Attention in the financial markets has been focused on the struggles of developed world institutions. To date, there hasn’t been much coverage of the impact of the financial crisis on microfinance—either on the flow of new capital to microfinance or the impact on MFIs that have borrowed money in hard currency while making loans in local currencies. Roger Frank is a partner at Developing World Markets, an investment banking and asset management firm specializing in microfinance, and has a front-row seat as the credit crisis increasingly impacts emerging market countries and microfinance. Roger spoke with Philanthropy Action recently about how the credit crisis is affecting investors and MFIs.

Philanthropy Action: There’s been a lot of coverage of the impact of the credit crisis on financial institutions all over the world, but very little about the impact on microfinance institutions. Is the crisis impacting microfinance institutions? Is it affecting the investors in microfinance institutions? Are they changing the way they think about risk in relation to microfinance institutions?

Roger Frank: Yes, it’s having a big impact. Like the rest of the world, the cost of capital has definitely gone up. For example, we’ve seen a couple MFIs that we were not able to reach an agreement with on the terms of a loan six months ago come back and ask us if those terms are still available. I just came out of a credit committee meeting this morning, and the same issue came up. The rate was a couple of months old and the MFI still wanted it. We’d say there’s anywhere from a 50 to 75 basis point increase in the cost of capital. The other issue is clearly, from the investors’ side, whereas in the past a lot of the microfinance investment vehicles were in the form of CDOs [Collateralized Debt Obligations], frankly that’s just not a viable financing option right now given what we’re seeing in the credit markets. So it’s changed the very nature of the type of investment vehicle that will bring money to microfinance. The third way it’s really impacted the industry is really in the perception of risk. You know people have been losing a lot of money so they’re more conservative; they’re more concerned about preserving their capital.  We understand the underlying dynamics of microfinance in terms of its lack of correlation with other markets and how robust the assets are. But it’s definitely a more difficult environment to get people to think about new types of investment alternatives.       
     
PA: Usually you’d expect people in a market like this to be looking for the historical returns and security that microfinance investments have provided so far. Is it because microfinance is such a new asset class that people are still skeptical or dubious of the track record and the returns?

RF: I’m asked the question frequently if the crisis has helped or hurt microfinance. And the answer is both. And let me explain what sounds like a convoluted answer. The initial reaction is clearly more negative. ‘Poor people, emerging markets, why should I touch this?’ However, if we can get people’s attention and to really look at the underlying dynamic, the fact that the repayment rates are so high, the returns on equity are pretty strong. We have not really seen any kind of a deterioration in the loan quality. This is really what gets people’s attention. We’ve actually seen a number of people who hadn’t really thought about it before, in fact, interested. However, there is a practical matter of going from interest to actually getting people to invest in the asset class, and I think some of the overriding concerns are about a need for liquidity which is keeping people from actually putting capital to work right now. Clearly, I think that will change. Right now, we happen to be at a very difficult time in the cycle. 

PA: You’ve done some research on the correlation between the microfinance returns and other investments and instruments. Could you describe some of the research you’ve done and what you’ve found?
RF: We sponsored what has, at this point, been recognized as kind of a landmark study on the correlation of microfinance and other assets. And it proved, really, what we all in the industry have sort of known and sensed intuitively, which is that regardless of what the capital markets are doing, the woman on the street corner in Peru is still going to be selling vegetables. What we did was to analyze performance data of MFIs compared to market moves. The caveats for our study are one, the amount of data that we used is not that great. But, in fact, it was all the data that was available. And two, we compared operating data at the MFI level, or the emerging market company level, to market moves, such as the S&P, so it’s not quite kosher in terms of like for like. In fact, the updated conclusion of this study is going to be published in the Journal of Development Economic sometime next year. But, the conclusion that we found is that if the S&P is moving upward or downward, there is virtually no impact at all on the operating performance of MFIs. The GDP of Peru or Argentina moving up or down has very little impact in terms of the net operating income performance of the MFIs. The only place that we really began to see the slightest correlation between MFIs and a domestic economy was a slight, slight uptick in portfolio at risk when the economy is deteriorating. The other interesting thing we found is that while there is a small increase in portfolio at risk for an MFI during a downturn, it’s a significantly smaller impact than on the portfolio risk of commercial banks in emerging markets.         

While there is a small increase in portfolio at risk for an MFI during a downturn, it’s a significantly smaller impact than on the portfolio risk of commercial banks in emerging markets

PA: Some of that is counter-intuitive, particularly the difference between the impact of a downturn on a commercial bank versus an MFI. The assumption would be the commercial bank is using higher standards and more of its portfolio is going to be out to borrowers with more ability to weather a downturn and pay than one would expect from the poor people that are borrowing from an MFI. What is your thinking on the reason why the poorest borrowers seem to be affected less?

RF: It’s a great question because you’re right it is counter-intuitive. I think a couple of things are driving it. One, I think the sector of the economy that MFIs and their borrowers are operating in is really much more granular. It’s not affected by whether there is a 150 or a 175 basis point spread in what the sovereign rates might be. The second thing I think is a factor is that the primary borrowers are women, and the primary use of their capital is to improve the quality of their lives for them and their families. So what’s driving it is not people using their money to pay back a loan for a color television set. In fact, it’s people really addressing some of the most basic needs food and healthcare, et cetera.

