Blended Value Investing : Capital...
World Economic Forum March 2006 Blended Value Investing: Capital Opportunities for Social and Environmental Impact COMMITTED TO IMPROVING THE STATE OF THE WORLD
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3 Contents Preface 5 Organization and Conclusions 6 Innovations in Debt Financing: Advances in the Fields of Microfinance and Community Development 7 Introduction to Microfinance Debt Offerings and Securitization 7 Access to Capital Markets 8 Microfinance Bonds and Securitization: A Primer 9 First Case Study: ACCION International���s Domestic Market Bond Offerings 11 Second Case Study: Global Partnerships��� International Debt Offering 14 Emerging Issues in Microfinance Securitization 18 A Note on other Debt Financing Innovations 21 Third Case Study: Community Investing, Media Development Loan Fund, and Calvert Social Investment Foundation 21 Credit Guarantees and Enhancements: Flexible Catalysts for Blended Value Investment 27 First Case Study: Nurcha and the Open Society Institute 29 Second Case Study: Deutsche Bank Microcredit Development Fund 32 Third Case Study: MicroCredit Enterprises 33 Fourth Case Study: Grameen Foundation USA���s Growth Guarantees Programme 36 Fifth Case Study: Global Commercial Microfinance Consortium 37 Innovations in Private Equity Investing 42 Introduction 42 Variations on Traditional Venture Capital 44 First Case Study: ACCION International���s Domestic Market Bond Offerings 45 Second Case Study: Aavishkaar India Micro Venture Capital Fund 49 Third Case Study: ShoreCap International and ShoreCap Exchange 51 Fourth Case Study: Actis 53 Building Blended Value Portfolios 56 A Cautionary Conclusion: Maximizing Blended Value Returns by Embracing Market Fundamentals 59 Appendix A: Other Notable Developments in Microfinance 70 Appendix B: A Glossary of Blended Value Investing Terms 72 Acknowledgements 74 Endnotes 75
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5 Blended Value Investing: Capital Opportunities for Social and Environmental Impact The World Economic Forum is pleased to issue this report, which seeks to explore how ���Blended Value Investing��� (BVI), as distinct from either market-rate investing or philanthropy, can leverage economic performance while also creating social and/or environmental value within a single, unified approach to investing and capital finance. BVI is, by definition, a market-based approach to addressing many of the challenges facing the global community. BVI seeks to engage capital in creating sustainable, long-term solutions to those same challenges. Such strategies are defined as ���blended value��� and not ���double bottom line��� or philanthropy since they view the value being created as neither solely economic nor solely social, but a blend of both. This approach recognizes that economic value can create various forms of social and environmental impact and cannot be viewed as a separate component of the value proposition found within any given investment. Therefore, BVI seeks not a double bottom line, but rather a single bottom line with multiple value components. In September 2004, the World Economic Forum���s Global Foundation Leaders Advisory Group hosted an international meeting of investors, foundation executives and representatives from non- governmental organizations to discuss the state of blended value investing and explore what barriers exist to expanding the use of private capital for social gain. Private Investment for Social Goals: Building the Blended Value Capital Market was published by the Forum in 2005 and presents the key discussion points and findings from that session. At the conclusion of the 2004 meeting and follow- up discussions during the World Economic forum's Annual Meeting in Davos in 2005, session participants requested that a research project be undertaken during 2005 that could explore in greater detail how a variety of capital finance strategies are being applied to the area of blended value investing. Furthermore, since the arena of microfinance is viewed by many as an excellent example of how economic and social value may be leveraged through investment innovations, participants asked that this research also summarize current practices in microfinance that might inform investing activities in other related areas. In fact, many of the examples presented in this document are taken from the field of microfinance and could be applied more broadly to other areas of interest, whether housing, local building projects, small/medium enterprise development, healthcare, education or beyond. We wish to thank Cisco Systems Foundation for making this project possible, Jed Emerson of the Generation Foundation and Joshua Spitzer for drafting and researching the report, and the members of the Forum���s Global Foundation Leaders Advisory Group for providing comments and overall guidance. We also wish to thank Adele Simmons, Senior Adviser to the Forum, and Sam Mbugua, Global Leadership Fellow, for their support of the project. The World Economic Forum���s efforts at catalyzing and sustaining the important debate around Blended Value Investing have received support from many quarters. In gratefully acknowledging these contributions, both financial and intellectual, we also look forward to the positive evolution of this discussion and to the expanded application of creative investment approaches that can accelerate progress on pressing social and environmental problems. Richard Samans Managing Director March 2006 Preface
