Currently several microfinance industry efforts are underway
to define and operationalize the idealistic concept of “balanced returns” which
is included in a number of statements of principle or codes of conduct
including the PIIF and the SPTF Universal Standards. These discussions force us to confront two
distinct views of what microfinance can accomplish and how: Is microfinance effective by accelerating
the entry of the poor into mainstream markets, specifically markets for
financial products, where market forces will ultimately deliver improved lives
to the bottom of the pyramid through “financial inclusion”? Or can microfinance directly benefit the poor
by enlisting private capital and market incentives in targeted, pro-poor
interventions not available in the mainstream?
These different views both cite evidence and research, and each is enjoying renewed energy and dynamism: from financial inclusion efforts on the one hand and pro-poor efforts on the other. And each defines “balanced returns” somewhat differently, with those focused on financial inclusion emphasizing synergies between financial and social objectives while the pro-poor camp is more apt to point to trade offs and the need to prioritize client benefit and social goals. The potential wedge between the two on the question of returns to microfinance investors is driven by three remedial efforts:
Second, efforts are underway to develop a framework for ensuring that the financial relationship between poor borrower and MFI lender allows borrowers to retain a sizeable (to be defined) proportion of the fruits of their initiatives. These frameworks require MFIs to achieve high levels of operating efficiency and set interest rates at levels determined with the client’s well being in mind, rather than simply what the market will bear. This framework is still developing and needs to be elaborated to encompass loans for non-productive activities and non-loan products, like savings and insurance.
Third, initiatives such as the Pro Poor Seal of Excellence seek to return microfinance to its roots such that the MFI serves as the nexus of a coordinated web of financial and non-financial interventions with the objective of demonstrably impacting a particular social ill, be it poverty, gender inequity, youth unemployment, or access to healthcare or education.
Each of these remediations may act to push returns “below market”. Even “do no harm” can depress earnings, although it can be argued that in the long run it serves as institutional risk management as much as client protection. Limiting interest rates to enhance client income, though, moves in only one direction, unless you want to argue that future business from healthier, more prosperous clients will more than make up for the immediate fees and interest foregone. That argument is may be correct in macro terms, but probably is not compelling as a business plan for any specific company. Similarly, most pro-poor or non-financial interventions like health clinics or business development services have at least an extended period during which they do not fully cover costs and require some cross subsidy. Again, these might be justifiable to some extent for brand management, or building client loyalty, but probably not at a meaningful scale.
Nearly all MF practitioners subscribe to at least the first of these, and many to two or all three. The broader the concept of “balance” the greater the potential reduction in ROE; how much greater, we don’t yet know. But if we take some of the initial guidance for “acceptable” ROEs emerging from discussions about appropriate interest rates, the implications for investors are significant. Chuck Waterfield has proposed a stringent “green zone” for microfinance investors at an ROE between 6-15%. Grassroots has run a portfolio of such investments through its standard investment fund model and finds that after fee and expense leakage, one or two failed or underperforming investments, and factoring in the timing of investments and holding periods, the returns to equity investors are in the neighborhood of 5%, well below “market” for emerging market private equity.
This recalibration of the microfinance investment proposition is taking place within the context of the development of the broader impact industry. If microfinance is to rely on impact investors to fund its future growth, it is crucial that it build credibility with both financial first investors (2/3s of the total, according to JPMorgan) and below market investors. For financial first investors, this means delivering the targeted financial returns with acceptable levels of reputation and political risk. For impact first investors, this means placing in the forefront how microfinance differs from other impact investing sectors and making appropriate adjustments in investor expectations. Unlike some impact investments – in green tech, or food and energy systems, for example – microfinance exclusively targets the poor. Thus there is a fundamental zero sum relationship that raises a moral dimension for impact first investors: every dollar extracted from clients through interest rates or fees is taken from the pockets and mouths of the poor and put in the bank accounts of the relatively wealthy: it is a wealth transfer from the bottom 40% to the top 5%. This is not necessarily the case with other “good” companies, like Whole Foods or Starbucks or Zappos, who merely transfer wealth form the top 15% to the top 2%.
As financial first investors we point out that this is the way the world works, and high priced money can be better than no money at all. But as impact first investors this hard-nosed answer doesn’t really get us off the hook. Is bringing poor people into a more or less conventional system of financial products enough to position them for improved lives? Or has the mainstream financial industry failed to earn our trust as having the best interests of poor clients at heart requiring us to build an alternative industry designed and dedicated to serve and benefit the poor?
Acknowledging these different views is important because without clearer and more accurate investment propositions, microfinance risks disappointing and alienating all its investors: those financial first investors who believe that social and financial goals are always synergistic and impact first investors who will forego some financial return so long as microfinance is clearly bettering lives. Microfinance can both join the mainstream and be an alternative to the mainstream, but only if investment managers and MFIs are clear and specific about the balanced investment proposition they are offering in each case and then deliver.
