you grow that quickly and not be lending to people who have a pyramid of loans (from moneylenders as well as other MFIs)?” We haven’t yet really seen what a negative cycle looks like in the industry at scale. Somewhat related to the first concern is our second concern which is around valuations. Based on our assessment of the risk in the industry, we believe that valuations are stretched. We look at valuations relative to three buckets. The first is relative to MFIs in other parts of the world, the second is relative to mainstream financial institutions in India (which are more diversified and have less risk but also slower growth), and the third is relative to other financial services companies in India who provide credit to the unbanked or credit starved population and who are also growing quite rapidly. Relative to all of these buckets, we find the MFI sector to be quite pricey on a risk adjusted basis.

That brings up another question. To what extent does Lightspeed see value in investing in the double bottom line industry?First and foremost we are a financial investor, and we are measured based on the returns we generate to our investors. However, the double bottom line aspect is certainly something that we factor into the investment calculus. It’s one of several factors that we consider.

It’s interesting that you brought up valuations, because one of the things we have heard repeatedly is the mismatch in expectations between an investor and a potential investee/MFI. There obviously

seem to be things that the MFI can do meet the expectations of the investor. Do you have a word or two for the MFIs?I don’t think it’s that simple. The difference in expectations is driven by a fundamentally different perception of risk. The MFIs and even some existing investors might be wondering, “What are the risks these guys are talking about? I’ve been growing at 300% a year, or 200% a year, or 100% a year and my PAR is less than 1%.” They don’t necessarily see a risk in their business. They may be right, we may be wrong, or conversely we may be right and they may be wrong. Time will tell. I don’t think any of us know what the answer is and this is quite normal in an evolving industry. Everyone interprets the data differently and reaches different conclusions. We might perceive risks that may not be there but we have found in our over two decades of investing that when things sometimes look too good to be true, it is because they usually are. Again, our current perspective on valuations is really a reflection of our assessment of the MFI sector relative to the other sectors I mentioned earlier, in terms of risk and opportunity.

The financial crisis has proved microfinance’s resilience, but there is still considerable debate on it being an asset class. What are your thoughts on this? If you think yes, then how so? If not, what do you think is the status of the sector at the moment?In the last 6-9 months we’ve seen default rates outside India as high as 20%. We must be careful, therefore, when we make such conclusions. I agree that there certainly appears to be an element of decoupling – at least in India – but once again we must keep in mind that the current dynamics of


ProfileHiti SinghInvestment Manager, CDC GroupLondon, UK

As a DFI, CDC is committed to funding a number of areas – agribusiness, clean tech, energy and utilities, healthcare, education and so on. Do you think that microfinance is still the ‘hot new thing,’ or is there now wider acceptance of it as a viable asset class? CDC’s investment policy has been recently revised to reflect a growing focus on Low Income Countries (LICs) in sub-Saharan Africa and South Asia, and our portfolio includes a broad array of mainstream private equity investments as well as “alternative” asset classes such as microfinance, clean energy, and others. CDC views microfinance as a highly developmental investment opportunity which promotes social entrepreneurship and the ability to develop sustainable businesses at the ‘bottom of the pyramid.’ We regard it as a commercially feasible yet nascent asset class that has yet to reach its full potential of attracting commercial capital on a global scale, and one that remains an attractive investment with high development impact.

Fifty six percent of your portfolio is Africa-based. However, there is sense among the microfinance community that Africa tends to get sidelined when it comes to commercial microfinance investing, particularly in comparison to South Asia and Latin America. Why do you think that is so? What are the particular challenges of the region?Africa in particular has remained a challenging market for microfinance which could be attributed to the absence of a standard operational model applicable to the various cultures and demographics across the continent. The lack of liquidity and limited existence of local commercial capital does not help.

There has been a lot of talk about the role of DFIs in microfinance. With growing interest from the mainstream, what emerging role do you see for DFIs? DFIs have certainly engaged as pioneering investors in microfinance by providing risk capital to MIVs and MFIs through the early stages of development. India which has emerged as a focal point for microfinance growth and investment, has successfully raised mainstream, commercial funding. However, on a global scale most regions (outside of Latin America and Central

Europe), and specifically Africa, still rely heavily on DFI funding and philanthropic capital. The future role for DFIs in the microfinance space still remains significant, at least until a broader forum of socially responsible investors emerges among institutional investors.

As an investor, what are some of the challenges you see in microfinance investing? And how can MFIs address those challenges?As an intermediated investor, we generally find that the valuations of many MFIs are aggressive and inflated and despite the current economic crisis, these have not decreased in line with some other sectors. This is an issue that most equity investors will cite especially around investments in Tier 1 MFIs. Additionally, MFIs themselves face several operational challenges especially at early stages. The key to these issues seems to lie within operational cost minimization and optimum capacity utilization, a formula that is difficult to perfect. Another area is human resources, and the ability to attract management with microfinance expertise. n

In It for the Long Run: The DFI Perspective on MFI Investing Over the last half century, many Western governments set up development finance institutions (DFIs), dedicated to helping poorer nations through technical assistance, soft funding, research and development and so on. Together with international financial institutions (IFIs) – those set up under international mandates – DFIs have been instrumental in bringing about significant changes in their areas of work. In the microfinance sector, DFIs have been credited with leading the move towards commercialization. By extending debt and equity funding, DFIs not only paved the way for growth and acceleration, but also proved to skeptical private equity investors that microfinance was worth their time and money. Today many DFIs are heavily invested in microfinance, and continue to play a supporting role. Hiti Singh is an Investment Manager at the CDC Group – a UK government-owned DFI which acts as an intermediated investor, mainly in private equity, and operates in emerging economies via a Fund of Funds Structure. We spoke to her to find out more about CDC activities, and the role of DFIs in microfinance.

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the industry are still relatively nascent. We believe that successful lending businesses are fundamentally about being really disciplined about who to lend to and how to recover. When I hear people say that we turn around a loan application in 4 days – that to me isn’t a good thing. What I want to hear is that “while our competitors may take 4 days, we take 7-10 days and the reason is because we are being much more rigorous in making sure of credit

quality. And while we recognize that this may cost us business in the short term, we believe that we will have a much more robust portfolio in the long term.” I don’t think we’ve been through a cycle in India so we don’t know what a downside scenario looks like. Once we have the benefit of seeing the MFI segment mature over the next 5-10 years, I think we will be in a much better position to comment on the sector’s resilience.

Having said all this, we still find the sector very exciting. As an investor, it is our job to assess the upside and the downside. We’re interested in the space because we believe there is a lot of upside. The potential risks do not mean we will keep away from it - it just means we will price opportunities as a function of the risks we perceive.


How to Win an Investor in 12 Stepsan mFI’s guide to Raising Private equity Investment

Get “people ready”As they say, investors don’t invest in ideas, they invest in people. It is important to line up a passionate, experienced team with clearly defined roles in order to execute the plan. Often underestimated in microfinance business plan documents, this is a highly critical part of “doing the deal.”

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Be clear about it, but don’t overplay the social causeWhile microfinance creates access to a much needed service for the poor, the jury it still out on the extent of its developmental benefits. Most social investors or microfinance-dedicated funds are patient investors who seek social impacts. Nevertheless focus on social impact should not be seen as a substitute for a well-thought through, profitable, business plan.

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Ensure an invest-able vehicle with clarity in ownershipMFIs across the world are moving into for-profit structures. NGO-MFIs are transferring loan portfolios to for-profit structures and most new age entrepreneurs start off as for-profit ventures. Approach investors with a facilitative legal structure, with clear ownership or a plan for transition into one within a defined period.

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Make sure your value proposition is clearKnow what is it that you have to offer the investor; you cannot be all things to all people. Identify those key attributes that give you a comparative advantage. Evaluate these criteria against the investor’s stated priorities and communicate them in your investor pitch.

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Know yourself, and know what to expectBe clear on what you want out of the partnership, and most importantly, what you want for yourself vis-à-vis the MFI’s future plans. A strong ego not backed by performance can create difficult moments in the future. Be realistic about the goals and milestones you set and be prepared to be answerable to the investor.

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Choose your partner carefully Scan the investor universe and reach out to those that fit your needs. Ask yourself if you need a passive or an active investor. While passive might sound less-demanding, some MFIs might need the advice, relationships and sounding board that an active investor brings.

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“In my view the key to handling commercial investors is to understand their objectives in entering into the microfinance space, their return expectations, and their take on the double bottom line.”

- Manab Chakraborty, CEO, Mimo Microfinance,Dehradun, India.

Mimo Microfinance received an equity investment from Bellwether Microfinance Fund in 2008

“There are a few key things an MFI needs to keep in mind. First, the promoters need to be clear on how much (equity) to dilute. Second, creating a niche and making sure there is good value proposition for both the investor and the MFI. Lastly, choosing the right partner is as important as getting the right valuation.” - Arjun Muralidharan, worked on the recent Gram Vidiyal

microfinance investment by Unitus’ MicroVest II fund

manju mary george, vice President at Intellecap, outlines 12 steps to help a microfinance institution court and win a private equity investment.

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Put your house in order Ambitious business plans need to be backed by strong institutional systems and processes that facilitate scale and manage risks. In the quest for scale, internally focused activities often take a back seat; MFIs need to watch out for the same.

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Think “Exits” before “Entry”For promoters, the business might be eternal but financial investors need clarity on their “exits” and potential returns well ahead of the investment. Be it sale to another investor, buy back by the promoter, or an IPO, the MFI seeking investment should know what it can offer and constantly work towards realizing that plan.

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Showcase a brief but well-analyzed plan In the business plan document, get the balance right between the extent of facts and technicalities about the organization vs. analysis of its current status and future prospects. Don’t make fuzzy assumptions on the market, growth and impacts; have a clear rationale to each number and decision.

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Make sure your value proposition is clearKnow what is it that you have to offer the investor; you cannot be all things to all people. Identify those key attributes that give you a comparative advantage. Evaluate these criteria against the investor’s stated priorities and communicate them in your investor pitch.

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Manage small loans; but think big businessEach private equity (PE) investor has thresholds on minimum and maximum investments and target scale and returns that often leave out some of the smaller, slower growing MFIs from their shortlists.

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Don’t do it all by yourself For many MFIs, especially those with non-profit origins, the private equity universe, its terminologies, metrics and ways are alien. Make sure you have the required competencies to support you through the process of raising investment.

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“After an investor comes in, an MFI must be prepared well for changes in several areas. Nominee directors to the Board would get appointed by the investor. Reporting requirements would increase on financial and operations data. And a higher degree of compliance would be required, as there might be additional procedures to follow.” - Baljeet Kaur, Company Secretary, BASIX, Hyderabad, India.

In April 2009 BASIX received a US$10m equity infusion from Lok Capital, Aavishkaar Goodwell and the Small Industries

Development Bank of India

To augment this list of ”to-dos” microfinance Insights also spoke with representatives of mFIs who have helped to raise private equity investment on behalf of their mFI.

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Think about this: 240 to 400 million target population; an estimated potential of

US$30-50bn; the largest microfinance institution (MFI) has less then US$1bn in assets, and—hold your breath—there are 800 small and large MFIs vying for the space. Add to this a growth rate of 70% year on year and an average capital adequacy in excess of 25 to 30% at large for-profit MFIs, and you are staring at the exciting potential of Indian Microfinance.

These highlights are the reason behind the positive interest that Indian microfinance has generated among investors. However, the implication of challenges such as complex geography, cultural and linguistic diversity, and

nascent infrastructure development, especially in rural India, are yet to be understood.

Geographic Outreach: Not as Broad as You ThinkAs a sector, Indian microfinance remains a concentrated phenomenon with most of the microfinance operations still focused in Andhra Pradesh and other southern states. The increasing size of operations, influence of banks and private equity investors, and general counsel from the credit rating agencies pushed the microfinance institutions (MFIs) to make an effort in building a more diversified geographical outreach.

The above strategic move, though being

implemented with greater intensity after the Krishna episode in the state of Andhra Pradesh,1 has yet to make a serious difference to the portfolio concentration of many large MFIs. Interesting insights may emerge if one analyzed the share of portfolio from new states among the top 10 MFIs with presence in more than 5-7 states. The numbers would reveal that the contribution of Andhra Pradesh to the portfolio remains above or close to 50% for most of them and interestingly, despite the talk of concerns about multiple borrowing, concentration and saturation, the portfolio growth in Andhra remains high for all of them.

What could explain this behavior? Maybe

Indian microfinance has been growing like wildfire, with some institutions adding hundreds of thousands of borrowers to their rosters each month. However, a closer look at the numbers indicates that penetration is still not that geographically diverse, with many mFIs still being supported by a portfolio with 50% of borrowers in just one state. What are the pitfalls that make expansion into new states difficult? Should microfinance institutions consider acquiring existing organizations in new states, instead of treating each new area as the next frontier? vineet Rai, Co-Founder of aavishkaar venture management Services, explores the prospects for mergers and acquisitions in microfinance.

The Next Frontier:Is M&A a Feasible Strategy for Expansion?

Is acquisition of small, regional MFIs a strong growth strategy for large MFIs expanding into new states?Photo: Mike Johnston

mergers & acquisitiONs


it is not as easy to scale up in other states as we think? Or maybe the MFIs are not serious about scaling up in new states and the expansion plan and new branches are just a smoke screen to keep the lender and investors convinced that there is an “in principal” agreement on diversifying the portfolio?

Barriers to ExpansionA quick discussion with some of the CEOs of microfinance institutions partially allays such fears. What seems to be the case is that large MFIs are witnessing variable performance and some states are performing much better than others. Ability to find strong on-the-ground leadership that can allow a push toward scale seems to be a major constraint. Other constraints cited include the low level of education of the borrowers in some states and the lack of discipline and understanding of loan products. In addition, dealing with local politicians and bureaucracies, that are yet to learn about microfinance, presents a challenge.

From an analytical point of view the problem appears to be related to classical organic growth challenges and may thus need a strategic shift in thought process. A question that may be relevant is whether there is merit in looking for inorganic growth through merger and acquisition (M&A) for these Indian MFIs to expand more rapidly. Additionally, would M&A strategies work in an essentially demand-driven space in terms of adding value to growth strategy?

Considering M&A for Growth Both the above questions need to be looked at closely. M&A as a strategy works best if organic growth appears to be slowing down

(if the protagonist is already set in the market and competition is heating up). Conversely, if you want to enter into a new market that has huge potential but has reasonably established competition, an acquisition may give you sound footing to compete in the market.

With that background, it would be interesting to see if there is merit in Indian MFIs thinking about M&A and discovering whether their stakeholders would support this approach.

A key point that needs to be looked at carefully while discussing M&A in the context of microfinance is its social evolution. Currently there seems to be a belief that microfinance continues to remain promoter-focused and hence not amenable to ownership swap strategies.

Is there Merit to Forging Inorganic Growth?Let me try to answer the first question by stating that while India is a single country, its diversity makes it a heterogeneous market. Each new state is a different market requiring a different mind set, different leadership and at times different products to successfully scale. For large MFIs, acquisition as a growth strategy to enter a new state may be a better strategy than rolling out its own branch network and going through start up growing pains again. Similarity of model (largely Grameen) would make the process of acquisition much less complex and acquisition of talent would solve the local leadership and management bandwidth issue making it easier to build value through this inorganic growth strategy.

Support from Stakeholders is NecessaryThe second question on the support from stakeholders including investors appears to be not such a big challenge if the strategy for M&A by the MFI is clearly articulated and based on quelling the challenges that they have faced while entering new markets. Investors would view favorably the idea of addressing local human resource challenges in new states through acquisition if it takes into account the

quality of manpower being acquired and the compatibility of processes and systems.

The third question about the social entrepreneur and his/her influence in the business is a real issue. The two emerging trends that may allow such challenges to be addressed are a) The definitive movement of banks lending toward larger MFIs, leaving a bigger challenge of survival for the small, regional MFIs, at times forcing them to be more favorably disposed toward such offers b) Professional promoters with banking backgrounds have started setting up MFIs that are regional, bringing in a depth of local leadership and an open-minded approach towards ownership swap and acquisition.

