Microfinance: Asset Class with a Dual Return

Small loans in developing countries benefit the local population but are also good for the responsible wealthy investor. This relatively new asset class – microfinance – is proving very popular with many wealth managers as an addition to the asset mix. Kaiser Ritter Partner invests in a microfinance fund run by Liechtenstein-based Enabling Microfinance AG, which combines financial gains with social return. Managing Director Christoph Dreher answers our questions.

What exactly is microfinance?

Microfinance is basically a privately initiated form of development aid. Very small loans are extended in developing countries, which are then passed on to micro-entrepreneurs – helping them to help themselves. The concept was developed more than thirty years ago, but has really taken off in the last seven to ten years, partly because of the Nobel Prize awarded to Mohammad Yunus.

Microfinance investors tend to fall into one of two categories: exclusively socially oriented investors, and investors who would like to make financial as well as social gains.

What are the main target sectors for this type of investment? Are there particular geographical areas where it works best?

Overall, the split between rural and urban areas is practically even. We try to make sure that we have a good mix between the two. In terms of industries, the three main areas we invest in are services, commerce and agriculture.
The basic principle is always to supply a small sum that helps the business get to the next stage: for example, buying a new machine that will allow it to increase production.

Has there been a change over time in the types of sector you invest in?

Yes. Three or four years ago, agriculture was very much to the fore. But now it’s going more and more in the direction of commerce and manufacturing. The service sector is also becoming more significant. This shift has a lot to do with the different regions that receive this type of investment: South and Central America are simply more developed. You see this particularly in commerce, where the added value is also much greater.

Microfinance has experienced a boom in recent years. It is being touted as a miracle cure for poverty in developing countries.

The boom has a lot to do with the awarding of the 2006/2007 Nobel Peace Prize to Mohammad Yunus. Since then, volumes have grown by more than forty percent. Worldwide microfinance loans have now reached an overall volume of 65 billion US dollars. In recent years there have also been several initial public offerings: growth has made the sector much more commercial – with all the advantages and disadvantages this implies.

The appeal for private and institutional investors was partly to do with financial stability. What effect did the economic crisis have on this?

Investors are attracted by the correlation factor. They discovered microfinance as an effective portfolio diversification play. As an asset class it has a very low correlation with traditional investments such as shares, bonds, etc.

But did the financial crisis make it a less stable investment?

Microfinance as a whole remained stable during the financial markets crisis. However, most of the loans are extended for a two-year term, and there is no secondary market, so any problems tend not to become apparent until later on. In 2010 we saw some minor issues which will require provisions and which will reduce the fund’s performance. But generally the microfinance sector has adjusted well to the challenging conditions.

Haven’t we also seen the correlation to other asset classes increase during the financial crisis?

The correlation to most other asset classes is still relatively low. However, a new study has shown that this correlation did indeed increase from mid-2008. This is a general trend on the markets, but the diversification potential against conventional investments is still relatively high. It still makes sense to mix microfinance investments into a conventional portfolio.

What factors played a role here?

The BRIC countries certainly had an influence. Brazil and Central America in particular are locked into the world economy. The correlation is strong in Mexico, for example, because of the close economic links with the USA. Consequently, many funds concentrate on “country picking”. Countries that used to be relatively unattractive, like Azerbaijan for example, are now coming more into focus.

Is there a danger that the large inflow of money could lead to a bubble?

Yes, I believe there are definitely signs of overheating in some countries. It is up to the fund managers to deal with this, use their critical faculties and not just accept money blindly. If a fund can no longer place its money in accordance with its strategy, the whole market suffers as do the individual investors. The combination of great interest from investors and the MFIs’ low requirement for refinancing (MFI = microfinance institution) has also forced some funds to withdraw subscription opportunities for investors temporarily.

Where have things been particularly difficult?

Bosnia-Herzegovina, Mexico and India – and some South East Asian countries.

Are the same problems occurring in all these countries?

No, you have to differentiate between each situation. In Bosnia-Herzegovina many of the microfinance institutions were unable to cope with the growth and failed to provide the right management training. A very important factor is that these financial institutions did not have adequate risk management, if any.

Loans were often granted without proper checks. Sometimes there was also a degree of “mission drift”, with loans being given out for consumer goods – televisions for example. This is not what microfinance is all about. The market overheated and default rates have now gone up in some areas. Certain restructuring measures have had to be taken in Bosnia.

India has been in the headlines since November last year because of high suicide rates in the Andhra Pradesh region. This is one of the poorest parts of the country, and suicide rates were 80 percent higher than the national average. Microfinance attracted criticism in the wake of these figures, but the connection is not entirely clear since only a few of the people concerned were microfinance customers who had fallen into arrears.

Nevertheless, microfinance institutions shot up like mushrooms in India. Loans were extended without any controls, sometimes to the same people several times, and sometimes for consumer purchases. Unlike us, these institutions did not have a central credit information agency. Small local providers were responsible for most of the proliferation, and eventually the national bank had to step in.

Criticism has also been levelled at microfinance insurance solutions. The problem was that many of the suicides had taken out micro-insurance policies. They then killed themselves so their families could use the insurance money to pay off their debts. A dreadful unintended consequence, and one that could have been avoided if all the policies had specifically excluded this eventuality. In India the whole sorry story was then heavily politicized and exploited.  Politics has often muddied the waters of microfinance in neighbouring countries too. Mohammad Yunus was sacked by the Prime Minister of Bangladesh because he tried to set up a political party. As an investment fund, you have to proceed very carefully in these countries and be very thorough with the due diligence process.

High rates of interest have also attracted criticism.

Credit interest rates of 30 percent may seem very high. However, the alternative for these borrowers is to go to local loan sharks who charge more than a hundred percent. It should also be noted that two-thirds of the money is used to cover administrative costs at the microfinance institutions. These often give coaching to the people running the businesses, and their staff have to travel great distances in rural areas. Repayments are almost always on a weekly basis. Only a third of the interest is then left for refinancing on the capital market. But the borrowers really can earn enough to pay these rates.

Have you had to make readjustments in the light of all this?

We have always applied a very selective lending policy. And as well as the financial side we are interested in the social performance angle. We focus on business loans, not consumer credit. Consumer credit leads to poverty. We choose our partners carefully on this basis and visit each MFI at least once a year. We also receive regular reports.

Microfinance was known for its excellent repayment rates. One assumes that this has suffered of late?

The default rate for microfinance averages 2.2 percent. This is slightly higher than it was, but in countries where the market hasn’t overheated so much, default rates are still at two percent or less. This contrasts with western banks and credit card companies in the USA, which have to cope with non-repayment rates of more than 8 percent.

What can an investment fund do to counter the trend?

Our fund, for example, deliberately does not invest in India, because we saw two years ago that the market was starting to overheat. We also have to apply our own rules consistently. In March last year, for example, an investment in Mexico reached the end of its term. However, the microfinance institution was taken over by a commercial bank, so the investment was not extended. Why? Because a commercial bank could not fulfil our rules.

What are the current trends in the world of microfinance?

There are two big trends: microfinance investment vehicles are increasingly putting equity into the microfinance institutions they work with and taking on some of the risk, the aim being to increase the value of the business over the long term.

The second trend is about currency:  previously, loans were made in hard currencies like the US dollar and euro. This meant that local microfinance institutions carried a currency risk. Funds are now offering more and more loans in local currencies, including Mexican pesos and Jordanian dinars. They are deliberately taking on the currency risk so the microfinance institution doesn’t have to worry about it and can concentrate on managing the other risks. This does mean, of course, that the fund itself has to put the right hedging in place.

Share on Facebook
Bookmark this on Delicious