These different views both cite evidence and research, and each is enjoying renewed energy and dynamism: from financial inclusion efforts on the one hand and pro-poor efforts on the other. And each defines “balanced returns” somewhat differently, with those focused on financial inclusion emphasizing synergies between financial and social objectives while the pro-poor camp is more apt to point to trade offs and the need to prioritize client benefit and social goals. The potential wedge between the two on the question of returns to microfinance investors is driven by three remedial efforts:
First, in response to actual or alleged abuses in recent
years, major efforts have been made to strengthen the “do no harm”
infrastructure of the microfinance industry.
The SMART campaign, codes of conduct, efforts to increase transparency
and financial education can all be seen as meaningful efforts to ensure that
financial inclusion does not harm the vulnerable clients targeted by
microfinance.
Second, efforts are underway to develop a framework for ensuring that the financial relationship between poor borrower and MFI lender allows borrowers to retain a sizeable (to be defined) proportion of the fruits of their initiatives. These frameworks require MFIs to achieve high levels of operating efficiency and set interest rates at levels determined with the client’s well being in mind, rather than simply what the market will bear. This framework is still developing and needs to be elaborated to encompass loans for non-productive activities and non-loan products, like savings and insurance.
Third, initiatives such as the Pro Poor Seal of Excellence seek to return microfinance to its roots such that the MFI serves as the nexus of a coordinated web of financial and non-financial interventions with the objective of demonstrably impacting a particular social ill, be it poverty, gender inequity, youth unemployment, or access to healthcare or education.
Each of these remediations may act to push returns “below market”. Even “do no harm” can depress earnings, although it can be argued that in the long run it serves as institutional risk management as much as client protection. Limiting interest rates to enhance client income, though, moves in only one direction, unless you want to argue that future business from healthier, more prosperous clients will more than make up for the immediate fees and interest foregone. That argument is may be correct in macro terms, but probably is not compelling as a business plan for any specific company. Similarly, most pro-poor or non-financial interventions like health clinics or business development services have at least an extended period during which they do not fully cover costs and require some cross subsidy. Again, these might be justifiable to some extent for brand management, or building client loyalty, but probably not at a meaningful scale.
Nearly all MF practitioners subscribe to at least the first of these, and many to two or all three. The broader the concept of “balance” the greater the potential reduction in ROE; how much greater, we don’t yet know. But if we take some of the initial guidance for “acceptable” ROEs emerging from discussions about appropriate interest rates, the implications for investors are significant. Chuck Waterfield has proposed a stringent “green zone” for microfinance investors at an ROE between 6-15%. Grassroots has run a portfolio of such investments through its standard investment fund model and finds that after fee and expense leakage, one or two failed or underperforming investments, and factoring in the timing of investments and holding periods, the returns to equity investors are in the neighborhood of 5%, well below “market” for emerging market private equity.
This recalibration of the microfinance investment proposition is taking place within the context of the development of the broader impact industry. If microfinance is to rely on impact investors to fund its future growth, it is crucial that it build credibility with both financial first investors (2/3s of the total, according to JPMorgan) and below market investors. For financial first investors, this means delivering the targeted financial returns with acceptable levels of reputation and political risk. For impact first investors, this means placing in the forefront how microfinance differs from other impact investing sectors and making appropriate adjustments in investor expectations. Unlike some impact investments – in green tech, or food and energy systems, for example – microfinance exclusively targets the poor. Thus there is a fundamental zero sum relationship that raises a moral dimension for impact first investors: every dollar extracted from clients through interest rates or fees is taken from the pockets and mouths of the poor and put in the bank accounts of the relatively wealthy: it is a wealth transfer from the bottom 40% to the top 5%. This is not necessarily the case with other “good” companies, like Whole Foods or Starbucks or Zappos, who merely transfer wealth form the top 15% to the top 2%.
As financial first investors we point out that this is the way the world works, and high priced money can be better than no money at all. But as impact first investors this hard-nosed answer doesn’t really get us off the hook. Is bringing poor people into a more or less conventional system of financial products enough to position them for improved lives? Or has the mainstream financial industry failed to earn our trust as having the best interests of poor clients at heart requiring us to build an alternative industry designed and dedicated to serve and benefit the poor?
Acknowledging these different views is important because without clearer and more accurate investment propositions, microfinance risks disappointing and alienating all its investors: those financial first investors who believe that social and financial goals are always synergistic and impact first investors who will forego some financial return so long as microfinance is clearly bettering lives. Microfinance can both join the mainstream and be an alternative to the mainstream, but only if investment managers and MFIs are clear and specific about the balanced investment proposition they are offering in each case and then deliver.
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