Mr Serge LeVert-Chiasson is Vice President at Sarona and has over ten years of experience in private banking, international commercial lending, international accounts receivable insurance and international investment management. Mr LeVert-Chiasson also holds a Masters in Accounting and Finance from the London School of Economics, is a Chartered Financial Analyst (CFA) charterholder and has completed an international MBA at the Schulich School of Business (Toronto, Canada). He currently serves as chair of Agro Capital Management in the Ukraine and is an ex-officio officer on the board of the Working Skills Center (Toronto, Canada).

MicroCapital: First of all, would you please provide us with your interpretation of what “impact investing” means in relation to the microfinance sector and regulated banking channels?

Serge LeVert-Chiasson:  We first must recognize that microfinance is a subset of impact investments.  My interpretation of impact investments would include investments that seek a triple bottom line.  It impacts those communities they serve in a positive way.  This means better jobs, increased employment, as well as taking a strategic view on environmental issues that seeks to minimize any waste in the processes of their normal business operations.  So it is a triple bottom line that includes a value set that aligns to what the community would deem as beneficial to its interests including the environment.  It’s a holistic approach to investing.      

MC: What do you think is the growth outlook for impact investing over the next 5 to 10 years?

SL-C:  The impact investment industry could grow as much as USD 500 billion in the next 5 to 10 years based on research that I have read.  This estimate is a little bit aggressive, but it is quite possible given the interest and alignment of not only just fringe asset managers, but also large institutional investors and asset managers such as JP Morgan.  The view of large asset managers is that the future of these developing countries must include long-term improvements in the lives of the people living in those communities of need. 

MC: Please tell me how the Sarona fund group came to fruition within Mennonite Economic Development Associates (MEDA).

SL-C:  Sarona Asset Management Inc is a MEDA company based in Waterloo, Ontario, Canada.  MEDA started off as an investment fund group that later evolved into an economic development agency working in over 40 countries as of 2009.  Much of our work now relates back to microfinance consulting.  So we try to work with microentrepreneurs and farmers.  We also work in asset management.  The mission within Sarona Asset Management is to establish private capital as an effective tool to combat poverty.  Thus, we work with investment partners in creating new vehicles that bring capital from North America and Europe to developing countries.  That capital can be used to bring hope and change to many lives in developing countries.      

Within the company we have two major groups of funds.  First is the MicroVest group of funds; we own 45 percent of their asset management company.  We take a very active role in its governance and management.  We are always looking forward to new developments and partnerships.  We hope to move microfinance into a more respectable view from the perspective of Wall Street and Main Street in terms of it being an investable asset class.  

The Sarona group of funds that Gerhard Pries and I manage focuses on small and medium-sized enterprises (SMEs).  The objective is to provide capital to those businesses that have a double or triple bottom line.  The newest fund that we have is called the Sarona Frontier Markets Fund I, LP.  Effectively, it’s a fund of funds that focuses on some of the world’s best and most proactive SME fund managers. 

MC: What is the Frontier Markets Fund’s pipeline for SME investments?

SL-C: I can tell you at this time that we have subscriptions in excess of USD 12 million.  Our minimum closing was originally USD 5 million with a stretch goal of USD 10 million.  So we have exceeded our stretch goal and are very pleased. 

If you are looking from a macro perspective, fund managers in the SME sector are seeing an annual return on investment of 18 percent.  What that tells me is that there is a great deal of opportunity to invest in this field with greater rewards for those investors wanting to take those risks.  The challenge is that there aren’t many investment vehicles available to North American clients who want to take advantage of this new space. 

MC: What particular sectors and/or geographical regions are you focusing on?

SL-C: We are not focusing on any particular region.  We are generally not very supportive of fund managers that manage assets out of Canada or the United States and then make investment decisions on a wide geographic area.  We generally prefer fund managers that are locally based or have strong local teams that make investment decisions within a geographic area that makes sense. 

MC: What type of due diligence is involved in selecting the best fund managers?

SL-C: There is an extensive due diligence process.  What we are evaluating is the fund management and its ability to succeed in its investment thesis.  I had the opportunity to have good conversations with the Inter-American Development Bank (IADB) and the International Finance Corporation (IFC).  We are likely going to speak with the Overseas Private Investment Corporation (OPIC) and share our own perspectives and processes to build upon everyone’s experience and improve the investment decision-making process.

The process that we have right now is built on 12 years of fund management experience and a combined 57 years of investing in the SME sector.  The due diligence process is a commercial approach.  It begins with a simple conference call that consists of an exchange of information such as a pitchbook with marketing material.  It follows up with an extensive conversation and review of the legal material in greater detail.  The next step in the process entails a visit to the fund manager’s office coupled with a visit to 2 to 4 investment or prospective investment sites.  We will also look at the track record. 

Of particular importance for us is the environmental, social and governance process.  We are very interested in understanding how they submit a proposal and evaluate criteria when they make a decision to invest.  Lastly, we look at how they monitor and report that information to their limited partners.  We then draft an extensive investment memo, assuming that we are pleased with their process.

MC: Fund-of-funds in the U.S. have fallen out of favor in the past year.  Investors are requiring greater due diligence on the investment mangers selected.  How does Sarona insure that the funds themselves are properly managed and that they truly invest in SMEs?

SL-C: Performing onsite due diligence is critically important for us.  We don’t invest with any fund managers unless we speak to at least 2 to 4 committed investors.  Generally there are other institutional investors involved in the analysis when we perform this process.  If it has gone through their due diligence process, and they have thoroughly evaluated the management teams, then we include their recommendations with our own analysis. 

We come in as a private investor and like to see that investors have done their own due diligence.  We are looking for ethically and socially motivated fund managers who are professional and responsible, coupled with their ability to provide proper governance for their investors.   

By Zoran Stanisljevic

MicroCapital: First of all, would you please provide us with your interpretation of what “impact investing” means in relation to the microfinance sector and regulated banking channels?

Paul DiLeo: I think that impact investing is increasingly important for microfinance because of the kind of transition that the sector is experiencing in terms of its investor base at this time.  Up until the last couple of years, since microfinance started to establish itself, the investor base for microfinance has not changed much.  You had a lot of the same development or philanthropic institutions that had gradually moved with microfinance as the sector had become more commercial, experimenting with investment instruments and structures as microfinance became an investment rather than mostly a philanthropic opportunity.  I guess I am really focusing on equity where there is particular influence to be exerted over the nature and character of the institutions.  More recently, I think that you have seen new types of investors come in who are, at the extreme, motivated entirely by financial considerations and potential for financial return.  Not to say that they don’t care about the social story, but that the social story is entirely an additive beneficial feature and not necessarily required for them to pursue this as an investment opportunity.  But for an important segment of the investor base — the “impact investors” — the social story stands on its own and remains essential.  What that means for the microfinance industry is that microfinance institutions (MFIs) need to be much clearer about the objectives of their traditional and newer investors.

MC: Grassroots Capital has been formed as a “spin-off” from the Gray Ghost Microfinance Fund. What was the drive behind that evolution?

PD: Originally Gray Ghost was the brainchild of Bob Pattillo and David Weitnauer, the head of the Rockdale Foundation, Bob and Katy Pattillo’s foundation at that time.  I joined them to devise an investment strategy for Gray Ghost and help launch it. I was the investment director for about five years.  About three years ago we started looking ahead to the day that Gray Ghost would be fully invested and whether Gray Ghost’s mission of trying to draw other private investors into the microfinance space might be accomplished not just by way of example, but by directly providing for the intermediation of private capital into the industry by raising a fund that would take in capital from private investors other than Bob and Katy Pattillo.  So when we started down that route, it very quickly became clear to us that the most credible way of launching such a vehicle into the market was going to be on the basis of an independent manager–one who would be seen as fully aligned with the interests of all the investors as a group.  It basically came about as a way of positioning the new fund in the most favorable possible way, so as to maximize the chances of launching the new fund successfully.