While the case for acquisition opportunities in Indian microfinance is quite clear, mergers remain a more complex and difficult proposition. It seems a merger in the Indian scenario can come about either driven by the goal of enormous scale to create value for investors, or by regional MFIs coming together to deal with larger pan-India partners. My belief is that many MFIs may not want to deal with the complexity of mergers, in addition to the management of egos, which are often the key drivers behind social enterprises. However, acquisitions may become a reality in the near future. n

Vineet Rai is the Co-Founder of Aavishkaar Venture Management Services, and the Co-Founder of Intellecap, the company that publishes this magazine.

“……the contribution of Andhra to the portfolio [of the top 10 MFIs in operation in more than 5-7 states] remains above or close to 50% for most of them and interestingly, despite the talk of concerns about multiple borrowing, concentration and saturation, the portfolio growth in Andhra remains high for all of them.”

1. A dispute between the government authority and MFIs in Krishna district, Andhra Pradesh. In 2006, accusing MFIs operational in Krishna district under the provision of the AP Private Lenders’ Act, of allegedly charging high interest rates and being responsible for the death of one of the borrowers, the district authorities closed down more than 54 microfinance branches. The root of the dispute was thought to be a competition between non-governmental MFIs and a subsided microcredit scheme provided by the state and the central government, which was caused by the rapid expansion and concentration of MFI’s presence in the area. The Economist reported this incident as a turf war. See http://www.economist.com/businessfinance/displayStory.cfm?story_id=7803631

“It seems a merger in the Indian scenario can come about either driven by the goal of enormous scale to create value for investors, or regional MFIs coming together to deal with larger pan-India partners.”

mergers & acquisitiONs


As noted elsewhere in this issue, during the last five years we have seen a dramatic

increase in the number of transactions – and in the dollar volume of transactions – in which non-affiliated parties have been investing in MFIs. For countless reasons, many of them cited in this issue, the private equity investment has become the investment of choice in MFIs – not only for socially responsible investors, but for international financial institutions, hedge funds, private equity funds, pension funds and a host of other investors.

Oddly enough, and something of which many younger microfinance practitioners are unaware, much of the groundbreaking work in private equity investment in MFIs was done back in the mid-‘90s by a group called ProFund Internacional, S.A., managed by the legendary Alex Silva as the first microfinance equity fund. A principal goal of ProFund was to demonstrate that for-profit MFIs could actually provide investors with a reasonable return on capital over the scheduled life of the fund, which was ten years. The initial investment in the fund – US$22m – was supplied mostly by bi- and multi-lateral development organizations. The fund ultimately invested in 12 Latin American MFIs that were transforming from NGOs to regulated status and earned an impressive return in excess of 7%.1 ProFund led the way and pointed the direction for the current rush to invest in the equity of MFIs. Among ProFund’s most important lessons:• Exit Strategy: ProFund’s promise to investors was that their cash would be returned to them in 10 years. Thus management was required to have an exit strategy with respect to each investment it made. The fund attempted to secure “put options” for each investment that

it made, either with a controlling shareholder group or with the MFI itself. Although only two of these options were exercised, they undoubtedly gave ProFund greater leverage in negotiating a buyout.• Investment Strategy: Although ProFund did not have specific investment guidelines, it did have a specific geographic target (Latin America) and was focused on investing in a specific type of MFI – one converting from NGO to regulated institution.• Achievement of Social Purpose: Many microfinance private investors wrestle with the question of the extent to which their investments should generate social as well as business returns. The ProFund investors did not see these goals as conflicting and actively worked with their investee MFIs to foster the social benefits they believed microfinance generates. In addition to its capital infusion, the fund provided “value added” through its presence on the boards of directors of the MFIs and its working hand-in-hand with management to scale up their operations to reach the maximum number of clients.

I encourage those entering the microfinance private equity world to review the ProFund precedent for the lessons that may be learned.

Today, certain ProFund lessons, such as identifying an exit strategy and investment purpose, remain among the most important issues for those on the various sides of microfinance private equity negotiations -- MFIs selling equity, MIVs purchasing equity and investors in MIVs -- should be aware. At the outset, it is important to note an important distinction between the microfinance sector and most other businesses. Whereas in most businesses, profit maximization is the

overriding and permanent goal,2 microfinance is infused with the social goal of poverty alleviation. Thus, even the most profit-driven MFI has at its core the belief that its profit-maximization business plan will ultimately result in more effective poverty alleviation due to its ability to attract more and more capital at more favorable rates and thereby expand its outreach to an increasingly large client base and offer that base a broader array of services. (Let us call this MFI the “Max-Profit MFI.”) On the other hand, there may be a commercially oriented MFI that believes that its profits should be kept at the minimal level so that (i) the rates that it charges to its customers can be maintained at lower levels than the market would dictate, (ii) it will be able to serve those who may be greater credit risks and (iii) it may offer services to the poor that simply cannot be provided on a profitable basis. (Let us call this MFI the “Min-Profit MFI”.) Of course, most MFIs are somewhere on the rather large continuum between the Max-Profit MFI and the Min-Profit MFI.

I bring up this distinction because it is important to determine where an MFI is on this continuum before it seeks equity partners and even more important for prospective investors and for investors in MIVs. A Min-Profit MFI should not become an equity partner with an MIV driven by a high Internal Rate of Return (IRR) threshold, and vice versa. Thus, both MIVs and MFIs should screen each other based on where they stand on this continuum before investing significant time negotiating a deal that will probably not be consummated, and if consummated would result in frustration (at the very least) by both parties. For MFIs, this means that you should be doing serious diligence on the types

one often-overlooked issue within microfinance literature is the legal angle. But, in the world of microfinance, the law serves as the framework for what is above board and what’s not. our new legal correspondent, Howard j. Finklestein, a lawyer working within the microfinance sector for more than 7 years, reminds us that we can learn a lot from the past, and gives us the low-down on what to expect when you’re investing in a microfinance institution.

Private Equity in Microfinance:Some Legal (and Some Non-Legal) Perspectives

It is important for an MFI to determine where it is on the profit-maximization continuum before it seeks equity partners.Photo: Tom Martin.

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of returns an MIV has generated and expects to generate for its investors. For MIVs, this means you should seek to understand where a prospective investee stands on the profits vs. social goal continuum. For both sides, it is important that you memorialize your goals (I tell clients that an oral agreement is worth the paper it is written on) in an agreement of some form or another.

Which brings me to one of my most serious concerns with the manner in which a good deal of equity investing in MFIs is being done today: the lack of shareholder agreements or, where there are shareholder agreements, their failure to deal with issues that, at the end of the day, could mean the difference between success and failure.3 The shareholder agreement should be a road map detailing the aspirations of the parties involved and dealing with the more predictable contingencies that can arise during the life of an investment. Below is a list of most of the key issues that can be covered by a shareholder agreement:• Governance: If a prospective investor wishes to participate in the governance of an MFI, the shareholder agreement should guarantee it a right to representation on the Board of the MFI and/or key committees thereof. Similarly, the shareholder agreement (and in many jurisdictions, the MFI’s organizational document) should deal clearly with what actions management may take without Board approval and what matters require super-majority Board consent as well as clearly spelling out dispute resolution mechanisms and mechanisms for avoiding deadlocks. In addition, the shareholder agreement should be drafted so that the investor is sure of securing the degree of transparency it expects, including access to books and records, ability to discuss matters with the MFI’s accountants and lawyers and the ability to conduct on-site examinations.• Ongoing Protective Provisions: Almost every MFI in which equity investments are being made today will, within a relatively short

period of time, be making fundamental balance sheet changes. A shareholder agreement will deal with the impact of those changes. If the MFI does another round of equity capital to raise, what type of anti-dilution rights will the current investor have? Will it have rights of first refusal on future stock issued and, if so, at what price? What right will the MFI have to repurchase investor shares? What restrictions should exist on the manner in which the MFI deploys the funds it raises in this and future capital raises? Will there be non-competition covenants governing the investor and/or MFI management? What are the investor’s rights to indemnification from the MFI? How long will management be required to hold on to its shares? These and similar questions should be covered by the shareholder agreement.• Exit: Ask a sophisticated group of professional investors to list the three most important factors in evaluating potential equity investments, the answers will probably come out: exit, exit, exit. Yet there are many MIV managers who will tell you regarding exit, “Look, the MFI will continue to be profitable, will continue to grow, there will be opportunities for exit. Maybe there’ll be an IPO. Maybe there’ll be a buyout.” To this, most investors will say, “Not good enough.” As the ProFund managers discovered, it is a lot easier than people think to build an exit strategy into a shareholder agreement. The fact that these provisions may not resemble current practice in the MFI’s domicile does not mean they cannot be effective means of exit. MFIs should remember that one of the ways to ensure successful equity issuances is to have a long list of happy former shareholders. Thus, the shareholder agreement should contain one or more of the following provisions dealing with exit: put options; bring-along and drag-

along rights;4 and rights of shareholders in an IPO or a merger or acquisition.

Two final areas of concern should be noted: First, valuation. Much has been written recently regarding valuation of MFI equity.5 Many MIVs and others investing in MFI equity rely on judgment which, though often valuable, can also be a fool’s paradise. I believe a more systematic method of valuation should be sought, one which can deal, at the same time, with both an MFI growing at a rate in excess of 100% and a well-managed, profitable MFI in a country where competition among MFIs places an inherent limitation on growth.

Second, a few words regarding local law. For the seven years I have been involved in microfinance, I have told prospective investors how important it is to actually understand the local law of the countries in which they are investing. This does not only mean retaining local counsel to review documents. It means understanding how the local law differs conceptually from the system of law with which you are familiar. This can – and should – be done by retaining local counsel familiar with microfinance and with handling the expectations of outside, often Western, investors. The last thing an MIV wants to hear at some crucial moment is that it had never been informed about what turns out to be a crucial limitation in local law (e.g., “Oh, didn’t you know there is no such thing as bankruptcy in this country?”).

As with most things in microfinance, events often outpace our ability to think them through fully. I believe that five years from now we will look at the manner in which private equity investment in microfinance was made in 2009 much as we would view email communications back in 1990 (when I got my first email address): primitive. n

Howard J. Finkelstein has practiced law since 1980, specializing in finance, structured finance, corporate and international transactional law. He has advised clients in microfinance-related transactions bringing close to US$1bn of Western funds into microfinance. In January 2009, he established The Law Offices of Howard J. Finkelstein (http://www.hjflaw.com).

Information regarding ProFund is derived from Brusky, B. “Linking MFIs to Commercial Financing in Latin America: Inter-American Development Bank Support of 1. ProFund.” 1994, available at CGAP (www.cgap.org); ProFund Fund Report 2005, available, inter alia, Gray Ghost Fund at (www.grayghostfund.com); and information available at the Mix Market (www.mixmarket.org).There are many different strategies for profit maximization in all business sectors. R&D oriented firms have a much longer-term profit maximization strategy, for instance. 2. But there are very few business sectors where the inherent purpose of a for-profit business model is a social one.It is more than the success or failure of a particular transaction that is at stake. If one of the overriding goals of the microfinance sector is its advancement as an “investable” asset 3. by institutional investors, investors need to be convinced that the degree of professionalism in the sector is at least equal to that of more traditional investment arenas.E.g., Startup Company Lawyer, “What is a drag-along or bring-along provision?” 7 Nov 2007, available at http://www.startupcompanylawyer.com4. See, e.g., J.P. Morgan and CGAP, “Shedding Light on Microfinance Equity Valuation: Past and Present,” 2009, available at www.jpmorgan.com; Mirchandani, Bhakti. “Gauging 5. and Hedging the Upside: The Need for a Publicly Traded MFI Index.” Microfinance Insights, Vol 11, Mar/Apr 2009, available at http://www.microfinanceinsights.com.

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Three decades after Muhammed Yunus founded Grameen Bank, about 80

million people in developing countries are served by microfinance institutions. DFIs and foundations deserve much credit in the progress made in by the microfinance sector. Around the world, they have incubated greenfield microfinance institutions (MFIs) through their early stages of development, tried and tested business models to find those that work with local markets, communities, and clients, and set up the vehicles and infrastructure that have established microfinance as an asset class in its own right. Despite this progress, the majority of people in developing countries are still ‘unbanked’ – they have no access to formal financial services. While the sector showed early signs of success in attracting the private capital needed to scale up to meet this demand, the global financial crisis has temporarily set this back. DFIs will continue to play an important, but perhaps changing role in the sector as it deals with the financial crisis and then continues to mature, innovate, expand, and become more integrated into the capital markets.

Corporate LeversEvery transaction structured at the IFC must go through a double screen beyond the normal filters of financial soundness, management quality, etc: does it provide “additionality” and does it make a “development impact”? Additionality is the ultimate tool of the devil’s advocate, with no possible escape for

microfinance deals in view of their inherent objective to benefit those at the bottom of the pyramid. Every IFC investment officer (IO) must demonstrate that our role will have a material impact on the transaction, and prove that our absence from a project would adversely impact its success.

Should there be any doubt that our presence might displace, as opposed to enticing the private sector, the project is rejected.

IFC’s Microfinance StrategyAdditionality is the premise of IFC’s microfinance strategy. Our strategic objective is to both scale up microfinance investment volume and maximize development impact according to a fourfold orientation: (a) Adopt

wholesaling solutions based on collective investment vehicles and structured finance (e.g., microfinance-dedicated funds, structured finance and risk sharing facilities); (b) Work with network partners so as to optimize the delivery of technical expertise in multiple geographic locations and roll out investment backed by strong delivery capability; (c) Pursue individual investments in MF entities when IFC can share the due diligence with another partner; (d) Initiate advisory services to support the first three solutions, especially to unlock the potential of a large market, owing to the top level dialogue that IFC has with the authorities of a particular country (regulatory reform, financial infrastructure projects such as credit bureaus, etc.).

To DFI or not to DFI? The Continuing Role of Development Financial Institutions in Microfinance InvestmentDevelopment Financial Institutions (DFIs) have laid the foundation for the microfinance sector’s growth into an established, investable asset class. As the microfinance investment space matures, André Laude, Chief Investment Officer at IFC, makes a case that DFIs have a vital role to play in enabling the sector to develop and become more integrated into the capital markets.

“DFIs will continue to play an important, but perhaps changing role in the sector as it deals with the financial crisis and then continues to mature, innovate, expand, and become more integrated into the capital markets.”

Development Financial Institutions (DFIs) have laid the foundation for the microfinance sector’s growth into an established, investable asset class.


These four strategic solutions are further embedded in IFC’s priorities to massively facilitate access to finance at the bottom of the pyramid (BoP): (i) Focus on large countries where microfinance is hardly developed (e.g., China, Brazil, Turkey, etc.); (ii) Develop local institutional capacity in Central America/Caribbean, Africa, the Pacific Rim); (iii) Build local currency funding through deposit mobilization and savings/payment services.

Crowding in the Private SectorStemming from our strategy, it is hardly conceivable today that IFC would allocate its time and resources to support each and every small microfinance player to simply dot the planet with a flag of our presence. That role is best fulfilled by specialized microfinance investors who can have leaner structures and greater proximity to small players to foster their institutional development.

Instead, now that the sector is coming of age, the role of IFC, as a AAA multilateral is threefold: we must preserve our capital standing, maximize profitability and social impact, while also promoting financial instruments that develop the microfinance industry. That is why most of our microfinance clients benefit from our value-added services such as swaps (currency and interest rate swaps), CDOs and structured solutions, partial guarantees, securitizations, etc. Overall, for IFC, as well as for our partner DFIs, we should be promoting innovation while further enhancing the integration of microfinance into the capital markets.

Enticing capital markets to buy into microfinance is our daily bread. In this perspective, one could argue that in 2004-2005, IFC’s credit enhancement for Compartamos’ MXP500m bond issue allowed the then SOFOL (Sociedad Financiera de Objeto Limitado, a special purpose NBFI) to be on the radar screen of institutional investors such as major insurance companies and pension funds. This transaction had many benefits: not only did it diversify the offer of AA paper domestically, but also achieved record pricing and longer maturities for the issuer (5 years vs. 3 years). One could also argue that this transaction sowed the seed for Compartamos’ landmark IPO a few years later. IFC also brought to market other bond issues to whet the appetite of institutional investors, as was

the case in Peru for Edyficar’s 2007-2008 PEN55m bond issuing program.