6 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Organization and Conclusions This paper is organized into three inter-related sections, each with case studies presenting details on the process of innovation within the blended value investing arena. The first section explores innovation in debt finance. It has two subsections. The first subsection presents the process by which loans to microfinance institutions are ���packaged��� as financial securities that offer the opportunity to expand the capital available to such funds. These developments serve as examples of what could take place in other emerging areas of investing. The second subsection explores another novel application of debt finance applied in the realm of community investing, which further investigates how blended value investing strategies can be made accessible to individual investors. The second section presents cases in which credit guarantees and enhancements have been used to manage the risk (perceived and real) associated with various blended value investment opportunities. In several cases, such enhancements helped other investors price risk more accurately so that ultimately capital could flow more freely to those investments. The third section presents private equity investing innovations, which provide risk capital to new funds and enterprises that generate both social/environmental impacts as well as economic value and returns. Those attending the discussions at the Forum in Geneva asked that several of the anecdotal stories of participants around the table be brought together and formally presented to others interested in understanding more about: ��� How these deals evolved ��� The challenges of structuring them ��� The possible prospects such investing practices hold for broader application by others interested in creating innovations in capital finance. This paper is offered not as a fully comprehensive survey of the emerging area of blended value investing, but rather as a set of examples of how such investing practices are being developed and applied around the world. The paper���s intent is not to provide a single answer for all investment challenges, but to demonstrate how groups of investors are mobilizing capital on new terms to meet the challenges of emerging investment opportunities, as well as the demands of investors seeking out new asset classes in which to place their capital. While the paper presents part of the history of groups and individuals who have worked to advance these practices, it is does not present a history of the field or a comprehensive overview and should not be taken as such. Other documents by CGAP, ACCION and related groups should be sought out by readers looking to understand how, specifically in the area of microfinance, various instruments and approaches have evolved. This paper presents innovations in capital finance that promise to bridge market-rate interests with strategic opportunities to create blended value that benefits shareholder and stakeholder alike. The following examples speak to an evolving capital convergence wherein mainstream capital markets and investing will increasingly become drivers of new solutions to historic problems. Blended value investing funds and instruments offer financing strategies from a set of tools that go beyond traditional philanthropy or market rate investing and which complement the vision we all share of a world with greater equity and opportunity for its members. This paper also identifies several areas of research that would help advance the field of blended value investing. In summary, those projects include the following: ��� An in-depth survey of blended value investors that would ultimately segment the market and identify strategic investor groups and categories ��� An inquiry into blended value portfolio theory to understand how investors have applied modern portfolio theory concepts and analytics to building diversified blended value portfolios ��� A deeper inquiry into applying lessons learned from microfinance to other blended value systems. Finally, the paper concludes with words of caution that suggest a prudent approach to developing blended value capital markets. It offers a critique of the state of the markets, presents a strategic vision for the blended value capital markets, and suggests specific steps that participants might take in moving toward the ideal.
