What Green Businesses Should Know About Microfinance

What Green Businesses Should Know About Microfinance

 [Editor's Note: This is the second in a three-part series on the growing field of impact investing, in which investments are designed to generate both financial return and positive social and environmental impact.   

The series explores the progress, challenges and practical applications of impact investing in the context of institutional portfolio management and looks at emerging investment strategies in forest carbon, microfinance and energy efficiency. The first segment is available at GreenBiz.com.

The posts are written by industry practitioners and drawn from content created for a new course at the University of Michigan's Erb Institute for Global Sustainable Enterprise.]

With global markets still recovering from the 2008 financial crisis and the reputation of many traditional financial instruments tarnished, investments in microfinance institutions (MFIs) have emerged as a promising option.  

The basic business model of microfinance focuses on creating sustainable long-term economic value for all stakeholders. Leading MFIs are characterized by high portfolio quality and strong profitability and operate in a market with many still-to-be-realized opportunities.

Microfinance commonly falls under the broad green business category because it is often associated with its positive social impacts -- its products and services realize the social and capital aims of its clients, including an increase in income, assets and fulfillment of basic needs. 

To scale its social mission, microfinance embraced a sustainable business model which allowed MFIs to expand beyond donor capital. Today the microfinance industry includes billions of investment dollars from commercial institutions.  What qualities have made MFIs a compelling financial proposition?

The numbers of the microfinance industry may surprise you: MFIs manage in excess of $40 billion in assets with a client base that exceeds 100 million borrowers. In fact, a recent publication from the Financial Access Initiative reported that there are 800 million low-income adults using formal and semi-formal financial services offered by a variety of channels including microfinance.

However, the report also concludes that there are 2.5 billion adults who remain outside of the formal financial system, quantifying the outstanding opportunity for microfinance. As MFIs pursue this opportunity, they'll need additional investment from the capital markets. Thus a better understanding of the unique financial attributes that define these institutions is necessary. This article summarizes what we believe are some of the most compelling attributes.

A View of the Microfinance Market

Emerging markets are enjoying an astonishing -- if complex -- ascension. These regions' share of global GDP (adjusted for purchasing power parity) rose to 45 percent in 2008 from 36 percent in 1980; multinational corporations predict that 70 percent of global growth in the next several years will come from emerging markets. 

With this growth comes the expansion of purchasing power and the creation of new markets for goods and services across the socio-economic spectrum. Even the massive low-income demographics known as the Base of the Pyramid (BoP), the 4 billion-person market whose households earn less than $3,000 a year, are being engaged in a meaningful manner. In aggregate, their economic strength is impressive. Renowned strategist C.K. Prahalad estimated the GDP of the BoP to be $13 trillion and the World Resources Institute measured their annual expenditure on goods and services at $5 trillion.

Over the last decade, the business community has come to appreciate that this low-income demographic possesses enormous economic power. Financial services is no exception. Microfinance, the provision of formal financial services to low-income communities, has exemplified the essence of BoP business models: deliver a relevant affordable product at scale. Since the 1970s, a wide array of development and commercial agents cultivated microfinance into an industry with meaningful products and services targeting the economically active poor.

Matching MFIs with Market Demand

In the realization of scale, MFIs have developed compelling and distinct attributes compared to other emerging market financial sectors. Based on an analysis of the financial characteristics of MFIs, there are fundamental differences between microfinance and emerging market commercial banks, which make microfinance as an investment worthy of consideration. These distinctions relate to the intrinsic credit quality of MFIs and their established financial metrics as well as the environment of support that is specific to the microfinance industry.


For example, in the creation and management of the loan portfolio, the principal asset, MFIs operate according to a different lending methodology based on cash-flow analysis rather than the hard collateral requirements of commercial banks.  A typical loan portfolio of an MFI has a large number of small, short-tenor (< 1 year) working capital loans across a variety of industries and geographies.

This method has demonstrated to be quite effective with historical average client repayment rates exceeding 95 percent across a myriad of economic cycles.  By contrast, the loan portfolios of emerging market banks have longer term assets and significant exposure to real estate markets and industries that rise and fall with global risk appetite, making their portfolio performance more volatile.

MFIs are also characterized by lower levels of leverage than banks which further add to their conservative nature. The average debt to equity ratio of the Symbiotics 50, an index of global MFIs, was 22 percent compared to JPMorgan's BIS estimate of 13 percent for emerging market banks.  Conservative leverage and high portfolio quality are key elements of what makes MFIs attractive for investment.

MFIs differ from emerging market banks in terms of their financial flexibility, measured by their ability to mobilize financial resources as market conditions change. This is derived from two important features of microfinance: 
* The tenor of available funding available to MFIs typically exceeds the average tenor of underlying loans, allowing MFIs to remain nimble in their operations.
* MFIs have unique access to a large network of well-capitalized development financial institutions (DFIs), foundations and donor agencies because of their role in the alleviation of poverty.

These assist the MFI in their growth trajectory: strengthening their risk management systems, developing new products, integrating appropriate technology and expanding to interface with new clients. This support can also manifest in grants and long-term investments to increase equity capitalization and loan guarantees to protect commercial investors. Perhaps most importantly, there is a history of development financial institution support increasing in times of economic stress.

Standing Out from the Traditional Finance Crowd

In the 2008 Microfinance Funder Study by CGAP, DFIs and other forms of donors and investors reported that they have committed $11.7 billion to the microfinance sector in the form of funding and technical support. 

An example of support from international partners is the Microfinance Enhancement Facility, a $500 million liquidity facility sponsored by the AAA-rated German development bank KfW and the International Finance Corporation created to mitigate potential liquidity shortages due to the recent financial crisis.  DFIs also use their balance sheets to encourage private sector involvement and expand the investor base of MFIs. The Minlam Microfinance Fund purchased a $100 million Loan Portfolio Guarantee at a subsidized rate from the U.S. Agency for International Development to attract additional private sector investment.

MFIs have strategic importance in achieving economically-sound development goals and these organizations would rather draw upon their deep financial resources than see MFIs fail. How do these compelling attributes translate to investment performance? In a comprehensive study of over 3,000 debt transactions between 1994 and 2008, the International Association of Microfinance Investors (IAMFI) concluded that the cumulative default rate of MFIs to investors over the period approximated 2.0 percent and that the volume of MFI defaults equaled 0.2 percent of invested capital.

These compelling financial attributes are part of what makes MFIs attractive and conservative investments in emerging markets, especially against other industries that are not able to access subsidized support in periods of stress. Investing in microfinance still entails risk and there is evidence that performance of MFIs bears some correlation to global markets. 

In the 2008 financial crisis, refinancing difficulties and increasing portfolio arrears impaired profitability and caused MFIs to reduce their growth targets.  It appears we can expect global volatility to continue over the short to medium term. Leading MFIs are adapting to this volatile environment by improving their risk management processes and systems, becoming more disciplined about the credit worthiness of their borrowers and slowing down their growth plans.

Long term, we believe that the industry will continue to grow at a sustainable pace, creating compelling investment opportunities for investors and fund managers whose activities contribute to broad-based financial, social and environmental prosperity.

Michael Hokenson is the managing director of marketing at Minlam Asset Management. He is a graduate of the Erb Institute of Global Sustainable Enterprise at the University of Michigan, where he earned an MBA at the Stephen M. Ross School of Business,  and is now a lecturer for the institute.