Op-Ed: The Potential Marriage of Private Equity and Microfinance - Dysfunctional or Blissful?

The composition of the microfinance sector is becoming increasingly hybridized, as microfinance institutions (MFIs) morph into profit-making entities, and global financial institutions such as Citigroup, Inc. or HSBC Holdings become (unintended) vectors of poverty alleviation (refer to “Global Financial Institutions and Microfinance: A Promising Marriage?” for further context). The equation isn’t anything new (in fact, I’ve waxed philosophical about it at length) – “self-interest” + “social good” = “sustainability”, but the actors involved are becoming increasingly fluid, and therefore, so is the landscape. In this post, I will analyze the emergence of another actor – private equity firms – and its implications for the Indian microfinance sector (also refer to and “Should SKS Microfinance go Public?“ for further background).

Currently, India’s microfinance sector reaches 36.8 million borrowers, of which approximately 25%, or 10 million customers, are associated with the 60 largest microfinance institutions (MFIs). Despite the rapid proliferation of these MFIs, however, the remaining 50% of the borrower market remains untapped, translating, therefore, into a reservoir of untapped profit. For this reason, the involvement of profit-oriented entities such as private equity firms is rapidly accelerating, with at least 4 PE investments totaling USD 43 million since 2007 alone.

For the purposes of providing some background on the nature of private equity firms, a brief summary from Microcapital.org follows:

Private equity firms typically seek extraordinary returns and are seen as aggressive, non-transparent, difficult to regulate and uninterested in the broader social aspects of businesses they invest in. PE firms typically invest in closely held companies in which they see possibilities of extraordinary returns that can be obtained through an exit strategy involving initial public offer (IPO) or takeover by large firms.

Naturally, the question that follows, then, is – for what specific reasons are PE firms interested in MFIs? The aforementioned article cites two reasons:

First, there is a perception that the microfinance sector is capable of providing extraordinary returns. Compartamos, a Mexican bank specialising in microfinance, made a successful IPO of 30 percent of its shares with a valuation at 12 times its book value, implying an internal rate of return of roughly 100 percent per year from the time it became a for-profit entity.

Second, studies indicate that returns from the sector are not sensitive to swings in global economic cycles. This makes such investments desirable for risk diversification.

This post continues after the break.

These are two very compelling reasons for the involvement of PE firms in the microfinance sector, but what about the beneficiaries of these services? What advantages can potentially come from the increased involvement of PE firms?

According to the article, the following can be seen as advantages:

1. Access to PE opens up a new source of funding for the Indian microfinance sector, which has so far relied on commercial bank funding to drive operations. Availability of PE could help MFIs increase their equity, resulting in more sound leverage levels.

2. The funding from PE could enable MFIs to build scale, reducing their average costs. With more funding, MFIs can invest in cost reducing technologies, which in turn may lower lending rates.

3. PE investors could bring international expertise in finance and technology to the microfinance sector.

The disadvantages, however, must also be taken into serious consideration:

1. There is a fear that extraordinary returns sought by PE firms may result in MFIs losing their focus on social impact, causing ‘mission drift’.

2. The availability of PE funds could well lead to aggressive lending by MFIs. Such a situation was witnessed in Andhra Pradesh in 2005, when there was a saturation of certain areas with too much micro credit, leading to over-indebtedness of borrowers and attendant problems.

3. As bigger loan sizes tend to reduce transaction costs, lending policies may lead to targeting of more well-off segments of the population who can service bigger loans.

The question, after weighing these concerns, isn’t, “Should PE firms get involved in the microfinance sector?” because the trend is already gaining momentum, but rather, “How can we build regulatory mechanisms so as to ensure the best interest of the beneficiaries?” In response, I return again to a previous post, “Measuring the Social Impact of MFIs,” in which I argue that “what is required is a gateway organization that regulates adherence to universalized social performance standards by MFIs.” To this date, the only “universal social performance standard” for MFIs is “SOCIAL”, a structured framework developed by ACCION International for assessing and measuring the social performance of MFIs. Further work in this regard is clearly lacking, and, in my opinion, desperately needed as the microfinance sector continues to evolve.