Thus, together with my partners, David FitzHerbert and Viswanatha Prasad, we spun off the management company — Grassroots — as an independent management company with no ownership from Gray Ghost or Bob Pattillo to launch the new fund: the Global Microfinance Equity Fund.

MC: Given your interest in integrating social performance measurement into the investment process from the start, would you please provide a description of the social impact indicators that you use?

PD: Starting with Gray Ghost, we have tried to come up with a set of indicators of social impact that would be non-burdensome from both the standpoint of the MFI and the investment process.  We tried to identify indicators that would have some social content, but also be indicators that were meaningful in the day-to-day management of the business and were relevant to the analysis of an investment in any case.

More recently with Grassroots, we have taken advantage of some developments in the industry to try to incorporate more of a focus at the client level.  One of the developments that we took advantage of was the emergence of the “poverty scorecard”.  It really provides a snapshot of the poverty status of the client and can be used to evaluate the development of changes in the client’s poverty status over time and even ideally compare it to some kind of national benchmark.  This would give us an idea of how an MFI’s client base is developing over time relative to the general population.  We encourage MFIs that we invest in to incorporate it into their practices.  We have also integrated recent developments with respect to client protection principles into our analysis.

MC: What types of investors are involved in your fund?  Can you also provide greater detail as to the due diligence required when evaluating one’s investment options from a client’s perspective — what are investors looking at when they come to you?

PD: The first fund, Gray Ghost was capitalized by an exceptional individual, Bob Pattillo, who committed a very substantial amount of capital to microfinance at a time where there was essentially no purely private investment in microfinance, certainly nothing of that scale.  As of today, we have about 15 investors with the new fund.  There are probably eight or so individuals, most of whom have some particular interest in microfinance or social investment.  The rest are a fairly diverse group of institutions such as a large European pension fund, a European insurance company, a US socially oriented wealth manager and a US hedge fund.  It’s gratifying in that it’s a pretty diverse group of investors.

With regard to the due diligence required when evaluating one’s investment options from a client’s perspective — it varies.  I think that the principals involved in Grassroots had a reliable and complementary combination of skills, access and market experience allowing them to execute the investment strategy.  I would say that is one of the main things.  Some of the investors, particularly the individual investors, have known or had exposure to us in the microfinance field before; many of them satisfied themselves in that regard, on the basis of personal relationship and personal knowledge.

When you get into the institutional end of the investor group, there is quite a bit of focus on examining the structure of the investment manager, the resources of the manager and the track record.  They would look at how we mobilize the supplemental resources of legal due diligence or analysis of the investment.  This is done in a very formal and rigorous way.

MC: So from an investor’s standpoint with regards to rating microfinance investment vehicle (MIV) fund managers, the qualifications that you have just mentioned are necessary for a ‘competent’ manager?

PD: Yes.  Certainly in terms of the evaluation of the key people involved.  I think that investors are really looking for people that demonstrate some ability to execute these kinds of transactions in the microfinance market.  Also, that they share an appreciation of what the investors are really looking for.

MC: According to the CGAP (Consultative Group to Assist the Poor), microfinance private equity transactions have become increasingly common–JP Morgan at one point identified 144 such transactions completed since 2005, with total value of about USD 300 million. What kind of role do you think private equity firms will play in the microfinance sector in the next 5 years?

PD: I think that there will be a tier or a set of MFIs that achieve scale and have growth prospects that will be attractive to private equity investors.  I think we have seen the beginning of that in Mexico with Banco Compartamos.  I think that the next few steps along that path will be in India.  My guess is that worldwide, the participation of private equity probably won’t become a dominant driver of transactions in microfinance.  I just don’t think that the scale will be that attractive to private equity firms.  India is a very special case.  You are not going to see those kinds of opportunities in many countries.

MC: Would you please provide greater detail as to what an investor should look out for in term of risk/reward when examining the operational structure of an MIV?

PD: Grassroot’s investment approach has been based on the experience that Prasad and I had when building up Gray Ghost and the Bellwether Fund in India.  Fairly early on we had come to the impression that from both a social and financial standpoint, microfinance equity investing was best done very close to the ground–done by people who were in and from the market.  These are people who had information networks and resources throughout their respective market, as well as the capital markets, and also had legal expertise.  I am not talking simply networks and resources in microfinance but in different areas that were relevant to the success of the transaction.

From a social standpoint, we found that microfinance penetration was very uneven.  We learned that there were not many high-quality microfinance services to be found in many markets.  At that point, we felt the most likely way of extending microfinance to some of the blank spots was by either promoting new institutions or helping promising institutions to expand more quickly and develop their capabilities.  For those types of investments you really need very close oversight and a fair amount of inputs to supplement the capabilities of the initial management team.  Thus, it was not an investment that you could manage by flying in and out once a quarter or every couple of months.  It was really something that needed a continuous engagement.

From a financial standpoint, we found those types of investments to be more attractive.  The alternative, which was investing in some of the larger, more established and mature institutions with a track record, five years of financial statements, western auditor, etc., was not attractive due to the large amount of capital chasing those investments.  We found that they just tended to be overpriced.  So we started from that observation and set out to build a capability, first through Gray Ghost and then through Grassroots, of having those kinds of teams deployed in the markets that we were targeting.

MC: How does one evaluate and recognize any potential signs of trouble for a MIV?  I am not just talking about early warnings, but whether there are any structural features that increase the risk for the investment vehicles?

PD: Two things come to mind.  One is concentration.  We have had experience with one vehicle that was a regional vehicle.  The advantage of a regional vehicle is that it could bring to bear this kind of regional expertise.  It would not have this geographical diversification, so, of course, if something goes wrong in that country/region, then there would be a problem.  I would still argue that kind of regionally focused vehicle is preferable for the reasons that I was just describing.  But I think investors need to be aware that it creates a concentration risk given that these are typical emerging markets and there can be heightened country risk or regional contamination risk.

The second thing would be the capability of the vehicle in terms of really being able to develop an independent, well-informed view of the MFI.  That is obviously something that you would expect from an equity manager.  I would argue that unless you have a team in place, it’s pretty much impossible to do.  I think even for a debt fund, you really want to have some reason to believe that the debt fund is going to be able to genuinely make some kind of independent, ongoing evaluation of the MFI, rather than relying entirely on secondary sources, reports, ratings or decisions of other investors.

MC: What type of due diligence is involved in selecting the MFIs that you invest in?

PD: In terms of the regions, I think we would want to have a good understanding of the MFI’s market penetration and what the particular niches are that an MFI might be able to fill.  It’s certainly not inconceivable that you can find a good MFI in Bosnia or Bolivia to invest in, notwithstanding the fact that those are highly penetrated markets.  But you want to be careful and understand how these institutions differentiate themselves from other MFIs.

I think in terms of what we would then look for in the MFI, certainly at an early-stage institution, you are placing a huge weight on the manager and the individuals who are going to be executing the business plan.  You might have some track record of those individuals, but not necessarily from that institution because they may have a long track record at another institution.  A lot of times the promoters of these early-stage MFIs come from an existing institution where they have held some kind of senior management position.  So you get a good feel for the managers.  That’s a huge part of the evaluation.

I think that with more established and mature institutions, you will have to look very carefully at their loan approval process and how they manage risks in the portfolio in terms of the initial underwriting of the loan.  We also look at how they monitor risks that may develop once the loan is made with that borrower–is that borrower taking on excessive debt from other sources?  We look at when that borrower might migrate from being a very attractive asset to being something more questionable and do you have the ongoing ability to reassess that periodically?

