Microfinance Investment
Microfinance Fast Facts
- Total estimated microfinance loans outstanding: $35 billion (CGAP)
- Total estimated microfinance customers: 154 million (MicroCredit Summit)
- Total estimated potential customers: 1.5 billion (CGAP)
- Total number of microfinance institutions eligible for commercial funding: 250 (CGAP)
- Total estimated investment by microfinance investment funds (MIVs): $13 billion (IAMFI)
- Estimated compound annual growth rate of MIV investment: 79% (CGAP, 2004-2008)
- Number of MIVs: 109 (IAMFI)
- Percent debt deals: 67% (IAMFI)
- Percent equity deals: 30% (IAMFI)
- Percent guarantees: 3% (IAMFI)
- Microfinance funding gap to meet demand: $265 billion (CGAP)
Introduction to Microfinance Investment
In this era of multiple bottom line goals and the emergence of the four billion people living at the base of the socioeconomic pyramid as a target market for products and services, many investors are attracted to the concept of doing well by doing good. Microfinance investment offers them the opportunity to leverage capital effectively to achieve financial and social returns.
Commercial microfinance investment presents challenges as well as opportunities for both investors and microfinance institutions (MFIs). In terms of challenges, from the investors’ perspective the industry suffers from a dearth of information, a low level of transparency, a lack of accepted guidelines and standards, and an absence of many investor services common in more established asset classes such as: uniform credit ratings, credit bureaus, debt default tracking, objective equity valuations, exit strategies, a secondary market for liquidity, and fund manager rankings. Local legal, regulatory and fiscal environments can give rise to daunting hurdles. Furthermore, the vast majority of commercial MFIs have their roots in non-profits that transformed to regulated entities, and ownership, governance and management capacity often raise concerns.
In the view of many MFI managers and social investors, commercial funding may cause mission drift. Regulated MFIs’ loan portfolios reflect a higher average loan size, a smaller percentage of women borrowers and a lower ratio of rural to urban clients; this evolution in client profile indicates that given their obligations to lenders and shareholders, commercial MFIs may lose sight of serving the poorest of the poor.
On the other hand, there are compelling business and social justifications for the increasing commercialization of microfinance. From the investors’ standpoint, the market demand for microfinance is significant. Penetration in eight large emerging countries is only 4.4%, and the industry overall offers a 15x growth factor. MFIs exhibit attractive business attributes: 1) a loyal client base to lower acquisition costs, 2) high interest rates to cover hefty operational expenses, 3) excellent loan repayment rates due to strong portfolio quality, and 4) high solvency and liquidity resulting from short loan tenors. In addition, microfinance offers investors broader emerging market diversification, thanks to exposure to countries not typically covered by emerging market instruments. Microfinance helps investors align their investments with their values in an active way, not just through passive screening.
MFIs likewise recognize the many benefits of commercial funding. Philanthropic contributions are insufficient to close the $265 billion microfinance funding gap. The turmoil in financial markets reduced many U.S. foundations’ endowments by 30% to 40% in 2008, which has decreased grantmaking in 2009 and 2010.
In contrast, private sector funding allows MFIs to increase loan portfolios on a greater scale. Debt and equity instruments further diversify funding sources and create a more stable financial structure with longer-term capital, helping MFIs reach sustainability. This helps them fulfill their social mission by expanding outreach to more unbanked individuals.
A fundamental argument in favor of MFI transformation from a non-profit to a for-profit business model relates to the legal constraints prohibiting non-regulated institutions from accepting deposits. Evidence shows that savings – not loans – alleviate poverty by providing families with a safety net in the event of an illness, natural disaster, or economic crisis. Furthermore, deposits provide an inexpensive, stable source of funding for MFIs. Clients of regulated, deposit-taking MFIs benefit doubly from secure, liquid savings products that augment the capital base for loans.
Significantly, the profit motive has proven essential in accelerating MFIs’ expansion, which increases access to financial services for the unbanked and drives down consumer costs thanks to competition.
