Friday, May 20, 2005

Council of Microfinance Equity Funds

The Council of Microfinance Equity Funds (CMEF) (http://www.cmef.com/) is the first membership organization bringing together the leading private entities that make equity investments in microfinance institutions (MFIs) in the developing world. The Council’s members seek both social and financial returns from their investments in these institutions, all of which provide a range of financial services to poor households in developing countries.

ACCION International serves as Council Coordinator and provides the secretariat for the Council.

Contact:Deborah Drake, CMEF Coordinator

email: ddrake@accion.org

tel: +1 617-625-7080 x1045
Fax: +1 617-625-7020

Members
ACCION International Gateway Fund

ACCION Investments in Microfinance, SPC

AfriCap

Andromeda Fund

Calvert Foundation

Citigroup

Deutsche Bank

Développement International Desjardins (DID)

Gray Ghost Microfinance Fund

Oikocredit

Open Society Institute

Opportunity International

ProFund International

Shorebank

ShoreCap International

Solidarité Internationale pour le Développement et l’Investissement (SIDI)

Triodos International Fund Management., B.V.

Unitus

Equity in Microfinance: Some Reference Text

Financing Microfinance Institutions: The Context for Transitions to Private Capital, de Sousa-Shields, M., Miamidian, E., Steeren, J., King, B. & Frankiewicz, C., Dec 2004, USAID - U.S. Agency for International Development

This paper states that the microfinance sector is at crossroads between financing dominated by non-commercial sources and one that is increasingly and necessarily responding to private sector financing needs and interests. The authors observe that if the sector has to meet its goal of serving a large portion of the world’s poor with permanent financial services, it must continue to prove the viability of its core low income market and must develop significantly deeper access to domestic commercial capital.

Tapping the Financial Markets for Microfinance: Grameen Foundation USAs Promotion of this Emerging Trend, Meehan, J. Oct 2004, Grameen Foundation

This paper attempts to define the role of the financial markets in the microfinance sector. Stating that the global unmet demand for microfinance is pegged at around US $ 296 billion, the paper makes a case for long term role of the financial markets in biding the huge unmet demand. The author has made the following suggestions for greater integration of the microfinance sector with the financial markets:

· Hiring of an Experienced Chief Financial Officer;

· Hiring of an Advisor to communicate with potential investors;

· Preparation of a Business Plan;

· Training in Corporate Finance.

Raising Capital Through Equity Investments in MFIs: Lessons From ACLEDA, Cambodia, Kooi, P. Jun 2001, UNCDF

This paper presents issues in equity investment in microfinance institutions (MFIs).The paper also presents the fundamentals of the investment criteria that public and private investors would apply before investing:

· Development phase of the microfinance industry;

· Leadership status of the MFI;

· A clear vision and commitment to become a profitable MFI;

· A realistic business plan;

· Appropriate ownership and governance structures;

· Adequate management information systems;

· A sound exit strategy.

Raising Capital for Microfinance: Sources of Funding and Opportunities for Equity Financing, Fehr, D., Hishigsuren G, School of Community Economic Development, Southern New Hampshire University, Working Paper No. 2004-01

This paper reviews financing sources commonly used in microfinance, and suggests an outline financial analysis that MFIs might use in approaching potential equity investors. The authors state that these proposed financial procedures, while quite common corporate techniques in well-developed countries, have not been widely applied in microfinance. While this may partially be attributed to the lack of comprehensive financial and operating data in MFIs, most providers of donor and grant funding have been satisfied to concentrate on the social benefits of their investments. The authors argue that, if mainstream investors are to become investors in microfinance projects, they will likely require financial analyses similar to those used for their for-profit investing activities.

Monday, May 09, 2005

Limitations of Using Book Value Multiples to value MFI stock

In the absence of market information, (as the sector is still in a nascent stage and MFI’s stock don’t trade except for a few MFIs in Latin America), it is natural for most investors to value an MFI based on its Book Value – utilizing a valuation range constructed from multiples of book value . Book value – variously called shareholder equity and net worth – is broadly defined as total assets minus total liabilities . This difference is the excess value a business has generated in its life. Book value is then multiplied by pre-determined coefficients to create the valuation range. However, the Book Value method may not be appropriate for valuing MFIs because of the following reasons:

1) Backwards Looking Nature: Book value is sum of the total excess value generated by a business. Hence, book value measures only what a business has done, and does not necessarily have bearing on what it will do. In mature companies and industries, past history is often a strong indicator of future performance; in such situations, book value is an effective tool for determining a company’s present value. Microfinance, however, is not a mature industry, nor are many MFIs truly mature companies. Prior operating history is therefore not a good predictor for future results.

