March 2010 issue
Small Loans, Big Impact
Microfinance investments may be very appealing to some clients, but advisors should look closely to see whether they meet the goals of retail investors.
By CAREN CHESLER
Juan Alberto Davila has gone green. A farmer who grows beets and potatoes in San Isidro, Nicaragua, Davila recently borrowed $700 to buy a solar panel that he installed on the roof of his tin and mud home. The panel generates enough electricity to run four light bulbs, a television and a radio—items that are so extravagant in his village they have made his home the hub of activity. The electricity has also enabled Davila’s 10-year-old son Alexander to play outside after school, something he couldn’t do before because he needed to use those daylight hours to do his homework. He couldn’t do it at night because their home had no light.
“He got his childhood back,” says Jon Bishop, whose company, Madison, Wis.-based Envest, helped finance Davila’s loan.
Welcome to the world of microfinance, a market in which small loans are made to people so poor and lacking in credit history that they are not even on a bank’s radar. Most of these people, as it happens, have proved to be more responsible at repaying their loans than their more accredited counterparts in developed countries.
“People think because he’s poor, he won’t repay. But there are literally millions of examples of when you do the due diligence correctly, the poor are particularly good risks,” says Bishop.
Of course, you can’t just go into a slum and start lending money, but if you look at the institutions that understand the community and the financial sector, you’ll find their default rates—about 1%—are something the American banks would envy right now, Bishop says.
“I’d much rather have my money in microfinance than in mortgage-backed securities.”
The average loan sizes vary, from $300 in places like Nicaragua and India, to $1,000 for countries in Eastern Europe. Default rates are low in part because the borrowers often take on the debt in groups and guarantee each other’s loans (some 70% of microfinance loans are group loans). But it’s also because loan officers at micro-financial institutions know their borrowers well—something that can’t be said of the large banks that made subprime loans. Loan officers not only know what their borrowers look like, they probably know what their children look like and what they’re studying—because they’ve driven to their borrowers’ houses once a month to collect their loan payments.
Bishop says when he went to visit one of the microfinance institutions in Nicaragua in which invests, the loan officer came back to the office splattered in mud because he’d just driven miles and miles on a motorbike through the hills and valleys of Nicaragua—something he does every month—to collect his customer’s interest payments.
Bishop’s fund—which has a minimum investment of $5,000—offers investors notes that pay 5% to 7% interest, depending on the size and length of the loan. The money is then invested with a couple of microfinance institutions in Nicaragua. To date, not one has defaulted.
Envest is just one of several funds in this expanding marketplace. While emerging market funds have experienced a 20% sell-off, the assets of the top ten microfinance investment funds grew by 32% in 2008. As of December 2008, there were 104 active microfinance investment funds, with total estimated assets under management of $6.5 billion, according to the CGAP (Consultative Group to Assist the Poor), an independent microfinance research organization housed at the World Bank.
Retail investors helped fuel that growth. The responsAbility Global Microfinance Fund, based in Switzerland, for instance, grew 96% in 2008. It doesn’t hurt that microfinance was one of the few asset classes to end 2008 with positive returns.
Among the most popular retail products are Calvert Community Investment Notes. These pay a consistent return for the social-minded investor, and the product, which is very established, is fairly liquid and transparent. Other retail products include the PlaNet Finance Fund and MicroPlace, a microfinance broker owned by eBay that enables people to invest as little as $20 in a variety of microfinance products, including notes from Calvert or Oikocredit, a Dutch company that makes loans to microfinance institutions.
Some advisors say they like MicroPlace because it’s very user friendly. Users open an investment account, as they might at Schwab or any other brokerage. They then choose an investment based on some social need, a region in which they want to invest, or a level of return they hope to make. They can then make their investments through PayPal or a bank account. At maturity, the principal and interest is deposited directly into those accounts.
“MicroPlace is like the Schwab of microfinance. They’re the holder of many microfinance investment options,” says Jennifer Lazarus, a CFP licensee in Durham, N.C.