7 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Fortunately, a growing number of microfinance institutions possess the business fundamentals necessary to access those capital markets. Before commercial capital may fund the microfinance industry on a large scale, capital markets will require investment products capable of meeting the needs of both microborrowers and investors of capital. This section examines several very promising early examples of these products, which may represent the path toward a suite of investment instruments offering truly blended returns that maximize social and financial value. The Microfinance Success Story In the thirty years since the Grameen Bank, ACCION and other MFIs showed the rest of the world that small loans to poor women could dramatically improve the lots of families and communities, microfinance has become a widely celebrated model of economic development. Many sources document the growth of the sector over recent decades, and this paper���s Appendix A presents a brief review of key microfinance innovations. Those innovations have made microfinance securitization possible. Much of this section explores how securitization has opened new options to capitalize on and invest in both financial performance and social impact. Among many blended value investing strategies, microfinance is one of the most mature. Its sustainability and replication have introduced innovations that are not only enhancing the fundamental value proposition of microfinance, but now appear applicable to other blended value investment programmes. These innovations continue to bring microfinance to new levels of large-scale efficacy, and may eventually find application in other areas in order to bring those areas to a similarly substantial scale. Since other publications have explored the current state of the field, this section will not examine the overall state of the microfinance industry.1 Though the section will discuss several innovations in the sector, more complete explorations of those innovations can be found in other sources cited later in this text. The following narrative examines the structure and actors in several microfinance securitization deals, delving more deeply into one particular deal to offer lessons learned and help identify emerging issues associated with successfully securitizing debt to MFIs. Introduction to Microfinance Debt Offerings and Securitization Many blended value investors��� primary goal is to achieve real social returns together with financial returns that are not concessionary to the risk- adjusted rate investors could otherwise attain. Investments meeting that goal would be fairly easy to trade and have investment terms that are understood by the average investor. Such characteristics would generate significant demand from all sorts of investors���especially those who do not now take account of how they might create blended value in making capital investment decisions. For these reasons, the practice of securitizing loans to microfinance institutions (MFIs) is a very promising prospect for many involved in BVI. Built on hundreds of millions of dollars in donated and concessionary-rate (which is to say, below market rate) capital, microfinance has proven to be a sound and powerful investment in blended value. However, despite wide-spread growth in microfinance around the world, the industry has now reached a critical point: many funds have lent all or most of their available capital they must either sell some of the debt on their balance sheets or otherwise secure substantial new funds in order to expand their lending activity. Those investing philanthropic capital for social returns have supported microfinance institutions in becoming viable, in proving that poor people make good customers for financial services, and in reaching a remarkable scale. Nevertheless, the size of the microfinance industry has the potential to be dramatically larger, and philanthropic capital alone will not be sufficient to achieve this potential. To extend microfinance to a substantial majority of the world���s poor, a new kind of capital must enter this market, and that capital will most likely come from the mainstream capital markets, where the majority of funds are currently invested without regard for social or environmental returns. Innovations in Debt Financing: Advances in the Fields of Microfinance and Community Development
8 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Direct Lending to MFIs Investors with sufficient scale and knowledge of the sector may loan funds directly to MFIs (often on a concessionary rate basis, and foundations can structure such capital as programme-related investments). Nevertheless, there are limits to the effectiveness of these lending practices. Such lending is difficult to scale and offers only limited access to mainstream capital markets. Each loan requires a separate due diligence process, which, in the case of direct lending, is not leveraged over many investors. Diversification is very difficult and requires considerable investment scale (i.e., the investor must initiate several direct loans to various MFIs, each requiring a separate due diligence and investment process). Furthermore, once such loans have been made, they cannot easily be transferred or exited. Accordingly, such lending practices tend to be limited to the few institutions that have deep knowledge of microfinance and have made an investment commitment to the sector. In truth, this strategy is not likely to attract mainstream capital flows. In response to the various limitations of direct lending practices, a number of actors in the MFI arena have begun exploring how intermediaries could work to aggregate loans to MFIs and provide access to more mainstream capital by creating investment vehicles with greater market appeal and availability to mainstream investors. Such products have a variety of features: ��� They can offer investors a measure of broader diversification ��� They can leverage due diligence and similar costs across multiple investors ��� They offer potential investors a standardized product with attributes that are familiar to them ��� They have the potential to be transferred. Driving the increasing scale of microfinance (engendered by replication, the growth of MFI networks and improved transparency) is a tremendous demand for microloans���and an equally large attendant need for capital. Jennifer Meehan, Director of Capital Markets, Grameen Foundation USA, explains: Some MFIs have scaled dramatically to achieve greater coverage. For example, Meehan reports that the number of Grameen Bank clients