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
Debt Investment
As of December 2009, lending represented 67% of microfinance investment, decreasing from 77% in 2007. While there is a recent trend in microfinance investment of moving away from debt, this instrument remains the most common. Some development financial institutions (DFIs) invest directly in microfinance institutions (MFIs), but the vast majority of private investors make debt investments through microfinance investment vehicles (MIVs).
The default rate on MIV loans to MFIs has been historically low, about 2% in terms of number of loans and 0.2% in terms of volume. A fundamental component of debt investment is knowledge of defaults in terms of what factors tend to lead to default and therefore may be used to determine the level of risk in a particular debt investment. There are numerous and often interrelated reasons why MFIs default on their loans to MIVs. Typically default occurs because of a combination of several reasons.
Default may be a direct result of an MFI’s personnel, through ineffectual management, governance, or various types of fraud. Underlying these issues are often weak internal controls, flawed methodology, or ineffective methodology. Illiquidity is one of the most common causes of default, typically resulting from either poor management or exchange rate fluctuations. Stemming from these basic issues are other drivers of default, such as poor portfolio quality, unachieved growth, overexpansion, and an inability to attract additional investment. These are typically the result of a failure to address the target market appropriately with products, terms, and practices making repayment difficult.
Even with skilled management MFIs may be driven to default by external factors such as competition, regulatory and legal issues, country environment, and natural or manmade disasters. Political, social, economic, and even environmental issues affecting the country in which an MFI is located may have significant impacts on an MFI’s ability to repay its loans, both due to an inability of managers to navigate difficult situations and increasing difficulty for borrowers to may payments.
Many factors have contributed to the positive performance of microfinance debt to date. On the part of an MFI, rapid growth may successfully avert default but simultaneously mask underlying portfolio problems. MFIs have big incentives to take whatever measures necessary to avoid default, as the investor pool in microfinance is small and news of a default could inhibit an MFI’s ability to obtain loans from other sources. Several external factors may contribute to the low incidence of default as well. For example, networks may intervene to help promising MFIs at risk of default. They may also leave weaker MFIs to go bankrupt and therefore minimizing the number of institutions likely to default. Simply the fact that the microfinance industry has a relatively short track record could cause the default rate to appear lower than it really is, as default data is often inaccurate or incomplete especially further back in time when the industry was less sophisticated and probably more prone to default.
The entities perhaps most actively involved in default mitigation are the MIVs. Practices such as restructuring and payment acceleration may avert default in situations where it is likely to occur. Similarly, if default is narrowly averted on a loan or an MFI’s future repayment capacity is in doubt, a MIV may decide not to renew the loan, avoiding the possibility of a future default. Tranched loans are another MIV tactic for reducing risk, where future disbursements are dependant upon an MFI meeting certain performance milestones first. Use of a Material Adverse Change (MAC) clause is another way for MIVs to accelerate or terminate a loan if any of a specified set of events occurs to significantly worsen an MFI’s financial condition. Specifying that an MFI default to one lender will cause cross-default to all other funders is another way to protect against default in MIV loan documentation, raising the stakes by essentially hinging an MFI’s financial viability on the repayment to any one of its funders. Another way that MIVs minimize risk is by investing in certificates of deposit in commercial bank MFIs as opposed to direct lending. Just the fact that MIV lending is concentrated in the most creditworthy MFIs indicates practices adopted out of concern about defaults. This mentality is manifested in MIVs’ rigorous due diligence processes, credit risk assessment, and on-site visits that also help to ensure that their chosen investees to stay on track for repayment.
MIV reporting issues may contribute to the apparently low default rate as well. MIV documentation of defaults is not always complete. Without a standard definition of default in the industry, the credit events that MIVs consider as defaults vary so that not all non-payment of MIV-MFI loans is recorded as default.
