New Partnerships for Innovation in Microfinance_3 doc

At least four other commercial microfinance investment funds have been set up since then, thereby contributing to widening the range of commercial investment vehi-cles in microfinance av

Raising MFI Equity Through Microfinance Investment Funds 41

Promoters of microfinance investment funds should target the investment folios of individuals These portfolios are potentially much larger than their alloca-tions to investments producing a clear social return but only a modest financial return Microfinance development funds will always attract individual investors because these investors can feel good about these investments They are likely to invest larger amounts if they can make a slightly higher return

port-Will these individuals find suitable investment funds? Including those investing exclusively in debt instruments, at the time of the surveys, only five commercial microfinance investment funds attract a large number of private individuals Three are in the Netherlands, mainly geared towards Dutch investors The other two are

in Luxembourg, targeting international investors All five are growing rapidly At least four other commercial microfinance investment funds have been set up since then, thereby contributing to widening the range of commercial investment vehi-cles in microfinance available to individual as well as institutional investors Commercial microfinance investment funds will almost certainly continue to be essentially debt driven with potentially a small portion of their assets in equity investments, which corresponds to the risk profile of the private investors targeted They are likely to be an important source of debt financing in hard currencies for the most mature MFIs This will encourage DFIs and other development oriented investors to focus on less mature MFIs and on local currency funding As the eq-uity portion of these funds will remain small and certainly well diversified, they are likely to co-invest in the equity of MFIs either with quasi-commercial microfi-nance investment funds or directly with DFIs or NGOs, without taking an active role in the governance of these MFIs

This activity will constitute a new form of public-private partnership in the field of equity investment in MFIs, between DFIs (and potentially NGOs) on the one hand and commercial microfinance investment funds on the other The former will provide expertise in microfinance and the checks and balances required to maintain the development mission of these MFIs The latter will hopefully provide funding in much needed far larger amounts by giving MFIs access to the wider capital market

Raising MFI Equity Through Microfinance Investment Funds 43

Raising MFI Equity Through Microfinance Investment Funds 45

Raising MFI Equity Through Microfinance Investment Funds 47

Goodman, Patrick: Microfinance Investment Funds: Key Features, ADA, February 2005, originally presented at the KfW Financial Sector Development Symposium, Berlin (November 2004)

Ivatury, Gautam and Abrams, Julie: The Market for Microfinance Foreign Investment – Opportunities and Challenges, CGAP, KfW Symposium (Novem-ber 2004)

Kaddaras, James and Rhyne, Elisabeth – Characteristics of Equity Investments in Microfinance – Council of Microfinance Equity Funds (April 2004)

Köhn, Doris and Jainzik, Michael: Microfinance Investment Funds – An Innovative Form of PPP to Foster the Commercialisation of Microfinance, in Matthäus-Maier and von Pischke (2005)

Matthäus-Maier, Ingrid and von Pischke, J.D (eds.), EU Accession – Financial Sector Opportunities and Challenges for Southeast Europe, Springer (2005) Microrate: The Finance of Microfinance (September 2004)

Silva, Alejandro: Investing in microfinance – Profund’s story (2005)

Schmidt, Reinhard H and Moisa, Nina: Public-Private Partnerships for Financial Development in Southeast Europe, in Matthäus-Maier and von Pischke (2005) van Maanen, Gert – Microcredit – Sound Business or Development Instrument (2004)

C HAPTER 3:

Market Transparency: The Role of Specialised MFI Rating Agencies

Sanjay Sinha

Managing Director, Micro-Credit Ratings International Limited

The Rationale for MFI Rating

in-vestment funds available for microfinance The latter study indicates that there are now over 40 investment funds supporting microfinance institutions (MFIs) and that some 75% of the funds available are allocated to debt financing with virtually all the rest being allocated to equity financing However, as the CGAP study indi-cates, overall foreign investment is only a small proportion of the global total of microfinance lending – $1 billion out of an estimated global total of $15 billion in microfinance loans at end-June 2003

This substantial amount of microfinance lending has taken place because of a significant shift in the financing of microfinance portfolios from being almost exclusively donor-funded to significantly investor-financed Finance is now being sourced from domestic sources (apex-level NGOs, development banks and even from commercial banks) as well as from the international investment funds re-ferred to above Prominent amongst the institutions lending to MFIs in Asia are the Palli Karma Sahayak Foundation (PKSF) of Bangladesh, Permodalan Nasional Madani (PNM) in Indonesia, People’s Credit and Finance Corporation (PCFC) in the Philippines and the Small Industries Development Bank of India (SIDBI) The encouraging experience of these institutions in revolving wholesale funds for mi-crofinance has accelerated interest in microfinance investment As a result, more

1 CGAP Foreign Investment in Microfinance: Debt and Equity from Quasi-Commercial Investors Focus Note No 25 Washington DC: Consultative Group to Assist the Poor, January 2003