grew at an annual rate of 33.7% between 1983 and 1996, while the bank���s portfolio grew at an exponential rate while maintaining its high quality. Grameen Foundation USA estimates that ten percent of a potential US$ 300 billion microfinance market has been penetrated. In order to approach that potential or even to grow appreciably, Meehan indicates that philanthropy alone will remain inadequate: Individuals and institutions wishing to finance microlending can provide capital to MFIs directly, or investors can syndicate their capital, forming funds or other investment instruments that can share risk and invest in multiple MFIs. Whether they are investing directly or through funding intermediaries, microfinance investors can deploy their funds in four ways: 1. Donate to an MFI (and any number of reputable programmes for doing so can be found with little effort) 2. Leverage assets through loan guarantees to MFIs (an investment vehicle addressed in Section Two of this paper) 3. Purchase MFI equity 4. Loan money directly to MFIs. Thus far debt investments have shown considerable promise and, after donated funds, make up the bulk of capital that has flowed to MFIs. The following section describes a range of approaches to debt investments in MFIs. Access to Capital Markets ���Around the globe there are 2.8 billion people, approximately 560 million families, who are considered poor, living on less than US$ 2 per day in purchasing power parity (PPP). Of those, 1.2 billion people live in abject poverty the ���poorest��� surviving on less than US$ 1 per day PPP. Despite recognition of microfinance as a proven poverty reduction tool, fewer than 18% of the world���s poorest households have access to financial services.��� 2 ���Despite the important and catalytic role played by the international donor community in promoting microfinance, it has invested only US$ 1.2 billion in the sector and allocates an incremental US$ 800 million to US$ 1 billion per year in new financing." 3
Microfinance Bonds and Securitization: A Primer 9 This paper assumes that the reader comes to this discussion with an introductory level of knowledge regarding this area of capital finance. The following section is offered to ensure a shared baseline of familiarity with the concepts in order to help the reader make the most of the examples that follow. Securitization Defined Securitization in general refers to pooling many financial assets and ���packaging��� them as new securities that can be purchased and sold by investors unable to invest in each fund individually. Most commonly, loans are aggregated into notes, the cash flows of which are provided by many underlying loans. Housing mortgages are commonly so packaged by investment banks. The practice has been extended to all sorts of debt instruments, including credit card receivables and car loans. The following example of mortgage-backed bonds illustrates the securitization process. The microfinance capital markets are approaching securitization as a means of bringing more funds to microentrepreneurs. Most of these investment structures cannot, strictly speaking, be considered securitizations, though they have many features of that type of asset. In most of these examples, securities are sold to investors and the proceeds lent to MFIs. Cash flows to bond investors are derived from payments being made on existing and new microloans to MFI clients. Unlike the mortgage-backed securities described in the example above, most MFI bond offerings have not been linked directly to specific, individual loans. Instead, they are structured as obligations of the MFIs, which, in turn, are supported by the individual loans made to microentrepreneurs. As such, the microloans stay on each MFI balance sheet as loans receivable, and the MFIs also undertake financial obligations that they must record on their balance sheets as notes payable. A securitization (in the technical sense) would enable the MFI to bring in cash without increasing its own liabilities (though in doing so, the MFI would need to sell the loans receivable). Increasing cash without increasing liabilities, as is the case with securitization, allows the MFIs to loan more money without raising additional equity to meet capital adequacy requirements. Loan Tranches Many loans are structured in multiple layers, referred to as ���tranches.��� Each tranche is a set of securities that has a particular risk-reward profile and is then marketed to investors seeking that type of investment opportunity. The most senior tranches are the safest, that is, they are first in line to receive cash flows from the underlying loans. Consequently, they bear a lower interest rate than the more junior tranches. The junior tranches��� cash flows are only passed through to investors when the senior tranches have been paid. Any defaults in the underlying loan portfolio are assigned to the most junior tranches first. These junior securities carry a higher interest rate in exchange for assuming greater risk exposure associated with this characteristic. The ability to offer multiple tranches has been an essential feature of the more sophisticated microfinance debt issues to date. Those structures allow investors to purchase securities with the risk- reward profiles best suited to meeting their investment needs. In the existing deals, the very most junior tranche is called an equity tranche. It is termed such because the cash flows are so unpredictable that they cannot be assigned a coupon rate (namely, a fixed rate of return an investor receives when participating in any given round). The equity investors have a residual claim on cash flows after all of the other investors have been satisfied. Such investors will not know the return on their investment (if any) until all of the other tranches have matured: they are assigned the first (and potentially all) losses in the investment portfolio. Blended Value Investing: Capital Opportunities for Social and Environmental Impact A bank will initiate a large number of home loans, lending the bank���s money to home buyers. The bank can then package the debt into new bonds, and the coupon and principal payments associated with these bonds are passed from the home owners through an intermediary and eventually to the purchasers of the security. Typically, banks will sell those bonds (and the homeowners��� associated cash flows) to third parties that can manage the various cash flows and can distribute or resell the bonds. Doing so effectively converts a bank���s loans receivable into cash immediately, and the bank can then loan that cash to new home buyers, starting the cycle anew.