By Zoran Stanisljevic

Previously, Mr. Crawford worked for the Latin American Financial Markets Division at the International Finance Corporation (IFC), created and ran Seed Capital Development Fund and was the Assistant Project Director for Africa Venture Capital Project. Mr. Crawford received his bank training at Chase Manhattan Bank in the mid 1980’s after working in Africa for the Red Cross and the US State Department. He graduated from Johns Hopkins University School of Advanced International Studies (SAIS) (US) in 1983 and Bates College (US) in 1980.

Gil Crawford: I’ve found that in some countries with credit bureaus there has been over-indebtedness. Part of that is a result of the hangover of the enormous amount of consumer finance that is being pushed back into the emerging markets. We have seen a reduction in demand for senior debt but an increase in interest in equity. We are also seeing MFIs restructure their balance sheets.

MC: Please tell me what the vision was when establishing MicroVest and how the vision has evolved since inception.

GC: The vision was very simple. Bowman Cutter, Chairman of CARE USA, realized that while non-profits make effective use of donations, financial intermediation is not part of their core competency. He realized that the MFIs owned by CARE and many others were growing very rapidly, and they would need separate funding, so he worked to set up a separate funding facility outside of CARE. Our common vision was that we wanted to demonstrate to the capital markets that microfinance was an investable asset class. It was not simply a CARE fund–we brought in a couple of other partners. We did have some basic principles including that the initial fund would have to be large enough to be viable, that we would have a pro-business board of directors and that we would have an economist on the investment committee. This was done in essence so that non-profits would not distort the investment process. In addition, we would pay our investment officers a reasonable wage. Lastly, we would have balanced ownership of the management company.

MC: Please tell me more about the funds that you manage.

GC: The first fund is MicroVest I (MV I). It was a demonstration fund that started at USD 15 million and will probably grow to USD 50 million. The fund composition entails 80 percent debt and 20 percent equity investments. It has 100 investors, almost all of whom are social investors including individuals and family foundations. The fund is currently outperforming its projections. Quite frankly, we have been very successful with our equity investments and our exits.

The second facility that we did was not a fund but a mono-buyer collateralized debt obligation (CDO). That is beginning to wind down successfully now. The second fund we did, called MicroVest II (MV II), was around USD 60 million. About 70 percent of it came from institutional equity investors. We also have a number of investors in MV II that were investors from our first fund (MV I). Our anchor investors are the IFC and JP Morgan. JP Morgan is also acting as the placement agent. We have been very pleased with JP Morgan, as they have successfully raised this funding in the midst of the global credit crisis.

MC: Kinnevik (Investment AB Kinnevik) announced that they had committed to investing USD 10 million in MV II in June 2009.  Is MV II a private placement sold to accredited investors?

GC: Yes, MV II is a private placement, which we closed on September 30, 2009. We have started the investment process with about 5 percent of the fund having been invested so far. So we are at the early stage and have three years to make those investments. We will be focusing on the top 120 MFIs and will have a relatively diversified portfolio (i.e. more investments than a typical private equity fund). We do not need to take a board stake.  The stakes will be typically 10-15 percent of an MFI. We think that is very attractive to management.

We have an investment in Tamil Nadu, India and are wrapping up an investment in the Andean region right now. We are also looking at Mexico, Columbia, Brazil, Africa, East and West Africa, the Balkans and other parts of India.

MC: With regards to MV I, many of the Asian and African countries have a lot of donor money, and you had found that you could not get commercial pricing because so much donor money was being pushed in those regions. Do you still find that to be the case now that the global financial crisis has passed?

GC: We don’t think pricing has improved much in Africa. In India, the issue was less government money and more government-mandated priority sector lending. That has been reduced, and we have seen some more opportunities there than in the past.

MC: Have senior debt rates risen considerably during 2009, especially in the first half?

GC: I have been surprised and I think everyone had been surprised that rates have not gone up. I think it’s because many MFIs are not growing their portfolios as quickly, in addition to the government money that I had mentioned earlier.

MC: Since the capital markets/securitization spigot had essentially been shut down during 2009 and possibly will remain closed for a good portion of 2010, are you still looking at structured finance options?

GC: I don’t expect the CDO market to come back for MFIs.

MC: Do you think fund rating in the microfinance sector will prove to be a useful tool for investors coming into the market?

GC: We think that these fund ratings will be very useful. I think that one of the problems that rating agencies will encounter is that the funds will have very distinct investment objectives. It’s very hard to compare a liquid mutual debt fund to a holding company or even a CDO. To begin with, I really think that the rating agencies should start looking at the management companies–their back office, investment strategy, policies and procedures. That will be useful for investors coming into the market. I know that MicroRate has begun doing that, and I was quite impressed at how they are approaching it.

MC: Why do you think that there have only been a few specialized funds (MIVs) that have been registered by a market authority in the United States?

GC: It’s an interesting question. The Europeans were much further along in direct social investing. I also think that the U.S. pension fund laws and the make-up of the pension fund boards are different from the European model. The European pension funds have a little bit more leeway and more of a history of investing in social investments. The Luxembourg mutual fund industry really has funds designed to fit the microfinance asset class much more neatly. I also think that Europeans are much more comfortable trading return for social impact; whereas Americans tend to maximize their returns and then make a donation. If you think about it, many (particularly) northern Europeans do not count on their investments for the core of their retirement–they count on the state. So if you are Dutch, Swedish or German, then you are not looking to your mutual funds to take care of your future. If you are an American, your perspective is relatively different. So I think that a middle-class American saving for retirement has a different perspective than a middle-class northern European whose retirement and healthcare is provided.

MC: Would you please provide greater detail as to what an investor should look out for in terms of risk/reward when examining the operational structures of an MIV?

GC: I think that these fund ratings will be helpful. I also think it would be prudent to look to the boards to determine if their reputation is sound. One of our large investors speaks to many management companies, and they have recognized that there are a lot of funds that have microfinance experience but lack private equity experience and vice versa. I would also be very cautious with people who have just entered the microfinance industry, as very few funds have experience in both microfinance and private equity. At MicroVest the combined experience of our senior management team is on average 15 years. There really are not a lot of funds out there with microfinance experience.

MC: What is your perspective on ensuring sustainable industry growth by attracting more institutional investors to both debt and equity?

GC: I think there are more and more institutional investors who now understand this sector. The thesis that this is a relatively uncorrelated asset is being borne out in many cases. The hardest thing about getting to private investors is getting an introduction; that is a very time consuming process. Also, in a normal period, few institutional investors are interested in anything less than USD 25 million. We felt a small equity fund such as MV II was the right size given the market; however, since many institutional investors don’t want to own more than 25 percent of a private equity fund, it was too small for some institutional investors.

MC: What is your firm’s greatest achievement?

GC: What I strive for us here at MicroVest is to balance our continuing belief in commercial microfinance and the social requirements of this field. I think we are entering a period where it is going to take a lot of focus to make sure we don’t forget that balance.

MC: Can you tell me what you are working on now?

GC: We are working very closely with a partner on a fund for Africa.

By Zoran Stanisljevic

As microfinance institutions (MFIs) continue their quest for more accessible and affordable financing, little information is freely available to the public regarding the due diligence required when evaluating microfinance investment vehicles (MIVs).  This whitepaper provides a framework for how investors can evaluate MIVs.  The author’s interview with Christina Leijonhufvud, Managing Director of the Global Social Sector Finance Group at JP Morgan, resulted in a general framework that investors and MFIs can utilize to better understand one another’s requirements and expectations in order to make informed decisions in meeting both social and financial goals while achieving rational, sustainable industry growth.

