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 poor, has 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 non-technical overview of key findings of the report. MicroCapital will run a two part “Paper Wrap-Up” series (I & II) with a considerably greater level of detail regarding the specific financial models commonly used.
Investor Interest and Constraint
Equity investment in MFIs, whereby the organization injecting funds takes an ownership stake in the future profits of the MFI at hand, has been limited to date compared to debt financing, whereby an investor extends a loan to a MFI that leaves no ownership claim after repayment. At the same time, interest has been growing markedly in the former approach. There were 24 specialized microfinance equity funds with total assets of 1.5 billion USD under management by the end of 2008, while institutional investors such as pension funds Teachers Insurance and Annuity Association – College Retirement Equities Fund (TIAA CREF) and Stichting Pensioenfonds ABP, a European pension fund for government workers in the Netherlands, have made microfinance equity allocations of over 100 million USD as part of their socially responsible investment strategies. Likewise, well known private equity houses Sequoia and Legatum have made meaningful forays.
However, a major limitation to drawing in equity to MFIs has been the lack of organized secondary markets (i.e. stock exchanges) for microfinance securities, meaning that an investor who places money into an MFI cannot then sell their ownership claim on to another party with relative ease. Indeed, only two MFIs are actively traded in secondary markets. Equity Bank of Kenya is listed on the Nairobi Stock Exchange, while Mexican bank Compartamos is traded over-the-counter between stock dealers based out of New York and Mexico City.
Consequently, most equity investment in MFIs has been undertaken through direct / private placements – investors going straight to the receiving institution and negotiating an ownership claim on future profits in exchange for a fixed sum of money. The study therefore principally looks at how the valuation process works in these instances, although it offers some insights into public MFIs as well.
Core Findings
– Microfinance Institutions will be affected by the global financial crisis, but remain fundamentally sound. Specifically, MFIs will be hurt by higher interest rates on funds that they borrow from other financial institutions to lend on to micro entrepreneurs, and in turn, their valuations by outside investors looking to provide equity financing will be diminished as MFI profitability temporarily declines. Nonetheless, their robust performance will keep operational credit flowing, and in the long term, raise their valuation numbers once the temporarily high cost of such capital comes down.
– There is a lack of consensus over the value of MFIs amongst private equity firms looking to make equity placements. The need to project highly volatile streams of future profits, especially for up and coming MFIs, along with occasionally weak or non-standard accounting practices is a major contributor to this valuation diversity.
– Publically listed low-income finance institutions (LIFIs) – which in many ways mimic the goals and operations of MFIs – were aggregated into a securities index. It outperformed a broader index of global financial institutions by 238 percent since 2003. However, since September of 2008 when investment bank Lehman Brothers collapsed, the difference has been just 8 percent.
– Investors should consider five factors which differentiate MFIs from traditional banks when making valuations, namely: a double bottom line approach (painted as potentially distracting from profitability), high net interest margins, excellent asset quality, high operating costs (due to greater lending scrutiny), and longer term funding available from development investors.
– The authors argue in favor of absolute valuation methods which include, to some degree, a projection of an MFIs future income, rather than more simple relative valuation methods that only consider the present performance of an MFI.
– MFIs, when added to broader portfolios held by investors, can hedge against market risk as their performance is strongly robust to economic cycles. At the same time, inability to easily sell microfinance equity holdings on to other parties means the value of such investments should be marked down for liquidity risk.
– Net income growth and transaction size are the main drivers of valuations. That is, investors consider both how fast an MFI is generating new profitability, as well as how their own equity injections will help an MFI achieve its strategic goals.
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, with CGAP. This report is the result of a collaboration between CGAP and JP Morgan.
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
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