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UNITED NATIONS CAPITAL DEVELOPMENT FUND Microfinance |
Issue 8 / January 2005 |
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Finding a Role for Public Donors in the Privatized World of MicrofinanceBy Marc Jacquand While direct investment (grants and loans) from the more traditional players such as public donors, foundations, and Non Government Organizations (NGOs) still exceeds that of the newly formed investment funds(1), it is widely recognized that the expansion of the financial sector frontiers to meet the global demand for financial services will have to be fueled by private commercial capital. Public funding from bilateral and multilateral sources is simply too limited in volume and too restricted in the ways it can be disbursed. In fact, recent initiatives have shown that links between Wall Street and microfinance can and should be established. This new development is forcing the traditional donors to rethink their role in supporting microfinance. Already, some of them have embraced the growing privatization and commercialization of capital flows to microfinance. The role of the International Finance Corporation (IFC), KFW Bankengruppe, and other entities in the development of debt and equity funds is now well known and documented. Beyond these funds, public institutions have started facilitating more complex transactions. Such institutions and deals include the IFC guarantee for Compartamos bond issue, the US Agency for International Development (USAID) guarantee for the Mibanco bond issue, the Department for International Development (DFID) First Loss protection for the Deutsche Bank platform and the Overseas Private Investment Corporation (OPIC) guarantee for the Blue Orchard securitization deal. Yet, the birth of a truly integrated financial sector, where the multiplier effect of market-based transactions among commercial actors is maximized, is a slow and risky process. For example, it took Blue Orchard three years to finally complete its first securitization transaction. The divide between capital markets (local and/or international) and financial intermediaries that have an inclusive approach is still too wide. A closer look at some of the constraints currently slowing the process sheds some light on the potential role that donors could play in facilitating these transactions. Asymmetry of information between the supply and the demand sources prevents many deals from taking place. The microfinance sector still suffers from insufficient visibility, despite recent initiatives. Lack of donor knowledge also includes the uncertainty regarding potential exit strategies. For many, if the question "how do I get in" has no easy answer, the question "how do I get out" is even more insoluble. MFI capacity and resources, including the capacity and resources to apply for and close complex financing deals: to work with international investors requires a certain degree of knowledge, skill and resources that few MFIs currently possess. Another hurdle lies in the limited number of institutions that have grown to the level where a link can be established with capital markets. The Consultative Group to Assist the Poor (CGAP) estimates that there are about 150 to 200 MFIs that would have the absorptive capacity for such transactions and that with the emergence of investment funds, and the doubling of the capitalization in the past year, supply may actually surpass demand. As a result, the pipeline of "investable" organizations may be drying-up. Furthermore, given the complexity and high cost of these transactions, they are worthwhile only if they generate sufficient volume. Yet, in most developing countries the microfinance sector has not reached sufficient operational scale. Fund managers are obliged to seek diversification and/or volume by working in more than one country, which adds to the costs and complexity, since each country presents its own challenges. Capital market transactions are very complex, costly and time-consuming, regardless of the success of the transaction. Such costs include legal fees and investment banking charges that few are willing to bear at full risk. One way to bypass the risk of having "sunk costs actually sink the deal" is to sign success-only deals with lawyers, where a fee is charged only if the deal goes through. It is, however, not always possible and very difficult to negotiate. Legal and regulatory obstacles for microfinance have been well documented. These are compounded when transactions include international partners, which add new layers of complexity and hurdles. For example, in Peru any borrowing from private foreign sources requires a 30% reserve, which significantly increases the effective cost of the borrowing for the institution. Other challenges also include legal and registration red tape. Microfinance policy work to date has focused on enabling the development of retail institutions on the ground; the next policy frontier will be to remove the barriers to entry for international and local capital. International transactions face foreign exchange risks. For now, most international capital market flows to microfinance institutions have been structured on the premise that the risk is borne by the recipients. Most debt funds transfer the risk to the institutions by lending in hard currency (CGAP estimates that 75% of current flows are provided in the form of hard currency debt). More