There are several reasons why the microfinance debt default rate is not likely to remain as low as it is now, not least of which is the global financial crisis. Despite the stability of the microfinance industry relative to global economic trends, the macroeconomic environment and operating context for MFIs will affect boy MFIs’ ability to repay loans and MIVs perception of lending risk. Through the industry’s steady development many new default-causing factors will arise as well. For example, commercialization will likely expose the financing challenges of weaker MFIs, with less charitable support to prop them up. Investors may also begin to branch out from the small segment of top MFIs to which they are currently focused, leading to increased investment in higher risk MFIs with the potential for more attractive returns. Increased competition among MFIs may lead to microborrower overindebtedness as MFIs push more loans onto their customers, potentially causing portfolio deterioration to the point where MFIs can not repay their funders. Even simply with a longer track record and improvements in reporting the debt default rate may rise to more accurately reflect the microfinance debt investment environment. The challenge then is for investors to read this likely increase in the default rate as a positive indicator of the development of the microfinance industry.
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
Equity Investment
Until 2007, lending was the predominant investment strategy, and in 2008 debt represented about 77% of sector funding. However, with too much debt capital chasing too few deals, pricing has become less attractive for debt investors seeking market returns. Furthermore, many microfinance institutions (MFIs) have reached leverage limits, or are seeking to decrease leverage as a defensive measure in light of the global economic slowdown. In addition, many MFIs have transformed to regulated entities, creating an ownership structure that facilitates shareholder capital.
Consequently, investors and MFIs have been exploring equity investment opportunities more aggressively. According to the J.P.Morgan – CGAP microfinance equity valuation study published in February 2009, by September 2008 24 specialized equity funds were managing a total of US$1.5 billion. Several microfinance investment vehicles (MIVs) that previously invested exclusively in debt have been allocating a percentage of their portfolios to equity as well.
The rising microfinance equity market presents both attractive opportunities and maddening obstacles for investors. The latter include the low number of investable MFIs, difficulty in valuation, the lack of a secondary market or alternative exit options, and governance issues such as divergent views on organizational vision and mission among the founders and new, perhaps more market-oriented, shareholders. The JPM-CGAP study suggested that MFI valuations should receive a liquidity discount due to the industry’s small size.
On the positive side, the study cited five MFI characteristics that justify a different valuation approach compared to traditional banks: the double bottom line return target, excellent asset quality, high net interest margins, high operating costs, and longer-term funding provided by developmental investors.
Based on data obtained for the 2009 study from 144 private equity transactions, J.P.Morgan analysts determined that historical median valuations in private equity ranged between 1.3x and 1.9x historical book, and between 7.2x and 7.9x historical earnings, from January 2005 through September 2008.
In the J.P. Morgan- CGAP microfinance global valuation study conducted in 2009 and published in March 2010 with a larger sample of 200 private equity transactions, the analysts found that despite the global financial crisis, equity valuations have continued to rise globally, with MFIs trading in the private equity market at a median of 2.1x book value, a 62% increase since 2007 that reflects sustained demand for microfinance equity.
According to a MIX MicroBanking Bulletin published in 2006, return on equity (ROE) averaged 17% among the larger, mature MFIs. The JPM–CGAP studies gathered ROE data that diverged widely according to region and country, ranging in the 2009 study from -3% in Africa to 23% in Bolivia and Cambodia in 2009, and from -3.2% in Tajikistan to 26.7% in Cambodia the following year. Comparing MIX’s return figures to the latest JPM-CGAP study, median ROE dropped by 9% as of May 2009 to 6%. Additionally, the data demonstrated no link between profitability and valuation. The analysts ascribe this phenomenon to the immaturity of the microfinance private equity market and the lack of consensus on MFI valuation.
Experts believe that the global financial crisis, by causing deterioration in MFI loan portfolio quality and a drop in growth, will reduce overall financial performance that impacts equity investors as well lenders.
A survey of microfinance private equity investors done jointly by IAMFI and Intellecap in May 2009 identified several issues and trends in the microfinance equity market. The survey identified divergent perceptions of risk and return among limited partner (LP) and general partner (GP) investors, indicating a communication gap between these two entities.
The first major discrepancy in terms of perception arose in relation to return expectations. While nearly half of the LPs surveyed had decreased their return perceptions, just 12% of GPs reported an expected drop. The primary reason LPs cited for decreased return expectations was a commensurate expected decline in valuations, which the JPM-CGAP study refuted.
