Micro scope widens
Clive Davidson, Risk Magazine, May 01, 2007

A number of micro-finance equity funds and collateralised loan obligations have been launched over the past year, with investors attracted to high returns and relatively low default rates. Is micro-finance emerging as an asset class in its own right? Clive Davidson reports

When Grameen Bank, a Bangladeshi firm that specialises in providing micro-loans to the poor, and its founder, Muhammad Yunus, won the Nobel Peace Prize in 2006, it proved that micro-finance has firmly been accepted as an effective way to alleviate poverty in developing countries. And when Geneva-based micro-finance investment intermediary BlueOrchard Finance issued its first stand-alone collateralised loan obligation (CLO), also in 2006, it was a sign that micro-finance is also emerging as a new asset class.

The BlueOrchard Loans for Development (Bold) CLO raised $99.1 million - at the time, the largest single commercial investment transaction in the history of micro-finance. Morgan Stanley structured the deal and managed the distribution to investors. The senior notes were sold to mainstream institutional investors, including a number of large European commercial banks, many of which were investing in micro-finance for the first time. Meanwhile, the Netherlands Development Finance Company, a Dutch development bank, underwrote the entire subordinated note class. The investment was disbursed as fixed rate, five-year funding to 21 micro-finance institutions (MFIs) in 13 countries and five currencies.

The Bold CLO achieved a number of firsts in the micro-finance world, says Jack Lowe, Genevea-based chief executive of BlueOrchard. "Bold was a classic CLO deal, done without anybody giving a guarantee. It was the first micro-finance CLO done with a big investment bank, the first to include local currency lending in five currencies, and the first with one of the development banks buying a portion of the deal," he says.

Bold is one of a growing number of capital markets deals involving micro-finance. Last May, ProCredit Bank Bulgaria securitised a EUR47.8 million micro-finance loan portfolio, with Deutsche Bank acting as structurer and the European Investment Fund and KfW, a German bank and development agency, providing guarantees. Then, in April this year, Citi and Pakistani micro-finance organisation Kashf Foundation announced the first tranche of a $22 million term-financing package, with risk participation by the Overseas Private Investment Corporation, a US government agency. That followed the setting up of a micro-finance equity fund in March by Unitus, an organisation based in the US state of Washington that provides financial, technical and other support to micro-finance providers. The fund closed with $23.4 million in private capital. These deals are in addition to the more than 80 funds already investing in micro-finance, 50 of which include private investment.

Because of the nature of micro-finance activities - which mostly (but not exclusively) take place in the poorer areas of developing countries where there is little infrastructure and where banking arrangements are often recorded manually - there is little hard data on the industry. It is believed there are around 10,000 micro-finance organisations worldwide, while estimates for the current number of micro-finance borrowers range from 100 million to 200 million.

However, the potential market for micro-finance loans and other financial services is around 3 billion people, according to estimates by the Consultative Group to Assist the Poor (CGAP), a Washington, DC-based consortium of 33 public and private development agencies that aims to expand access to financial services for the poor in developing countries. This offers micro-finance service providers enormous potential for growth - hence the emergence of equity funds and CLOs, and growing interest among capital markets investors.

In a sample of 500 MFIs, the CGAP reported that 80% of borrowers were women, borrowing on average $345 and paying between 18% and 60% in interest. The high levels of interest and therefore the potential for good returns on loans to MFIs is just one of the factors attracting the attention of investors. Another is the low rates of default. "We have made over 400 loans and never had a default," says BlueOrchard's Lowe.

Accion, a Boston-based micro-finance organisation, has similarly not had any defaults in its funds, says Lauren Burnhill, head of the financial markets and services group at the organisation. Meanwhile, Oxford-based Christian micro-finance charity Opportunity International reports repayment rates of 98% on loans made over the past 15 years.

Micro-finance fund managers ensure they minimise risk by diversifying their investments across MFIs and geographies. In 2005, Paris-based Edmond de Rothschild Asset Management launched the Saint-Honore Microfinance Fund in conjunction with BlueOrchard. Saint-Honore is essentially a fund of funds that invests in organisations that lend in Latin America, eastern Europe, Russia, India and elsewhere. "We cannot say that investing in micro-finance is without risks, but with good diversification - we invest in several countries - classic credit risk is not high," says Humbert Garreau de Labarre, who set up the fund for Rothschild (but who has since moved to Shanghai to establish asset management operations in China for the firm).

Klaus Tischhauser, managing director of Zurich-based micro-finance investment intermediary company responsAbility, agrees: "If you invest in just one MFI then, like any other investment in a single stock or bond, there is a certain risk." ResponsAbility's Global Microfinance Fund invests in Ecuador, El Salvador, Montenegro and Cambodia, as well as the Middle East and Africa. As of February 2007, the fund had invested $95.5 million, with loans disbursed to 140,000 micro-entrepreneurs.

The responsAbility Global Microfinance Fund is one of three to be accredited by the Luxembourg Fund Labelling Agency (Luxflag), an independent organisation that evaluates Luxembourg-registered funds and awards its label - a micro-finance stamp of approval - to those that meet its criteria. The other two are the Dexia Micro-Credit Fund (managed by Luxembourg-based Dexia Asset Management and BlueOrchard) and the European Fund for Southeast Europe (a fund led by KfW and managed by Luxembourg-based Oppenheim Pramerica Asset Management).

To obtain the Luxflag micro-finance label, the fund must be supervised by a European Union or equivalent regulator. In addition, micro-finance investments must comprise at least 50% of total assets, and the fund must invest at least 25% of its assets in MFIs rated by an agency recognised by Luxflag.