complex transactions require more complex risk management tools. Few microfinance institutions around the world have the capacity to use such tools, which inevitably restricts the pool of eligible targets. Other arrangements that include currency guarantees with leverage from local banks require that the domestic financial market be sufficiently developed. The few funds such as Africap that bear the risk, structure their debt instruments with appropriate terms, interest rates and acceleration provisions to provide some protection against the loss in value due to currency depreciation. So it is a question of choosing, on a case by case, the lesser of two problems: high costs for the MFIs or complicated arrangements for the investor. To remove these constraints, one can imagine a number of possible donor interventions. MFI Capacity Building: It is imperative to keep the pipeline of deals moving forward and set up the next generation of MFIs to be eligible for capital market financing. Donors should continue to support capacity building programs for MFIs to graduate from donor funding at the end of the pipeline and participate in transactions with capital markets. Yet, as evidence from donor portfolios demonstrates, the donor hit rate in successful investments is low and building the next generation of eligible MFIs will require donors to strengthen their own investment performance. Capacity building is a complex task that demands rigorous due diligence in the selection of a technical service provider and the target institution, disciplined enforcement of contractual obligations among the parties and scrupulous monitoring for results. From the donor perspective, funding a technical assistance program is a delicate balancing-act between micromanaging the work of the MFI and accepting poor performance. Donor training: Donor trainings should incorporate a greater focus on the role of local and international capital markets and how each donor can best support this trend. Few donor institutions currently possess sufficient knowledge on the issue. By teaming up with investment funds and including their perspective in training materials, donors can decide how, if, and when to act as deal makers. In most cases, that role will be restricted to building capacity and, in most cases, that will be good enough, since most donors already struggle to do it well. "Bottleneck grants": Donors can support some of the sunk costs, or set up risk-sharing mechanisms such as guarantees in the event that the deal does not go through. In case of success, these costs can be re-covered as a percentage of volume or through management fees. Other challenges such as the regulatory framework require donor support in the form of grants for studies, training, and technical assistance to remove the policy bottlenecks that constrain and complicate capital flows. Local capital market development: the development of local capital markets would increase the supply of funding while removing the risks and costs inherent in international transactions. Some also argue that domestic financing is more conducive to economic growth, as savings are kept and re-invested locally instead of fleeing abroad. This is however a very complex, long term, endeavor for which institutions need to partner with one another and determine which role each can play. Credit enhancement mechanisms: these mechanisms come in a variety of ways: from first loss protection, to loan guarantees, foreign exchange risk insurance, donors can reduce risks, and thus reduce costs (by achieving higher transaction rating) and attract a larger and more diversified pool of funds. While many donors have experience in loan guarantees, few have so far ventured into first loss protection and FX pooling. CGAP is currently working on a donor FX pooling mechanism, in which donors could all partner to share and thus spread the risk. First loss protection has the advantage of - relative - simplicity and can be provided in the form of an equity stake or an operational grant to the lender, fund, or platform. Equity, subordinated debt in Special Purpose Vehicle, equity funds: An initial stake (equity or quasi) to capitalize funds, instruments, and Special Purpose Vehicles (SPVs), can constitute the required leverage to attract larger sources of funding, and provide a risk cushion for other investors. Donors need to have the legal authority and freedom to take equity participations. These transactions, however, can be highly complex and require in-depth expertise that few donors currently have. Public donors have a number of options when it comes to playing the midwife to the privatization of capital flows to the microfinance market. Yet, since few of them have the capacity to do all of the above, perhaps it is important to remember, given the donor community's overall track record, that building the capacity of institutions on the ground should be the first and foremost priority and that they should focus on getting better at it. The other aforementioned roles may appear more sophisticated, thus fancier and more attractive in a context where everyone wants to be seen as ahead of the curve, yet, their relevance is ultimately contingent upon the existence of solid institutions on the ground. The unglamorous field of retail capacity building is still where public institutions can best contribute to the expansion of the financial frontier.
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