Between crisis and progress

Indian womanKaspar Wansleben of the Luxembourg Microfinance and Development Fund discusses how microfinance meets the market with Stefanie Eschenbacher.

Microfinance institution’s high repayment rates and rapidly expanding client base in emerging markets have caught the imagination of mainstream investors.

No longer a niche market, microfinance accounts for two-thirds of financial activity in Cambodia. There, as well as in Bolivia, the largest banks by number of clients are former microfinance institutions.

Specialised investment funds and, increasingly, mainstream private equity investors are seeking opportunities in the sector.

A handful of microfinance institutions – including Bank Rakyat Indonesia, SKS Microfinance in India and Grupo Compartamos in Mexico – have gone public in recent years.

The arrival of for-profit investors in microfinance has not only changed market dynamics but also sparked a debate on the ethics of profiting from the poor.

The Luxembourg Microfinance and Development Fund (LMDF) was launched at the onset of the microfinance crisis in 2007 when asset growth started to slow, profitability declined and portfolio risk rose. Many poor borrowers found themselves in a downward spiral of debt caused by easily available credit and high interest rates.

Kaspar Wansleben, the LMDF’s executive director, says his mandate encompasses both social and economic objectives. He says there is a risk that for-profit investors will put pressure on microfiance institutions, which could lead them to neglect their social mission. This could also increase the risk that loans are then given away easily and cheaply, thereby increasing the risks of defaults

“It is a positive development that more questions are being asked,” he says. “The industry is undertaking a number of initiatives to address problems.”

His social venture capital sub-fund has more than €12.2 million ($15.9 million) of assets under management, €9.8 million of which are invested in microfinance institutions.
Part of its portfolio is also invested to local funds that invest in microfinance institutions. Such an indirect approach is taken when direct investments would be smaller than €300,000.

The other part of the portfolio is invested in 26 microfinance institutions in 15 countries, lending to 20,651 borrowers. These serve underbanked areas or provide niche products, such as microinsurance or savings schemes. Female borrowers account for 74% of clients.

“We are early-stage investors,” says Wansleben. “We have a specific investment mandate, with a market-building mission.”

Eastern Europe is the most profitable region for microfinance, as loan sizes are larger, while Latin America is home to some sophisticated microfinance institutions. But Wansleben’s fund is biased toward sub-Saharan Africa, where 24% of its portfolio is invested.

The biggest credit gap is still in the informal economy – where economic activity goes unrecorded, is untaxed and unregulated – and the semi-formal sector.

He says South Asia – India, Pakistan and Bangladesh – has a large number of potential and existing clients. This, however, does not necessarily translate into higher growth prospects.

When selecting investments, his main criteria are operational efficiency, portfolio risk, and the business model.  

The industry standard to measure portfolio risk is the value of all loans outstanding at the end of the reporting period that have one or more instalment of the principal in arrears for more than 30 days.

This varies within regions. While in Latin America between 2% and 3% would be deemed acceptable, , says Wansleben, and in Africa the number ranges between 5% and 6%.

He says microfinance institutions closely linked to the community or faith-based organisations tend to have lower arrears. The group model, where borrowers co-guarantee each other’s loan, has proven successful. “[Microfinance] is not about consumption, but productive economic activity. If clients divert from that and use their loans for non-business activities, such as buying a TV, the model is bound to fail.”

High interest rates associated with these loans mean borrowers need to invest in their business to generate higher profits, and repay promptly.

The stated aim of the LMDF is to contribute to the alleviation of poverty in developing countries while also giving investors a financial return to at least compensate for inflation and preserve capital in real terms.

There are three share classes designed for the needs of different types of investors.

Share class A is intended for what Wansleben calls “mission-driven investors”, who are willing to take on a higher risk. Among those are foundations, non-government organisations and the Luxembourg government.

Institutional investors, mostly banks, invest in share class B. It has a higher risk/return profile, targeting a return of between 3% and 4%.

In 2010, a third option, share class C, was added for retail investors. It targets a return of between 2% and 3%, carries no fees and requires no minimum investment. There is a loss protection, too, which is financed through the mission-driven share class A.

“Our investors are not overly return-driven,” he says. “Higher returns will come with size. Our investors want stable returns.”

Investments are hedged through MFX Solutions, a company based in Washington, DC, that provides currency risk solutions for microfinance institutions by pooling hedging volumes. This reduces hedging costs for volatile, exotic currencies that lack market depth and trade at low volumes.

Other microfinance institutions still receive hard currency loans, denominated in either dollar or euro, which means they take on currency risk. “We specialise in credit risk, not currency risk,” he says. “Local microfinance institutions will be less qualified to manage this risk. Currency risk translates into credit risks.”

Despite the challenges, Wansleben says long-term trends in competitive countries with a sophisticated microfinance sector are encouraging. Two decades ago average interest rates in Bolivia were between 40% and 50%, but are now closer to 20%.

Some microfinance institutions have converted into for-profit formal financial institutions, a process called upscaling.

“When a microfinance institution becomes a deposit-taking facility, it changes the refinancing because it becomes cheaper,” Wansleben says. But he adds that a savings-led model needs adequate regulation.

Some banks have tried to tap into more profitable sectors of microfinance, a process called downscaling. “Banks that have taken their existing credit models and tweaked them have usually failed,” he says. “They need to set up dedicated units or buy a microfinance institution.”

Governments sometimes subsidise refinancing schemes, which Wansleben says makes it difficult to operate for those with a commercially-led approach. “We are always concerned about regulation. Regulation is either not there or there is often scope for improvement.”

©2013 funds global asia

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