Historically, the microfinance industry operated along purely social lines. MFIs sourced operating funds from donors and philanthropic organizations in the form of grants, soft loans, and subsidized loans. These investments did not require profit maximization; at most, some investments required a nominal interest rate and future return of capital. MFIs utilized these funds as budgets, not as commercial equity investments; the firms did not have an incentive to build a surplus. Excess funds were generally utilized to explore new niches or to lower borrowing costs. Additionally, microfinance activities were often only one of many initiatives under an NGO’s umbrella. Excess profit generated through microfinance quickly flowed back into other parts of the NGO.

MFIs looking for commercial financing have refined their outlook to marry their social missions with the profit seeking ends of capitalism . Managing their businesses for profit while offering financial services to the poor and very poor allows MFIs to dramatically scale their businesses. Commercially financed MFIs will necessarily operate very differently than they have in the past; investments can no longer be viewed as budgets, and an entire class of investors will demand profit maximization. Examining their history of value creation – the premise behind a book value valuation approach – is a misleading method of determining an MFI’s value creation potential.

2) Lack of Comparables: Without commercial history in the microfinance sector comparables to assess potential MFI profitability and an MFI’s risk profile do not exist. Selecting the appropriate coefficients for book value is impossible in such an environment. Multiple coefficients for the book value approach are based upon two factors: one, the return to an investor a unit of book value will yield, and two, the return an investor expects from a particular investment. In practice, the amount of profit delivered per unit of book value (or sales or assets, or otherwise) is generally not known to any degree of specificity. This value is generally determined by examining multiples ascribed to similar companies or by examining a “standard” long term business model of a company or industry. Owing to its unique evolution and young age, microfinance sector does not have a set of comparable companies from which to draw from. A long term “standard” business model for the microfinance sector is also difficult to ascertain; at this stage, no one knows if a 2% return on assets, a 20% return on sales, or a 15% return on net portfolio outstanding is appropriate. Without either tool, determining the appropriate multiples is impossible.

The situation is further complicated by the differences between microfinance firms. Due to the youth of the industry, a plethora of models continues to persist. Each model has different operating profiles, different profit potentials, and carries different risks. Some key differences include:
• Full Grameen model vs. Self Help Group – Grameen hybrid
• Livelihood consulting vs. pure MFI
• Full intermediation vs. service company operations
• Significant regional variations
A multiple used to value one microfinance firm rarely transfers to another. Hence, even after a handful of MFIs successfully source investments in the near to medium term, selecting book value multiples based on comparables will be difficult. An effective approach must both be forward looking and function in a nascent industry. A valuation approach that meets these requirements is the discounted cash flow (DCF) valuation.

Why is Financial Self Sufficiency not the best measure of commercial sustainability of institutions?

An MFI that has achieved a Financial Self Sufficiency of 100% is often assumed to have reached the epitome of sustainability. However, Financial Self Sufficiency may not necessarily mean commercial sustainability. The reason, I say this is because while calculating FSS, the cost put to equity is just the inflation rate, which we know is not true. The cost of equity depends on the risky-ness of the business the equity is invested in and will always exceed the inflation rate by an amount equal to atleast the risk-free rate. In effect FSS puts no real cost to equity. In this light Subsidy Dependence Index which puts the cost of equity as market rate of debt would seem to be a better indicator. However there are two main limitations with SDI:

  1. Cost of equity is not the same as cost of debt;
  2. It’s a dependence index and hence it is not suitable for measurement of sustainability. To measure sustainability using SDI one would need to interpret negative values of SDI.

The sector needs a sustainability measure that puts a commercial cost to equity, which is adjusted for the risk profile of a Microfinance Institution. However, the rating methodologies in use today may not be appropriate to arrive at a risk-return relationship to arrive at a cost of equity.