2 Goodman, Patrick Microfinance Investment Funds: Objectives, players, potential Paper presented at the 2004 KfW Financial Sector Development Symposium Berlin: 11-12 November 2004

50 Sanjay Sinha

domestic apex institutions (as wholesale lenders) as well as domestic commercial banks, such as ICICI Bank in India and Bank Mandiri in Indonesia, have become active in this field In addition, international funds have also shown increasing interest in investing in microfinance

Investment inevitably generates concerns about the borrower’s cash flows, profitability and sustainability, making the availability of skills for MFI appraisal and risk analysis an increasingly important issue The response of the domestic apex organisations that wholesale development funds to MFIs has been to at-tempt to develop these skills internally PKSF (Bangladesh) and RMDC (Nepal) are in this category Banks – such as Sonali Bank of Bangladesh and SIDBI and ICICI Bank in India – with large portfolios but relatively minuscule exposure to the microfinance sector have been more reluctant to undertake appraisals as purely internal exercises

There are two reasons for this First, as custodians of commercial rather than development funds, their risk analysis is more sophisticated than is customary in the development sector Second, a bank with a loan portfolio of a billion dollars or more, invested in a diverse range of activities, may find it difficult to persuade many of its staff to specialise in MFI appraisals when they expect the microfi-nance portfolio to be no larger than $20-30 million in the immediate future Yet, the potential for microfinance lending in India alone is estimated to be between

$6-8 billion if the substantial liquid resources of the banking system could be channelled in this direction

The microfinance funding situation can therefore be characterised as one of formation asymmetry Commercial banks and international investors have funds but not the specific expertise to assess and analyse microfinance operations MFIs have a high demand for funds but in many cases doubtful records on sys-temic strength, sustainability and profitability While apex institutions financing MFIs have preferred to develop their own appraisal systems with varying suc-cess, the development and commercial banks – along with many international funds – have preferred to use the services of specialised MFI raters that have en-tered the field since 1997

in-The Progress of Microfinance Rating

Microfinance rating started around 1996-2000 with the advent of three specialised raters – MicroRate in Washington DC, Planet Rating in Paris and Micro-Credit

M-CRIL grew out of microfinance assessment and appraisal expertise developed by a team assembled by Damian von Stauffenberg in the US and EDA Rural Systems

3 MicroRate was the first actually to be established and to undertake a commercial rating assignment – in 1997

Market Transparency: The Role of Specialised MFI Rating Agencies 51

in India Planet Rating was set up in 2000 by Planet Finance, a French NGO that promotes the development of microfinance

These three agencies have become the market leaders, accounting for over

two-thirds of some 900 ratings of MFIs As Table 1 shows, these three had undertaken

600 ratings (according to the website of the IDB-CGAP Rating Fund) through end-March 2005, covering all regions of the world with significant microfinance activity By 2005, M-CRIL emerged as the market leader in numbers of ratings (accounting for over 30% of the total) with a volume of 50-60 a year

Using M-CRIL as an example, in the six and a half years following the launch

of its rating service in 1998, M-CRIL assembled a team of 8-10 professionals It has an active Board of Directors made up of professionals and academics with intimate knowledge and experience in microfinance These professionals are part

of its Rating Committee to provide independent oversight of the ratings process This vetting mechanism has served to mitigate the risk of prejudice, conflicts of

Table 1 Ratings undertaken by agencies recognised by the Rating Fund

Microfinance ratings Rating agency Area(s) of operation

Total con- ducted

%

of total

Financed

by ing Fund

Rat-All ratings during

12 mos to March 05

Pacific Credit Rating Latin America 7 0.8% 80 Standard & Poor’s Latin America 3 0.3% 1 50,000 Sub-total 180 20.3% 11

Source: CGAP-IDB Rating Fund website www.ratingfund.org

52 Sanjay Sinha

Fig 1 MFI ratings undertaken by M-CRIL and lending recommendations (financial years

from April to March)

interest or sins of omission that might otherwise cloud the judgements made by M-CRIL’s analysts As a result, M-CRIL’s MFI ratings are accepted as a highly reliable assessment of the creditworthiness of institutions engaged substantially in providing financial services to low-income clients

Ratings are based on intensive visits of 3-6 days (depending on the size and spread of an MFI) by a team of at least two analysts to MFI head offices, branches and clients The analytical reports emerging from these visits provide detailed, independently verified information on MFI operations that financial institutions and investors require in order to make lending/investment decisions and judge-ments of creditworthiness M-CRIL rating reports are normally accompanied by projections of the MFI’s growth Based on these projections, M-CRIL makes a recommendation for the level of investment that would be appropriate (in M-CRIL’s opinion) for external investors in the rated MFI

