Fixed‐Interest Investments and Equity Commitment

Similar to traditional investment funds, investments in microfinance offer the option of fixed income investments or investments in stocks. For this reason, there are funds that exclusively invest in fixed income papers, or solely in equity capital. Other funds may prefer a mixed portfolio. Fixed income in this case refers to the fact that investments are only made in loans that go to MFIs. On the other hand, funds with equity exposure lend equity capital to the MFIs. At 80 per cent, the global market for fixed income investments is considerably more substantial than the stock market with its roughly 20 per cent share.²

Thematic Funds

Microfinance investment funds may have a thematic focus, meaning that a fund is mainly used to promote and develop a particular topic such as agriculture, health, education or energy. Thematic funds issue loans and equity to MFIs that exclusively deal with the respective topics or engage in their funding (see Figure 10.3). Another possibility is to distribute funds to MFIs that commit to implementing the capital they receive in the name of these pre‐defined goals, albeit they may additionally use the remaining funds to issue micro loans for other goals.

Public–Private Partnerships and Risk Sharing

The risk sharing between public and private investors is an appealing aspect of several microfinance funds. Several microfinance funds are set up as public–private partnerships, where public and private investors invest in the same funds. Very often, public investors provide a guarantee in the form of horizontal and vertical risk sharing. Horizontal risk sharing means that a public institution carries a certain share of potential risks. In the event of a 5 per cent loss, and in the case of horizontal risk sharing of 50 per cent, this public institution would carry half of the loss, and the private investors the other. With vertical risk sharing, public investors bear the brunt of the risk to a certain degree. This is also referred to as first‐loss tranches. Vertical risk sharing of up to 20 per cent means that the public institution takes over losses of up to 20 per cent of the capital. Private investors are only affected by losses that exceed the 20 per cent mark.

Closed‐End vs. Open‐End Funds

As MIVs, i.e. investments in MFIs, predominantly feature in private markets with limited tradability, closed‐end funds have several advantages over open‐end structures.³ Their fixed maturities manage to achieve a higher level of investment. Closed‐end products at the same time are better suited for long‐term loans, and can be managed more efficiently: no trading of shares needs to be assured, and their net asset value (NAV) needs to be assessed and published less frequently. Due to a limited circle of investors, the implementation of regulatory guidelines is usually easier than in open‐end funds, and annual audits are less elaborate. For closed‐end funds this results in lower costs and higher net returns.

Costs

At 2 to 4 per cent annually (TER), the management costs of microfinance funds are traditionally slightly higher than those of traditional investment funds, the reason being the labor‐intensive analyses of MFIs. Professional microfinance fund managers are represented by their staff in the regions in question, which allows them to assess MFIs locally. This includes due diligence visits to MFIs that may take several days, during which interviews are conducted with the board of directors, the management, the MFI's employees and clients, and also loan documentations are reviewed.⁴

Microfinance Funds: Possible Pitfalls

As with any other financial investment, investing in microfinance funds is a question of diligence. Alongside the well‐known factors, microfinance features additional characteristics that need to be taken into consideration.

Regardless of whether a microfinance fund provides MFIs with equity or debt capital, investments are largely conducted in private markets and are not traded on a stock exchange. Investments therefore have to be identified, reviewed, negotiated and structured locally. In many cases, critical information is only available locally and may be coded with local idiosyncrasies. Thus, the decisive factors in the choice of a fund manager are how well and in what regions the manager is represented by local staff, and in addition to that, how familiar the manager is with the local and regional setting and the economic and legal framework. Being proficient in the local language is mandatory, especially when conducting interviews with clients, reviewing and negotiating contracts. During the investment process, it is advisable to investigate whether the manager bases their decisions on their own research or whether they buy their data from third‐party suppliers.

As mentioned earlier, the debt to equity ratio is around 80 to 20, i.e. 4 to 1. Apart from genuine private equity funds, therefore, in most cases a manager's loan experience is crucial. Investors are advised to carefully examine a fund manager's degree of experience. Among other factors, the investment team's specific wealth of experience, as well as the default rate of a loan portfolio, are clear reference points when it comes to assessing the quality of the loan process. It is equally relevant to establish the manager's experience in handling problematic loans. With private equity funds and mixed funds, a careful screening of the assessment methodologies and policies for equity investments is inevitable. Mixed funds additionally carry the risk of conflicts of interest, as in some cases the same MFIs are funded by means of debt capital and equity at the same time.