Structuring asset offerings to make them palatable to private investors ought to be the ultimate goal of International Financial Institutions (IFIs). This is how IFC initially conceived the Global Microfinance Facility (GMF, for which we selected Cyrano as the Manager) and pitched in as sole equity investor, then brought in other IFIs in its mezzanine tranche to be able to entice private investors (from foundations to specialized players such as Desjardins International, Cordaid, as well as France’s Crédit Coopératif) to invest in GMF’s senior tranche. Yet, if one always wants to be bullish in advocating microfinance in view of its developmental appeal and generally healthy financial fundamentals (that is how we were successful in bringing Citibank as an equity investor in GMF), one must also realize that the line held by private investors may sometimes be closer to a communications strategy than actual, concrete appetite.

That said, IFIs must also be consistent and adapt to market circumstances: lobby for microfinance with regulators either for bond issuing of MFIs, or for specialized MIVs, but also be prepared to take up the slack when market appetite slims down, as we definitely are experiencing through the global recession. That is in sync with our role as countercyclical players.

Crisis ResponseOur creed is to facilitate and pursue capital markets integration. In the current liquidity crunch, however, we cannot but uphold those MFIs that have successfully made inroads into the capital markets and have graduated to the

big league. When the big league is bleeding, we need to shore up MFIs with large outreach so that they are not unduly exposed to credit rationing, hence preventing the crisis from rippling through the most vulnerable segments of society. This is why in February 2009, IFC and KfW launched MEF, the Microfinance Enhancement Facility, as our primary crisis response instrument. MEF, at a target size of US$500m, aims to address the refinancing needs of MFIs worldwide. MEF is managed by three leading private fund managers and is built on a bottom up analysis of MFI refinancing needs through 2009-2010 that are estimated at US$1.8bn. MEF is a fast response instrument designed to address liquidity issues, yet, here again, its financial structure (first loss, mezzanine and senior tranches) aims to attract private investors, once markets return to greater normality.

Frontier and BeyondIf I had to project future developments of the industry, I would highly encourage IFIs to foster new and more efficient business models for the delivery of microfinance products, reach scale faster than organic growth through the brick and mortar approach, while also offering value-added services such as insurance products (life, health, property and casualty, climate protection for rural finance, etc.) For example, IFC has the convening power to maximize branchless delivery tried out by Tribanco, Brazil’s most successful nationwide player with the biggest outreach, while also supporting China’s Zhong An Credit’s expansion into multiple provinces through downscaling agreements with the country’s commercial banks. Where potential is stalled because of regulatory barriers, we also demonstrate the soundness of the asset class and the benefits of financial inclusion. Overall, microentrepreneurs should then be the winners, as more private sector players will be entering the industry, thereby tackling the enormous demand gap beyond the estimated 10% of microentrepreneurs currently being served. n

André Laude is Chief Investment Officer at IFC’s Global Financial Markets department focusing on Micro and Small Business Finance worldwide. He has over 15 years of financial market experience in Wall Street, London, Mexico City and Casablanca, including management consulting for the Financial Institutions Group at Booz-Allen & Hamilton. The author can be reached at [email protected]. For more information, visit www.ifc.org.

“Enticing capital markets to buy into microfinance is our daily bread….Structuring asset offerings to make them palatable to private investors ought to be the ultimate goal of International Financial Institutions (IFIs).”

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Microfinance is rapidly becoming a strong viable asset class and, accordingly,

an attractive investment for commercial investors. An April 2009 CGAP report states, “Microfinance is one of the few asset classes with a positive return in 2008…in stark contrast to the 12% drop for fixed-income corporate indices in emerging markets.”1

As noted by Michael Hokenson, Managing Director, Minlam Asset Management LLC, “Microfinance, due to its common underly-ing economic drivers and its dissimilarity to other asset classes, can be considered its own asset class. It has risk that can be categorized, an index can be created, and benchmarks can be established.” Hokenson adds, “We believe there is genuine interest in microfinance from the institutional market. It meets the tremen-dously important criterion of diversification. Given the proper strategy, it has the ability to deliver attractive risk-adjusted returns.”

Several investors & managers echo this view. Roger Frank, Managing Director of Benchmark Asset Managers LLC, a commercial, for-profit investment firm, states, “While the common perception of sustainable investing is that it

is a niche activity, our experience shows that positive sustainable investments can also yield competitive returns.”

Given the conventional view that the demand for microfinance loans is US$250bn, microfinance represents a significant investment opportunity. As of December 2008, CGAP lists 104 active Microfinance Investment Vehicles (MIVs) with estimated assets under management (AUM) of US$6.5bn2--this highlights an impressive threefold increase from US$2bn AUM in 2006.3 Much of this growth can be attributed to private investment funds and institutional investors. Surveys by CGAP indicate that investments in MIVs by institutional investors jumped from 14% to 41% between 2005 and 2007.4

Investors currently favor fixed-income instruments (representing close to 80% of investments5), but equity investments grew by 95% between 2006 and 2007.6 A February 2009 joint JP Morgan/CGAP report notes that by the end of 2008, there were 24 specialized microfinance equity funds with total AUM of US$1.5bn.7

Institutional InvestorsInstitutional investors in microfinance in-clude corporate pension funds, public pension funds, commercial banks, and university and foundation endowments.

According to Xavier Reille, Lead Microfinance Specialist, CGAP, European institutional investors represented approximately 80% of all MIV AUM in 2007. European institutional investors often invest through MIVs registered in Luxembourg and the Netherlands, and some are active participants in microfinance investments in line with their SRI strategies. According to Paul DiLeo, Co-Founder and Managing Partner of Grassroots Capital, “European institutions, particularly Dutch institutions, are generally more comfortable with socially responsible investing and microfinance, and they also feel that their clients want to see them active in this space.”

US institutional investors, on the other hand, have been less responsive to microfinance investments with the exception of three major participants: TIAA-CREF, Omidyar-Tufts Microfinance Fund, and The General Board

Microfinance equity investments grew by 95% between 2006 and 2007. But, according to CGAP, the majority of the funding is flowing in from European institutional investors. US institutional investors remain reluctant to engage with this sector. In light of the impressive gains and industry growth, this article discusses the participation of U.S . institutional investors in microfinance investments, addresses some prevalent investor concerns, and offers several reasons for the relatively slow growth of this sector in the U.S..

The Time is Right for US Institutional Investors

The microfinance sector’s history of philanthropic support blurs the notion that it is actually a viable commercial investment for US institutional investors.Photo: Dan Zen

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of Pension and Health Benefits of the United Methodist Church.

TIAA-CREF created the Global Microfi-nance Investment Program with US$100m. Established in 2006, the fund is fully invested with allocations to ProCredit Holding, Cata-lyst Microfinance Investments, and Develop-ing World Markets. It is interesting to note that the fund’s manager, Scott Budde, touches on themes relevant to mainstream investments (i.e. performance and sustainability) as well as the double bottom line. “TIAA-CREF’s Global Microfinance Investment Program continues to deliver a combination of both competitive returns and positive social impact across a range of MFI models,” said Budde, Manag-ing Director, Global Social and Community Investing Department, TIAA-CREF. “Also, mi-crofinance has shown significant resiliency in the current environment.”

Investing in microfinance has been an equally positive experience for Omidyar-Tufts Microfinance Fund (formed in 2005). The fund’s original US$100m is fully committed, but the fund continues to review new opportunities in microfinance.8 Tryfan Evans, Director of the fund, stated that long term financial performance is paramount, and because of their fiduciary responsibility, OTMF seeks the same financial return from microfinance investments as from other investments. Evans further noted that OTMF includes high-grade fixed income, high-yield fixed income, private equity and venture capital microfinance investments. For the fiscal year ending June 30, 2008, the fund returned 12%.9

The General Board of Pension and Health Benefits of The United Methodist Church has diversified its US$50m microfinance investment through structured financing vehicles “that offer market-rate returns to investors that are commensurate with risk. The General Board has participated in three of these transactions…[reaching] more than 50 microfinance institutions…”10

Addressing Investors’ ConcernsMicrofinance investment managers, fund managers and other microfinance participants frequently note the difficulty in securing com-mitments from US institutional investors. US institutional fund managers and industry par-ticipants revealed several common concerns

regarding investing in microfinance. Many of these concerns are beginning to be addressed, as outlined below.

Performance Results: Readily available, standardized and comprehensive valuation metrics for microfinance are limited. While some basic investment information on MFIs and microfinance transactions are already available, Roland Dominicé, Executive Director of Symbiotics S.A. confirmed that “information on the funds is indeed often not publicly available and there is no public site available today unfortunately. We are working on something ourselves, among different initiatives.”11 Yet, investors should note that credit ratings and valuations are now provided by mainstream global agencies such as Standard & Poors and Fitch, and that specialized agencies such as MicroRate, PlaNet Finance, MicroFinanza, and M-CRIL provide ratings on MIVs and MFIs. In addition, the Symbiotics Microfinance Index (SMX) tracks the financial performance of regulated MIVs12 and the 2009 JPMorgan/CGAP report aims to establish benchmarks for valuations of microfinance equity.

Size of MIVs: While there are currently over 100 MIVs, the ability for institutions to invest corresponds less with the number of MIVs than with the ability of MIVs to meet investors’ parameters. Most MIVs are small in size compared to typical investment funds. Since US institutional investors typically have minimum investment requirements of US$10-15m, with a cap of 50% fund participation, the size of the funds is an important consideration. At the end of 2006, roughly 86% of total MIVs had less than US$20m under management.13 However, investors should note that the top ten MIVs as of December 2008 each had over US$100m in AUM with a combined AUM of almost US$4bn.14 Nonetheless, Ann Miles, Managing Director, BlueOrchard Finance USA, stated that “microfinance investment vehicles will have to achieve scale to attract larger pools of capital.”

Liquidity and Secondary Markets: It is inter-esting to note that for some US pension fund managers, liquidity is of particular concern given that the US private pension system is shifting from defined benefits (managed by

the employer) to defined contributions (man-aged by the contributor). As employees in the defined benefit system are retiring, and fewer new employees are added to plans, pension fund managers primarily seek shorter term and more liquid investments to meet shorter term pension payout requirements. As inves-tors require liquidity to meet their financial ob-ligations, a secondary market for microfinance investments has been steadily growing. For instance, Antares Equity Participation Fund (managed by Grassroots Capital and Omtrix) has executed several secondary transactions. DiLeo of Grassroots Capital states, “Antares was created by Gray Ghost to give a push to the deepening of the secondary market in mi-crofinance equity, as well as to take advantage of the general illiquidity to acquire assets at good prices.”

Exit Strategies: As the microfinance industry matures we have seen an increasing number of favorable exit transactions. Initial exits have included two significant IPOs (Compartamos Banco, Mexico and Equity Bank, Kenya) and the exit of ProFund International (Panama). Additionally, Gil Crawford, Chief Executive Officer of MicroVest Capital Management states: “We have had several in-depth successful negotiations with buyers, including local investors, local companies, IFIs, and MIVs, which have resulted in a number of sales where both buyer and seller felt the transaction was positive and was of value.” Addressing this issue, W. Bowman Cutter, Managing Director of Warburg Pincus LLC, states, “Microfinance has shown steady growth, stability, and significant returns which typically result in favorable exit strategies.”

Blurring the Message: Philanthropy, Grants and AidUS institutional investors need greater clarity regarding the proper allocation for microfinance. Philanthropy, grants and government aid have been at the forefront of microfinance initiatives, and the benefits from these continuing contributions cannot be overstated. However, such assistance sends the message that microfinance is principally a philanthropic endeavor. US investors have noted that this blurs the message making it difficult for them to recognize microfinance as a viable commercial investment. Budde

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of TIAA-CREF says, “…the presence of un-regulated, philanthropic lending models may complicate attracting investment dollars from investors. These types of models send a signal to investors that microfinance is more about philanthropy than investing. Given that the growth of microfinance will probably require large investment flows, focusing on mainstream investors and regulated investment vehicles will be a necessity.”

Regulatory EnvironmentWhile European investors recognize the positive returns of microfinance, their

participation in microfinance can also partially be attributed to tax incentives for such investments. For example, Etienne Gentil, Finance Partner with Latham & Watkins in Paris, states that the Netherlands, Belgium, Germany and several other European countries have favorable tax regulations for microfinance and socially responsible investments. However, he cautions that these are not uniform and are connected with the EU Lisbon Strategy.15

Reaching the Tipping PointPlacement agents and institutional advisors have stated that they are unaware of microfinance opportunities. Few placement agents have mandates to place microfinance instruments, and institutional fund managers indicate that few opportunities have been presented to them.

Microfinance investments are lauded at numerous global microfinance conferences throughout the year. However, the audience rarely includes prospective institutional

investors. Most microfinance conferences are attended by professionals already engaged in microfinance (i.e., practitioners, NGOs, development agencies, and existing investors). To reach a broader investor base, the microfinance industry should more actively participate in mainstream investment conferences, trade associations, and the mainstream financial media. Larry Comstock, an institutional placement agent, states that, “Now is the time for MIVs to present their case directly to leading US institutional investors, as well as to their consultants and advisors, to begin the process of microfinance being recognized as an attractive alternative asset category.”

ConclusionCommercial investors are receptive to reviewing microfinance investment opportunities, but need to be better informed about the microfinance investment environment. While the positive message about microfinance investments is beginning to reach a broader investor base, more can be done. It behooves all parties (investors, MFIs, non-profits, and for-profit entities), to collaborate more effectively in establishing microfinance as a mainstream investment opportunity. Size being a hindrance for many US institutional investors, more large funds and possibly more funds of funds should be developed. Emphasis should also continue to be on transparency, liquidity and development of secondary markets to meet institutional investors’ needs. Finally, for-profit microfinance investing needs to be promoted more pro-actively by all constituents. With its strong performance in 2008, improved access to information and variety of investment products, microfinance now presents a real opportunity for US institutional investors. n

Susan Salerno, an independent consultant, specializes in the development and sale of alternative investment funds including private equity and microfinance funds. Clara Lipson, an independent consultant, specializes in international development with a focus on financial services and emerging markets. She serves on the boards of several microfinance organizations in New York.

Secondary MarketTransactions

Although there is limited public information about secondary market microfinance transactions, by some estimates, the annual trading volume is less than US$100m. Examples of secondary market transactions include:

Minlam has participated in several secondary offerings including: a) adding to a core bond position when it reflected mark-to-market losses (due to market conditions); b) helping an MFI de-lever its balance sheet by assisting in buyback trades; and c) purchasing a private loan from a lender that needed liquidity.

Antares engaged in several secondary transactions including purchase of a 4.5% equity stake in Financiera de Desarrollo S.A. (FINDESA), a 2.42% ownership holding in Edpyme Confianza, and an 8.42% equity interest in Edpyme Crear Tacna.

1. “Microfinance Funds Continue to Grow Despite the Crisis.” CGAP Brief, April 2009.2.“Microfinance Funds Continue to Grow Despite the Crisis.” CGAP Brief, April 2009.3. “Microfinance Investment Vehicles.” CGAP Brief, April, 2007.4. “High Growth and Improving Returns for Microfinance Funds.” CGAP MIV Survey, 2008. 5. “Microfinance Funds Continue to Grow Despite the Crisis.” CGAP Brief, April 2009.6. “CGAP 2008 MIV Survey Main Findings.” CGAP, September, 2008.7. “Shedding Light on Microfinance Equity Valuation: Past and Present.” J.P. Morgan and CGAP, February 3, 2009.8. http://www.tufts.edu/microfinancefund/?pid=139. http://www.tufts.edu/microfinancefund/?pid=1310. http://www.gbophb.org/sri_funds/articles/micro.asp11. Additional information sources include: CGAP, CMEF, EMPEA, IAMFI, and MIX.12. “Reaching Out Through Investments.” Symbiotics S.A. Quarterly Corporate Newsletter, April 2009.13. “Microfinance Investment Vehicles.” CGAP Brief, April, 2007.14. “Microfinance Funds Continue to Grow Despite the Crisis.” CGAP Brief, April 2009.15. http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=COM:2007:0708:REV1:EN:PDF

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“…the presence of un-regu-lated, philanthropic lending models may complicate at-tracting investment dollars from investors. These types of models send a signal to inves-tors that microfinance is more about philanthropy than in-vesting. Given that the growth of microfinance will probably require large investment flows, focusing on mainstream inves-tors and regulated investment vehicles will be a necessity.” - Scott Budde, Managing Director, Global Social and Community Investing Department, TIAA-CREF


Methodology: We reached out to the managers of the 65 MIVs listed on the MIX Market with US$5m+ AUMs. We interviewed 28 of these managers on structuring, capital raising, human resources, operations/systems/administration, investment, deal making, exiting and risk management best practices and lessons learned. These managers advised or managed 53% of total MIV AUM. We are deeply grateful to these managers for making the time to ensure that their MIVs2 were included in this survey. The syndicated responses of the managers are presented on an anonymous basis in this article. Below are the recommended best practices for MIVs.