In terms of risk perceptions, GPs and LPs agreed that management quality/capability is a top concern. This is a perspective reported in several other surveys, including the Banana Skins 2008 report in which investors cited Management Quality as the top risk. For GPs, exits, or lack thereof, and MFI valuation/loan portfolio quality are also top risks. LPs by contrast are more concerned about inadequate internal systems to handle growth, and currency risk as it relates to the volatility of the economic environment. Their perception of the level of risk in microfinance private equity investment in general is heightened due to the 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 MIV tranches to close, and a delay in their ability to recoup investment.
In order to mitigate their perceived 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, to make field visits with the MIVs to see onsite MIV due diligence, and to conduct their own on-site due diligence. GPs echoed the need for stricter evaluation and due diligence, and also mentioned a need to seek out less aggressive business plans.
In evaluating the effects of the global financial crisis on microfinance investment, GPs and LPs agreed that impact varies across regions. Many believe that the impact on microfinance is far less than on other asset classes—a perspective that bodes well for future microfinance investment flows. Private equity investment in microfinance has been rather stable during the past 12 months. In fact, attractiveness of the sector has not decreased significantly for the majority, and many GPs have successfully raised equity funds. Despite LPs’ overall rise in risk perception, they have in large part kept their allocation to microfinance the same or increased it.
Other issues in microfinance private equity investment reflect the nascent character of commercial microfinance. LPs observe that few MIV managers possess both a private equity background in emerging markets and microfinance investing experience. The small deal size is a constraint for large institutional investors. This issue suggests the potential role for brokers to bundle transactions and provide related due diligence. The establishment of a global microfinance stock exchange to promote a secondary market would also be a helpful development, as valuation of MFIs is difficult without one. Further, valuations are highly specific to each MFI and to local macroeconomic, legal and regulatory conditions. This makes the relative value of microfinance private equity as compared with general emerging markets private equity unclear.
GPs and LPs acknowledge the important role that development financial institutions (DFIs) play in microfinance equity investment. DFIs were early investors, 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 GPs 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 (start-up) MFIs, 2) DFIs should focus on catalytic investments that attract 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 near-term outlook for microfinance private equity is mixed. In spite of liquidity challenges and market turmoil, 58% of MIVs have been able to meet recent funding targets. In general, however investor risk appetite appears to be down. LPs feel that equity multiples are higher than expected. Some GPs have observed an LP paralysis, as LPs are in no rush to invest in a market that may be due for a correction. While some countries struggle, equity investment activity in others such as India is strong. It is encouraging that many LPs followed through with microfinance equity allocations during the height of the crisis. As MFI growth slows and loan portfolio quality recovers, GPs must seek out well-priced opportunities and articulate to LPs the value proposition of microfinance private equity investment.
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
Guarantees
Loan guarantees or credit enhancements are a way to share the risks, both real and perceived, of funding microfinance institutions (MFIs). In a situation where a commercial bank or investor views an MFI as too risky an investment or without sufficient collateral, another party (the guarantor) may pledge assets or its general credit to repay the loan should the MFI default. This may also be a way for MFIs to reduce their cost of borrowing through a lower risk rating by association with a more established organization such as a foundation or an investor, even if the MFI has to pay its guarantor a fee.
Guarantee agreements are commonly structured by a standby letter of credit, which can be issued by banks for a fee. If financial assets are pledged by the guarantor, according to the guarantee agreement just as they are responsible for any losses incurred they may also be entitled to the benefits of any capital appreciation generated by the MFI. Through this arrangement some guarantee agreements allow investors to earn market-rate returns. More often this type of microfinance investment typically involves little or no return.
The loan guarantee approach is often used in riskier situations, such as with new MFIs or the introduction of new products. They may incorporate additional forms of support such as technical assistance or consulting services in order to help the investment succeed. A major benefit inherent to guarantees is protection for MFIs from currency risk. In this model the investor takes on the currency risk, as a reduction in the MFI’s exposure to currency fluctuations by shifting it to the guarantor. Under this arrangement an MFI can borrow in its local currency, so currency conversion would only take place in the event of a default resulting in a capital call.