Microfinance funds are known to predominantly invest in developing countries, which are as a rule less politically and economically stable than industrialized countries. A microfinance manager therefore ought to have the skills to hedge the interest rate risks of local currency areas as well as exchange rate fluctuations. Country risks such as political crises and natural disasters are other well‐known and monumental challenges that MIVs have to face. Diversification across different countries and regions is a crucial evaluation criterion when it comes to funds. Loans that have been granted or equity stakes are usually not traded on a stock market, which explains the relevance of the liquidity management.

If a fund can fall back on a bank line, potential funding gaps can be bridged. A bank line allows for flexibility on the investor's side and can be used to temporarily finance applications for and redemptions of shares in a fund.

Strategic and Tactical Asset Allocation

In simple terms: the result of the top‐down process is a structure that defines the cornerstones of an investment strategy. It aims for optimal diversification across countries, regions and individual investments. Establishing this structure, however, is by no means trivial, as there are different dimensions that have to be considered and brought in line with one another. The following questions have to be addressed in this process:

• Which countries should be invested in?
• What (maximum) amount should be invested per country or region?
• What overall risk is acceptable?
• Which MFI segments (tiers 1, 2 or 3) should be invested in?
• How many MFIs should be included in the portfolio?
• What (maximum) amount should be invested per MFI?

Only a wealth of experience and in‐depth knowledge of the global microfinance and financial markets will answer these questions. Successful fund managers adamantly have to know the risks involved with individual countries and regions and gauge them accordingly. They have to be able to pinpoint the MFI segments in each country and region that are attractive and ultimately investible for international investors.

The percentages for the strategic asset allocation are defined based on the country analysis (see Figure 10.6). Strategic asset allocation is rather rigid in its design and focuses on long‐term goals. For this reason, tactical fluctuation bands are established that allow the fund manager a certain degree of flexibility in reacting to favorable and adverse conditions. This may be helpful especially when the political framework of a country takes a turn for the worse and emphasis on this particular country has to be tactically reduced. The contrary may be the case when a country becomes particularly attractive, which would lead to a temporary increase in portfolio weighting.

Analyzing and Selecting MFIs

There are around 4000 microfinance institutions. A single microfinance fund – depending on its size and geographical orientation – invests in about 50 to 200 institutions in this universe. Apart from the central risk‐return considerations, several other factors influence the selection process.⁶

A microfinance fund manager's main task is to select the “right” MFI. The MFI analysis and selection process is crucial for the quality of a portfolio. The following illustrates the seven steps of this process (see Figure 10.7).

1. Define selection criteria

   Along with the benchmark figures defined by strategic asset allocation, further (quantitative or qualitative) basic selection criteria for investments may be either mandatory or supplementary, depending on the mandate. These additional conditions further reduce the investible universe.

2. Pre‐DD committee review: screening and approval of due diligence

   Once the selection criteria have been defined, the screening follows. This means that MFIs are identified that appear to meet the criteria. Special databases and networks are used in this step.

   At this point, it will also be necessary to establish how much equity and debt capital these individual MFIs can or should raise.

   The information that has been gained so far is by no means sufficient to make an investment decision; however, it is usually substantial enough for a preliminary report on the choice of interesting MFIs. This report is typically compiled by an investment specialist. Due to possible conflicts of interest, she or he has no discretionary competence. Therefore, an investment committee will be needed to either terminate the process, seek more information or grant the investment specialist permission to continue with the process.

   If the fund manager pursues a hedging strategy with respect to currency and/or interest rate risks, it is further advisable to assess the hedging conditions early on in the process. The approach again depends on the individual fund manager. Some will hedge all transactions against interest rate and currency risks, others will only partly do so, and some investment managers will deliberately take a currency and interest rate gamble in the hope of an added profit alongside interest payments.

3. Conduct on‐site due diligence

   As soon as the investment committee has given the green light, an in‐depth analysis will be conducted locally in order to gain a better understanding of the MFI and the essential risks on hand. Previous to that, an investment specialist will have gathered additional information from the MFI and prepared further steps accordingly. These preparatory operations will allow the investment specialist to travel to the resident country of the MFI under investigation.

   What follows is the due diligence investigation of the MFI, which usually takes a few days. The information gathered locally will then be presented in a detailed report and handed over to the investment committee for further inspection.

4. Assign rating

   The due diligence of the MFI informs the fund manager about the quality of an MFI. For an even more accurate assessment of an MFI, it can be assigned a rating, which pools all the relevant information. Quality is thereby defined as a probability of default, meaning that the rating should indicate the probability of an MFI sliding into financial difficulties.

   Larger MFIs have already been rated by well‐known rating agencies such as Fitch, Standard & Poor's or Moody's and may serve as a reference point for the fund manager's own judgment. Most MFIs, however, have not been rated yet – all the more reason why a fund manager's own evaluation may even be of vital importance to the MFI itself.