Microfinance Investment Vehicles:Best Practices and Lessons LearnedMicrofinance Investment Vehicles (MIVs) are rapidly growing in number and assets under management (AUM). There were 96 MIVs at fiscal year-end (FYE) 2007; half were created in just 3 years (2005 - 2007). MIV AUM increased from US$637m at FYE 2004 to US$3.7bn at FYE 2007 and US$5.4bn in October 2008. As MIVs proliferate, the microfinance industry must study and share best practices. In this article, Bhakti Mirchandani and Howard Finkelstein distill the best practices and lessons learned from the collective wisdom of key MIV managers for the benefit of current and potential microfinance investors1 and managers.

Structure: 1. Establish regulated vehicles to increase adherence to quality standards and protect investors. For example, the General Partner (GP)-Limited Partner (LP) structure is ideal because investment exits are independent of LP approval. Many MIV shareholders have multiple microfinance investments, creating potential conflicts of interestTax Treatment: 2. Create the right subsidiaries for large and strategically important investors in different jurisdictions to optimize tax structure. For example, guarantee funds that are non-profits allow losses to be deemed donations for tax purposesFee Structure:3. First, share fees fairly among players, including the sales channel. Second, fees should be transparent to investors, particularly upfront and exit fees. Third, given current downward pressure on fees, new equity funds

may wish to reduce fees to 2% and 20% even if minimum investment size must increase to ensure profitabilityReinvestment Criteria: 4. Keep some AUM in very liquid investments to allow redemptions and establish redemption limits, or “gates,” to protect MIVs against the illiquidity of microfinance investments. Closed-end funds should invest with the exit in mind and target MFIs that are merger/takeover candidates for regional competitors or other MIVsLessons Learned: 5. Some MIVs invest in MFIs transforming from non-profit to for-profit via bridge loans that convert to equity upon transformation and are callable if the MFIs do not transform

Structuring

New MIVs: Finding a Niche.1. (i) Defining a specialized strategy is critical to reach scale. (ii) Socially responsible retail investors represent stable funding; first mover advantage is key, given the stickiness of retail investments. (iii) Institutional investors have more rigorous due diligence requirements than individual investors. MIVs therefore need to be more involved with the sales processes for institutional investors, whereas they can outsource that function for individual investorsFollow-on MIVs: Expanding Scope.2. Build a strong track record and reputation to facilitate subsequent capital raises. Having a follow-on fund more than 3-4Xs the AUM of the prior fund is a major undertaking in terms of processes/systems and requires significantly more resources Investor Selection:3. Ensure alignment of investor time horizons, financial return expectations, and risk tolerance with other investors and with the MIV manager. Selecting

investors that share MIV vision is also critical. Long-term investors who care about development are ideal; aggressive investors can hurt the industryInvestment Minimum:4. The primary driver of investment minimum should be target group, and the secondary driver should be operational capacity. A high stated minimum (e.g., US$5mn) that is subject to manager discretion (waiving) allows exclusion of undesirable investors and inclusion of desirable small investorsLessons Learned:5. Funds focused on a single sector and geography have superior deal flow vs. diversified funds. It is better to have a pool of loyal shareholder investors who understand microfinance and the fund’s geography to minimize investor education time/cost. MIV managers should do due diligence on investors (past MFI & MIV investments, exits, returns)

Capital Raising

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Human Resources:1. Outsource only non-core functions, like legal, marketing, and IT. Investment management decisions/key relationships should be internal. An active volunteer board can reduce outsourcing and staffing needs. Matching compensation levels of comparable industries increases talent attraction/retention Operations/Systems:2. Request data that MFIs collect to reduce administrative burden. Have a VP of Finance, a strong professional back-office, and adequate controls—

investment policies and procedures, portfolio monitoring. Funds seeking US institutional investors should be able to report to FAS 1573

Administration: 3. Use as much as possible from the mainstream fund industryLessons Learned: 4. MIV employee and investor incentives should be aligned. US$40m+ MIVs have sufficient scale for internal back-offices, which enhance quality and control

Entering New Markets:1. Country analysis/selection is top-down vs. selecting MFIs bottom-up. Determine which regulatory approvals are critical and obtain themCompeting with Investors:2. Collaborate with existing investors when possible. Conflict between commercial and social investors can arise and should be managed. Key MIV competitive advantages from the MFI perspective include management team expertise, due diligence process (including understanding MFI managers), local presence, and technical assistance Finalizing Valuation (Equity MIVs Only): 3. Using a number of valuation methodologies (discounted cash flow, comparable—country, sector—price/book value and price/earnings multiple comparisons, and net asset value methodology) and triangulating to hone in on a valuation

can be helpful MFI Investment Exits (Equity MIVs Only):4. Thinking about exiting in advance (vs. many MIVs exit opportunistically) is what distinguishes equity investing from debt investing and is key to successful equity investing. Trying to understand if an MFI can be part of a larger story in a merger or in consolidation is a more socially responsible way to exit than via put options. One MIV exits when it deems it has reached its developmental goal and it can add no further valueLessons Learned:5. Have a presence on the ground if possible to fully understand the MFI in its geographic context. More systematic valuation methodologies, including market-specific methodologies, should be developed. In some markets, MIVs need to value MFIs on a price/client basis

HR & Operations

Dealmaking

Market Risk Management:1. Market knowledge should be developed in-house. Currency diversification makes sense, as does having investors vs. borrowers take currency risk. One MIV provides seminars on corporate governance for MFIs deficient in this area. For transforming NGOs, governance is a key risk. MIVs should focus more on political risk and perhaps consider OPIC political risk insuranceCredit Risk Management: 2. Develop/use in-house risk-scoring/monitoring models. Having an on-the-ground presence in portfolio company countries is ideal. Visit portfolio companies at least annuallyOperational Risk Management:3. The more investment professionals with private equity and venture capital experience, particularly through different cycles/crises, the better. In-house vetting/monitoring capabilities are critical even when MIVs outsource due diligence. Country and MFI

investment limits are also criticalLegal Risk Management: 4. Set a policy to avoid loans to unstable (e.g., coups, wars) countries. Use local law/local counsel to be a socially responsible investor, rather than burdening an MFI to learn about the laws of other jurisdictionsLessons Learned:5. In risk assessment, qualitative factors typically prevail over quantitative. MFI performance is a stronger determinant of overall investment risk than country risk. Improve portfolio MFI valuations by improving their risk management systems. Transfer risk is too expensive to hedge; evaluate it and discuss with MFIs/investors/ intermediaries. Screen for socially responsible investors if limiting investor pressure to trade returns for social goals is important. Educate investors to ensure that they understand microfinance

MIV Risk Management

This survey is just an incremental step towards developing a best practices regime for MIVs. We believe that MIV managers can catalyze microfinance industry growth by sharing best practices and lessons learned. We are happy to share our survey results on an anonymous basis and will work in the future to both update and broaden this study. Please do not hesitate to reach out to us with comments or questions at [email protected] and [email protected]. n

Due to space constraints, we were not able to include all survey results. The complete article is available on www.microfinanceinsights.com and www.hjflaw.com 1. A listing of the names of the MIVs whose managers participated in the survey can be found at http://www.hjflaw.com/microfinance and in the online version of this 2. article at www.microfinanceinsights.comFor a primer of FAS 157 reporting, see http://blogs.wsj.com/marketbeat/2007/11/15/a-fas-157-primer/3.

research


perspective

Microfinance Insights (Insights): What is your outlook for investment and growth in microfinance over the next year?Michael Chu (Chu): Although we’re currently going through the eye of the storm, now is when you’ll see that management quality matters. The leading microfinance institutions are actually going to strengthen their market positions. In terms of opportunities to invest, I think there will be plenty in the sense that capital has gotten very scarce. However, I think it will be more important than ever to do your analysis right. The weak institutions will get weaker, and the strong will get stronger.

Insights: Does that mean there will be an industry shakeout?Chu: I don’t know if it will actually lead to a shakeout because microfinance is a world in which there’s a lot of donor money sloshing around. So institutions that would have died a long time ago if this were a pure market.

Insights: What would you like to see to facilitate growth for microfinance?Chu: I’d like to see more microfinance institutions in large markets that are really good operators and capable of providing tough competition, because that’s when the market really grows and prices drop and service increases.

Insights: Are you talking about big markets in China, Nigeria and India?Chu: Well, hopefully one day China will open up and allow a real market system to operate. I think India is changing by leaps and bounds; it’s headed that way. I hope the efforts in Nigeria, which has several MFIs that didn’t

exist seven years ago, will also develop into a vibrant market. And in places like Mexico, I hope that great competitors will emerge to challenge Banco Compartamos. I hope that you will also see this in Indonesia, with new alternatives disputing the leadership of Bank Rakyat.

Insights: But can’t increased competition lead to over-indebtedness on the part of poor people, as has happened in Bangladesh?Chu: That’s always a problem, but it may be a necessary step in the evolution of the market, as was the case in Bolivia. There, over-indebtedness came as competition increased because money began chasing after clients. Then, as the shakeout occurred, the market was left with fewer but very strong competitors, really contesting for market share. And that led to all kinds of positive developments for microfinance in Bolivia.

But you have to have industry evolution as the outcome for this process to be good. If you only have over-indebtedness and nothing else, then it’s incurring high social cost for no benefit. I don’t know enough about Bangladesh, but it’s always been surprising to

me why intense competition in Bangladesh leads to over-indebtedness, but not to a significant drop in price. I think it’s worth analyzing.

Insights: What positive or negative trends do you see in the industry today?Chu: Well, I certainly like the incorporation of microfinance into the financial sector. I think that brings a lot of clarity.

For example, there are now webinars where you can hear Banco Compartamos talking to financial analysts after the release of quarterly earnings. The dialogue is really interesting. Compartamos starts by making a statement about its mission and social impact, while the financial analysts ask all the types of questions that you would expect. Then, Compartamos answers each of these questions in detail, explaining what the bank is doing and what its objectives are.

That, I think, is a lot more important than theoretical discussions about whether the IPO will make Compartamos abandon the poor or fleece them to maximize profit. The financial analysts don’t discuss these matters at all. They’re not asking for increased prices or for Compartamos to move upscale. They’re trying to understand at what rate Compartamos is growing and whether that can continue as fast as before, how the portfolio quality is evolving, what the operating challenges are, all within the market segments currently being served. They’re not saying, “I don’t want you to serve the poor anymore.”

And that makes all the sense in the world. Why would you expect a financial analyst talking to McDonalds to egg them on to fine French cuisine? You expect the analyst to ask

Into the MainstreamHow Commercial Investing Brings Clarity to the SectorMichael Chu is Senior Lecturer of business administration at the Harvard Business School, and Managing Director of the IGNIA Fund, an investment firm based in Monterrey, Mexico, dedicated to investing in commercial enterprises serving low-income populations in Latin America. He is also a former President and CEO of ACCION International. He offered the keynote remarks at the Chicago Microfinance Conference held on May 8, 2009 at the University of Chicago’s Booth School of Business. Microfinance Insights’ correspondents Paul Welvang and Peter Rich took the opportunity to interview Mr. Chu and ask about his outlook on microfinance, the global credit crisis, and regulation.

“The potential of a disaster like the sub-prime mortgage meltdown in microfinance is certainly there. Now there are some things that are barriers against that. But to the extent that the industry forgets these things, then there’s nothing to hold back the possibility of a mess like that.”

Michael Chu


perspective

them how many hamburgers they’re selling, not why they are not offering foie gras. In microfinance circles we’re worrying about Compartamos ending up in fine French cuisine! That’s not what capital markets are pushing for.

Insights: Do you envision more IPOs similar to that of Compartamos?Chu: Yes, when the market comes back, whenever that is. There are institutions poised for IPOs. I think that’s good because it’s establishing that serving the financial needs of the poor is just as legitimate any other successful business, and I think that only goes to benefit the poor.

In general, having microfinance institutions able to do an IPO, and therefore tap into the capabilities of the capital markets is great. Access to the stock markets provides microfinance institutions, just like any other company, enormous power to grow.

For example, when Compartamos did its IPO, its price-earnings ratio was double that of the average company on the Mexican stock exchange. That meant that it could access capital much more cheaply than most Mexican companies, making it possible for it to think of extraordinary things that would have been unimaginable for a microfinance institution.

Insights: If Compartamos has such cheap access to funds, yet charges high rates of interest, isn’t that taking advantage of the poor?Chu: No, because the theory of change always was that the fastest way to get people served was to create an industry, and the only know way I know to do that is by generating above average returns.

Ultimately, Compartamos is a very irrational player from a traditional business point of view, because it actually helps people that are setting up to compete against it. There’s a group called enConfianza, which is a brand new, really serious competitor. And whatever they want to know, Compartamos actually tells them. Board members of Compartamos have been guests at board meetings of enConfianza, where they have answered any question posed to them, to the surprise of the enConfianza board directors.

In fact, you could argue that the smart strategy for Compartamos is to actually set a much lower pricing, because Compartamos for sure could survive at 20% return on equity, but at those price levels it would make it extraordinarily difficult for others to come in. But the model always was that we’re going to make it easy for people to come, in order to create an industry. If you go to the Compartamos website, there’s a ‘letter to our peers’ that the two Charlies wrote as a response to all the criticisms after their IPO, where they set out in great detail the thinking behind the model. (Read excerpts from “A Letter to our Peers” in the July 2008 issue of Microfinance Insights.)

Insights: In your remarks [at the conference] you commented that the global credit crisis exposed the fact that many financial activities are so sophisticated they are over the head of regulators. What will prevent a similar crisis in microfinance?Chu: First of all, I think the potential of a disaster like the subprime mortgage meltdown in microfinance is certainly there. Now, there are some things that are barriers against that. But to the extent that the industry forgets these things, then there’s nothing to hold back the possibility of a mess like the one we are witnessing in traditional global banking.

Having said that, if you look at the subprime mortgage meltdown, the way the industry used to work, based on 30-year fixed rate mortgages, was itself a huge financial innovation. What we now think of as the traditional mortgage market was something that came in the 1950s and revolutionized home ownership.

Then a few years ago, people came and innovated again. They broke every rule in the old system. The result was a system that was like an accelerating train fed on steroids, getting faster and faster. But within

every wagon on the train, everyone was acting absolutely rationally. For example, the mortgage originator was saying, “I’m a salesman; I’m getting compensated if I sign you up. So why shouldn’t I sign you up? Now the new rules of the market say you that you don’t need to put down 20% of the value; in fact, I can get you a mortgage with no down payment, because there’s a deep pocket willing to fund that. So why shouldn’t I sign you up?”

So each wagon of the train made sense, as the train rushed to go over the cliff. Now, you ask if there are some things in microfinance that hold us back from such a disaster. Yes, but they are all things that can be dismantled by people who forget the basics of microfinance.

For example, microfinance loans are usually very short-term, say, with maturities of 6 months. But in reality, since the implicit business agreement is that clients who repay always get their loans renewed, and if they are growing, they also get an increase in their loan size, what MFIs actually do is extend not a short term loan but a multi-year line of credit. But unlike a consumer credit card, that credit line has to be fully repaid every six months. This is a built-in guarantee against over-indebtedness. An MFI’s analysis can be good or bad, but if the loan is repaid every six months, you know it’s a good loan.

This is what the credit card industry forgot when it went to minimum monthly payments, sometimes less than even the monthly interest charge, let alone repayment of principal. When this was first implemented, it was seen as a fantastic innovation that brought in new customers and increased credit balances. Now, some MFIs are beginning to discover this innovation. They are beginning to say, “Why are we forcing our clients to repay? It is so costly to process all that paperwork when all we are doing is just renewing their loan. Besides, we know these people well.”

