MEET THE BOSS: Discussions on Successful Due Diligence When Evaluating Microfinance Investment Vehicles’ (MIV’s) Financial Viability: Interview with Christina Leijonhufvud, Managing Director, Social Sector Finance Group (SSF)/Investment Bank (IB) at JP Morgan (Part II of a Three Part Series)

Ms. Leijonhufvud is Managing Director of the Global Social Sector Finance Group at JPMorgan. The SSF unit leverages JP Morgan’s products and skills to help bring financial services to microfinance and social enterprises around the world. The scope includes capital markets, structured products and principal investments. The unit seeks to achieve a double bottom line of social benefit and financial returns. According to JP Morgan, potential demand for sustainable financial services is immense, at an estimated USD 300 billion. JPMorgan utilizes its global IB platform to raise capital to support poverty alleviation initiatives in developing economies.

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: At the PlaNet Finance Global Microfinance Investment Congress in May 2009 you were part of a panel that discussed creating a successful due diligence model for evaluating microfinance investment vehicles (MIVs). Can you provide greater detail as to the due diligence required when evaluating one’s investment options?

Christina Leijonhufvud: Let me try and give you a basic framework. We have started with a standard due diligence checklist which is organized along a number of categories. The key components that we look at are:

First and foremost, when we look at a MIV from an investment point of view; our very first and most important screen has to do with who the people are behind the MIV. So basically we look at the GPs (General Partners) and what is behind the ownership structure of the MIV. Thus, we look for experienced fund managers that have some experience in this space and a track record within the asset class.
Then we look at the staff and spend time in the office getting to know those people.
It’s important to look at investment committee members and structure.
We look at key persons or key man provisions. We look at who the owners of the MIV are and what kind of backing do they have, as well as the reputation of the owners behind the fund.
We then go on to look at investment strategy, investment philosophy and process. So we want to know that there is a very strong in depth due diligence process within the MIV. One of the things that I have become concerned about in the microfinance space (as some MIVs have grown in asset size and perhaps have grown almost too quickly for their capacity) is that I have seen a tendency to outsource some of the due diligence process to third-party providers. That is something we would like to avoid (that outsourcing of due diligence) here at JP Morgan. If we invest in a MIV, we want to know that we are investing in the capacity to really undertake in-depth due diligence and really stay close to those investments. So that is also a comment on some MIVs that have transformed from directly investing in MFI’s to a sort of morphing into a ‘Fund of Funds strategy’; where they invest in other MIVs. That is also something that we here at JP Morgan would like to stay away from. We are not operating a ‘Fund of Funds strategy’ at JP Morgan and do not want to be investing in ‘Funds of Funds’.
So we look at the portfolio construction process, the geographic diversification, targets of the portfolio, how they manage the portfolio and the investment due diligence process. Generally, this would entail that I or someone from my team would travel (with a portfolio manager at MIV) to the investment site and go through the due diligence process (with them) to understand how this works.
Risk management processes and controls, the credit evaluation process, country risk regulatory, FX risk management and liquidity management are important. Importantly enough, we ideally love to hear from the MIV, that they have lived through a crisis. Frankly, I don’t take a great deal of comfort from someone that has said ‘we have never lost a penny and have never had any problems’. I actually like to know that there have been some problems in the portfolio that the MIV has had to manage through and as a result, they have learned some lessons and put in place crisis management procedures.
We also look at the operations of a MIV and what kind of back office support they have, as well as accounting and reporting procedures. We look at who is responsible for valuing the portfolio, by what method they are valuing the portfolio and clearly the regularity of reports sent to investors (and the contents of those reports).
Obviously, we look at investment returns; the historical performance of the MIV and the robustness of the return model behind the fund that they are raising. We tend to look at the MIV’s return model and run our own return models alongside. We stress returns for a number of different (conservative or aggressive) scenarios (whether FX or another factor is an issue). Then we come up with what we think is a reasonable expectation of return. In other words, we don’t take return forecasts at face value.
Related to the investment returns, it’s important for us to have a very active discussion on social mission, the clarity of the social mission of the MIV and impact measurement around that. The MIV may believe that they are actually achieving their social mission just by doing a thorough due diligence process and investing with those microfinance institutions that they truly believe are achieving their social mission; however; we definitely look to see that there is a culture at the MIV and a common vision in terms of what the social responsibility requirements are.
Naturally there are also other structural issues that obviously come up with an MIV, conflicts of interest, fee structures and things like that. That basically covers the broad categories of the kind of things that we here look at.

MC: With regards to rating MIV fund managers, what qualifications are necessary for a ‘competent’ manager?