There are a number of agencies that specialise in rating MFIs, including MicroRating International (the result of a recent merger between Micro-Credit Ratings International, based in Gurgaon, India, and MicroRate, based in Washington, DC) and PlaNet Finance, based in Saint-Ouen, France. Introducing the rating requirement was a way of encouraging MFIs to obtain ratings, explains Eleanor de Rosmorduc, manager of Luxflag. "Getting rated is the best way for MFIs to raise money in the capital markets, but we didn't want to set the level so high that we discourage investment funds from going below the top tier of MFIs," she says.

Nonetheless, most of the investment funds - both from development agencies and private investors - have so far invested in the top tier MFIs. And that has caused some problems. In a recent paper (Role reversal: Are public development institutions crowding out private investment in micro-finance?), MicroRate founder Damian van Stauffenberg and Julie Abrams, head of Maryland-based micro-finance investment consultancy Micro-finance Analytics, point out that government-owned development institutions are concentrating their loans in the top tier of micro-finance lenders. In doing so, they are forcing private investors to look for opportunities among the smaller, potentially riskier MFIs. This is not in line with the stated objective of development institutions, which claim to take risks the private sector avoids. As private funds are now showing an interest in micro-finance, the development institutions should move beyond the top tier of MFIs, argue van Stauffenberg and Abrams.

Subsidised loans by development institutions are distorting the market and making it more difficult for the private sector to achieve acceptable returns, notes BlueOrchard's Lowe. "If we are talking about micro-finance becoming an asset class, investors want to know that they are investing in something that is not subsidised, and is a normal market where they can calculate their risk and reward," he says.

However, it is still early days. Tischhauser argues that private investors have only recently started showing interest in micro-finance as an asset class, and points out that it will take some time for the development agencies to begin investing in the lower tier of MFIs. "It is normal that development institutions do not move out of a market at exactly the same speed and to exactly the same extent as the private players come in, so there will be some overlap," he says. "The present discussions are valuable, and will lead in time to a new distribution of roles."

Those active in micro-finance are eager to see the flow of private investment increase, along with broader use of a variety of capital markets instruments. But there also needs to be growth in infrastructure and lending. "There are 2 billion people living in poverty but only around 200 million have access to micro-finance," says Accion's Burnhill. "It's hard to imagine that we can reach all the people who should be reached purely with philanthropic capital, and we may not need to. The poor may be poor, but that does not mean they are less of a market - it just means that it is more of a challenge to reach them."

Burnhill argues there needs to be a consolidation of MFIs in order to reach the volume and value of transactions that will interest commercial banks. The CGAP reports that 60% of the 10,000 MFIs in existence have fewer than 2,500 clients. "Accion has also decided that technology is going to be one of the factors that makes micro-finance more efficient and attractive to commercial investors," says Burnhill.

To encourage the development and use of dedicated technology, Accion created the Gateway Microfinance Infrastructure (GMI) Fund in 2006, which invests in micro-finance-orientated technology and information services companies. In March, the fund announced its first investment - in Maryland-based Pay Rent, Build Credit (PRBC), a credit bureau for people with little or no credit history. PRBC uses the internet to enable its members to build up a credit history from the online payment of utility, insurance, child support and other bills. (Operating in the US, it also demonstrates that micro-finance is not restricted to developing countries.) Accion is now evaluating an African software company that works with micro-finance, which it would not name.

"What investors are seeing here is the opportunity to support the micro-finance industry in a way that gives them the possibility of very high returns without the ethical questions that might arise if an MFI suddenly reported a 200% return on equity," says Burnhill. The GMI Fund has a target return of 15%, although Burnhill is confident that the fund will exceed this.

Other factors are likely to attract greater numbers of mainstream investors and capital market players to micro-finance, including better industry data and more transparency in reporting by MFIs, and greater use of the mainstream rating agencies by micro-finance funds. For instance, Accion is currently working with Standard & Poor's and its Indian subsidiary, Crisil, to develop a methodology that bridges conventional and dedicated micro-finance rating practices.

In the meantime, most of the interest in micro-finance is coming from those investors seeking socially responsible investments (SRI). This constituency is growing and increasingly includes not only retail investors and high-net-worth individuals, but also pension funds and insurance companies. This in turn is drawing asset management firms and banks, especially those with large private banking operations, into micro-finance.

Credit Suisse is one bank active in this area, and manages the responsAbility Global Microfinance Fund. "The responsAbility Global Microfinance Fund enables our clients to invest in poverty alleviation and economic development, while at the same time earning a financial return that is comparable to, and often higher than, many high-profile bond funds and other money market investments," says Maria Lamas, head of financial products and investment advisory, private banking, at Credit Suisse. "Establishing the link between the users of funds - the micro-entrepreneurs - and the growing number of private and institutional clients of Credit Suisse who are looking for opportunities to invest in sustainable, equitable growth and development, is a natural responsibility of a global solutions provider."

Rothschild's clients include pension funds and insurance companies, and Garreau de Labarre says these organisations are coming under increasing pressure to initiate or expand the SRI component of their portfolios. The problem is that many so-called ethical investments are ambiguous and provoke scepticism - for example, some funds include nuclear power while others exclude it, both on environmental grounds. "Often, pension funds and insurance companies prefer micro-finance because it is clear. They know it will help people - in India, for example, someone can borrow EUR100 and it can change their lives - but it is a business arrangement from start to finish."

Whether it is the potentially high returns offered by micro-finance instruments or the socially responsible investing angle, interest in micro-finance investments looks set for growth. "After a bank created the first mortgage-backed securities transaction, everyone was in the market within two years because it was an incredible investment and way to finance and create liquidity for housing," comments Brent Kessel, president of California-based Abacus Wealth Partners, one of the major investors in the Unitus Equity Fund. "I think micro-finance is in a similar situation."