PA: Are you hearing anything about demand for loans going up or down in relation to food inflation and inflation in general? Are the MFIs you talk to seeing a correlation between inflation and demand for loans?

RF: Not yet. But I think it’s inevitable. If you look at some of the inflation trends of many of the countries that we operate in, there is no doubt that inflation has really jumped over the course of the last year. What we do continue to see is a tremendous demand for capital in very broad terms. You know people have talked about too much capital coming into the sector. Well maybe in more robust times that was the case, but money is a scarcer commodity these days. So the overall demand is very, very high.  What I don’t see is how much of that is directly related to the notion of inflation and the impact that that’s had.

PA: Lets delve into the idea of “too much capital”. Are there more and more MFIs becoming ready to take advantage of commercial capital? Are there more sources or less sources for them because of the new entrants into the broker or financing market? What’s happening to them at the macro-level of commercial capital?

RF: Clearly there are more MFIs that are commercially viable. But it’s a slow, gradual process. Yes, there are definitely more commercial funders, but we’ve seen some of the funders retreat a little bit. It’s always a balance. Are there too many MFIs? Is there too much capital? Right now I would say, frankly, there is more demand than there is supply in the terms of capital.  That’s my view when I look at the MFIs that we’re speaking with, how they’re growing their capital needs relative to the capital that investors are trying to put out. One of the interesting questions and debates is what type of capital is coming in and what type of capital should be coming in? There are still a lot of players who are providing below market-rate capital, subsidized capital—the development agencies, for example. One of the great industry debates now is what is the appropriate roles for those institutions. Do sustainable, profitable MFIs need that kind of capital? Or should it be channeled down the food chains, so to speak, to really help the next generations of MFIs become profitable and sustainable?

There are a lot of MFIs now that are not sustainable and I think some are going to have a hard time trying to be sustainable at a time when there is a lot of competition for capital

PA: Do you think the combination of the credit crunch and rising inflation is going to cause a shakeout in the market where we’ll see a lot of consolidation? Will we see, for the first time, a number of MFIs closing doors just because they were not well run enough to survive blips in portfolio at risk or capital availability?

RF: Yes. I absolutely do. You know, there haven’t really been many “failures” so far because historically a lot of them have been supported by philanthropy. But, we for the first time are starting to see MFIs thinking about consolidating, either within a country or within a region. It’s definitely a trend I expect to see more of in the future. There are a lot of MFIs now that are not sustainable and I think some are going to have a hard time trying to be sustainable at a time when there is a lot of competition for capital. So without question, I think it is the inevitable maturation of the industry that there is going to be a shakeout, a consolidation. The landscape is definitely going to change. So I think as you look around the globe there will be many, many different manifestations of consolidation. But fundamentally, I think it’s a trend that’s inevitable.

PA: Let’s turn to the investors in microfinance and how they think about the investments that they’re placing. There is a lot of talk in the foundation world about mission-related investing, the idea of putting the endowment to work in a way that furthers the foundation’s mission. Microfinance, in general, would seem to be the first place to start because there is a commercial capital market that already exists, and it is a well-known social investment. How many of the people that you deal with think of microfinance as a double-bottom-line investment, a mission-related investment? Are they coming to it with dual motivations, as opposed to the people who are just looking for another investment asset class?

RF: I think what gets people in the door is clearly an interest in the double bottom line. As I tell people, the returns are solid. They’re not going to knock your socks off. But at the end of the day it’s the lack of correlation and the social impact which we find investors are attracted to. We’re managing a lot of institutional monies, and we had some of the pension investors for whom we’re managing capital come to our office and perform due diligence on us, just as they would on any other type of manager. They found that from the point of view of their fiduciary responsibilities, they were able to check the box that their assets were being looked after in an appropriate manner. Despite all the talk about mission-related investing the thing which has really held back a lot of capital coming into it isn’t intellectual agreement but that there haven’t been a lot of investment options that are truly double bottom line. I think we’re unique in that regard, in that we feel we provide investors risk adjusted market rate returns. They’re not making any kind of financial compromises, and there is a huge social impact on the back of their investment. But it’s still a bit of an uphill fight to go from general awareness to putting capital to work And a lot of the Chief Investment Officers, the Boards of Trustees that we work with, while they understand the mandate, they’re just taking a fairly conservative and cautious approach.

PA: At the microfinance summit that happened this summer in Indonesia, one of the headlines was Mohammed Yunus again criticizing the idea of for-profit microfinance as a distortion of his vision, as a dangerous trend. Do you think what we’re seeing in the terms of credit markets and inflation is going to have an impact on the for-profit versus non-profit debate?