The report mentions that the very first and most important screen relates to the individuals behind the MIV.  One must begin by examining the ownership structure and the general partners.  Examining the operational structure and how much on-site due diligence is performed are also important components when evaluating a MIV.  Is the MIV taking an indexed approach to investing, or are they outsourcing much of the due diligence?

Because many fund managers in the microfinance sector have limited track records, rating MIV managers is another important component in the evaluation process.  What kinds of work did the fund managers do prior to managing the MIV?  Is there private equity or credit expertise on their board or advisory committee?

Understanding the investment policy and process from A to Z is key.  One should begin by reviewing copies of the MIV’s very first investment memoranda as well as proposals that go to the investment committee.  Does the MIV directly invest in MFIs or does it use a “fund of funds” strategy?  Investors should spend time with the committee and understand the types of discussions involved in their investment selections.  One should supplement this by traveling with the portfolio manager or investment officer to the MFIs that the MIV invests in.

With regards to risk management, items to consider are credit risk, foreign exchange risk, liquidity risk and country risk.  Some questions to ask are:  Is the MIV taking a credit or equity position? What are the credit quality and profiles of the MFIs in question?  What does the credit evaluation process consist of at the MIV?  Does the MIV undertake its own credit analysis, or does it supplement its analysis from a specialized rating agency?

In conclusion, an increased focus on fundamental issues and transparency in microfinance makes the industry more attractive to prospective investors. As more investors enter microfinance, the author believes that MIVs will play a greater role as financial intermediaries, connecting private capital to MFIs.  Since microfinance has outgrown donor funding, this private capital becomes critical, allowing for the achievement of both financial and social objectives.

By Zoran Stanisljevic

Mr. von Stauffenberg previously worked for 25 years at the World Bank and its private sector affiliate, the International Finance Corporation (IFC).  He has been president of Seed Capital Development Fund (SCDF), chairman of the investment committee of ProFund, chairman of the executive committee of MicroVest and a member of the executive committee of the Latin American Challenge Investment Fund (LA-CIF).

MicroCapital: What services does MicroRate offer to investors considering entering the microfinance sector?

Damian von Stauffenberg:  It’s really a simple concept: transparency.  It is giving investors insight into what is going on inside a microfinance institution (MFI).  That in itself is indispensable to an investor.  When it comes to small investors or other people who cannot directly invest in an MFI, they have to deal with intermediaries.  That is by far the majority of investors out there.  Even these intermediary MIVs (microfinance investment vehicles) to some extent rely on ratings.  We can afford to spend a week at an MFI and really ‘kick the tires,’ which hardly anybody else can do.     

MC: MicroRate was founded in 1997. What was the drive behind the evolution of the company?

DvS: What really kicked that off was a presentation in 1996 by Bob Christen, who is now the head of microfinance at the Gates Foundation.  He presented his findings on a study that he had done on microfinance institutions.  The results showed me how little we really knew about MFIs.  I later came to my own conclusion that microfinance is such a powerful tool that donors would not be able to fund its growth for very long.  Only investors and capital markets are big enough to fund the future growth of microfinance.  Capital markets need transparency; otherwise, they cannot measure risk and determine price. 

MC: What is your approach to evaluating performance risk of MFIs? 

DvS: We feel that while default risk is an important consideration, it is not the main thing or first thing that funders will want to know about the microfinance sector.  MicroRate’s concept of the performance ratings tells you how good an MFI is at providing microcredit compared to its peers.  Even if we had originally wanted to do credit ratings, we could not because there is not a statistical base in existence.  You need statistics from hundreds of MFIs over many years before you can predict this with any kind of accuracy.

MC: Please walk me through how you evaluate an MFI’s performance risk in detail.

DvS: First you ask the company to send you statistics based on an established questionnaire, such as their financials and balance sheet.  Next, you would want to be able to see the kind of reporting information that the leadership team utilizes to manage the MFI.  You look at what kind of reports their management information systems produce.  That gets analyzed by our team before we visit the client.  Next we travel to visit the MFI.  The first rating of the MFI would typically take four to five days.  The field visit is the heart of our ratings process. 

Once at the MFI’s site, we first meet with the CEO and later with second-tier management.  At this point, we differ from conventional rating agencies in that we also talk to middle management and loan officers.  We spend much more time with the companies that we rate. Conventional raters typically spend one day with their client. We are there up to a week with two analysts. This allows us to meet with more of their employees at various branches.  Talking to middle management and loan officers is important since the loan officers are the ones that are ‘out in the trenches’ issuing the loans.  We randomly visit several branches of our choice. 

The first thing we look at is portfolio quality.  There are certain tests that we conduct that can give you some assurance that what an MFI says about their portfolios is real.  We don’t have enough time and enough manpower to do a statistically valid sampling of their entire portfolio.  However, you can still get a clear picture even if you sample a few dozen client files, which is what we do.  Then you look at: What do they analyze?  How are investment decisions made?  What are their decisions based on?  We then always make a point to sit in on a of couple credit committee meetings where these decisions are made and listen to their discussions and how they are conducted. 

Another factor that comes up in our ratings analysis is evaluating their governance process.  Basically: Who calls the shots?  How effectively are decisions being executed?  Is anyone giving direction and, if so, who is that person(s)?  Are they positioning themselves in their market, or are they drifting from their mission statement?  These are very important qualities that allow one to decide if these MFIs are effective or not.

You also need to look at the market environment and country in which the MFI operates.  Is there MFI legislation and supervision?  Is there a banking supervisor that takes a hand in microfinance?  How strong is the competition?  Are clients over-indebted in the region?  If so, what are the MFIs doing to protect themselves against that?  This is very important.

Another component that we look at is the MFI’s management information systems.  The process of buying and implementing a system and pushing it upstream may take a couple of years.  By that time, the MFI has already outgrown that system.  That happens fairly often to MFIs.  The question then becomes: Does the MFI have an adequate technology system in place that can tell management what they need to know? 

You also want to get a feel of how the MFI balances its developmental role versus financial success.  Quite often you will have consumer credit agencies posing as MFIs.  That is a pretty common phenomenon where sometimes you have an unholy alliance between funders and these so-called MFIs, which are really consumer lenders.  The funders have not had any incentive to look closely at these consumer credit agencies who pose as MFIs because it increases a funder’s potential market many folds.  Thus, the question of what truly is microcredit is in flux.  

We feel that microcredit is not only based on loan size, but it also has to enable the borrower to create wealth.  In turn, this wealth is used to repay the microcredit. 

MC: Can you provide greater detail as to what a client or investor should look out for in terms of risk and reward when examining the operational structure of an MFI?

DvS:  First, you ask the question: Is that portfolio quality ‘dressed up’ and not what the MFI claims it to be?  That “dressing up” is fairly easy to do, but not that easy to spot from the outside.  The common way of doing it is when you see clients starting to run into trouble making their monthly payments.  An MFI calls in its client, tears up the loan agreement and reissues a new one for a larger amount with a longer repayment term.  That is not just specific to microfinance, but also a problem with banking in general, that you have a hidden bad portfolio.  Top management may not be particularly aware of it.  If management is not on top of things, then they will create the incentive for lower-level managers and officers to start ‘refinancing’ their portfolio and thereby hiding bad loans.

Secondly, one must ask: How solid is the MFI’s lending methodology?  How effective are they at spotting good clients?  That is the hard part.  What distinguishes a good MFI is the ability to identify those clients that can become productive and create wealth if you lend them the money.  That is the basic skill of an MFI that we look for.    