So, there are built-in defense mechanisms in microfinance today. But they are only as good as people’s understanding of the fundamentals of why microfinance works. There’s nothing sacrosanct about microfinance or the poor. MFIs can come up with ideas that sound great and end up trashing the industry. The poor can get over-indebted just like yuppies do. n

“There are institutions poised for IPOs. I think that’s good because it’s establishing that serving the financial needs of the poor is just as legitimate as any other successful business, and I think that only goes to benefit the poor.”


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The Need for More Sophisticated PlanningFinancial institutions in the developed world have relied on highly sophisticated systems and models to capture the risk of liability and debt mismanagement. While the current state of the world economy brings to question some of these techniques, the ability to bring transparency to the liabilities on a balance sheet is important for any investor. Consider for example, the initiative by the United States Treasury and Federal Reserve to “stress test” the largest banks in the US. The logic behind this type of exercise is, of course, to determine what amount of capital would be needed in the worst kind of economic conditions, and how these institutions would fare under a variety of different scenarios. By broadening the assumptions of what can happen and the needs under each set of circumstances, an institution can more confidently plan its capital and funding strategy.

Microfinance institutions (MFIs), by and large, do not have access to sophisticated risk management tools. Beyond this, MFIs generally do not engage in scenario analysis or other techniques to more effectively manage liabilities against conditions of volatile currency and interest rate markets. In the July 2008 edition of Microfinance Insights (“Foreign Exchange Risk: The Onus of Hard Currency Debt”), Matthijs Egelie and Nico Mensink, stated that “with improved access of MFIs to international capital markets in

recent years, FX risk from funding local currency assets with US dollar-denominated debt has increased significantly.”1 This trend, in the context of the currently volatile foreign exchange (FX) and interest rate markets, has further created the need for better liability risk management. However, MFIs often do not understand the risks they take on with their unhedged FX exposure, and the impact their funding decisions can have on their credit profile. While this problem is prevalent, MFIs do not currently have proper access to tools and education that would instill liability planning best practices into their operating infrastructure.

Investors and MFIs Working TogetherFrom an investor’s perspective, an MFI’s ability to plan its liabilities is paramount in the selection criteria used to evaluate potential investments. Therefore, it is important that

the investor pay attention to the strategy or (lack thereof) behind the MFI’s funding composition. MFIs increasingly have options for both local and hard currency loans; however, there should be some logic or plan to why it chooses certain loans. As is often the case, the MFI will merely be attracted to the loan that offers the lowest interest rates, without considering other factors that would increase the cost of borrowing under adverse conditions. For the benefit of the industry as a whole, investors and MFIs should work more seamlessly to ensure that the right criteria are used to evaluate funding decisions. Investors should not lend to MFIs that don’t have a coherent planning mechanism in place – but they should take the time to work with MFIs and encourage them to think more about these issues.

Effect of Lack of Planning: An Indonesian ExampleAn example of how shortsighted liability planning leads to a host of problems for an Indonesian MFI can demonstrate the point. This particular MFI was perceived to be a sound, well managed institution by international investors. A snap shot of their balance sheet in July 2008 indicates a Debt to Equity ratio of 2. What the ratio doesn’t capture, however, is the composition of the debt – which is significantly comprised of hard currency debt (35.8%, as shown in Figure 1). It is likely that the MFI’s liabilities reflect a propensity to take loans in dollar denominated debt, as these were offering attractive borrowing rates.

Between July and December 2008, the Indonesian Rupiah (IDR) depreciated by approximately 23%. And the impact that this event had on the balance sheet is seen in Figure 2.

Dollar debt made a 22.3% leap (to 43.79%

Liability Planning:How can Investors and MFIs Navigate Funding Options and Devise Strategy?The growth in commercial microfinance investment has lead to MFIs being able to choose from several funding options. However, what MFIs lack are the tools for evaluating their choices in ways that capture all the implications of a particular funding decision. Investors on the other hand need to be able to make sound investing decisions based on the knowledge of a particular MFI’s liability planning. In this article Sonia Mukhi explains how investors and MFIs can work together to fill in gap.

“From an investor’s perspective, an MFI’s ability to plan its liabilities is paramount in the selection criteria used to evaluate potential investments. Therefore, it is important that the investor pay attention to the strategy or (lack thereof) behind the MFI’s funding composition.”

Figure 1: Balance Sheet of an Indonesian MFI: July 31, 2008(Exchange rate: US$1= IDR9,090)

Assets LiabilitiesLoans 8,942 $Debt 3,200 35.8%

LC Funding 4,160 48.5%Equity 1,582 17.7%

8,942


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1. Matthijs Egelie & Nico Mensink. “Foreign Exchange Risk: The Onus of Hard Currency Debt.” Microfinance Insights, Vol. 7, July 2008. 2. London Inter Bank Offer Rate – It is the interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers’ Association. It is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year. (Definition: Investopedia – www.investopedia.com)

“As microfinance continues to transform and further integrate with world capital markets, it becomes more and more important that MFIs have access to tools and education that allow them to properly evaluate the new types of risks that will arise.”

Sonia Mukhi is an Associate at MFX Solutions, a provider of currency risk management solutions to the microfinance industry.

of the total liabilities). Meanwhile, equity depleted by 45.3%, as a larger portion of the MFI’s equity went into servicing the ballooned hard currency debt. The new debt to equity ratio is now a staggering 4.5. While this MFI may have performed well on a variety of other metrics, the failure to properly strategically plan its funding and prepare for adverse economic scenarios, was enough to dramatically alter its credit profile. It is important to note that, while this example highlights the impact of FX risk or a currency mismatch – it is not the only external risk that the MFI should concern itself with. Other economic factors such as inflation and domestic interest rates will tend to mirror currency volatility and cause additional stress to the MFI. Therefore, the ability to analyze an MFI’s liabilities in the context of a broader economic environment is vital to effective planning.

Promoting Risk Management EducationThe call for better liability planning is one aspect of an overall need to introduce better risk management practices in microfinance. Many MFIs are not regulated institutions, and are therefore not held legally accountable for maintaining certain standards and capital adequacy ratios. However, as MFIs integrate into international capital markets and transform into regulated institutions, it is imperative that they implement more rigorous risk management procedures. Fortunately, the issue has received reasonable attention from practitioners,

and efforts have been made to create education tools and promote awareness.

How, for example, would an MFI general manager looking at a 3-year dollar floating rate loan at LIBOR2 +3% vs. a 2-year fixed local currency loan at 12%? It might be the case that the a lower rate hard currency loan might be better for profitability but at the same time require that additional capital be set aside for regulatory capital adequacy. Or a decision that might make sense in the near-term might change the institution’s credit rating by adding currency risk, raising its cost of funds in the future. While there is no “right answer,” these are the types of questions that an MFI CFO must answer in order to survive in a regulated world.

A tool to facilitate MFI managers to begin considering these issues is being rolled out by MFX Solutions, a provider of foreign exchange hedging products to microfinance funds and institutions. MFX is in the midst of developing an online-based tool to help MFI treasury managers move past the hurdles demonstrated in

the Indonesian MFI case. The Liability Planning Tool (LPT) helps MFI managers compare various loan offerings in different currencies and terms evaluate a variety of complex factors – potential currency and interest rate volatility, how each option would offset or augment the risk of the MFI’s existing liabilities, how it would match existing or expected assets. All these factors will impact a variety of different performance and regulatory measures in different ways. The tool would allow the decision-maker to clarify all of these factors, and come up with a clear picture of the financial trade-offs involved with a particular choice.

Concluding Remarks As microfinance continues to transform and further integrate with world capital markets, it becomes more and more important that MFIs have access to tools and education that allow them to properly evaluate the new types of risks that will arise. An investor should not only make decisions based on how an MFI plans its funding, but also help MFIs to understand the necessity of liability planning and think about the loans they receive in context of the broader economic environment. An easy and practical way to do this is to stress test the balance sheet and the funding an MFI receives against different economic scenarios. This allows the MFI to better understand the consequences of its decisions – and therefore pave the way for better planning and risk management practices. n

Figure 2: Balance Sheet of an Indonesian MFI: December 31, 2008 (Exchange Rate: US$=IDR11,123)

Assets LiabilitiesLoans 7,308 $Debt 3,200 43.79%

LC Funding 3,400 46.52%Equity 708 9.69%

7,308Source: MFX Solutions


The Future of Microfinance Investing: Microinsurance & Portfolio Risk ManagementThe modern microfinance movement has thus far been dominated by its flagship product: microcredit. At the same time, the industry is witnessing a marked trend toward commercialization and increased attention from investors. Consequently, the demonstration of general commercial acumen by MFIs and the enforcement of key corporate governance functions such as risk management by investors will become more important to the success of microfinance investments. In fact the Council of Microfinance Equity Funds has already acknowledged in its 2005 policy paper, The Practice of Corporate Governance in Shareholder—Owned Microfinance Institutions, that “good governance for financial institutions…is built around risk management.” This maxim has been underscored with astonishing clarity by the ongoing global economic crisis.

Risk management then will clearly be at the core of near-future microfinance industry developments, and an integral aspect of this new doctrine will revolve around revenue-stream diversification. While the market for microcredit is hardly saturated, other financial products – particularly insurance – have a great deal of utility for the poor, are in high demand (if presented and designed appropriately) and can be used by MFIs to improve their overall product offering, increase clients’ ability to cope with and recover from loss events, and supplement their other existing business segments with uncorrelated returns and related protections.

As an example LeapFrog Investments, the world’s first private equity firm focused exclusively on microinsurance, has been endorsed by the Clinton Global Initiative and

Maximizing Microinsurance Investment Returns:A Closer Look at Microreinsurance and Private EquityThe market potential for microinsurance is extensive and microfinance private equity investors have begun to take note. However, in order for the microinsurance market to reach its full potential, investors and microfinance institu-tions (MFIs) must access effective and efficient microreinsurance and other secondary risk transfer solutions. Micro-reinsurance can provide MFIs and their investors with the necessary resources to effectively stabilize and leverage existing capital supplies. Alex Bernhardt explains the merits of looking beyond plain vanilla microcredit invest-ments, and exploring the micro(re)insurance market during the next phase of microfinance investing.

Like a flying buttress, microreinsurance helps to transfer risk to an external party, providing MFIs with surplus relief, and enabling them to leverage existing capital supplies.Photo: Ewen Roberts

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is currently raising its first US$100m fund.

Microreinsurance for MFIsDespite this added attention, many barriers to microinsurance market entry, sustainability, innovation and growth will need to be addressed by investors and MFIs alike, before truly meaningful and commercially viable micro risk management products and services can be made available to the poor. Key among these barriers is the current lack of an enabling secondary risk transfer marketplace. While microreinsurance is still very much a developing field, related products will serve as an irreplaceable outlet for accumulated risk and a source of alternative capital inflows as the microinsurance market continues its rapid and far-reaching development.

While some microfinance risk has been transferred to reinsurers and investors in the past, an enabling commercial secondary risk transfer marketplace – whereby risk can be transferred to third parties regularly without subsidization or incurring disproportionate charges – does not exist for MFIs today. This is especially true in the wake of the current financial fallout where the budding market for microfinance product securitizations has been effectively frozen for the time being.

This lack of access is largely due to inefficient supply. Because of the relatively small size of the microinsurance marketplace and its dispersion throughout emerging economies, reinsurers are usually unable to access sufficient business to warrant the production and underwriting expense associated with writing individual microinsurance accounts. However, firms like Guy Carpenter, a reinsurance intermediary, are working actively to address this issue through the creation of a global multiline microreinsurance facility, which aims to aggregate microfinance risks worldwide and to structure effective risk transfer solutions that are affordable for microinsurers and reasonably profitable for reinsurers.

The current lack of access aside, microreinsurance and other forms of secondary risk transfer – though not a panacea for all the problems associated with microinsurance design and delivery – can have an overwhelmingly positive effect on the microinsurance industry. Reinsurance provides reinsureds with five fundamental

financial and operational benefits: capacity creation, surplus relief, results stabilization, catastrophe protection and access to networks, resources and expertise. Microreinsurance can be utilized by MFIs or MFI stakeholders to surmount or ameliorate many of the crucial barriers to microinsurance market massification today, since many microinsurers require some form of secondary risk transfer to buttress healthy long-term operations.

Barriers to EntryPrimarily for MFIs, microreinsurance and associated services can be indispensable toward the creation of new microinsurance schemes. In fact, microreinsurance can be used to foster the establishment of multiple program types, including the Partner-Agent model, the Full Service Model, and the Hybrid Model (see Figure 1).

The availability of microreinsurance protections can entice global and regional commercial insurers to enter this new marketplace or entertain partnerships with specific MFIs by diminishing the volatility and uncertainty associated with new market entry and by increasing the risk capital available for deployment. Microreinsurance can provide MFIs interested in establishing their own full-scale insurance operations with the same assurances. Furthermore, on a case-by-case basis, microreinsurance can facilitate the structure and implementation of risk-sharing programs through access to alternative risk transfer mechanisms, such as captives or captive cells. These can enable MFIs to expand their revenue profiles to include both commission income and potential underwriting income.

Barriers to SustainabilityMicroreinsurance is perhaps most useful as a guard against covariant (catastrophic) losses and related insolvency. Many microinsurers,

especially those operating on a small, regional scale, are particularly exposed to such events due to their relatively small size, capital supply and scope. Additionally, the poor in developing countries are often marginalized, forcing them to live riskier lifestyles and increasing their exposure (and that of their financial services providers) to covariant losses. This underscores the importance of integrating enterprise risk management into corporate governance procedures and undertaking risk transfer where necessary to guard against worst-case scenarios.

As protections against unforeseeable future portfolio loss events, microreinsurance agreements act as contingent capital arrangements and provide MFIs with a supply of crucial liquidity when under duress. Thus, instead of suffering insolvency or – as a stopgap to avoid such a fate – withholding claim payments, curtailing policy issuance or halting lending activity after a loss event, MFIs can continue operations when they and their low-income clients are likely most in need.

Barriers to Innovation & GrowthThe variety and usefulness of microinsurance products on the market today is limited. Few programs exist that provide the poor with full spectrum protection against loss. For example, natural or manmade disasters are rarely covered by microinsurance policies. Effectively applied, microreinsurance could spark the innovation necessary to make disaster products available to the poor en masse by supplying the risk capital required to support the primary assumption of such rare and severe risks.

Microreinsurance arrangements allow microinsurers to engage in constructive dialogues with commercial (re)insurance company partners about product development. And, microreinsurers can help MFIs implement and offer innovative commercial

Figure 1: Microinsurance Program Models

Hybrid Model

Microinsureds

MFI as Agent MFI Owned Captive

Microreinsurer

Full Service Model

Microinsureds

MFI as Microinsurer

Microreinsurer

Partner Agent Model

Microinsureds

MFI as Agent

Microinsurer

Microreinsurer Arrows represent flow of permiums

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market solutions in a micro market context such as index- or parametric-based products. This can reduce costs by streamlining product distribution and facilitating claims administration practices. Microreinsurance analytics also can be used to approach product design strategically to avoid undue risk assumption and prevent under- or over-pricing.

Beyond stimulating product improvements, microreinsurance can be used by microinsurers to support regional expansion and product line growth in current geographies, through the performance of pro forma analytics and the structure of forward-looking risk transfer arrangements. As a form of “rental” capital, microreinsurance can provide MFIs with surplus relief, enabling them to leverage existing capital supplies. This can result in increased market penetration and more rapid, sustained program growth. In general, microreinsurance can serve as an attractive alternative form of capital especially in the current economic environment where more traditional forms of debt and equity financing are constrained.

Microreinsurance for Private Equity InvestorsMicroreinsurance is a boon for existing and potential new microinsurers, though its associated benefits are equally important for microinsurance private equity investors with a vested interest in the success of microinsurance enterprises. Perhaps the most obvious benefit of successful portfolio-level microreinsurance and risk management for active private equity investors is enhanced investment performance in the form of more stable risk-adjusted returns. By enforcing best practices amongst portfolio MFIs, investors better secure the sustainable success of their portfolio companies (and their own). Microreinsurance and secondary risk transfer capacity can also be used by private equity investors to accelerate portfolio growth by leveraging invested funds so as to maximize their impact.

