Business, The Spectator, India - Wed March 12, 2008

Funding a path out of poverty

Elliot Wilson explores how investors can back ventures that lend to the world’s poorest entrepreneurs.

Prathminda Kaur is the modern version of the Little Match Girl, only with a twist: instead of perishing in a Victorian winter, she’s making a nice living for herself selling red onions and bell peppers in a Mumbai market. Kaur arrived in the Indian coastal city eight years ago. To start with she slept on the street, borrowing money from a loan shark at dawn, handing him more than 90 per cent of her profits at dusk. On an average day, the interest on her loans worked out to an annual rate of 10,000 per cent. But two years ago a friend introduced her to SKS Microfinance, an Indian lender that makes millions of tiny loans to local entrepreneurs like Kaur. She borrowed £100 which she paid back in full (with £75 interest) over the course of the year. A year ago she borrowed £250 from SKS: she has since expanded her stall, and now sells vegetables directly to a couple of local restaurants. Her long-term aim is to buy a small flat for herself in the distant suburb of Navi Mumbai.

Microfinance institutions (MFIs) such as SKS are slowly but inexorably weaving themselves into the complex fabric of global wealth and capital markets. An estimated 3,000 MFIs operate around the world, providing up to 120 million mostly poor customers like Kaur with tiny loans, ranging from £50 to £750.

At its most basic level, microfinance — a concept developed and made famous by Nobel laureate Muhammad Yunus, creator of the Grameen Bank in Bangladesh — is founded on a simple but compelling investment principle: that around a billion and a half people are potential entrepreneurs who have little or no access to capital. For decades, the traditional banking sector has overlooked microfinance, due to the assumed high risk of dealing with borrowers with no assets, and the cost of managing millions of tiny loans.

Yet that attitude is changing and commercial banks and investors are taking a closer look at microfinance. Martin Holtmann, co-head of microfinance at the Washington-based IFC, a multilateral institution with £400 million invested in the microfinance sector, says that within two to three years MFIs will have become an asset class in their own right, with insurance firms, wealth managers and pension funds seeking exposure to the sector in their portfolios. ‘There is more interest in microfinance than ever before,’ he says.

Ian Callaghan runs Morgan Stanley’s 12-strong microfinance banking team in London. The US investment bank has launched two ‘collateralised loan obligation’ deals over the past two years in collaboration with BlueOrchard, a Swiss fund management firm specialising in microfinance products. The second of these deals, called BOLD 2, was launched in May 2007, attracting £55 million from institutional investors that was used to extend loans to MFIs in countries including Azerbaijan, Bosnia, Mongolia and Cambodia.

Callaghan says what appealed to global investors was the quality of the MFIs out there and the surprisingly low levels of ‘non-performing’ loans in them. MFIs are attractive at times of economic stress because their borrowers are unlikely to default or skip payments. The Microfinance Information eXchange, or MIX, a US-based information provider, reckons that the average MFI has a loan default rate of no more than 2 per cent. One former European investment banker now working in the industry notes that MFIs across the board have ‘far better performing portfolios than commercial banks’.

According to Martin Holtmann of IFC, very few MFIs run into financial trouble. ‘If you look at the long-term performance of MFIs, you will see that the leading institutions have sailed on very smoothly even in times of economic crisis. They are generally very well run and they provide high returns to investors, both in good times and bad.’

The potential size of the microfinance industry was highlighted in a recent report by McKinsey which estimated that the £8.5 billion in outstanding microfinance loans at the end of 2006 represented just 10 per cent of the potential market, and that as many as half of the world’s three billion poor might be eligible for microfinance loans.

Another reason microfinance is gaining attention in the broader investment community is that many MFIs are becoming commercially viable in their own right. Compartamos, a publicly listed Mexican lender, has opened many investors’ eyes to the potential profits in this sector. MFIs charge unusually high interest rates compared to commercial banks — although not compared to the loan sharks that are the only other source of finance available to their client group.

A loan shark may charge, believe it or not, as much as 1 million per cent interest on a short-term loan, while an MFI is unlikely to push for more than 100 per cent; Compartamos typically charges 80 per cent over the full term of any loan. That may still sound usurious, but MFIs face high costs to service their portfolio of small and often rural loans — and you’re also unlikely to have your fingers broken if you’re late with a payment.

These relatively high interest rates can ensure healthy returns to investors, helping microfinance to gain traction in the mainstream investment community. According to the Consultative Group to Assist the Poor, or CGAP, fixed-income microfinance funds return on average 5.8 per cent per year to investors, while ProFund, the first microfinance private equity fund, returned 6.6 per cent a year in the ten years to 2005.

The idea of making money from the poor is anathema to some investors. But proponents of commercially viable MFIs, such as IFC, argue that attracting private capital to institutions run as businesses is the only way to expand the industry to reach the world’s unbanked population. ‘Profits do more to motivate investors than philanthropy,’ says Holtmann. ‘MFIs that can attract private capital, improve their services and deliver profits will be able to scale up to respond to demand. Even socially motivated investors demand profits because profitability is an indication of sustainability and it provides comfort that their money will achieve their development goals.’

The future of microfinance is likely to involve commercial banks and private sector investors, rather than just the development agencies and NGOs that currently dominate the industry. ‘We need slowly to extract ourselves from the market, and private sector money needs to replace us,’ says the head of a leading European NGO prominent in the industry. ‘Eventually, [commercial] banks will find that MFIs are the next frontier, perhaps the final frontier, in investing.’

So there are solid reasons to invest in this fast-growing sector, but as with all emerging asset classes, liquidity is key. There are several routes available. Franco-Belgium bank Dexia’s £150 million Micro-Credit Fund, launched a decade ago, has extended loans to 92 MFIs across Latin America, Central Asia and Eastern Europe — none of which has ever defaulted. The fund’s managers charge no exit fee, and target only private individual and institutional investors with minimum investable capital of £5,000.

Geneva-based BlueOrchard, which co-manages the Dexia fund, chooses only ‘profitable, well-managed and fast-growing’ externally audited MFIs, boasting a minimum capital base of £500,000, according to its chief executive officer Jack Lowe. BlueOrchard is also an adviser to the £100 million Luxembourg-registered responsAbility Global Microfinance Fund, an open-ended fund covering MFIs across 24 countries.

Other possibilities include the Global Microfinance Facility, a pooled investment vehicle created by IFC in 2004 and managed by Cyrano Management. It originally invested $30 million in MFIs in te
n countries and now a second facility of $165 million is being raised to invest across 17 countries.

It’s harder to play microfinance directly on the capital markets, as so few MFIs are listed. Investors could buy the frankly rather expensive shares of Compartamos in Mexico, which has more than 800,000 borrowers. In April 2007 Compartamos, which has an A+ local rating from Standard & Poor’s, completed an outsized listing, raising £200 million from institutional investors in a still-sizzling stock market.

If that doesn’t appeal, keep an eye out for the number of other microfinance groups that are currently preparing listings — including Prathminda’s benefactors, SKS Microfinance.

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