MC: What else is a challenge when rating MFIs, and what is the ratings reporting cycle at MicroRate?

DvS: One challenge is that you are forced to reach a judgment on a fairly large institution based on a very short visit.  So you have to extrapolate from what you see through the entire organization, and that is risky business.  It gets a bit easier than it sounds just by experience over time.  If you have previously analyzed dozens of MFIs, then you develop an instinct that tells you whether or not you will like the responses that an MFI provides.  So you may have to keep on ‘digging’.  You need to have that instinct; otherwise, you have to dig everywhere. 

With regards to a ratings reporting cycle, a year is roughly the life of a rating for us.  The rate at which MFIs have been growing this past decade is on average 40 percent per annum.  That means they double in size every two years.  Even a year is a long time for an MFI.  So I would be very careful of a rating that is older than a year.  But sometimes, very rarely, we do publish subsequent ratings earlier than a year later because of a specific event or because we have learned something new about the MFI.

MC: Is MicroRate starting to have a stronger commercial focus when rating MFIs – covering liquidity and debt covenants and providing further clarity as to how microfinance rating grades are comparable to mainstream rating grades?        

DvS: The ratings are going in that direction.  For the last two years we have been performing financial strength ratings (FSRs).  Whenever we do a performance rating, we also do an internal FSR.  That is much closer to a credit rating, but it still doesn’t try to predict the statistical likelihood of default.  It takes a more narrow view of how financially strong an institution is.  We have not yet published these findings because we needed to perform at least a hundred before we could roll them out and jump to certain conclusions.  We are now ready to roll them out and are using the Moody’s methodology for the definitions and class of ratings scale.

MC: A New York Times article in November 2009 covered how the Big Three credit rating agencies have received harsh criticism from lawmakers in Washington for their role in the housing market collapse with regards to the potential conflicts of interest that were embedded in their ratings model.  Banks and other issuers have paid rating agencies to appraise their securities, and this obviously has the potential to cause a conflict of interest.  What are your thoughts on this? 

DvS: In my opinion, the criticism from Washington is richly deserved.  We saw that when we first rated a microfinance CDO (collateralized debt obligation).  We looked at how other raters analyzed the CDO.  To our amazement, we saw that when they rated CDOs, they did not look at the underlying assets.  They looked at the structure, who was subordinated and under what conditions.  They also use very sophisticated Monte Carlo simulations, which hardly anyone understands.  However, the quality of the underlying assets must have something to do with the riskiness of the product, and that has been ignored by the traditional raters.  They did not look at the underlying assets.

MC: Outside of achieving a “double-bottom” line, how much different is it to rate an MFI versus a traditional financial institution? 

DvS: The difference is easy to spot, and it is in the lending technology.  The way that MFIs make loans is quite different from any other financial institution.  It’s the need for a more simplified cashflow model and to better understand the MFIs that one is analyzing without making a doctoral thesis of it.  Banks and other traditional lenders are not equipped to do that.  If you are not equipped to analyze that process, then your rating of an MFI has a glaring weakness.  If you look at MFIs through conventional lenses, they tend to look good.  The real risk is in an MFI’s portfolio because it is not typically backed by collateral.  So if your borrowers at the bottom of the pyramid stop paying, there is not much one can do to protect oneself.

MC: What is the current market demand for ratings and assessments from MFIs and investors? 

DvS: First off, development organizations do not rely on raters.  They have their own staff and are not cost-conscious.  They can afford to do their own due diligence.  The first generation of MIVs tended to perform their own due diligence and analyzed every MFI.  That is now turning out to be awfully expensive.  As competitive pressure builds among microfinance funds, I think these MIVs cannot keep up with the work.  That means that they will increasingly have to rely on something else, such as ratings.  At the moment, they are using the ratings as a supplement to their own analysis.  We are not yet at the point where you can leave risk assessment entirely to the raters.  It would be a cost-effective system, if that were the case, and advantageous to have the analysis done independently by objective people who have no ‘axes to grind’. 

If you look at the cost structure of an MIV, the costs are around 2-3 percent of assets.  That is very high for a fund.  They should be less than one percent.  You can’t have costs of less than one percent if you have to send a team to every MFI that you invest in throughout the world; quite apart from that, you may not have the country or sector expertise in that exotic country.  The trend is to rely more on ratings. 

By Zoran Stanisljevic

He joined Citibank in 1982. After a first assignment in Greece, he held a number of senior treasury, risk and corporate positions at Citi in Athens, Bahrain, Kenya, London and New York.  Mr. Annibale completed his BA degrees in History and Political Science at Vassar College and his Masters Degree in African Studies (History) at the University of London, School of Oriental and African Studies.

Mr. Annibale served on the Board of Advisors for the United Nations High Level Commission on Legal Empowerment of the Poor. He represents Citi on the Board of the Microfinance Information Exchange, on the Council of Microfinance Equity Funds and with the Microfinance Network. He also serves on a number of other external boards and councils.

Robert Annibale, Global Director of Citi Microfinance

MicroCapital:  You had recently been mentioned by the WSJ that more microfinance institutions (MFIs) will begin to seek banking licenses to broaden their sources of funding due to the lack of liquidity caused by the financial crisis; thus, creating a situation in which MFIs need diversified funding and that deposits are one source that MFIs should draw from.  Furthermore, as debt and credit markets have slowed down during the financial crisis, these sources of funding have been more difficult to obtain, which has not been the case with deposits.  You cite the trajectories of MFIs such as Peru’s MiBanco and Mexico’s Banco Compartamos SA, which started as non-government organizations and later became banks in order to offer a wider range of products as being indicative of a greater trend to come in microfinance.

How do you foresee the MFIs and the microfinance landscape to look like in the next 5-10 years?

Bob Annibale: I come from a treasury background and I think it is important for all financial institutions to have a diversified funding source.  Clearly deposits are one of the most important products for both MFI clients and for institutions themselves.  Some MFI strategies are more liability driven than asset driven, such as Equity Bank (Kenya) or SEWA (India).  I anticipate that there will be an increased effort by MFIs and a number of regulators to increase the number of institutions that can accept deposits.  We have seen some very progressive banking laws introduced, in Pakistan for instance, and others under review by regulators that create a specific category of licensed microfinance banks. In some cases, as with Equity Bank, Pro Credit, Banco Compartamos or Banco Sol, these institutions have full commercial banking licenses.

Domestic banking and capital markets are also an important source for stable funding.  Foreign exchange hedged internationally sourced funds can be another source of often long tenor financing, and thankfully more microfinance investment funds are lending in local currency and the need to hedge foreign exchange risk is increasingly appreciated.  We expect that more MFIs will be seeking to transform into deposit taking institutions, both to serve their clients’ savings product needs, and to support their asset growth.  There aren’t that many markets where you can reach scale by just being wholesale funded institution.

We are presently observing a wider range of local commercial banks that are expanding their strategies and reaching much more deeply, to new previously underserved clients, than they have for some years. This is an important trend, however we refer to MFIs, as a wide range of financial institutions, whether NGOs or banks, which primarily provide financial services to poor, low income and the underserved clients. I think more institutions will eventually also serve some of those clients, including banks and I hope that they learn from the experiences and values of the MFI sector.   The landscape for providing services will widen.  This is being supported by institutions, such as the Bill and Melinda Gates Foundation, that focus on the expansion of access to savings products and services by MFIs, but also by postal savings banks, cajas, cooperatives and credit unions, while stressing the need to ensure that new participants and products are appropriately structured for serving such first time clients.