Table 1 lists rating agencies financed by the Rating Fund that are active in ferent regions and provides the total number of their rating activities Corporate rating agencies have made a few ratings of microfinance institutions, which are included in the overall numbers of ratings made by these large agencies

dif-Figure 1 shows the progress of M-CRIL’s rating activity over the six and a half

years through end-March 2005 It had undertaken 269 MFI ratings in Asia ing in a cumulative lending recommendation (“absorption”) equivalent to US$171 million

result-Market Transparency: The Role of Specialised MFI Rating Agencies 53

The professional opinions emerging from the risk analysis and capacity sessment of MFIs undertaken by M-CRIL have served as a key factor in the lend-ing and other investment decisions of a number of investors in microfinance M-CRIL’s rating service has greatly accelerated the rate at which commercial (or near-commercial) investment has become a source of funds for MFIs in Asia It is the author’s understanding that MicroRate’s work in Latin America and South and East Africa and that of Planet Rating and others in the CIS and north Africa has had a similar effect Though precise figures on the investment stimulated by the other rating agencies may not be available, it is likely that these numbers – in terms of funds invested – would exceed those of M-CRIL since average MFI port-folios (as opposed to client numbers) in Latin America and Eastern Europe tend to exceed those of Asian MFIs by significant multiples

as-Use of Ratings for the Financing of Microfinance

Internationally the demand for microfinance rating services has grown slowly but steadily as an increasing number of ratings are being commissioned by a variety of clients These clients include donors such as USAID, DFID, Swiss Development Cooperation, HIVOS, and CGAP Also, MFIs seek ratings directly at the request

of investors such as Blue Orchard Finance representing the Dexia Micro-Fund and others, as well as by social funds such as Unitus and MicroVest Again using M-CRIL as an example, this section discusses how rating services play a role in the funding of international microfinance (Annex 1) The various ways in which rat-ing services have been used can be broadly classified as:

• initiatives to raise international financing,

• facilitation of seed capital finance for emerging MFIs,

• demonstration to commercial banks of the utility of the rating service, and

• benchmarking of performance and identification of institutional weaknesses MFI Initiatives to Raise International Financing

MFIs that want to raise funds from international investors use the opportunity offered by their donor supporters and/or by the CGAP Rating Fund to obtain a rating – paying part of the cost from their own resources MFIs use the rating re-ports provided by a rater such as M-CRIL as independent assessments to attract investors – whether donors or lenders In Asia, MFIs/banks in Cambodia (Amret, Hatha Kaksekar), Indonesia (the erstwhile Bank Dagang Bali), the Philippines (CRBBI, NWTF, TSKI) as well as in India (SHARE Microfin, Spandana) have used M-CRIL’s ratings in this way Blue Orchard Finance, Deutsche Bank, Citi-bank and a number of private Indian banks have used M-CRIL’s rating reports as part of their appraisal for lending to these MFIs

54 Sanjay Sinha

Facilitation of Seed Capital Finance for Emerging MFIs

The Dutch NGOs, Hivos and Cordaid, have gone further and used M-CRIL’s ing for their programmes that provide seed capital to emerging MFIs Ratings have been used to advise on the suitability of MFIs for support under the pro-gramme and for determining appropriate capitalisation levels over a three year period Such ratings have covered an MFI in Kazakhstan, another in Timor-Leste and three MFIs in Indonesia Following the investment phase, M-CRIL was asked

rat-by Hivos to undertake quarterly desk reviews (based on information provided rat-by the MFI) and periodic rating updates The object of this process is to enable the MFI to obtain near-commercial funding The Kazakhstan Community Loan Fund was the first to graduate in this way from a seed capital partner of Hivos to a bor-rower of Triodos Bank

In Myanmar, M-CRIL’s rating methodology was used to recommend the future capitalisation of three UN-funded microfinance initiatives At the request of

to determine the capitalisation requirements of the three projects In addition, the analysis of performance identified areas for capacity building and institutional development of the projects

Demonstrating the Utility of Rating to Banks

A Bank Indonesia pilot initiative in 2002 funded by USAID/Asia Foundation rated three BPRs (licensed micro-banks) to determine the suitability of M-CRIL’s rating methodology as a basis for obtaining commercial bank funding for BPRs This exercise led to a discussion about the establishment of a joint venture rating agency focused on BPRs The revenue model for this proposed joint venture was based on the expectation that the commercial banks and the BPRs would share the cost of the rating

In Nepal, the technical support network, the Centre for Microfinance, sioned four ratings by M-CRIL in 2000 to determine the utility of the rating exer-cise for the local microfinance industry

commis-Benchmarking Performance and Identification of Institutional Weaknesses Others have used rating for benchmarking and to identify shortcomings in MFIs’ capacity to provide services in an effective and cost-efficient manner Essentially, benchmarking compares the performance of the rated MFI with “best practice” norms emerging either from the specialised raters’ own databases or by compari-son with international averages available from the MicroBanking Bulletin This

4 United Nations Office for Project Services – the executing agency for the UNDP-funded programme