Furthermore, microfinance private equity investors are in a unique strategic position to gain from the enforcement of preferred procedures. Not only do they wield significant influence at the senior management level amongst investees, as aggregators of information and capital they are also able to affect markets, vendors and service providers. In so doing, benefits manifest in the form of efficiency and economies of scale associated with portfolio microreinsurance market representation. The resultant aggregation allows private equity investors to leverage the power of group purchasing for their portfolio MFIs and can realize several positive results, including:

Reduced cost of risk transfer;•Reduced third-party vendor costs;•Decreased loss cost uncertainty resulting •in lower associated capital allocations and premium payments;Increased bargaining power resulting in •improved coverage terms and available services.In addition, by contracting with

microreinsurers and MRSPs, private equity investors can gain access to a host of complimentary resources, including:

Risk tracking and mapping technology;•Catastrophe and actuarial modeling •capabilities;Enterprise risk management and advisory •services;In-depth product knowledge;•

Global industry networks of distribution •and risk transfer partners.

ConclusionAs the microfinance industry continues its trend toward commercialization, MFIs must continually improve their understanding and management of risk so as to remain an attractive source for funds. As competition for investor attention intensifies, it will be increasingly important for MFIs in need of growth capital to focus on key elements of effective corporate governance, such as risk management, to provide would-be investors with added assurances of corporate continuity in the face of covariant losses or other adverse underwriting experience. Secondary risk transfer tools such as microreinsurance are at the core of effective risk management strategies for MFIs, not only because of their indispensible financial benefits, but also because they provide MFIs with access to a number of otherwise inaccessible tangible and intangible benefits such as human, relationship and intellectual capital and analytical expertise.

To increase the number of investable MFIs and improve the success of equity investments, microfinance private equity firms must enforce effective risk management strategies at all levels of the investment supply chain. In this way, investors, in conjunction with their portfolio MFIs, will help stabilize underwriting results and increase returns by fostering rapid and sustainable program growth. By working with potential or current MFI investment targets to manage their risks through microreinsurance and related services, private equity firms can multiply the positive effects of their investment dollars by unlocking performance and expense efficiencies through scale and providing effective backstops against negative experience – ultimately improving total returns. n

“More and more private equity sponsors are increasing stakeholder value by improving the operating efficiencies of their portfolios...effective insurance risk management (IRM) at portfolio companies is one of the ways for private equity sponsors and management to drive value…Private equity sponsors who have a common portfolio insurance risk management program have much to gain…Often, sustainable cost savings can be achieved by making simple improvements to the risk management and safety practices at portfolio companies. By leveraging the purchasing power and aligning IRM strategies of portfolio companies, private equity sponsors can decrease insurance premiums and vendor costs while improving services and coverage terms. Typically, implementing a leveraged purchasing arrangement decreases premiums, vendor fees and loss costs by 5 to 20% a significant cash saving.” PricewaterhouseCoopers; TS Insights; Volume 5 No. 3; November, 2008.

Alex Bernhardt is an Assistant Vice President in Guy Carpenter & Company, LLC’s Seattle office. Alex spearheaded Guy Carpenter’s recent grant-writing initiative, which culminated in the firm’s receipt of support from the Microinsurance Innovation Facility to pursue the creation of a multiline global microreinsurance facility. For more information regarding this article, please contact Alex by email ([email protected]) or phone (1-206-621-2924).

risk / reward


Before we started this survey, we were certain about two things: microfinance limited partners (LPs) are an elusive bunch, and there is a distinct communication gap between LPs and General Partners (GPs). Our survey undertook to learn about the differences in GP and LP investment expectations regarding risk and return, and also to gauge the effect of the economic crisis on these two parties.

Survey SampleOur sample consisted of 27 general partners and 19 limited partners. There were 30 microfinance investment vehicles (MIVs) in our sample, or 50% of the total international pool of 60 MIVs that make equity investments.1 Most (55%) of the respondents are MIVs with a consolidated fund size below US$100m. As expected, many of the LPs are fairly green to microfinance investing. Sixty percent have entered the microfinance market within the last four years, and half of LP respondents have invested less than 25% of their private equity portfolio in microfinance.

Divergence in Return PerceptionsThe first major discrepancy in terms of perception arose in relation to return expectations. Forty-two percent of LPs had decreased their return perceptions, significantly higher than the reported rate of decrease by GPs, which was only 12%. The primary reason LPs cited for decreased return expectations was a commensurate expected decline in valuations. While LPs believe declining valuations reduce the value of existing portfolios, they also create attractive investment opportunities.

As LPs predicted, valuations in microfinance investment have been declining, though to a very limited degree. GPs tend to disagree, with 38% finding that there was no change in valuation. Of those that responded that there was a change in valuation, half found that valuations had decreased by less than 20%, and 30% found that they had dropped between 20 and 40%. Although the drop between 20 and 40% is of concern, we have found that valuations in microfinance have not declined to the extent that they have in more established sectors. We conjecture that this reported decline is in line with the financial market and part of an organic downward correction, and less a statement about the sector itself.

Risk PerceptionsWhen asked about risk perceptions, GPs and LPs agreed on one thing:

management quality/capability is the top concern. It is a perspective reported in several other surveys, including the Banana Skins 2008 report in which investors cited Management Quality as the top risk.

GPs and LPs diverge when it comes to secondary and tertiary risks. GPs cited exits, or lack thereof, as their second top risk, and valuation/portfolio quality as their next biggest concern. On the other hand, LPs were more concerned about inadequate internal systems to handle high growth, and currency risk as it relates to the volatility of the economic environment.

Interestingly, 59% of LPs reported an increased perception of risk over the last 12 months citing several reasons for this change: global financial crisis and the resulting slowdown of the sector’s growth; increasing portfolio at risk (PAR); overall market volatility; inefficient use of capital while waiting for tranches to close; and a delay in their ability to recoup investment.

To counterbalance these risks, LPs expressed a desire for more control over investee MFIs. They specifically mentioned the need to require certain performance benchmarks, terms or other covenants (89%), to make field visits with the MIVs to see onsite MIV due diligence (78%), and to conduct their own on-site due diligence (78%).

GPs echoed the need for stricter evaluation and due diligence, and also mentioned a need to seek out less aggressive business plans. Perhaps the days of 200% growth have stalled.

Global Financial Crisis and Microfinance InvestmentWhen it comes to evaluating the effects of the global financial crisis on microfinance investment, 45% of GPs and LPs agree that there are variations in impact depending upon region. An equal number of total respondents (45% of GPs and LPs) stated that the impact on microfinance is far less than on other asset classes—a perspective that bodes well for future microfinance investment flows.

GPs have not felt drastically negative consequences of the financial turmoil. Private equity investment in microfinance has been rather stable during the last 12 months. In fact, attractiveness of the sector has not decreased significantly for the majority. Forty-four percent of GPs reported an increase in the equity deal flow in the past 12 months. Fifty-eight percent reported that they raised the targeted amount of funds in the last 12 months.

Paradoxically, while the LPs reported increased risk perception (see Risk section above), the GPs’ perception is corroborated by the LPs who, despite the global financial crisis, have in large part kept their

Taking the Pulse of an Emerging Investment

IAMFI-Intellecap Microfinance Private Equity Investment Survey In the following survey summary, we take a reading of the tea leaves and share the survey findings. For a visual representation of the survey findings, please see pages 50-51 in this issue.

In May 2009, the International Association of Microfinance Investors (IAMFI) and Intellecap joined forces to assess investor views on microfinance private equity investment. Our goals were to understand the risk and return perceptions of microfinance investors, gauge the impact of the global economic crisis on microfinance investing, and evaluate investors’ expectations for the investment class. In this collaboration, IAMFI and Intellecap conducted an online survey in early May, presented the findings at a forum held on 21st May in New York, and created the venue for equity investors to share perspectives and to network among peers.

events


allocation to microfinance the same (61%) or increased it (31%).

Outlook GPs predict that we will see a consolidation of MFIs and/or a reduction in MFI and/or MIV growth rates in the near future. See article by Vineet

Rai on page 24 about M&A. LPs, when looking at their future allocation of funds to MIVs, have

projected increased growth for equity focused MIVs, direct equity investments, and debt-focused funds but have projected a decrease in direct debt (80% of respondents).

During facilitated breakout sessions that followed the survey presentation, attendees discussed 1) the gap in LPs’ and GPs’ perceptions of microfinance private equity risk and return, 2) the role of development financial institutions in private equity investment, and 3) the discrepancy between LPs’ stated allocation to microfinance and many MIVs’ fundraising shortfalls. The take-aways from those sessions are highlighted below.

There is a Gap in Knowledge and Communications Between GPs and LPs. This likely accounts for divergent perceptions of risk and return in our survey. Many LP investors in microfinance make a small allocation of their portfolio to microfinance, and cannot justify conducting lengthy due diligence and monitoring. The sense that they don’t have direct knowledge regarding their microfinance investments may make LPs perceive greater risk. GPs would do well to increase feedback to their LP investors on the microfinance sector and their fund’s performance. Those LPs seeking more information should make periodic field visits with their GPs and conduct independent due diligence as required.

Despite “Crowding Out” Concerns, DFIs Play an Important Role. DFIs were early investors in microfinance equity, creating opportunities for the private sector to enter the market. DFIs regularly facilitate the exit of private investors, and the DFIs’ continued commitment to the microfinance sector in this turbulent time brings stability and comfort. However, anecdotal comments by private investors indicate that in some instances DFIs continue to offer capital at below-market pricing, effectively “crowding out” private investment. The consensus view is that 1) DFIs should only make investments that private investors are unwilling or unable to make, e.g. in lower-tier or greenfield MFIs, 2) DFIs should focus on catalytic investments that entice private investment, especially in the current economic downturn, and 3) DFIs should exit investments once they have achieved the demonstration effect and private investors are ready to supply substitute funds.

The Nascent Nature of Microfinance Private Equity Reveals Infrastructure Needs in the Sector. LPs observe that few MIV managers possess a private equity background in emerging markets and

microfinance investing experience. The small deal size is a constraint for large institutional investors; one group discussed the potential role for brokers to bundle transactions and provide related due diligence. A participant advocated for the establishment of a global microfinance stock exchange to promote a secondary market.

There is Concern that a Backlash Against Commercialization will make Microfinance “The Stillborn Asset Class.” The case for commercialization must be made in a collegial way: clear and compelling in order to generate market demand, while acknowledging the significant role that philanthropic actors and non-profit leaders have played in the sector’s development. Energetic debate continues about whether a for-profit business can truly maintain a “double bottom line.” Lack of consensus on social performance metrics persists among donors, “Social First,” and “Financial First” investors.

Valuation of Microfinance Equity is Problematic. It is difficult to value MFIs in the absence of a secondary market or other avenues for equity investment exits. Valuations are highly specific to each MFI and to local macroeconomic, legal and regulatory conditions. The relative value of microfinance private equity as compared with general emerging markets private equity is unclear.

Current Investment Trends are Mixed. Participants were encouraged that 58% of MIVs met recent funding targets despite liquidity challenges and market turmoil. In general, however, attendees believe that investor risk appetite is down. LPs feel that equity multiples are not dropping as quickly or as low as they expect. Some GPs have observed an LP paralysis, as LPs are in no rush to invest in a market they believe will drop further. One investor noted that GPs must better articulate to LPs the value proposition of microfinance. While some countries struggle, equity investment activity in others such as India is strong. n

IAMFI-Intellecap Microfinance Private Equity Investment ForumOver 40 LP investors, GP investors and industry service providers such as wealth advisors, law firms and rating agencies attended the Forum. Some were experienced microfinance investors while others were beginning their evaluation of the sector. J.P.Morgan, an IAMFI Charter Member, hosted the event in Manhattan. The meeting offered participants the opportunity to hear the summarized survey feedback from LP and GP investors in microfinance equity, presented by Anurag Agrawal, Senior Vice President, Investment Banking, Intellecap, and to network among peers.

events

Lindsay Clinton, Managing Editor, Microfinance Insights, Joan Trant, Executive Director, IAMFI, Julie Abrams of Microfinance Analytics, and Jordan Filko of IAMFI contributed to this article.

1. Research conducted by IAMFI.


resources

Recommended Reading

Articles

The Role of Private Sector Investment in International Microfinance and the Implications of Domestic Regulatory EnvironmentsWilliam Langer, 2008 While private sector investor participation in microfinance is a positive move, MFIs worldwide will need to demonstrate the ability to achieve sustained outreach and profitability. This article, divided into two main sections, analyzes the impact of domestic legal and regulatory regimes that impact an MFI’s capability to achieve the profitability and scale required to make it an attractive private investment option. It examines the relationship between the microfinance industry and private sector investment in the first part and then moves towards analyzing the legal and regulatory challenges that constrain the reach of microfinance.

Debt and Equity FinancingMicroenterprise Development Office, USAID, 2009 Experience points to the fact that apart from deposits, even some high-performing MFIs have had difficulties raising private capital. This is in contrast with the widely accepted knowledge that MFIs will be able to facilitate expansion through savings, commercial debt, and equity investments. This contradiction forms the basis of this paper which examines two fundamental research issues: market conditions that hinder MFI access to and use of private capital, and which investment vehicles and industry interventions are critical to supporting access to capital.

Microfinance and Capital Markets: The Initial Listing/Public Offering of Four Leading InstitutionsIra W. Lieberman et al, 2008Some of the world’s leading MFIs have entered into new capital markets through Initial Public Offerings (IPOs). This paper discusses the history and IPOs of four leading MFIs that have carried out such transactions: Bank Rakyat Indonesia (BRI), BRAC in Bangladesh, Banco Compartamos in Mexico and Equity Bank in Kenya. The IPOs and listings have allowed the four institutions to tap into the mainstream investor community. The four institutions share similar characteristics like excellent management, governance, systems and technology, methodology and product lines that enable these institutions to achieve remarkable outreach to the lower-income segment and stay highly profitable.

The Microfinance Collateralized Debt Obligation: A Modern Robin Hood?Hans Bystrom, 2008The aim of this paper is to highlight the link between micro-entrepreneurs and international capital markets. The paper argues that commercialization of microcredit is probably the only way to reach the billions of people in the world who need financial support but have no access to it. The author underlines the steps that need to be taken to ensure commercialization, and the roadblocks that may be encountered in the process. The paper also looks at the

role securitization and microfinance collateralized debt obligations (MiCDOs) can play to provide funds to small, but profitable enterprises. The author also uses a hypothetical, but realistic, example to discuss the implications of real microfinance CDO deals.

Websites

http://www.microcapital.org/cgap-microfinance-dealbook/The CGAP microfinance dealbook, a compilation of microfinance capital market transactions, is the result of a collaboration between the Consultative Group to Assist the Poor (CGAP) and MicroCapital. This list of microfinance deals is available on the MicroCapital website and in the MicroCapital Monitor every month. A detailed list of debt and equity transactions have been compiled from far and wide, starting in March 2009.

Books

Bridging the Equity Gap for Innovative SMEsEdited by: Elisabetta Gualandri and Valeria Venturelli Published by: Palgrave Macmillan, November 2008 (Hardcover)ISBN: 9781403948724Pages: 192 pagesBridging the Equity Gap for Innovative SMEs examines if Europe’s growth problems are caused by weaknesses in capital markets and access to risk capital. It evaluates the financial needs and constraints of start-up firms and suggests how these can be bridged. The third chapter “Equity Gap and Innovative SMEs” by Elisabetta Gualandri examines whether there is a financing and equity gap for ISMEs and elaborates on what factors cause it, particularly to ISMEs in the start up and early growth stages. It also explains ways to measure these gaps: the “macro” quantitative approach and the “micro” qualitative approach.

Financing Micro, Small, and Medium Enterprises: An Independent Evaluation of IFC’s Experience with Financial Intermediaries in Frontier CountriesBy: Denis T. Carpio, Independent Evaluation Group, International Finance Corporation, World BankPublished by: World Bank Publications, 2008ISBN: 0821374176, 9780821374177Pages: 85 This book talks about the strategies, investment projects, and technical assistance operations of IFC from 1994 to 2005 to support micro, small and medium size enterprises (MSMEs) in low income or high risk countries (also called the “frontier countries”). The second chapter “IFC support of MSMEs in frontier countries” by Patrick Goodman looks at the contribution of MSMEs to the private sector development and the risks they currently face in comparison to their larger counterparts. It later discusses the five main investment models IFC used to channel funds to MSMEs in a frontier country in 1996 and talks about the recent projects IFC is implementing.