MC:  Some believe that microfinance will become part of a larger sector of emerging market financial services and an increased linkage with the mainstream economy; developing into full service microfinance banks for the emerging markets sector with the anti-cyclical nature of microfinance potentially disappearing.  Do you believe that to be the case?  Please elaborate.

Bob Annibale: I think it varies so much.  If you look at some of the markets where microfinance operates a vast majority of the population doesn’t have access to a bank account, often more than 70 percent. Amongst that diverse population there are a whole range of people and needs; people who are salaried, self-employed, urban or rural based, men and women, old and young, etc.  It will take a range of diverse financial institutions to serve and provide choice to the majority who are currently underserved or unbanked.

That leadership and the need for the microfinance sector certainly won’t diminish, as it has unique experiences, values and models for serving the poor and it has been both innovative and successful, often also providing other services, such as education and health.  However, there is also a broadening of some MFIs strategies in terms of the clients, models and products that they provide. Microfinance has taken the lead in serving the unbanked and underserved, but a very large segment of the population in most countries still need to be reached and it will take a spectrum of institutions to achieve financial inclusion for the majority.

I don’t believe that microfinance is anti-cyclical with regard to global market trends, as some claim, but it increasingly correlates with domestic markets in many countries. Overall, the financial sector in most emerging markets was much more prepared for this global markets crisis than in the past, as most countries had real interest rates, floating exchange rates, deficits and inflation at historic lows and most central banks had higher levels of reserves.

MC: At the Global Microfinance Investment Congress last week, you were part of a panel that discussed how investors and MFIs can successfully manage key financial risks in today’s markets?  Can you provide detail as to what those key financial risks are and how one can successfully manage these risks?  Also, what is your perspective on the performance of microfinance investment vehicles/funds (MIVs) in the next couple of years?

Bob Annibale:   We discussed the Banana Skins report on risks in microfinance that Citi and CGAP sponsored, in which a wide range of respondents indicated that the greatest risks they perceived for the sector were credit, liquidity and re-financing risks.  These perceived risks were similar to the results of a report on the banking industry in 2008.  Another risk discussed included the quality of management, as this is key in terms of a firm’s ability to respond to unanticipated events and to support the very rapid growth in portfolios of some MFIs.

Where we have seen the biggest challenges in the last two years probably had less to do with the global markets than with an institution’s or local market’s specific characteristics. Morocco is an example where rapid growth by a number of MFIs and over lending has occurred in the absence of a credit bureau, leading to a rapid decline in growth and significant deterioration in their portfolios.  In Bosnia you have a multiplicity of institutions in a small and restrictive regulatory environment, as MFIs are not licensed to accept deposits. In Nicaragua you have specific country events that have led to a debt moratorium by many borrowers and the politicization of the sector.

Thus, you look at a couple of the markets that are having the hardest time and it is not necessarily because of global market events, but some patterns in terms of how fast the microfinance sector grew in that market and what were the tools in place (credit bureaus, financial education) to ensure that growth occurred at an appropriate pace for the institutions and their clients.

The MIV sector is doing well overall.  It is interesting that this is a moment when some of them have or are discussing loan loss provisions, which appears appropriate.  There are certainly more restructurings going on in MIV portfolios than in the past and there are a couple of countries where MIVs have been active that are specifically challenging.  The biggest MIVs continue to seek portfolio diversity and they are increasingly trying to diversify the countries and institutions that they reach.

MC: In general, can you explain the process involved in selecting the most sustainable businesses in which to invest?

Bob Annibale: Citi Microfinance has not focused on becoming an equity investor in MFIs or managing MIVs, but we are serving MFIs to provide funding, capital and debt structuring solutions, hedging and cash management innovations that lead to efficiencies and savings, and we seek to partner to develop remittance, insurance, savings products. Citi Microfinance works with a wide range of sustainable microfinance institutions, in 40 countries, which have clarity in their mission and objectives, transparency in their financials and operations, strong management and boards that provide the leadership and governance necessary to expand and address challenges.

By Zoran Stanisljevic

Part one of our interview can be viewed here: http://www.microcapital.org/meet-the-boss-interview-with-robert-annibale-global-director-of-citi-microfinance-part-one-of-a-two-part-series/

He joined Citibank in 1982. After a first assignment in Greece, he held a number of senior treasury, risk and corporate positions at Citi in Athens, Bahrain, Kenya, London and New York.  Mr. Annibale completed his BA degrees in History and Political Science at Vassar College and his Masters Degree in African Studies (History) at the University of London, School of Oriental and African Studies.

Mr. Annibale served on the Board of Advisors for the United Nations High Level Commission on Legal Empowerment of the Poor. He represents Citi on the Board of the Microfinance Information Exchange, on the Council of Microfinance Equity Funds and with the Microfinance Network. He also serves on a number of other external boards and councils.

Robert Annibale, Global Director of Citi Microfinance

MicroCapital: First of all, can you provide a quick market update and overview with regards to where the microfinance industry is currently at post global credit crisis?

Bob Annibale: The good news is that the microfinance industry has thus far proved pretty resilient to the impact of the global credit crisis–with differentiation by country and region. Clearly those institutions that were funding in local markets and local currency have fared the best, as have institutions that can accept deposits.

However, across geographies and types of MFI (microfinance institutions), it would be fair to say that most MFIs are paying more today (the cost of funding is higher) than they did a year or two ago.  In most cases MFIs haven’t passed the cost on to the end client, but they are absorbing that cost and trying to achieve efficiency in other ways.  We have also seen portfolio at risk (PAR) and net write offs increase in many markets, but this appears to have more to do with over lending or local market issues than as a consequence of global financial market events. In some countries, the increase in PAR may also be as a result of pressures on household incomes resulting from significant increases in the costs of food, fuel and declining remittances.

In some of the biggest markets, such as India, Indonesia and Bangladesh, there have been fewer issues of liquidity impacting MFIs.  Those that have been more impacted by liquidity were those in markets that were most integrated with the banking sector.  This is the situation, for example, in Central and Eastern Europe, especially Bosnia, where there was a great deal of bank and foreign currency borrowing (sometimes unhedged), which has been compounded by indications of over indebtedness.

We also saw that institutions that were in the process of tapping the capital markets generally delayed issuances and sought other sources of funding.  Access to bank financing tightened and capital markets almost everywhere became very thin last year for all types of borrowers. We are starting to see some markets reopen again. For example, Citi recently arranged a bond issuance for Mexico’s Banco Compartamos.  While targeting a placement of 500 million pesos of three year bonds, demand proved much higher and the issue was 1.2 times oversubscribed.  Citi ultimately placed a billion pesos with domestic retail and institutional investors.  The issue was also priced at a tight spread of only 200 basis points over the local benchmark rate.

MC: What is the story behind Citi with regards to the Microfinance unit and its founding?  How has that vision evolved?

Bob Annibale: Citi has a long history in microfinance.  The bank began working with the sector some 30 years ago through the Citi Foundation. It has been a supporter of groups such as Accion International, Women’s World Banking, SEEP Network and Grameen Foundation for many years in capacity building, local and regional network strengthening, financial education, training, etc.  I have worked in treasury, risk and investment banking for many years, covering Africa, the Middle East, Asia and Eastern Europe in the field and in London and NY.  I was in a very different role five years ago, Citi’s Senior Treasury Risk Officer, when I became most interested in microfinance.

It was the awareness that a number of MFIs were increasingly looking for a relationship with Citi beyond philanthropy, to be served as clients, supporting their needs in  areas such as  accessing  domestic markets, cash management, hedging foreign exchange risk or developing products together, such as remittances, savings and micro-insurance. This led to my launching Citi Microfinance with a group of colleagues that also had diverse banking skills and from a number of countries.  Citi Microfinance is focused on proving financial services to the microfinance sector – MFIs, investors, donors and networks. We believe in partnership, leveraging our respective expertise, capital, products and international presence, so that we can support the microfinance sector to expand in scale and scope.