10 Blended Value Investing: Capital Opportunities for Social and Environmental Impact 2. Investment Due Diligence: The fund must examine the likely MFI investments, interviewing management, observing operations, speaking with clients, and closely scrutinizing financial records. 3. Investment Monitoring: After the loans have been disbursed, the managers observe the MFIs for any signs of distress or other trouble. Should such difficulties arise, the fund managers are likely to provide technical assistance and counselling, helping the MFI get back on track, or, when necessary, working out of the investments. The sponsors and fund managers may serve other roles, depending on the specific situation. Investment Advisers and Professional Service Providers: An investment adviser may bring critical skills of structuring and placing investment instruments. The advisers��� structuring expertise makes possible the packaging of underlying loans in ways that are most beneficial to both the borrowers and the ultimate investors in the securities. Usually, the adviser that structures the security also ���places��� the final product, actually selling the notes to investors. The investment advisers typically work with legal and accounting professionals to structure and place the securities. Investors: In the case of the examples reviewed for this document, investors have included high net worth individuals, foundations (investing a portion of their corpus in some cases and in others using programme-related investments to qualify these investments as portions of their philanthropic payout), international development banks, socially responsible investment funds, and others. Some organizations are working to make investment products available to an increasing number of smaller investors. Investors��� motivations and appetites for risk vary widely, making the investment advisers��� placement expertise particularly important (as the advisers must have keen insight into the various investors in order to package and sell the bonds appropriately). Most of the investors in these offerings do share an interest in pursuing multiple returns on their capital, returns that are both financial and social. Further segmenting these investors, understanding their risk-reward propensities, and investigating their other concerns vis-��-vis blended value investing would be a fruitful subject for future study. Microfinance Bonds and Securitization: Key Parties MFIs and Their Clients: At the most fundamental level of a debt offering deal is the microfinance institution that makes loans to extremely low- income entrepreneurs. These microborrowers make interest and principal payments to the MFI, which reinvests those cash flows or passes them on to investors. MFI Networks: Numerous but certainly not all MFIs are affiliated with one of many highly reputable MFI networks such as CASHPOR, ACCION and others. These networks are key components to achieving underlying loan diversification. Personnel in those networks also offer deep expertise in the realm of microfinance: they may be enlisted to perform some of the due diligence and monitoring of the underlying portfolio, and they may also assist in providing oversight, ensuring that the borrowers (in this case the MFIs) maintain their covenants and other commitments associated with the securitization deal. Sponsors and Fund Managers: The securities are typically managed by a corporate entity that disburses funds to the MFIs, collects the cash flows from the MFIs, and coordinates all of the other actors. The fund managers are responsible for screening, due diligence, and monitoring of MFI investments (either performing it themselves or contracting with other organizations to provide it). Fund managers may work closely with partners (MFI networks for example) in dispatching their responsibilities, depending on the nature of their experience. They manage the administrative and reporting functions associated with note offerings. In the first of several deals, the sponsors have purchased all or part of the equity tranches. The fund managers and sponsors perform at least three very significant tasks, each of which requires deep knowledge of the microfinance sector. 1. Screening MFIs: The fund must determine the profile of potential MFI investments that will be eligible for the funds. Often the screens include parameters of the socioeconomic profile of microborrowers and geographic coverage of the MFI. The screens also include financial metrics and thresholds that determine a minimum quality potential investment. Microfinance Bonds and Securitization: A Primer
11 Blended Value Investing: Capital Opportunities for Social and Environmental Impact First Case Study: ACCION International���s Domestic Market Bond Offerings 4 The earliest examples of MFI bond issues have transpired in their own domestic capital markets. Elisabeth Rhyne, Senior Vice-President of ACCION International, reports that in many cases, ACCION particularly favours domestic financing deals over international transactions (which are described at length later in this document). She notes that domestic transactions offer the following benefits: ���Foreign exchange risk is not an issue sovereign risk does not limit the bond rating the magnitude of the funds raised is appropriate [to local MFI needs] local investors are looking for good placements." Such MFI bond issues allow those investors to deploy their capital in ways that also generate local social value. ���Moreover,��� she continues, ���there is a contribution to deepening local financial markets when MFIs seek local financing.