Christina Leijonhufvud: We have to start in the microfinance space by recognizing that most of the fund managers in this sector have limited track records; however, we do, first and foremost, like to see a track record, even though it may be a relatively short track one. At this stage of JP Morgan’s own evolution in the space (and knowledge in this space), it’s important for us that we work with fund managers that have built up an experience base in the sector. We are not looking at ‘greenfield funds’. We like to see the history of the GPs, what kinds of professional undertaking they had before they have managed the MIV. We look at how they’ve hired their staff and the competency of their staff. In some cases the board members of the MIV can be very important sources of expertise, such as private equity expertise on their board or their advisory committees and significant credit expertise, if it’s a credit fund. I am sure you know from your time in credit, that there is this highly subjective element of knowing ones customers and people. That is really the starting point for us in getting to know the managers and making sure that we feel our values and those of the manager are aligned with a track record to back it up.

MC: When examining the operational structures of a MIV (with regards to the overall structure of the fund, due diligence, term sheets or covenants) can you provide greater detail as to what an investor should look out for in term of risk/reward?

Christina Leijonhufvud: I would look out for the following things: outsourcing of due diligence. How much on-site due diligence? I think MIVs structured and staffed in such a way that they are able to afford and really maintain the level of on-site due diligence to acquire to truly manage the risk in the portfolio). So if MIVs are really just doing some indexed approach to investing or they are outsourcing a lot of the analysis of due diligence, then that’s a red flag. For us it means that MIVs are unlikely to be ahead of problems that may crop up in the portfolio in the future. They are likely to be behind the ball when it comes time to manage through crises or portfolio problems.

As I mentioned earlier, we are also not particularly interested in the fund of funds strategy for the same reason. The other structural component that crops up in some MIVs is conflicts of interest. There are some MIVs that operate both as broker-dealers and as investment managers. Some of these conflicts are unavoidable, but it is very important to see that a MIV has procedures in place to guard against and prevent those conflicts from affecting the way in which they invest. Another issue is if the MIV is running multiple funds: how are they deciding to distribute new assets across those funds? So if you are an investor in one of those funds, how can you be assured that they are investing that fund without any conflict inherent with the other funds that they are managing.

The other more obvious issue is that most MIVs are fairly small, although some of them have gotten scalable at this point. Fee structure is an issue as there have been some funky fee structures (such as charitable contributions carved out) that I have seen in the space that just are excessive, not transparent or highly standardized. On a percentage basis, it’s somewhat excessive fee levels. I think we are increasingly getting to a more standardized fee structure like we’ve normally seen in the mainstream private equity space (2 and 20%). I understand that there are exceptions that have to be made for MIVs that are running smaller funds. There has to be a way to cover their cost. We’ll still look at funds that charge a bit higher than the 2% level, but we like to have that as close to standard as possible.

Key-man provision and key person provisions are also very important to have especially in the micro-finance space. There are usually one or two people behind the MIV that are truly critical to its ongoing operations (succession plans, really ascertaining that they are strong ‘number two’s within the organization). Those are the kind of things that should be looked at.

MC: How does one evaluate and recognize and potential signs of trouble for an MIV beforehand?

Christina Leijonhufvud: That often relates to the topic of operations and operational control. As an investor in the MIV space, it’s important to have a regularity of reporting sent to us as an LP (limited partner). We like regular LP committees with a very substantive, full discussion of the pipeline and the portfolios that exist, the valuations of the portfolio and issues that are cropping up on that portfolio. We would like to see the GP (general partner) really out ahead of issues that could crop up on the portfolio. We like the communications channel to be very open and transparent. We do not want LP meetings to be a kind of celebratory gathering. They should be meetings where we really get into the ‘nuts and bolts’ of how the investing is going and issues on the ground at various MFIs. I’d like to hear in-depth reports of what some of the issues are in the portfolio from the GP and their experience managing challenges in other parts of their portfolios. I think it’s really important in that respect.

MC: What analysis is involved when assessing investment policy and process for a MIV?

Christina Leijonhufvud: We certainly would spend a few days at MIV’s office with the portfolio management team, investment officers, CFOs and back office people. We would really ask them to go through a number of case studies in terms of investments that have already been made and have them walk us through the investment analysis process from A to Z. We look at the very first visit to the potential investee, copies of the very first memoranda to copies of proposals that go to their investment committee and talk through with them what kind of discussions they have in the investment committee. We tend to supplement that by making sure we travel with them, whether it’s with an investment officer, a portfolio manager or the general partner.

By Zoran Stanisljevic

Stay tuned for the last part of our interview tomorrow. Part one of our interview can be viewed here: https://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/

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