Citi Microfinance works across geographies and businesses to serve the sector and, as Citi is present in over 100 countries, our relationships with MFIs are primarily managed locally. For example, BRAC is one of the largest MFIs, which Citi has worked with on a number of innovative financing structures, and our colleagues in Citi Dhaka maintain the primary relationship contact with the organization.  Since we operate locally in the same countries as many MFIs, we benefit from knowing the domestic market, regulators and can to work in local currency, under local law, and in local languages.

We have also embedded microfinance into Citi’s credit policies and risk procedures, with specific policies and debt rating models specifically designed to assess MFIs so that we can partner and develop products and services appropriate to the sector.

MC: Please tell me more about the scope of financial services that your group provides, such as capital markets, structured products or any principal investments?

Bob Annibale: Citi has arranged a significant amount and diversity of financing for microfinance institutions.  In the beginning we provided loan financing services but then realized very quickly that many MFIs had the quality of performance and scale to engage a wider spectrum of investors.  Understanding the needs of specific institutions and markets, we structure finance for MFIs as we have long done for other financial institutions. MFIs very often have not accessed their local capital markets before, either as an institution nor was there investor familiarity with the microfinance sector, despite so many of them delivering impressively on both financial and social impact.

One of the ways that we have broadened the range of funders to MFIs, for example, has been to arrange syndicated local bank funding, including for ProCredit (Romania), Kashf (Pakistan) and Buro (Bangladesh).

Very early on Citi arranged the first investment grade bond issue for Banco Compartamos, when it was still a quarter of its current size, and a private placement for MiBanco (Peru).  Citi also worked with, FMO (Netherlands) and Kfw (Germany) to structure the first AAA rated local currency securitization of microfinance loans.

I think what distinguishes Citi from other providers is that we really deliver locally.  Almost all the financing that we arrange is in the local market and local currency or it provides the hedging and structuring necessary to achieve local funding for MFIs.  Perhaps Citi having a dedicated microfinance group, and the extensive number of countries where we are present in the same local markets, are of greatest value to our relationships.

MC: Last month the Board of Directors of the Overseas Private Investment Corporation (OPIC) approved up to USD 250 million to expand a successful partnership with your organization that provides microfinance lending to borrowers in emerging markets worldwide.  As mentioned, the deal is reported as a USD 250 million Citi fund guaranteed by OPIC.  Can you provide additional details regarding the fund, such as how much is Citi committing?  Have there been subscriptions or is the fund capitalized by Citi itself?  Can you provide additional information with regards to what OPIC is committing?  Lastly, can you tell me the nature of their commitment?

Bob Annibale: It’s more a facility than a fund.  It’s not a SPV (Special Purpose Vehicle) structure based on levels of senior/junior debt, such as a MIV, CLO or CDO — often located offshore and denominated in US Dollars or Euros.  About two or three years ago we announced a USD 100 million dollar partnership program with OPIC that was a risk sharing program.  In this deal, Citi fully underwrites, manages the MFI relationship and funds the loan in the local market (Citi is the lender) and OPIC takes a risk participation in that facility for up to 70 percent of the credit risk which is similar to reinsuring the facility. As such OPIC is participating in the Citi loan to an MFI.  OPIC’s participation allows us to go further than our own capacity in terms of loan amount and tenor. We have done deals and transactions with other agencies also.

By Zoran Stanisljevic 

Ms. Leijonhufvud has led J.P. Morgan’s Social Sector Finance unit since its inception in late 2007. A double bottom line initiative that brings financial services and financing to microfinance institutions and other enterprises serving the base of the economic pyramid, Social Sector Finance also focuses on engaging the firm’s employees in these sectors. Outside J.P. Morgan, Ms. Leijonhufvud serves on the Advisory Board for the Center for Financial Inclusion, has been a consultant to Ashoka-Innovators for the Public in their social financial services venture, and has lectured widely on financial globalization and emerging markets risks. Ms. Leijonhufvud has held various risk management positions at J.P. Morgan, including as head of Country Risk Management & Advisory, Credit Portfolio Market Risk Management, Emerging Markets Market Risk Management, and Industry Concentrations. Prior to joining J.P. Morgan in 1996, Ms. Leijonhufvud worked at the World Bank as Country Officer, helping develop reform programs and borrowing strategies for the former Soviet Republics of Central Asia. In 1991, she served on the Economic Reform Committee for the Government of Kazakhstan. Ms. Leijonhufvud earned a M.Sc. degree in Economics from the London School of Economics, a M.A. degree in International Affairs from George Washington University, and a B.A. in Sociology from UCLA.

MicroCapital: I know that it is critical to have certain risk management measures set in place for MIVs to manage their own risk. Can you provide detail as to what those risk management measures entail? What do you look for?

Christina Leijonhufvud: I think it may vary a bit across MIVs, but I think the key elements of a robust risk management process are:

• If the MIV is taking credit or equity positions, then they need to understand credit quality and the credit profile of the MFIs in question. I think the credit skills within a MIV are very important.
• We look to what is the credit evaluation process? Does the MIV undertake its own credit analysis supplemented with the analysis from the specialized rating agency? How robust is that credit review and credit evaluation process? We like to see the whole paper trail behind the process.
• Country risk is obviously critical for microfinance institutions. I think a good recognition and understanding of country and related regulatory and legal risks is important. That’s a tough one for a lot of MIVs because clearly a lot of MFIs are operating in what would be very emerging markets, but the question is how are they looking at potential regulatory risk or political risk issues in the sector; are there certain mitigating factors, are there some countries that they simply won’t do business because of the perceived country regulatory risk?
• I think foreign exchange risk is one of the largest risks overhanging this space and it’s one that is not particularly, actively understood or managed by a lot of MIVs. Up until the last couple of years, many MIVs and many MFIs have gone through a period of unusually stable foreign exchange rates; even cases where foreign exchange rates have moved in favor of microfinance institutions. That has led to a degree of complacency in the market both on behalf of the MFIs and behalf of MIVs. That’s not to say the foreign exchange risk is necessarily something that’s readily and easily managed or hedged in this space. There are certain markets where a MIV can hedge their foreign exchange risk outright. I think there are other ways in which to stay on top of foreign exchange risk. There are certainly methodologies for measuring foreign exchange risk in a portfolio, for ensuring that you take at least a diversified approach to foreign exchange risk; that in certain markets you avoid it altogether and in other markets you look to hedge it.
• Liquidity risk is something that is a standard component of risk management that every MIV needs to have in place. What are their own liquidity needs and redemption rights of their investors? What are the policies in place to ensure that they are able to maintain that liquidity necessary to meet those requirements?
• Finally, there needs to be some level of crisis management experience and procedures. What are the procedures for investments and team when problems start to crop up? Are there early warning signals that the MIV have in place to monitor portfolios at the various MFIs? Do these early warning signals prompt conversations, interventions and visits with management to ensure it that the MIV is staying on top of the problems that might be rising early on?

MC: There has been concern that investors (who invested private capital in MIVs) may be forced to sell or discontinue investing in healthy assets due to their portfolios being hit hard by the falling equity markets and investments in structured products that have been written down. CGAP just came out with a report which stated that MIVs are likely to deteriorate during 2009 as the result of these changing market conditions. Though MIVs will likely continue to grow at double-digit rates, they expect returns to drop below to 3.5 percent in 2009. With MFI credit risk increasing and portfolio-at-risk showing a sharp rise in the first semester of 2009, this could hamper liquidity of MFIs which may be unable to fund their portfolio growth or even maintain their existing portfolios. What is your perspective on the performance of MIVs in the next 6 to 12 months?