��� Two of ACCION���s affiliates, Mibanco in Peru and Compartamos in Mexico, conducted notable domestic debt offerings. Mibanco 5 After financing microentrepreneurs for over a decade as an NGO, Mibanco transformed itself into a commercial microfinance bank in 1998. By 2001, Mibanco had established links with commercial financial institutions that helped finance Mibanco���s lending activities through certificates of deposit and lines of credit, which amounted to relatively expensive and short-term financing that was unduly concentrated in a small number of financing institutions. Buoyed by an improving capital market environment in 2001, Mibanco���s directors began to explore financing the bank���s operations through a corporate bond offering. Selling such a security had the potential to reduce the cost and concentration risks in Mibanco���s existing financing vehicles. Peruvian securities regulators approved Mibanco's demand to issue debt offerings up to 50 million soles (approximately US$ 15 million) and agreed to consider further offerings if the first 50 million soles in debt were successfully placed. In addition to domestic securities experts, Mibanco hired Peruvian Citigroup affiliates to structure and place the offering. The investment advisers began marketing an initial 20 million sole issue with a two- year maturity and 12% yield. USAID contributed a guarantee of up to 50% of the principle (thus investors would be protected against losses of up to 50% of their initial investments), which helped the issue earn an AA rating by two local credit rating agencies. Mibanco ultimately offered the bonds through a Dutch auction, which was ten percent oversubscribed. Though investor interest (much of it on behalf of local pension funds) was healthy, the notes��� yield was relatively high, 690 basis points above the domestic inter-bank lending rate.6 The issuers posited that the interest rate premium would shrink as the capital markets became more comfortable with the concept of an MFI issuing corporate paper. Indeed, their conjecture was confirmed when Mibanco issued a second 20 million sole tranche in September 2003. Structured similarly to the first issue, the second relied on a 50% guarantee from a regional commercial bank. These 27-month maturity notes yielded 5.75%, reflecting a 225 basis point drop in its interest premium. (Note that in the intervening months between the first and second issues, the inter-bank lending rate fell from 5.1% to 3.5%.) Furthermore, the investor base became more diversified, including Peruvian banks, insurance companies and other entities. ACCION and Mibanco estimate that Mibanco���s net cost for the second issue totalled 7.01% after factoring in the costs of the credit guarantee and other banking and legal fees. Ultimately, in October 2003, one month after the second issue and based on the favourable reception of its previous issues, Mibanco offered a third issue. This 10 million sole issue had no third- party guarantees to enhance the issuer���s credit nevertheless, it received ratings of AA- and A+ from local credit rating agencies. Again, the notes yielded 5.75%, this time with an 18-month maturity, but this issue was oversubscribed by 70%. Notably, Mibanco���s effective cost including fees was 6.1% the lower cost reflected, in part, the obviated need to purchase a credit enhancement. ACCION reports that the three note issues helped Mibanco match the maturity of its assets and liabilities and reduce its average cost of funds by more than 50 basis points. At the same time, Mibanco also reduced the average interest rates it charged its clients by more than 700 basis points, thanks in part to its new access to lower-cost funds. Microfinance Bonds and Securitization: A Primer
12 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Financiera Compartamos Like Mibanco, Financiera Compartamos is an ACCION International-affiliated MFI that began as an NGO. Operating in rural and urban Mexico, Compartamos converted to a regulated financial intermediary in 2000. Under Mexican regulations, Compartamos could raise funds through inter-bank borrowing and through the capital markets, though it was not permitted to take deposits from the public. Between 2000 and 2002, Compartamos had been capitalized with equity and short-term lines of credit, but by mid-2002 the bank���s 100% annual growth rate had outstripped the capital supplied by those sources. The terms on which Compartamos accessed short-term credit required the institution to maintain a significant reserve that effectively increased the cost of borrowing and limited the MFI���s ability to serve its customers. Compartamos turned to the capital markets to provide the funds that could support its growth. After obtaining regulatory approval, Compartamos contracted a local investment bank to structure the 100 million peso (approximately US$ 10 million), three-year issue that included no third-party credit enhancements. A Mexican-A1 rating from a local branch of Standard and Poor's allowed Compartamos to fix the yield at 250 basis points above the Mexican short-term treasury bills at the time of issuance. Though the yield was 13.1%, it was still 450 basis points below Compartamos���s prior cost of borrowed funds. A local brokerage (affiliated with Banamex-Citigroup) privately placed the notes with local institutions and investors. Given the success of its first offering, later in 2002 and then again in 2003 Compartamos offered two more 50 million peso issues (with a longer maturity but similar coupons to the first offering). Between the two private offerings, Compartamos was able to fully finance 35% of its lending portfolios with these lower cost liabilities. By 2004, Compartamos���s growth had continued, and it looked