Guarantees are an important component in the process of commercializing the microfinance industry. They provide commercial investors with a cushioned entry into a new sector, including commercial banks moving downmarket. Not only does this drastically increase the volume of funding available to MFIs, it also allows them to diversify their funding sources providing them with a more stable base. This in turn helps MFIs to improve their professional liability management, as commercial investors typically undertake more rigorous due diligence processes than donors. Guarantee schemes may raise questions of sustainability, however, when they become a consistent source of soft funding to an MFI rather than a tool to provide an MFI with the access and capability to pursue commercial funding options.
Other issues involved in guarantee schemes include information, risk, and compensation. Information gathering, analysis and monitoring are crucial but often costly. This burden must be divided between the guarantor and the lender to avoid duplication of work. Given the relatively high amount of risk involved in guarantee schemes, it is important to divide risk among a pool of guarantors according to the risk appetite of each. The risk premium must be shared appropriately among these entities as well. Removing too much of an MFI’s risk may be problematic, potentially leading to negligence in the client screening process and subsequent monitoring.
Because of the risk-return profile of this type of investment, it is more often made by governments, development finance institutions (DFIs), and NGOs rather than commercial investors. Some of the main private entities involved with guarantee investments include MicroCredit Enterprises, Shared Interest, and Grameen Bank. For DFIs, guarantee schemes are one of their primary investment vehicles. With the resources, capacity, and mandate to do so, DFIs often invest in highly risky environments. These may include new markets, areas of political, social or economic instability, post-conflict or post-disaster areas, or areas of the most extreme poverty. In these contexts guarantee schemes are often the most appropriate investment model since they distribute risk well and are not contingent on meeting minimum return levels. The structures of guarantee agreements may vary widely as well, for example covering a lender against any source of default vs only covering defaults arising from specified events. DFIs may also facilitate commercial investment by becoming involved in a transaction as a guarantor, in so doing making a commercial investment possible where it would normally be too risky.
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
Structured Finance
Structured finance is based on the process of securitization, through which formerly immobile assets become tradable instruments. Through this process, a pool of similar and stable loans in a microfinance institution (MFI)’s portfolio (often referred to as the receivables pool) form the underlying asset. Microfinance loans are an attractive underlying asset for investors because of their low default rates, high granularity, high standardization, high diversification, low prepayment risk, and the limited impact of macroeconomic factors on their performance. The MFI then sets up a Special Purpose Vehicle (SPV) which purchases the assets then issues securities to investors in order to pay the MFI for them. The SPV may issue debt and/or equity in multiple classes.
Investors that have purchased the issue receive the interest and principal payments on the underlying assets for the duration of the security’s life. Investors’ returns are therefore directly affected by the performance of the underlying assets. However, because the SPV is a distinct entity from the MFI, the rights of investors to the assets held by the SPV are protected should the MFI experience financial trouble. This typically involves a credit enhancement, liquidity facility, rating and/or factoring in a cushion amount when the securities are sold to investors. Under this arrangement an MFI legally surrenders ownership of its client cash flows, but retains responsibility for collecting loans and maintaining client relationships. In this way securitization affects an MFI’s balance sheet but not its outreach.
Women’s World Banking Capital Markets Guide for Microfinance Institutions (MFIs), November 2006
Securitization is typically done by MFIs that are rated and have a strong track record. High reporting standards are important for investor confidence, so the MFI must maintain complete and accurate historical records and have a good MIS in place. For a securitization transaction to be feasible the MFI should be located in areas with a legal and regulatory environment conducive to investment. Typically non-deposit taking MFIs seek structured finance investment as another type of funding alternative.
Securitization allows MFIs to procure additional funding without taking on new debt. Although it represents an initial decline in an MFI’s portfolio this is quickly replenished as the proceeds of the securitization are reinvested, typically resulting in an increased return on assets for the MFI. With this additional funding source an MFI may be able to increase liquidity to meet capital requirements so that they can offer new loans. This process is valuable in terms of saving the time on fundraising for an MFI’s management, especially once a first-time securitization transaction has been completed.