Beginning with this issue, Microfinance Insights will not only provide a list of articles and reports, but also list blogs/websites and books with relevant chapters to bring readers multi-media resources.


resources

maRk youR calendaR

JulyJOHANNESBURG, South Africa Mobile Banking and Financial Services Africa*20th July – 22nd July, 2009Through a variety of workshops, case studies, and interactive discussion sessions, this event will examine how mobile operators, banks, microfinance institutions, payment specialists and solutions vendors are developing and launching enticing products and services for a variety of market environments and customer segments. Addressing pan-African concerns, the program will examine business models, technical infrastructure, security and regulatory issues associated with supporting mobile banking, mobile money transfers, and microfinance. Sponsor: IIR TelecomsWebsite: http://www.iir-events.com

NEW DELHI, IndiaMobile Money Transfer World Conference 200928th-30th July, 2009The growing remittances market is seeing increased activity from major mobile technology service providers. With microfinance offering huge potential to expand mobile payment markets, this conference will explore the dynamics of this space including what drives the market, the barriers to operation, issues of regulation and so on. Participants will benefit from the experience of South Asia - one of the world’s largest mobile telephony and microfinance markets.Sponsor: Neo-edgeWebsite: http://neo-edge.com/events

AugustANAND, IndiaFinance and Accounting for Microfinance Institutions24th – 27th August, 2009This conference is aimed at providing MFI officers with the tools and techniques behind sound accounting principles, costing concepts and methods, financial analysis and cash flow management, skills often required when working on the ground. The programme will be a series of lectures, classroom discussions and group exercises. The program is intended for officers and managers of MFIs, NGOs, donor agencies and government bodies involved in the microfi-nance field. Sponsor: Institute of Rural Management Anand Website: https://www.irma.ac.in/pdf/mdp_cal_pdf/41.pdf

SINGAPORE, Singapore Asia Network Summit 200925th – 28th August, 2009Microfinance networks play a key role in strengthening the industry. To increase the effectiveness of their role, the Asia Network Summit 2009 will bring together microfinance networks from across the

region to increase collaboration, sharing of information, knowledge and technical exchange. The four day event will follow a workshop approach and will be jointly hosted by the Banking with the Poor Network, the SEEP Network and ADA. Sponsor: BWTP, SEEP and ADA Website: http://www.bwtp.org

SeptemberSAN FRANCISCO, CA, USASocial Capital Markets 2009 1st – 3rd September, 2009The strong growth in the intersection between capital markets and socially-responsible business is just one of the reasons why anyone interested in this space should attend this year’s SOCAP event. At SOCAP 09 you will have the chance to meet hundreds of investors, donors and entrepreneurs. The focus of the three day conference will be on showcasing how people and organizations are moving forward, building partnerships, networks and communities in these interesting economic times.Sponsor: Social Capital Media Website: http://www.socialcapitalmarkets.net

WASHINGTON, D.C, USAMicrofinance for Institutional Investors* 21st – 23rd September, 2009The fast growth that the microfinance sector has been witness to has lead to new growth opportunities for a new set of investors including pension funds, family funds and private wealth managers. This three day event offers such investors in-depth analysis of the sector potential. Speakers will include regulators and decision makers from regional and emerging markets.Sponsor: Hanson Wade Website: http://www.hansonwade.com/events/microfinance-for-institutional-investors/index.shtml

AREQUIPA, PeruFORMIC 2009: Inter-American Forum on Microenterprises 30th September – 2nd October, 2009This year’s annual Latin America and Caribbean microfinance event will be focusing on the current economic and financial crisis and how it affects the microenterprise sector in the region. Through technical sessions, plenaries, workshops, and trainings the confer-ence will also focus on other aspects such as responsible finance, regulation, technology, and innovation in services. More than 1200 delegates are expected to attend and exchange best practices, meth-odologies, and strategies for growth. Sponsor: Inter-American DevelopmentWebsite: http://iadb.org/mif/formic

*Indicates a Microfinance Insights recommended event. If you are interested in securing discounts to attend our recommended events, please [email protected]. Terms and Conditions Apply.


trends

Microfinance and Equity Investment – Market Indicators Statistics and numbers related to Microfinance Equity Investment, selected and compiled by the Microfinance Insights editorial team.

Global Trends of Fund Flow into the Microfinance Sector

Why is the Indian Microfinance Market Attractive?

Growth of Microfinance Investment Vehicles3

Instruments for Microfinance Investment1

About half of the total equity and debt investments were made •through MIVs.3

While equity investment comprised only 21% of total MIV •investment in 2008, it represents a 95% increase in comparison to the previous year.4

11newMIVswerecreatedin2008,sevenafterLehmanBrothers’•bankruptcy. 60% of the total assets under management are concentrated on •the top 10, mostly European, funds. The total assets of these top 10 MIVs grew by 132% in 2007-2008.3

DefinitionsROA=(AdjustedNetOperatingIncome-Taxes)/AdjustedAverage•Total AssetsROE=(AdjustedNetOperatingIncome-Taxes)/AdjustedAverage•Total EquityProfitMargin=AdjustedNetOperatingIncome/AdjustedFinancial•RevenueYieldonGrossLoanPortfolio(Real)=AdjustedFinancialRevenue•fromLoanPortfolio/AdjustedAverageGrossPortfolio

DefinitionsGLP=GrossLoanPortfolio•CAGR = Compounded Annual Growth Rate•

Total fundflowtomicrofinancereached US$12 bn in 2008.

Regional Concentration of MIVs4

Growth of Gross Loan Portfolio2

Demand Supply Gap5

Average Return of MIVs (2008)4

RegisteredMutualFunds 6.3%

PrivateEquityFunds 12.5%

Debt 6.3%

Asset Quality and Profitability (2007)

India5 Asia6

PAR>30 2.9% 1.7%

ROA 2.4% 0.2%

ROE 24% 2.3%

ProfitMargin 3.1% 2.6%

YieldonGlossLoanPortfolio(Real)

20% 18%

63%19%

9%6%

3%

Instruments for Microfinance Investment 1

Debt

Grant

Equity

Guarantee

Other

0.9

3.9

6.5

0

1

2

3

4

5

6

7

0

20

40

60

80

100

120

2004 2007 2008

Growth of MIVs

Number of MIVs

Assets Under Management (US$Billion)

GLP0.68

GLP5.7

0

1

2

3

4

5

6

2004 2008 Potential Demand

US$

Bill

ion

45%

32%

9%

8%6%

Regional Concentration of MIVs (No.) 4

ECA (Eastern Europe and Central Asia)

LAC (Latin America and Caribbean)

SA (South Asia)

Africa and MENA (Middle East and North Africa)

Other

0123456789

10

2004 2005 2006 2007

US$

Mill

ion

Growth of Gross Loan Portfolio 2

For-Profit

Non-Profit

0123456789

10

2004 2005 2006 2007

US$

Mill

ion

Growth of Gross Loan Portfolio 2

For-Profit

Non-Profit

US$(M

illion)

No.

of M

IVs

US$(B

illion)

59 Million Clients

ThoughconstantgrowthofthenumberofMFIsissignificant,theratiooffor-profittonon-profithasbeenstable:35%and65%respectively.

CAGR 79.9%

10

8

6

4

2

0

91 Million Clients

0.9

3.9

6.5

0

1

2

3

4

5

6

7

0

20

40

60

80

100

120

2004 2007 2008

Growth of MIVs

Number of MIVs

Assets Under Management (US$Billion)

Number of MIVs

Assets UnderManagement(US$Billion)

45%

32%

9%

8%6%




SA (South Asia)


Other

45%

32%

9%

8%6%




SA (South Asia)


Other

ECA(EasternEuropeandCentralAsia)

LAC(LatinamericaandCaribbean)

SA(SouthAsia)

Africa and MENA(MiddleEastandNorthAfrica)Other

22BillionCapital

Required


trends

SourcesAdaptedfrom“WhoisFundingMicrofinance?”ResultsoftheFirstGlobalSurveyofFunders’MicrofinancePortfolio,CGAP,2008.1. AdaptedfromMicroBankingBulletin.2. Adaptedfrom“MicrofinanceGrowthContinuetoGrowDespitetheCrisis,”CGAPBrief,April2009,MicroRateMIVSurvey2007.3. Adapted from CGAP MIV Survey, 2008.4. Adaptedfrom“InvertingthePyramid,”Intellecap,2008.5. AdaptedfromMicroBankingBulletin.6. AdaptedfromMixMarket.7. AdaptedfromMIXmarketandXacBankAnnualreports.8. AdaptedfromMixMarketandBancoCompartamosAnnualReports.9. AdaptedfromCGAPDealBook2007,2008.10. AdaptedfromMicrofinanceBulletin.11.

Comparison of 3 Major MFIs that Attracted Large Equity Investment

Analysis of Recent Equity Deals (Based on CGAP Deal Book 2007 & 2008)10

SKS(FY08)7 XacBank(FY08)8 Compartamos(FY08)9

Equity Raised US$75m(November2008) US$4.5m(December2007) InitialPublicOffering(IPO,April2007)

YearsinOperation 12 11 19

AverageLoanSize US$161 US$1819 US$359

Debt/EquityRatio 5.36 8.49 1.84

GLP/TotalAssets 78% 70% 71%

OperationalSelfSufficiency 120% 114% 166%

OperatingExpenses/GlossLoanPortfolio 12% 9.6% 32.4%

WriteoffRate 0.29% 0.06% 1.55%

CAGR(3years)PAT 225% 39.2% 55%

Regional Break Up of Total Investment Amount Average Transaction Size

Debt/Equity Ratio11

20082007

Equity Flow to Different Sizes of MFIs

29%

7%54%

10%

Regional Break Up of Total Investment Amount

EAP (East Asia and Pacific) ECA (Eastern Europe and Central Asia) LAC (Latin America and Caribbean) MENA (Middle East and North Africa) SA (South Asia) SSA (Sub Saharan Africa)

2008

15%

4%

72%

9%

2007

1.31

0.3

3.8

0.8

00.5

11.5

22.5

33.5

4

EAP ECA LAC MENA SA SSA

Average Transaction Size

00.5

11.5

22.5

33.5

44.5

5

2003 2005 2007

Debt/Equity Ratio 11

For -Profit

Non-Profit

37%

11%22%

26%

4%

Equity flow to different sizes of MFIs

Less than US$25M US$25M<50M US$50M<100M

US$100M<500M >US$500M

Gross Loan Portfolio

Deb

t/Eq

uityRati

o

5

4

3

2

1

5

4

3

2

1US$(M

illion)

m m m

m mm

m m


survey

Profile of General Partners (GP) ConsolidatedFundSize

Profile of Limited Partners (LP)YearsofExperienceinEquityMIVs

GP: Attractiveness of Microfinance Investment LP: Change in Risk Perception

Microfinance and Private Equity Traditionally, microfinance institutions (MFIs) have been funded by soft loans and grants mainly from Development Financial Institutions (DFIs) or foundations. However, the sector has been increasingly recognized as an “investable” asset class by global private players. Amid the global financial meltdown and the resulting liquidity crunch, the microfinance sector has been relatively insulated from the severe consequences of it, which further facilitated private equity investment stepping into the sector. In this issue, Intellecap, in collaboration with the International Association of Microfinance Investors (IAMFI) conducted a survey on private equity investment and explored private investors’ risk and return perceptions in microfinance investment.

Survey Sample Overview 46TotalRespondents:27GeneralPartners(59%)and19LimitedPartners(41%)

Risk Perception AlthoughamajorityofbothLPsandGPsagreethattheimpactoftheglobalcrisisonmicrofinanceisfarlessthanonotherasset

classes,LPshavefelttheriskmoreseverelythanGPs

30%

25%

30%

5% 10%

Profile of General Partners Consolidated Fund Size

0<US$50

US$50<US$100

US$100<US$300

US$300<US$500

>US$500

33%

17%

50%

GP: Attractiveness of Microfinance Investment

More Attractive

Less Attractive

No Impact

41%

42%

17%

LP

Increased

Decreased

No change

16%

46%

15%

23%

Profile of Limited PartnersYears of Experience in Equity MIVs

< 1 year

1 Year < 4 Years

5 Years < 9 years

10 Years <

Current Risk Perceptions about the Microfinance Sector

General Partners (GPs) Limited Partners (LPs)

1.MFIs’ManagementQuality 1.MFIs’ManagementCapability

2.Exits2. Inadequate internal systems to handle high growth and associated risks

3.Valuation/PortfolioQuality3.Currencyriskandvolatilityoftheeconomic environment

m

m

m

m

m > 10 years

Datapoint

SocialImpactandBetterRisk/Returnprofilesarethetwomain•motivationsforMFIinvestment 62%• havelessthan4yearsofexperienceinmicrofinanceequitymarket •82% invested through MIVs Half the respondents have less than • 25%ofmicrofinanceinvestmentintheirtotalPEportfolio

Datapoint

58%• of GPs were able to raise target amount of funds during the past 12 months •56%ofGPsdidnotplananyexitduetotheglobalcrisis •40%ofGPssawa“increase”inequitydealflowduringthelast 12 months “Lowcorrelationtootherassetclass”and“Lessimpact•fromglobalfinancialcrisis”arethetop2reasonsthatMFIsarethoughtofasanattractiveassetclass(GP)

Datapoint

•70% are MIVs •50%makealltheirequityinvestmentinmicrofinance


survey

Change in Return Perception

GP: Lower Equity ValuationsValuationsareLowerby...

GP: Key Long-term Impact of the Crisis

LP: Change in Microfinance Allocation in the past 24 months(BothMIVandDirect)

LPGP

Counter Measures Against Risk

General Partners (GPs) Limited Partners (LPs)

StricterFinancialEvaluationCriteria 39% CertainPerformanceBenchmarksandTerms 89%

FocusonLessAggressiveBusinessPlans 39% MakefieldvisitswithMIVstoseeonsiteMIVduediligence 78%

Greater Amount of Due Diligence 39% Conduct onsite due diligence 78%

Return PerceptionSignificant Difference between GPs and LPs

Projections Shiftoffocustoequityinordertocapturethegrowthpotentialofthemicrofinancesectoranddiversifyrisks

25%

12%63%

GP

Increased

Decreased

No change

25%

12%63%

GP

Increased

Decreased

No change

50%

30%

10%

10%

GP: Lower Equity ValuationsValuations are Lower by

0-19%

20-39%

40-59%

60-79%

80-100%

0%

6%

6%

39%

39%

Slowdown of MFI commercialization

Consolidation of MIVs

Change in MIV investor profile

Consolidation of MFIs

Reduction in MFI / MIV growth rates

GP: Key Long-term Impact of the Crisis

31%

8%61%

LP: Change in Microfinance Allocation in the past 24 months (Both MIV and Direct)

Increased

Decreased

More or less constant

41%

42%

17%

LP

Increased

Decreased

No change

GP: Allocation to Microfinance Equity in the Next 12 Months

Increase 31%

Decrease 0%

No Change 69%

LP: Allocation to Microfinance in the Next 24 Months

EquityFocusedMIVs 80%=“Increase”

Direct Equity 71%=“Increase”

DebtFocusedMIVs 56%=“Increase”

Direct Debt 80%=“Decrease”

Datapoint

Expecteddeclineinvaluationsisaprimereasonforthe•lowerreturnperceptionamongLPsSomeLPsreportedthatdecliningvaluationsreducethe•valueofexisitingporfolios,buttheyalsocreateattractiveinvestmentopportunities.ThepercentageofLPswhohadadecreasedperceptionof•returnoninvestmentissignificantlyhigherthanthatofGPs

Datapoint

38%• said there has been “no change”invaluationsValuationshavenotdeclined•totheextentthattheyhaveinestablished equity markets

Datapoint

The trend of increased M&A was also predicted in the •RiskRoundtablesurveybyIntellecap(January2009)

Datapoint

Despite the increased •perceptionofriskanddecreasedperceptionofreturn, few have decreased MFIinvestment


books

“Shedding Light on Microfinance Equity Valuations: Past and Present,” the publication by Consultative Group to Assist the Poor (CGAP) and JP Morgan on microfinance equity valuation, challenges traditional approaches to equity val-uation in microfinance and suggests that despite the global financial turmoil, the long-term outlook for equity investment in microfinance is positive. Microfinance Insights invited Gil Crawford, CEO of MicroVest Capital Management,1 to present his views on the publication and the future of equity evaluation in the microfinance sector.