again to the capital markets. After the success of the three privately placed issues, the MFI opted to offer securities to the public market. Public offerings are often synonymous with higher- risk, less liquid securities due to fewer investors and higher placement costs. Offering notes to the public would allow Compartamos to reach many more investors, though many of them would need additional assurance that indeed this new type of security bore predictable (and relatively low) risk characteristics. Accordingly, Compartamos arranged a partial guarantee on the bond���s principle from the International Finance Committee (IFC). The five-year, 500 million peso offering was structured in a series of tranches. The 190 million peso senior tranche enjoyed the benefit of a 34% guarantee from the IFC, which, in turn, helped garner an AA rating from local Standard and Poor's and Fitch-affiliated credit rating agencies. Examples Outside of Latin America: Approaching Securitization In 2004, Indian MFI SHARE Microfin Limited (SML, also an NGO that had converted to a regulated financial institution) and ICICI, one of India���s largest mainstream banks, initiated a transaction wherein the commercial bank purchased 25% of SML���s loan portfolio for US$ 4.3 million. Through the transaction, SML was able to borrow funds at approximately 8.75% (versus the 12-13% that it had previously paid to access commercial financing). The transaction was facilitated by a cash deposit (made by other partners, including the Grameen Foundation) that functions as a first loss provision. ICICI later resold the loan portfolio to another Indian bank.7 Though this transaction did not ���productize��� the loan portfolio to the extent that the commercial mortgage-backed securities productize their underlying securities, it is a notable and rare example of a secondary market transaction for MFI debt. The SML transaction also differs from the Mibanco and Compartamos note issues in that the deal packaged and sold existing loans, whereas the ACCION affiliates sold securities to initiate new loans. All of these transactions depend on the fundamental soundness of microentrepreneurs��� ability to be good financial customers who can generate financial value with small loans and can assiduously honour their loan commitments. From the perspective of an investor buying the securities issued by these MFIs, an investment in the Mibanco and Compartamos notes are first investments in the MFIs themselves. They will only meet their financial obligations if the MFIs fulfil all aspects of their business���from identifying customers to initiating business to administering loans���efficiently and competently (and, of course, through it all, the customers must pay their loans). The investors in the SML portfolio purchased loans Microfinance Bonds and Securitization: A Primer
that already had established track records, and so the success of that portfolio would have little to do with SML���s ongoing lending and other business practices (though SML remained the collecting agent for the loan portfolio). Barriers to Full Securitization A number of obstacles currently make it difficult for MFIs and their investment advisers to offer true securitization deals. These securities require considerable financial engineering and so such deals must be of a sufficiently large scale before a mainstream bank would devote its structuring and advisory services to such a deal. Microloans also require relatively expensive and active administration, and the MFIs themselves have the greatest expertise in this realm and in most cases can perform that maintenance at the lowest cost. Accordingly, it would be difficult for an MFI to sell its loans and then have nothing to do with them without third parties to continue administering those loans. The SML-ICICI deal overcame this obstacle by contracting SML to continue administering the loans even after it had sold them to ICICI. Finally, the maturity of the microloans (often less then one year) can limit the maturity of any securitized notes. None of these obstacles should prevent the ultimate securitization of microloans, and those challenges can be met with the sort of financial engineering that mainstream investment banks deploy in their regular business. As mainstream investors become more comfortable with the investment prospects of microentrepreneurs and as the cost of administering microloans continues to fall (through adoption of technology and sharing of best practices), full microfinance securitization deals will become reality. An Introduction to International Debt Offerings The examples above were confined to the countries in which the MFIs operate: the microentrepreneurs, MFIs, banks and investors were all in the same countries. Structuring such deals where the borrowers and lenders operate in different currencies magnifies the complications, particularly in that such international lending introduces foreign exchange risk, along with regulatory complications. Nevertheless, Figure 1: BlueOrchard Microfinance Security I Capital Structure Transaction Structure (Millions US$) Source: BlueOrchard and Developing World Markets, BOMFS-I Investor Presentation 13 Blended Value Investing: Capital Opportunities for Social and Environmental Impact international financial transactions have the potential to open a still-larger pool of available capital to microfinance and other blended-value- creating systems. One of the largest and first international securitization deals was completed by BlueOrchard Finance (BOF), a Swiss microfinance consultancy. In addition to offering BlueOrchard Microfinance Securities (BOMFS), BOF manages the Dexia Micro-Credit Fund and