   The rating methodology depends on the fund manager, though the calculation of a rating is highly complex and as a rule can only be performed by the most proficient service providers. The rating assignment process is ideally performed on several levels in a bid to avoid any conflicts of interest. Hence, although the investment specialist may well make suggestions for the rating, they will not be in a decision‐making position. In many cases, a rating will therefore be confirmed by a committee consisting of investment specialists, portfolio managers and risk managers.

5. Internal investment committee review

   Due to conflicts of interest, investment specialists do not decide single‐handedly whether an investment in a particular MFI ought to be encouraged or not. They submit both their own proposal and the rating to the investment committee for approval.

   There may be several investment committees along the fund hierarchy, which is why an investment proposal at times has to be approved by more than one committee. Combinations between internal investment committees at fund manager level and external committees for the fund, which is a separate legal entity, are quite common. The external thereby superordinates the internal committee.

6. Disbursement and hedging

   The decision of the investment committee is followed by a series of operative steps to complete the transaction. First of all, the loan contract with the MFI is concluded and signed by both parties to be legally binding, then the contract is transferred to the custodian – usually a bank – for safe custody.⁷

   What follows now are the hedging transactions, if at all provided. This encompasses additional tasks for the fund manager. They will begin to evaluate and select suitable hedging instruments and partners as well as structure contracts that are in line with the characteristics of the loan.

7. Monitoring

   During its term, the investment is closely monitored, both virtually and locally. To enable the fund manager to monitor the investments from far, the MFI is obliged by the loan contract to disclose certain information to the manager in a predetermined frequency. Special occurrences are to be communicated immediately.

   Ideally, these reports are evaluated by the investment specialists and risk managers involved. They assess the general situation of the MFI and check for breaches of the loan contract. In the event of negative developments or breaches of covenants, the risk management takes over the case and devises an adequate course of action.

Efficient Frontier

The efficient frontier concept was introduced by Markowitz in 1952 and is a cornerstone of MPT. It establishes the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a specific level of expected return. Figure 10.11 displays two portfolios that carry an identical level of risk, but generate different returns. Therefore, only the portfolios on the solid line (efficient frontier) are efficient. They yield a higher return with the same risk (volatility) than the portfolios on the dotted line. The dot indicates the mean‐variance portfolio, which is the portfolio that yields a specific return with the lowest risk.

Correlations naturally follow suit when the values of the different investments change. Investors therefore reshuffle their portfolio based on these changes. However, the changes in correlations between the different asset classes are rarely significant enough to have a dramatic effect on risk minimization.

Sample Portfolio: Microfinance in the Portfolio Context (According to Markowitz)

A sample portfolio will serve to illustrate how the value added to a portfolio by microfinance is assessed, by means of six sample asset classes that create a portfolio:

• Microfinance
• Cash
• Government bonds
• Stocks
• Stocks – emerging markets (EM)
• Hedge funds

Figure 10.12 displays the key performance measures of asset classes i.e. their respective indices. Over the period of ten years, emerging market stocks (MSCI EM index) yield the highest return at almost 11 per cent annually, followed by stocks of industrialized countries (MSCI World) at 6 per cent. Government bonds (Morningstar government bond index) yielded a return of 3.3 per cent a year, MIVs (SMX – MIV Debt) yielded 3.7 per cent, cash investments (six‐month US‐Dollar LIBOR) 2 per cent, and hedge funds 0.7 per cent (global hedge fund index). While stock indices were particularly subject to turbulence during the financial crisis, microfinance and the money market managed to remain largely unscathed.

A look at the relation of the risk and the returns (Sharpe ratio) clearly reveals the appeal of MIVs. Taking account of the volatility, the return of 3.7 per cent p.a. yields a Sharp ratio – i.e. a risk‐adjusted return – of 2.8 per cent and achieves the highest ratio of all the asset classes in the portfolio.

Figure 10.13 reveals that MIVs in fact correlate little with other assets. The value of the so‐called correlation coefficient may figure anywhere between minus 1 and plus 1. A correlation of plus 1 indicates perfect positive linear correlation between the two asset classes, whereas a correlation of minus 1 indicates a perfect negative correlation. A correlation coefficient around zero indicates no linear correlation.

An efficient portfolio is one where the return of a portfolio cannot be increased with a given risk, or where the risk cannot be lowered with a given return. Figure 10.14 illustrates that microfinance boosts a portfolio's efficiency. This essentially means that including microfinance in a portfolio generates a higher return at the same level of risk than a portfolio that only consists of conventional asset classes.