Lazarus says the Calvert notes are what she’ll usually put into someone’s portfolio if they’re interested in this asset class. They have a relatively low return, but it’s a fixed, stable return, and they’re easy to put in a portfolio. They’re on everyone’s platform, she says. She likens it to a CD. Her clients invest $1,000 or more, choose a time period—one, three, five, seven or ten years—and depending on how long they’re willing to tie up their money, they can earn from 0% and 3%.
Most of her clients are socially responsible investors. Since nearly all of the microfinance investments currently available are debt and not equity, Lazarus tends to use them as part of her clients’ bond portfolio.
“I do want to make clear that when I talk to people about MicroPlace and microfinance, it is for people who are looking for a way to use their capital to meet their philanthropic goals. The returns are not designed to be competitive financial returns,” Lazarus says.
And there’s the rub. While returns on some of the institutional products currently available in the microfinance arena are in the high single digits, the retail products are limited and often pay poor returns.
“If you’re talking wealthy individuals, who are usually accredited investors, generally a lot of the [microfinance investment vehicles] are open to them,” says Robert Summers, editor of MicroCapital Monitor, a Boston-based newsletter covering the microfinance industry. “If you’re somebody with $1,000 from your IRA, then you have two, three, maybe four choices.”
Wealthier investors, for instance, can buy seven-year collateralized debt obligations, in increments of $50,000 to $100,000, that might invest in, say, 60 microfinance institutions that then make small loans to poor people. The return? As much as 7%—far more than the retail products are paying.
“Calvert notes are popular for clients who are socially responsible investors. The big problem is they pay 3%. And the big advantage is that they pay 3%,” says Howard Finkelstein, an attorney who has worked in the microfinance area for a decade.
Finkelstein says that, despite Calvert’s low returns, at least they’re consistent—something he’s found in other microfinance deals. He says he helped structure one deal back in 2007, and a year later he bumped into someone from a U.S. bank who had invested $1 million in it. The banker says it was the best investment he’d made that year.
“Not one investor has lost a penny on these deals,” Finkelstein says.
But even if advisors have clients willing to pony up $50,000 to invest in a deal, the deals are hard to find because most of them are private placements. Finkelstein says he was at a conference in Tucson, Ariz., and he heard a lot of investment advisors saying they had clients in 3% products. They were searching for products that paid more, but they couldn’t find anything.
“There are deals out there, but people don’t know about them,” Finkelstein says.
While many of the retail investors in this marketplace are socially responsible and thus feel they are earning non-monetary dividends by doing something good—Calvert’s Web site states that about 10% of its investors choose to earn zero interest!—skeptics say these investors are not being duly compensated for the risks, despite the low default rates. Some question whether retail investors should even be in this market right now.
“There’s a lot of confusion about what the returns should be,” says Roger Frank, who recently left Benchmark Asset Managers to launch a firm that invests in microfinance projects—and pays higher returns. He wants his new firm to pay rates that are more in line with what emerging market investments might pay. “Calvert notes pay 1%, 2% or 3%. That’s low given the risk.”
Frank says most microfinance funds are geared toward institutional investors because these instruments are so illiquid no one is sure of their pricing on any given day.
“Typical retail investors need statements that show updates in value, and they need liquidity, and microfinance doesn’t provide those things,” Frank says. “For all practical purposes, investing in microfinance is not for the retail investor.”
Indeed, over the last year, an increasing number of microfinance institutions have entered the market and aggressively tried to gain market share. In this effort, they have become more lax on their lending standards, prompting some of the existing institutions to follow suit so they can remain competitive. The result is that some borrowers have wound up with two, three or four loans from different institutions, creating an over-debtedness that has some people concerned. Default rates in some cities ticked upward, from 1% to as high as 5%, though it’s still far less than the defaults experienced by American banks.
“There have been concerns with over-indebtedness over the last six months,” says Summers at MicroCapital. “But it has not been catastrophic. In general, especially compared to what’s happened in the world outside this market, they’re in pretty good shape.”
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