Establishing Benchmarks for Microfinance Equity Valuation

Anyone who has negotiated an investment in a microfinance (MF) private equity

fund will attest to the frequency of questions asked by potential investors about equity valuations: What is your exit? How do you value a microfinance institution (MFI) going in? How do you adjust absolute valuation methodologies for the idiosyncratic nature of the microfinance business?

The lack of efficient sources of information concerning MF private equity prices has been one of the big hurdles in the drive to gain ac-ceptance of MF investments as an investable asset. The lack of transparent price informa-tion raises difficult questions in the minds of sophisticated and institutional investors.

In February 2009, these hurdles to microfinance investing were lowered with the much awaited release of the JP Morgan-CGAP joint research project on MF equity valuation. The authors combined JP Morgan’s traditional investment bank equity research skills with CGAP’s deep knowledge of the MF sector. The result is a short, professional and readable work. The two teams elucidated four key aspects of MFI equity valuation in a language familiar to investors and digestible by practitioners:

How MFI valuation differs from that of tra-•ditional banksHow to use traditional valuation models •with microfinance institution valuationsStatistical review of 144 private •transactionsComparison of private deals to publicly •listed low-income financial institutions (LIFI Index) and to other traditional emerging market financial institutionsThe JPM-CGAP report does a very good job

of clarifying five traditional valuation models and discussing the relevance of both “relative

valuation” and “absolute valuation.” The industry has grown up on relative valuation, specifically book value multiple. These relative valuations often explicitly or implicitly adjust for country risk, management, asset quality asset quality (PAR), future management information systems expenses, and even hidden real estate value. A good starting point for valuation negotiations is provided through the four year comparison of book values and price/earning ratios benchmarks by region. One question raised by the analysis is if outsized sales of entities like Compartamos in a particular year skewed that year’s results.

Although undeniably useful, the report’s historical valuations may overstate current values. At MicroVest, we feel intuitively that the historical book value multiples might be high based on the deals we have seen. Other valuation data in this report, notably the general regional breakdown and the trends, seem to correspond with our experience. For example, it is clear in India that the valuations seen pre-crisis are a thing of the past in buyers’ minds. I do agree with JPM-CGAP predictions that valuations will drop from 1.9x book in 2008 to 1x book in 2009, but that good valuation growth over the next five to seven years will result from sound fundamentals including: strong and safe portfolio growth, more deposit funding and increasing expansion of pro-poor financial service products.

However, I found that one piece to the valuation puzzle is missing: the intangible, gut feel of “Does it make sense?” While the metrics detailed in this book provide useful starting points, equity managers and boards selling MFI equity also must calculate the value of intangible factors, such as partners’ fit, character and gut feel. As I’m sure the authors would agree, investors must not rely solely on the valuation models as outlined in this report, but complement them with experience.

In addition to clarification and comparison of valuation methods, this report contributes more broadly to our maturing industry. Microfinance has often been touted as an early and successful example of ‘Social Capital’ or Impact Investing. In order for MF to enter a stage of efficiency and scaling it must first build a marketplace for price discovery and efficient information exchange. That marketplace is being built: the MFI specific rating agencies, Microfinance Bulletin and the MIX marketplace, the International Association of Microfinance Investors, and the Council of Microfinance Equity Funds are all examples of a nascent marketplace’s infrastructure. The JPM-CGAP work is an important component of this marketplace development, as it establishes common methods and benchmarks and places them in the larger emerging market context. n

Ordering InformationShedding Light on Microfinance Equity Valuations: Past and Present (Paper-back)By: Elizabeth Littlefield and Nick O’Donohoe et al.Published by: J.P. Morgan, February 2009Pages: 64ASIN: B001ZE2Z4YAvailable on: Amazon.com

1. MicroVest is a customer of Chase NA and has JP Morgan as an equity investor in MV’s $70 million equity fund focused on the top 120 MFIs worldwide

“As an active participant in the MF industry, and more specifi-cally as an investor in MFIs, one piece to the valuation puzzle is missing: the intangible, gut feel of ‘Does it make sense?’”


books

The last few years have seen a dramatic rise in the penetration of credit bureaus in the microfinance sector, almost revolutionizing the way credit reporting is done. As investors eye microfinance as an asset class, there is a greater need for risk-control mechanisms like credit bureaus, which can track the repayment history of borrowers, and in turn, provide more information on borrower reputation, and determine if they are borrowing from multiple institutions. The excerpt below has been taken from “Microfinance for Bankers and Investors” and explains the origin of three informal credit bureaus, channels MFIs developed together by Elisabeth Rhyne in absence of a private credit bureau, to share information on borrowers transparently.

The Entry of Credit Bureaus on the Microfinance SceneBook Excerpt: Microfinance for Bankers and Investors - Understanding the Opportunities and Challenges of the Market at the Bottom of the Pyramid

Currently the three biggest consumer credit bureaus in the United States are Experian,

TransUnion, and Equifax, members of the Associated Credit Bureaus, an international trade union that represents its members to the public and to governments. Each of these three maintains credit information on more than 200 million Americans and businesses. These companies are seeking to expand into new countries, but they want to be sure that the conditions will support commercial viability.

Although only 12% of MFIs participate in credit bureaus, many MFIs recognize the potential of credit bureaus to lower costs. Bolivia is one of a number of cases where the microfinance sector banded together in the absence of a private credit bureau. Some of these efforts have developed into effective credit bureaus, while others are now being supplanted by international credit reference companies. We look briefly at some examples.InfoRed and DICOM, El Salvador: MFIs in El Salvador came together voluntarily to create databases of clients. In the 1990s, the US Agency for International Development supported the establishment of a common borrower database for microfinance programs run by CRS, FINCA, and other NGOs. The database then became the credit bureau for the greater microfinance industry run by a private entity, InfoRed (red is Spanish for “network”). Another credit bureau, DICOM, now partly owned by Equifax, was developed for the banking industry. Over time, and with the growth of the microfinance industry, the DICOM/Equifax credit bureau developed a product specifically for the microfinance market, and lowered its price to make it

more attractive to MFIs. InfoRed provoked DICOM’s quicker development of BoP market coverage.

CompuScan, South Africa: When the post-apartheid government of South Africa took over in the mid-1990s, it wanted to see credit extended to millions of previously ignored South Africans. But the private credit bureaus in South Africa, which were quite sophisticated, showed little interest. MFIs had few ways to find out about bad performing clients. Microfinance providers in Cape Town began sharing information on excel spreadsheet. Gradually, the number and geographic diversity of users expanded, and CompuScan was established as a private company. To cement its financial viability, it began offering other services as well, including training to microfinance providers through a specialized academy. Today, CompuScan serves more than 3,500 credit providers through South Africa, has operations in Namibia and Botswana, and plans to expand into Uganda and Zambia. CompuScan has an internet-based software platform. Its combination of flexible technology, training programs, and focus on the users demonstrates the profitability of providing credit bureau services to financial services providers to the

BoP markets.TUCA, Central America: The IFC’s global Credit Bureau Program, launched in 2001, and supported by VISA, has been instrumental in attracting private-sector companies into the credit bureau market. One of the main concerns of the private entrants is, of course, business viability. Credit bureaus earn their revenues by selling credit reports and other services. In most cases, the bureau charges a flat membership fee plus a charge per enquiry. In countries with limited liquidity or a small number of financial providers, a credit bureau may not be viable. Moreover, fees and fixed costs of upgrading information systems for digital access may leave some small MFIs unable to use credit bureaus.

In Central America, the IFC found the best strategy for reaching sufficient volume was a single credit bureau covering several small countries. In 2002, it invested in the first regional consumer, small business, and microenterprise bureau, Trans Union Central America (TUCA), operating in Guatemala, Honduras, El Salvador, Costa Rica, and (soon) Nicaragua. Standardization of credit reports across countries is also expected to facilitate cross-border financial services offerings in Central America. n

Ordering InformationMicrofinance for Bankers and Investors-Understanding the Opportunities and Challenges of the Market at the Bottom of the Pyramid (Hardcover)By: Elisabeth Rhyne (Author)Published by: McGraw-Hill, May 2009Pages: 352ISBN: 0071624066Price: US$45

“In countries with limited liquidity or a small number of financial providers, a credit bureau may not be viable. Moreover, fees and fixed costs of upgrading information systems for digital access may leave some small MFIs unable to use credit bureaus.”


In the last two years, the microfinance sector in India has attracted over US$230m

worth of equity capital.1 Among several trends associated with this inflow, the one pattern that doesn’t seem to receive much mention is that of Co-Investments. Interestingly, 90% of deals by value and over 50% of deals by volume in the past two years were executed as co-investments by two or more equity funds.

Is this merely coincidental or have investors consciously and consistently chosen this route as opposed to going solo into this new investment arena?

Co-investment is a common trend in early/VC stage investing and has been especially predominant in the Indian microfinance sector. There are several reasons behind this. First, most of the dedicated microfinance funds in India are nominal in size – US$20-50m as opposed to the average US$100-150m managed by conventional private equity funds. Their fund size has implications on

average investment ticket size, sometimes restricting them from being able to meet the complete equity requirement of an MFI in a particular equity round. Second, funds lacking a strong local presence often prefer the co-investment route with a fund that has this presence in order to manage their investment more efficiently. Third, sometimes investors share strategic linkages to one another (such as common Limited Partners or mutual understanding) and prefer to invest in unison, often conducting a common due diligence and negotiation with the investee company. Last, there are also cases of funds that have a clear policy/mandate to co-invest. These investors usually participate as token investors in a sizeable (US$10m plus) equity round. In a similar vein, high net worth individuals usually participate in a group with other individual or institutional investors.

It is worthwhile to remember that co-investments are not always driven by investors’

preferences. Many times, microfinance institutions seeking equity funds consciously seek co-investment to prevent dilution to any one particular investor and/or gain strategically from a diverse investor set. In such cases, the MFI has judged the benefits of co-investing to supersede the potential shortcomings, i.e., an elongated timeline for deal execution and the MFI’s bandwidth to manage multiple investors on its board.

Among all the reasons listed above, there is a common thread of sector infancy–in terms of the sector’s familiarity with commercial equity capital–which makes most investors take baby steps towards taking an exposure in this exciting yet relatively new sector. It is likely that over the next 5 years, as MFIs become more attuned to the rigors of equity investments and provide a clearer window for exits, co-investments will become less dominant with more investors opting to go solo. Until then, investing through coalitions is here to stay! n

The Curious Case of Co-Investments in MicrofinanceA recent trend that has developed in microfinance investing is that of co-investing—private equity players teaming up together to facilitate an investment, from conducting common due diligence all the way up to the allocation of capital. Megha Jindal, an Investment Manager for Aavishkaar Goodwell, sheds more light.

Megha Jindal is an Investment Manager for Aavishkaar Goodwell – an equity fund dedicated to Indian MFIs.

“…there is a common thread of sector infancy—in terms of the sector’s familiarity with commercial equity capital—which makes most investors take baby steps towards taking an exposure in this exciting yet relatively new sector.”

1. Deal information gathered from VCCircle (www.VCCircle.com) and other public sources.

Key Co-Investment Transactions over the last 2 years1

Investment Date

MFI InvestorsAmount (US$m)

Mar-09 BhartiyaSamruddhi AavishkaarGoodwell,LokCapital,SIDBI 10

Nov-08 SKSMicrofinance SandstoneCapital,SVB,Kismet 73

Nov-08 Ujjivan Sequoia,Lok,Unitus&others 19

Oct-08 SwadhaarFinServe DellFoundation,ACCION&UnitusEquityFund 3

Aug-08 Equitas Bellwether,IndiaFinancial,MicroVentures 10

Aug-08MASFinancial

ServicesICICIVentures,FMO 17

Aug-08 ArohanFinancial DellFoundation,LokCapital 1

May08 ASA-GV UnitusEquityFund,VinodKhosla 3

Jan-08 SKSUnitus,VinodKhosla,InfocomVentures,SIDBI,TejasVentures,SequoiaCapital,YatishTrading,

SVBIndia&ColumbiaPacific30

Jul-07 Spandana JMFinancial,OldLane 8

May-07 ShareMicrofin Legatum,AavishkaarGoodwell 8

last word

InterviewsSequoia and Sandstone

Mergers & AcquisitionsThe Next Frontier

How toWin an Investor in 12 Steps

Last WordThe Curious Case of Co-Investments in Microfinance

Features



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Fueling the Growth of MicrofinanceThe Role of Private Equity:

Vol.13, July/Aug 2009

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With over 300 million people in need of financial services, over 20 large MFIs, and a growing appetite for investment, there has never been a better time to take a closer look at microfinance in Africa. In this issue, read an overview of the African microfinance landscape from Women’s World Banking (WWB), a commentary from Wagane Diouf, Managing Director of Mecene Investments, interviews with James Mwangi, CEO of Equity Bank, and Ingrid Munro, Found-er of Jamii Bora, and more!

From water to education, health care to clean energy, there are numerous products and services that MFIs can offer to the communities they work with. This issue takes a critical look at how these services stack up in the move towards greater financial inclusion. Includes an interview with Harish Hande, Founder, SELCO India; an article on how MFIs can utilize carbon credits from MicroEnergy Credits; a perspective from Green Microfinance, and more.

This issue of Microfinance Insights looks at how the industry is coping with the greatest economic slump since the Great Depression. We probe the asset-worthiness of the industry, the risk involved in investing in the sector, and how MFIs will weather the storm. Articles include an analysis by Yana Watson of Dalberg Global Development Advisors on the recession’s effects, a critique of the sector by Prof. Milford Bateman, a perpective on how Islamic Finance can weather the crisis by Zohaib Patel of Fajr Capital, and as always, diverse perspectives from borrowers, investors and MFIs.

Having reached millions of clients, microfinance has proved its mettle as an effective way to touch the poor. In this issue, we ask, what is the real impact of microfinance? Is it the panacea to poverty, or merely a placebo? Articles include an exploration of the quality versus quantity debate by Sam Dailey-Harris of the Microcredit Summit Campaign; an exclusive interview with Ela Bhatt, Founder of SEWA; an exploration of the effectiveness of randomized experiments from the Financial Access Initiative. And practitioners from around the world answer the question, “Is microfinance making a difference?”

Volume 8 - Technology Solutions: Testing the Waters

Volume 9 - The African Landscape

Volume 10 - Connections & Partnerships

Volume 11 - Microfinance and the Global Recession

Volume 12 - Panacea or Placebo?

InterviewSunEdison & SELCO on Solar

SurveyProduct Development,Implementation and Partnerships

Point/CounterPointHow Many Bottom Lines do MFIs Need?

CenterfoldRenewable Energy Partner Index

Features


Extending Credit “Plus” Services for a Complete SolutionConnections & Partnerships:

Vol.10, Jan/Feb 2009 Cover Price: US$12/EUR 8/INR 75

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Tough Times Ahead? Global Crisis & Microfinance:

Risk & RewardExploring Risk in Microfinance

CritiqueWhy Microfinance Needs Radical Change

PoliticsInterference in Pakistan

CommentaryDangers of Leverage

Features



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Vol.11, Mar/Apr 2009

InvestmentBalancing Social and Financial

CritiqueIt’s No Magic Bullet

GenderThe Women’s Empowerment Myth

IndexSocial Impact Tools

Features



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Evaluating the Impact of Microfinance Panacea or Placebo?

Vol.12, May/June 2009

Think mobile phones, think smart cards, think biometric devices, think microfi-nance. This issue delves into technology solutions for Microfinance. Technol-ogy will not only make the lives of people at the base of the pyramid simpler, it could also be the great socio-economic leveller. The first bimonthly issue includes an exclusive interview with Prof. C.K. Prahalad, author of Fortune at the Bottom of the Pyramid, highlights from our Technology Survey, and perspectives from Intel, IBM, Microsoft, and PlaNet Finance.

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