Securitization may also improve their financial ratios, lower leverage and boost return ratios, lower the cost and diversify the sources of funding, improve asset/liability management and manage credit risk exposure. Additionally, structured finance investment addresses the issue of lack of absorption capacity among MFIs by meeting minimum thresholds. Because many MFIs may be involved in one structured transaction, a lot more opportunities for capital to enter the microfinance industry are created.
Securitization can facilitate investment and lower an MFI’s cost of funding because SPVs typically have a higher rating than an MFI itself. Securitization is initially expensive due to issuance costs, structuring costs, legal fees, rating agency fees and operating and servicing fees. However, structured finance transactions offer the possibility of economies of scale in terms of the ease in replicating transactions, greatly increasing the market impact.
Collateralized debt obligations (CDOs) are a type of securitization transaction limited to loans or debt obligations. More specifically, they may be backed by loans to MFIs, structured products or credit default swaps. Depending on the class of investment, investors in CDOs may include commercial banks, money managers, hedge funds, insurance companies, high net worth individuals, and others.
Investors may be more likely to invest in microfinance through a CDO than direct debt to an MFI since CDOs offer a diversified pool of debt. This also makes CDOs more feasible for an MFI since the minimum issue size is smaller and the associated fees are allocated between several MFIs. This is an attractive approach for investors as it essentially allows access to a portfolio of credit risks through a single investment and is easily customized to accommodate different risk appetites.
The senior tranches of structured finance vehicles are typically the best opportunities for commercial investors due to their credit ratings and well-covered default risk. According to CGAP BOLD II senior tranches, for example, were rated AA and BBB by Standard & Poor’s and were offered to private investors at a premium of up to 40 basis points and 95 basis points above three months Euribor, respectively. Junior and equity tranches are more often purchased by public investors and microfinance investment vehicles (MIVs).
The first formal CDO BlueOrchard Microfinance Securities I (BOMS), was structured in 2004–2005 by BlueOrchard in partnership with OPIC and Developing World Markets. By accessing the structured credit markets, this deal represented a major step in generating funding for MFIs. Morgan Stanley, Symbiotics, BRAC, Citibank, MicroRate and many DFIs have also been involved in CDO transactions in microfinance. CGAP reports that in addition to this initial CDO seven more have been structured and more than US$525 million in microfinance securities have been issued as of February 2008. They also determine the average deal size to be US$4.1 million, with 61% of subscribers institutional investors and 27% dev elopement finance institutions (DFIs). Additionally, at this point 93% of structured finance deals were done in the Latin American and Caribbean and Eastern Europe and Central Asia regions.
For investors, structured finance investment offers higher returns and portfolio diversity. Through this method investors acquire the advantages of micro-loans’ low correlation to the mainstream markets. To maximize the return opportunities of structured finance investments in microfinance while limiting risk, these investments are often made in combination with conventional debt financing. Investors with different risk appetites are accommodated as well through the creation of different tranches in a securitization. The major tranche is given priority in the receipt of interest and capital payments with the view of achieving “investment grade.” Investors who purchase junior/equity tranches carry more risk, typically hoping to achieve higher returns. Public or more social-oriented investors may also buy these tranches to support investment for social returns.
As structured finance is relatively new in microfinance there is much to be learned about the best approach. The major complicating factor in this setting is the added component of social returns, which may cause differences in strategies and implementation procedures from purely return-driven investments.
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
Currency Management
Currency risk arises when microfinance institutions operating in local currencies receive hard currency loans. This occurs because loans in hard currencies are relatively cost-effective and easy to obtain. This discrepancy forms a currency mismatch. In the case of a currency mismatch, an unexpected depreciation of a microfinance institution (MFI)’s local currency can drastically increase the cost of a hard currency loan relative to revenues, leading to default and therefore a loss of creditworthiness that hinders the MFI’s ability to access more funding.
This risk is exacerbated by other risks also involved. For example, when borrowing in a hard currency the loan may be indexed to a reference rate such as Libor or Euribor. This adds exposure to interest rate movements in addition to exchange rates. In some cases the national government can interfere with hard currency loans, prohibiting conversion between currencies or not allowing foreign currency to leave the country. If an MFI has passed its currency risk on to its borrowers, in the event of a devaluation there is a heightened risk of non-repayment.
