MICROFINANCE PAPER WRAP-UP: Shedding Light on Microfinance Equity Valuation - Past and Present, by Nicholas P. O’Donohoe, Frederic Rozeira de Mariz, Elizabeth Littlefield, Xavier Reille, and Christoph Kneiding, Part I of II

The Consultative Group to Assist the Poor (CGAP), a policy and research center housed at the World Bank dedicated to advancing financial access to the world’s underprivileged, released a path breaking report in February 2009 entitled, “Shedding Light on Microfinance Equity Valuation – Past and Present,” produced with limited analytical support from banking firm JPMorgan Chase & Co. The white paper is notable in providing an empirically grounded analysis of how financial valuation methods are actually applied by external actors to MFIs and other lending institutions with poverty alleviation goals. This is made possible by CGAP’s collection of information on 144 private equity transactions, the largest such dataset gathered to date, as well as information on 10 MFIs and other low income focused lenders that have raised funds through the issuance of securities. The original report is available at: http://www2.cgap.org/gm/document-1.9.9021/OP14v3.pdf

What follows is a summary of the first two major sections of the report – an introduction to the key issues at hand, and then an overview of alternative valuation methods. A second report at a later date on MicroCapital will cover the final two sections – specific microfinance valuation issues in the private equity sector, and then securities markets. While technical terms are utilized in as limited a fashion as possible, the subject matter requires some familiarity with financial statement analysis.

Introduction to Issues

As of 2007, there was a 5.2 billion USD aggregate equity base in the microfinance sector, with an increasing flow of equity capital coming from organizations lacking explicit poverty alleviation goals. That is, while multinational and governmental institutions such as the World Bank and the United States Agency for International Development (USAID) have injected 900 million USD globally, and another 1.5 billion USD have been provided by specialized, development oriented entities, there has been sizable growth in interest towards microfinance from traditional asset managers. Teachers Insurance and Annuity Association – College Retirement Equities Fund (TIAA-CREF), one of the largest financial services companies in the United States, and Stichting Pensioenfonds ABP, a state pension fund for government workers in the Netherlands, have made equity allocations of over 100 million USD, while prominent private equity shops Sequoia and Legatum have placed 200 million USD. Consequently, the authors of the paper felt it was vital that a better understanding be cultivated about how the accounting statements of MFIs are actually analyzed by prospective investors, especially in the context of today’s highly turbulent capital markets environment.

They begin by emphasizing that MFIs are fundamentally sound from an operational perspective, despite the broader woes gripping major banks. MFIs were largely divorced from markets for complex financial vehicles such as mortgage back securities and credit default swaps, which have decimated the balance sheets of full service financial institutions. Nevertheless, a major threat to MFIs in the near term is that their access to wholesale capital, which is then lent on by staff to microentrepneurs, has contracted sharply due to a major decrease in worldwide supply. Already, a 2-5% interest rate hike appears to have made its way on to MFIs, many of which are unable to pass along the full increase to borrowers as such changes undoubtedly price some microentrepreneurs out of the market. Fortunately, many MFIs remain predominantly deposit driven, with leverage of just 19% for those above 150 million USD in book value, and are hence are generally better insulated from interbank loan risk. However, a capital structure dominated by deposits should not be seen as a savior per se for MFIs, as handling a large number of small depositor accounts is often an expensive proposition, especially so for those institutions that lack the advanced information technology infrastructure that has greatly curtailed costs in the mainline commercial banking industry.

At the same time, despite its relative health, the flow of equity funds has nevertheless targeted certain subsectors of the microfinance industry over others. Eastern Europe and Latin American account for almost 2/3^rd‘s of equity holdings. Meanwhile, 85% of the equity investments are concentrated in the largest 100 MFIs. These flows then beg the question: what separates recipients from those passed over?

The authors note that five principal characteristics differentiate MFI from traditional banks. Positively, MFIs on average exhibit stronger asset quality, have a high net interest margin, and access to longer term, complementary funding from development mandate investors. Negatives include high operating costs, and somewhat controversially, the presence of a double bottom line that could in theory promote suboptimal lending in pursuit of social goals.

Specifically, in 2006, the average inflation adjusted worldwide microfinance lending rate stood at 24.8% – well above single digit long term rates of interest earned in mature markets such as the United State and Europe – while the default rate of the top 45 MFIs runs at just 3.7%. Certainly, MFIs interest rates are driven up by higher operating costs related to the detailed monitoring of borrowers, but there is also undoubtedly true profitability in sector given the quality of loans, further enhanced by oftentimes limited competition. Such numbers, when coupled to the fact that MFIs are more durable to economic downturns (two studies to date suggest little link between their performance and overall GDP growth), heighten interest in using microfinance equity as a hedge against risk associated with other asset classes. Yet, successful investments all start with successful valuations, and so the article turns to most popular methods in the field.