Christina Leijonhufvud: I think that 6 to 12 months might be too short a window to actually gauge the vulnerability of the MIVs to underlying problems in the microfinance sector. I do believe that like in any very fast growing industry, we’ve already begun to see portfolio problems and institutional level problems crop up in various markets. Those have been (in some cases) related to excessive portfolio growth, inadequate controls and risk management processes. In other cases, it is related to political risk, political events and political and regulatory interventions. But there have been enough cases of countries where we have seen localized problems. We can begin to say that the microfinance industry is certainly not immune to the knock-on effects of the global financial crisis and the slowdown in capital flows to every asset class. So my ultimate answer is yes, I do believe we’re likely to see some deterioration in the performance of microfinance institutions around the world. It will not be uniform. It will be in certain markets where we have seen excessive growth at the cost of the quality of that growth. The knock on effects of the MIV is likely to happen over the course of the next two years. I would not be surprised if we begin to see some deterioration in MIV performance.

MC: Country location is a critical factor due to the formative influences of an MFI’s economic and regulatory operating environment.  A Government can either alleviate or exacerbate the impacts of a financial crisis through central bank lending policies, fiscal stimulus measures and monetary policies. You have been involved in designing and implementing a stress-testing methodology that measures the firm’s potential loss in an extreme country event as the basis for setting country exposure limits at JPMorgan. Can you provide greater detail as to what that methodology entails?

Christina Leijonhufvud: That is something that I helped design a number of years ago (about 10 years ago) at the firm. It’s gone through various iterations since then. At its root is the recognition that as one country suffers (liquidity issues, credit or political crises) you tend to see strong correlations of problems within that country. In other words, country crises tends to bring with it dramatic moves in foreign exchange rate, dramatic moves in the value of equities in the country, dramatic knock-on effects on the credit worthiness of various financial institutions and corporate borrowers within that country. As the result of the recognitions of those facts, we designed a stress testing framework and methodology that essentially started from the perspective of what is JP Morgan’s portfolio in this country, what is likely to happen in extreme country event and we ‘stress test’ the country for an extreme set of shocks, where the sovereign itself suffers deterioration and its credit worthiness. That has implications for value of its local currency vis-à-vis the Dollar; it has implications of the credit worthiness for corporates, financial institutions and implications for the value of equity holdings in that country. In some cases it would carry assumptions of political and regulatory interventions and some factors whether it would be assumptions of capital controls, transferability risks and so forth. This is a methodology that we designed and apply across the board to all our country portfolios. We actually use it to set and size our appetite for risk across countries. We have a view on which countries are more vulnerable to such extreme event risk and which countries are not. We take an independent view from the rating agencies of that risk and run these scenarios and size our appetite for country exposure and country risk on that basis. That’s something we run and rerun frequently within the firm (a full set of scenarios at least monthly). I think that has served JP Morgan quite well. JP Morgan’s a very global investment bank and it has managed through a number of emerging market crises quite well. I think that is, in part, related to this fairly robust approach and methodology.

MC: MIVs typically are comprised of private equity holdings, holding companies of microfinance banks, structured finance vehicles, and fixed-income funds; with the preferred investment still being fixed-income debt instruments. Can you elaborate as to why you believe it may be much harder for institutional asset management firms to get involved in microfinance debt?

Christina Leijonhufvud: Microfinance debt is a challenge for number of reasons. First of all, there’s just the basic issue that investing in microfinance is still not hugely scalable. We faced this when we were helping to raise a microfinance investment fund with our institutional clients. Most institutional players who sometimes manage billions of dollars of assets; they simply cannot justify the time it takes to do the due diligence to make a USD 5 million investment. So scale is one issue. Another issue on the debt-side is that I still believe that microfinance debt is not priced on a fully risk-adjusted basis. There is still quite a bit of inherent subsidy in the pricing of microfinance debt. When it comes to investing in debt, the benchmark is very objective and transparent. A private institutional player investor is going to benchmark its investment in microfinance against, say for example, high yield, corporate debt in the United States and probably an emerging markets Bond Index. On those accounts, it’s been difficult to justify an investment in microfinance debt from a pure return standpoint. That being said if you take a more double line approach and factor in the benefits of social impact, then perhaps you can get there. We don’t as of yet (as an impact investing industry) have robust methodologies for valuing that social impact.

MC: What is your perspective as how to ensure sustainable industry growth by attracting more institutional investors to both debt and equity?

Christina Leijonhufvud: I believe we really need to nurture this market for double bottom line investing. That means very proactively recognizing social and financial returns inherent in investments. That is not an easy thing to do and we are not going to get there overnight. There is a lot of work that needs to go into the identification and measurement of social impact. I think if we can as an industry become more diligent about offering double bottom line products and backing that up with some degree of measurement, then I think there is a demand out there at the retail level for those products. If there is demand out there at the retail level, then the institutional level should follow.

MC: Can you give me your perspective as to why it can be challenging to get private and institutional investors involved?

Christina Leijonhufvud: It has to do with measurement issues. In some cases there is no trade-off between financial and social returns. In that case if you’re investing in a purely commercial microfinance institution that has inherent social benefit because of its scale and inclusivity (growing customer base and so on), then I don’t think that it is difficult to market to institutional and retail investors as a pure financial investment with the knock-on social benefit. But I think there is a very large space where there actually is some inherent trade-off between financial returns and social impact; where you have to have an honest conversation with investors about the fact that if you will really want to have a double bottom line impact, you have to be willing, at least in the short-term, trade off some level of financial return expectations for social good. To have that conversation, you need to have a robust measurement framework. That is still lacking. That’s part of the whole rational and reasoning behind the ‘global impact investing network’ and the infrastructure they’re trying to create. That’s one of the reasons why JP Morgan has really stood behind that.

By Zoran Stanisljevic

Part one of our interview can be viewed here: http://www.microcapital.org/meet-the-boss-discussions-on-successful-due-diligence-when-evaluating-microfinance-investment-vehicles%e2%80%99-miv%e2%80%99s-financial-viability-interview-with-christina-leijonhufvud-managing-di/

Part two of our interview can be viewed here: http://www.microcapital.org/meet-the-boss-discussions-on-successful-due-diligence-when-evaluating-microfinance-investment-vehicles-financial-viability-interview-with-christina-leijonhufvud/

Ms. Leijonhufvud has led J.P. Morgan’s Social Sector Finance unit since its inception in late 2007. A double bottom line initiative that brings financial services and financing to microfinance institutions and other enterprises serving the base of the economic pyramid, Social Sector Finance also focuses on engaging the firm’s employees in these sectors. Outside J.P. Morgan, Ms. Leijonhufvud serves on the Advisory Board for the Center for Financial Inclusion, has been a consultant to Ashoka-Innovators for the Public in their social financial services venture, and has lectured widely on financial globalization and emerging markets risks. Ms. Leijonhufvud has held various risk management positions at J.P. Morgan, including as head of Country Risk Management & Advisory, Credit Portfolio Market Risk Management, Emerging Markets Market Risk Management, and Industry Concentrations. Prior to joining J.P. Morgan in 1996, Ms. Leijonhufvud worked at the World Bank as Country Officer, helping develop reform programs and borrowing strategies for the former Soviet Republics of Central Asia. In 1991, she served on the Economic Reform Committee for the Government of Kazakhstan. Ms. Leijonhufvud earned a M.Sc. degree in Economics from the London School of Economics, a M.A. degree in International Affairs from George Washington University, and a B.A. in Sociology from UCLA.