Effective currency management is beneficial to MFIs in many ways. The most fundamental is the ability to continue and expand operations, so that an MFI’s clients are not subject to sudden declines in lending capacity in periods of currency volatility. Having a currency management strategy in place can keep an MFI from passing on currency risk to its clients, who are least able to handle it. It also enables efficient capital use, allowing MFIs to employ more of their capital in their core business instead of keeping a portion on reserve for the risk of devaluation.
From an investor perspective, currency management tools open up a wealth of new opportunities. Many regions, such as much of Africa, are yet untapped by microfinance investors due to extremely high currency risk.
There are a few basic methods for managing foreign exchange risk, such as hedging products, back-to-back lending, letters of credit, and indexation of loans to hard currency. These may be used in combination to minimize foreign exchange exposure while reducing the costs associated with hedging. Some ways that MFIs manage currency risk without the use of financial derivatives include back-to-back lending, letters of credit, guarantees or credit enhancements, and indexation of loans to hard currency.
One basic currency management product is the spot contract. Used for an immediate exchange of funds, a spot contract is an obligation to buy or sell an amount of foreign currency at the current exchange rate. Currency swaps are the most thorough way to hedge a loan transaction because the terms can be structured to match the underlying loan exactly. In this procedure, a MIV makes a loan to an MFI in local currency, receives payments in the local currency, then exchanges the local currency for hard currency with a third party according to agreed upon exchange rate terms. This is a way to circumvent government controls on foreign currency exchange. Forward exchange contracts are another method, locking in an exchange rate on a specific date so that repayment of funds is made at a future date at a previously agreed-upon rate. While they tend to predict future exchange rates inaccurately, they represent an industry consensus and are therefore one of the best methods of managing currency risk.
Recent experience proves the value of foreign currency hedging in microfinance investment. For example, four Latin American microfinance institutions (MFIs) experienced a year-on-year drop in net income of 7% to 14%, and fifth suffered a 75% decline, due to currency devaluations. Similarly, two Eastern European MFIs’ net income decreased by 14% and 43%. These currency-related losses occurred in different nations in different years, underscoring the importance of currency protection in prudent asset liability management.
It is therefore important for microfinance investment vehicles (MIVs) and MFIs to establish sound asset liability management policies that incorporate currency risk mitigation. In the current environment, this may be done through shorter-term loans and country diversification.
Investors tend to be better equipped than most MFIs to assume currency risks, particularly since they can better afford hedging. Investor use of currency hedging instruments isolates currency risk instead of passing it down the microfinance chain. In addition to cost, another limiting factor in the use of hedging instruments is prohibitive regulation in some countries that makes it difficult to hedge effectively. On the part of MFIs, the best way to mitigate currency risk is to seek increased local funding. For both investors and MFIs, a good foundation for managing currency risk is the establishment of a sound risk management strategy and policy.
The following organizations are involved with currency management in microfinance:
The Currency Exchange
www.tcxfund.com
MFXSolutions
www.mfxsolutions.com
Cygma
www.cygmafinancial.com
More information about microfinance investing is available in the Microfinance Investing section of IAMFI’s Current Research page.
To learn about microfinance investment vehicles, visit the Industry Landscape Microfinance Investment Vehicles page.
For more information on microfinance investing, view the websites of IAMFI’s members.
The information on this web site is provided for informational purposes only, is not comprehensive, does not contain important disclosures and risk factors associated with microfinance investments, and is subject to change without notice. IAMFI is not responsible for the accuracy, completeness or lack thereof of information from third parties which it facilitates on its web site. The information does not take into account the particular investment objectives or financial circumstances of any specific person or organization which may view it. Nothing in this web site may be considered an offer or a solicitation to purchase or sell any particular financial instrument. Nothing on this website constitutes any recommendation, express or implied, as to the suitability or otherwise of any investment. Before making an investment in microfinance, investors are advised to review such investment thoroughly and carefully with their financial, legal and tax advisors to determine whether it is suitable for them. Any person viewing any materials on this website is deemed to agree to the foregoing.
Member Login