RF: I think that one of the things that will happen is that it will sharpen the debate, a little bit, in terms of who the players are, what type of capital, what the expectations are. It’s our view that there is plenty of room for all these types of capital we’re talking about. But I think investors will really need to be clear about what their motivations are and what the opportunities are. You look at the Compartamos issue of last year which really raised the debate in terms of microfinance. Is it for a for-profit venture? Is it a non-profit venture? What’s the motivation of some of the investors? I think these are complicated industry questions, which, in fact, are going to continue to be very complicated for a while.

PA: So you don’t perceive any momentum on one side or the other?
RF: Not really. I think at the end of the day what’s really driving it is much more capital market conditions more than what Mohammed Yunus is talking about.

PA: Are your clients starting to ask questions about what’s next after microfinance and is Developing World Markets thinking about what’s next after microfinance?

RF: Yes and yes. I think investors are already talking and exploring other areas like environmental investing, small and medium enterprise investing, fair trade. Our goal is really to take a lot of what we’ve done in microfinance in terms of using the capital markets and using our experience in structuring and apply that to other areas of social investing. We’re certainly not alone in this field, at all. So much of the multi-trillion dollars that are in socially responsible investing right now is in the area of negative screening. No firearms, no tobacco, that sort of thing. One of the real growth areas of asset management and investing, I think, is the opportunity to invest in what we like to call pro-active opportunities. To me this is one of the more exciting trends, where investors will be able to achieve their financial objectives, but at the same time, have pretty significant social impact.

PA: Do you see any parts of the world as particularly interesting from that perspective? Countries or regions that are creating a more business-friendly climate for international investors who aren’t just chasing the commodities boom?

RF: Let’s take a ten thousand foot view. Historically the emerging markets have had the resources but they haven’t had the capital. One of the things and one of the dramatic shifts in the last couple of years is that these countries which were really outside of any kind of mainstream economic system now have access to the capital because of the fluidity of the money and the fact that they have resources. We spend a lot of time thinking about the fact that there’s truly a paradigm shift. You look at technology and technology applications, now Third World countries, who never bothered to put in a telephonic infrastructure, have first world technology so I had better cell connections when I’m traveling in the likes of Azerbaijan and Armenia than I do taking the train from Connecticut into New York City. I think these are some of the trends in the backdrop that I think are really making this whole asset class and this whole arena so incredibly exciting.

PA: From the MFI side do you see very many of the MFIs that you work with really starting to think through a strategy to change from microfinance to “mid-finance”, whatever that term would be? To follow their clients up the chain?

RF: Well, I think the term would be SME Finance, small and medium enterprise, and, without question, many of them,—particularly the larger and more robust ones—are thinking about that. To a large extent it’s not necessarily that they’re being proactive in terms of saying, “Well, we should really get into the SME lending business.” They’re really following their clients, because when they lent money to small entrepreneurs, the entrepreneurs get successful. They need more money. The businesses are growing. It’s really a natural evolution.

PA: Speaking of MFIs following their clients, is that one of the things that you track when you ‘re looking at the MFIs? Growth of the average loan size, because their clients are being successful and they’re able to make larger and larger loans over time?

RF: Without question. One of the things that is very important to us is truly the double bottom line in that we want to make money. We’re certainly a for-profit. But we also feel very passionately about the mission of what we’re doing in terms of really putting capital to work where it just has not been available. With a lot of the institutions we’re working with, before we make a loan, we look at their strategy. We look at their business plan. We look at the clients that they’re trying to serve. One of the things that we monitor on a monthly basis is the average loan size. If we start to see a dramatic increase, for example, of, you know, suddenly an institution that was making $200.00 dollar loans is making $3,000.00 dollar loans; clearly there is a significant shift in their strategy and their focus. Don’t get me wrong, if they’re providing capital to businesses and that employs people, that’s obviously a wonderful thing. But the point is we track this because it is a way to really get a very good sense of what is happening at the most basic level of the institution. 

PA: One of the big debates in the sector is tracking social impact. How much should MFIs be investing in tracking social impact? There are people that say, “We can just accept on faith that access to credit is good for people, and if the portfolio is increasing and being paid back then that means good social impact. We don’t need any more than that.” There are others who argue that microfinance should only be acceptable if there’s actual measurement of client well-being and livelihood. Where do you fall on that spectrum of thinking? What do you ask of the MFIs that you invest in, in terms of measurement and social impact?

RF: Our focus is finance. There are a lot of groups that we know that are doing wonderful, wonderful work in terms of really measuring Social Return on Investment. One of the issues that we find is that loan officers are busy growing their business. They want to really go out and get new customers rather than spend a lot of time documenting the social impact that they are having. So we track financial information on a monthly basis. But, some of the social measurements like number of women borrowers, et cetera, we track only annually just as sort of as a general and rough guide. It’s something that we spend a lot of time thinking about, but we tend to be more in the camp of, “if we’re providing capital, the bulk of which is going to entrepreneurs who are growing and starting small businesses, that’s fundamentally a very positive thing.” That’s our basic view. That said, clearly we are engaged in some of these conversations because the more that we can track and measure and quantify social impact, I think everybody wins. Our investors are happy because they not only are they getting their financial return, but—you know, we live in a world of numbers and the more we can quantify these things, I think the better off we’re going to be.