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 III 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: 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: 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/

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

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