Comparing Valuation Methods

Consensus on MFI worth is mixed. Private equity valuations run from 1.3-1.9 times historical price-to-book, and 7.2-7.9 historical price-to-earnings. Such spreads are in part engendered by information shortages: there are serious transparency issues both in terms of accessing private data and due to the frequent lack of uniform accounting standards akin to Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS). Moreover, an efficient markets paradigm offers little help, as primary security issuances are limited by the small pool of potentially eligible MFIs and the absence of an organized secondary market (where day-to-day trading of stocks would help, in theory, reveal the correct valuation). Rather, the vast majority of transactions are in the form of opaque private placements, where a single firm is responsible for the underlying analysis without reference to competing valuations from other organizations.

Nevertheless, some common threads emerge across placements. First, net income growth and transaction value are the main drivers of appraisal. In other words, investors consider not only the track record and potential growth of profitability of an MFI unto itself, but also how their own capital infusion will enhance its performance. Second, there appears to be a uniform penalty applied to MFIs for the lack of liquidity associated with any capital injection. For investors looking to take their funds out of even profitable endeavors, the lack of secondary markets means time and costs will inevitably be associated with finding a party to take over a position. Third, concerns loom about exchange rate risk associated with MFIs wholesale borrowing, given that local currencies can sometimes depreciate rapidly, markedly driving up the cost of repaying USD or Euro denominated loans.

The study goes on to find that relative valuation methods, while common in the microfinance industry, are somewhat analytically flawed, and that absolute valuation methods such as the discounted cash flow and residual income approaches are more sound. Specifically, the price-to-book value approach is the most widely used method, in large part because of the lack of intangible assets or goodwill reported by MFIs. At the same time, comparing book values of MFIs tells one little about differences in future profitability if they do not share underlying, comparable characteristics. Meanwhile, the less popular price-to-earnings multiple is plagued by issues of how profits are reported, as well as the volatility in profits that MFIs may earn. Consequently, because of widespread differences across MFIs, the authors suggest relying on the discounted cash flow (DCF) and residual income approaches, subject to certain criteria.

Unlike a pure DCF technique, which forecasts future cash flow values and then discounts them back to the present, the residual income model is a hybrid that starts with the current book value and then adds the present value of the expected residual income. Residual income is defined as the difference between net income and the opportunity cost to shareholders to invest in an MFI’s equity (calculated as the cost of equity multiplied by book value). A main advantage of this method over the DCF approach is that any projection about terminal value represents a smaller part of the total valuation. Hence, in the case of a young, fast-growing MFI, the residual income model may prove more useful, as accurately projecting future cash flows can at times be difficult. Meanwhile, for established MFIs with a stable earnings stream, the DCF model is often more appropriate. Nevertheless, an inherent problem with absolute methods vis-à-vis relative ones is that detailed assumptions must be made about both future profitability and the discount rate, which if incorrect, can significantly bias the ultimate valuation.

Setting aside the final valuation number, the authors then discuss how the discount rate is determined. The cost of equity is predominantly computed via the Capital Asset Pricing Model approach, which accounts for both the risk-free rate of return plus additional remuneration for risk associated with holding the specific asset (beta). The paper argues that beta is lower for MFIs, and hence they can be valuable to investors looking to bring down overall portfolio risk through diversification. Reasons include sustained operational success, lending to entrepreneurs who are themselves divorced from trade and exchange rate risk, and favorable duration mismatch with funds maturity.

The Authors

The authors of this report are Nicholas P. O’Donohoe and Frederic Rozeira de Mariz, both with JP Morgan, and Elizabeth Littlefield, Xavier Reille, and Christoph Kneiding of CGAP.

CGAP is a policy and research center dedicated to advancing financial access for the world’s poor. It is supported by over 30 development agencies and private foundations who share a common mission to alleviate poverty. Housed at the World Bank, CGAP provides market intelligence, promotes standards, develops innovative solutions, and offers advisory services to governments, microfinance providers, donors, and investors.

JPMorgan Chase & Co. is the United States’ largest banking institution by market capitalization and deposit base, with assets of 2.3 trillion USD, or approximately 1/6 of the nation’s annual GDP. It operates in every major segment of financial services, and maintains a global footprint.

By Yanni Hao