serves as a sub-adviser to the ResponsAbility Global Microfinance Fund, both of which work to link capital markets with MFIs. The first and second closing of the BOMFS-I securities in 2004 and 2005 respectively brought the total capital raised to US$ 87 million. Structured and privately placed with the assistance of boutique investment adviser Developing World Markets (DWM, discussed further below), the securitization deal included five tranches, all with a maturity date of 2011. The transaction structure is detailed in figure 1. Notably, the Overseas Private Investment Corporation (OPIC), an agency of the US government, guaranteed the senior tranche of the offering. The success of BOMFS-I has led both BOF and DWM to consider future offerings of similar securities. Writing after the first closing (but before the second closing) of BOMFS-I, Meehan reports: Microfinance Bonds and Securitization: A Primer ���There were a total of 66 total investors: 12 foundations, 15 MFI practitioners/investors, 11 socially responsible investment (SRI) managers, 3 SRI funds, 22 private investors, and 3 institutional investors. ��� Equity investors ���include BlueOrchard Finance ���Developing World Markets ��� .[Grameen Foundation USA], Omidyar Network, and Skoll foundation.��� 8
14 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Second Case Study: Global Partnerships��� International Debt Offering 9 The Global Partnerships Microfinance Fund 2005 was not the first international microfinance debt offering, nor was it the largest or the highest profile, but it is remarkable for a number of other reasons: ��� First, Global Partnerships (GP) has made an effort to extend the financial product to MFIs that would not likely have had access to commercial capital ��� Second, the very recent issue facilitated by GP demonstrates some of the trends toward a more efficient, broader market for these sorts of deals ��� And finally, the issuers are already considering another similar offering, which has thrown the lessons learned into sharp relief as they move forward. Introduction to Global Partnerships Seattle business professional Bill Clapp and his wife Paula founded Global Partnerships as a private foundation in 1994 after they saw the transformative power of microfinance in El Salvador. Their organization set out to support microfinance institutions in Central America, particularly in Nicaragua, Honduras, El Salvador and Guatemala. In particular, GP supports ���innovative microcredit programmes that incorporate components such as education or healthcare, or programmes that are working to solve challenges faced by the growing microcredit industry."10 In addition to financial support and technical expertise, GP has inaugurated a policy initiative to make poverty elimination a top American priority. GP���s programmes cover a range of issues and initiatives, but all intend to remove the barriers that prevent poor Central American families from exercising their inherent entrepreneurial ambitions. Beyond supporting microfinance-related programmes, GP also advocates for policy change and international dialogue that will enhance the economic and political environment for microfinance in Central America. In over a decade of supporting its Central American microfinance partners, Global Partnerships has developed a distinct expertise in helping scale and support growing MFIs and related programmes. Over the course of this work and in its close relationships with American donors, the organization recognized that Central American MFIs' need for additional capital (and their remarkable ability to deploy it for social and economic value creation) exceeded their donors��� capacity to provide it. They turned to the capital markets to generate those funds. International debt offerings are the product of many different partners, each bringing specialized skills. Global Partnerships brought its deep knowledge of Central American microfinance and the ability to get capital in the hands of MFIs very quickly. While the organization had close connections with donors and other potential investors, it lacked expertise in structuring investment products. Gary Mulhair, Global Partnerships' managing partner, found that expertise in the Developing World Markets (DWM), a boutique investment advisory in Connecticut, USA, and in Orrick, Herrington & Sutcliffe LLP, an international law firm. Developing World Markets DWM was founded originally as an emerging markets investment fund, a line of business that later led to investments in initial public offerings in developing markets. DWM partners Peter Johnson and Judy Kirst-Kolkman found their entr��e to microfinance in 1999, when they invested some of the profits from their successful investment funds into a revolving loan fund for Pro Mujer, an organization that establishes and supports Latin American MFIs. What began as a philanthropic venture became a business proposition as DWM increasingly focused its attention on providing professional financial services for MFIs. In the early 2000s, the partners began to conceive of a new mission for DWM, one that would deploy their extensive finance and investment expertise in the microfinance field. DWM���s first high-profile deal closed in 2004, when it replaced a ���white-shoe��� investment bank in structuring BlueOrchard Finance���s first international microfinance debt offering. Though the BlueOrchard deal totalled over US$ 87 million (including the first and second closings), Johnson indicates that such debt offerings are still too small to appeal to large-scale investment banks. Accordingly, such deals are ideal for boutique investment advisories like DWM, which now devotes the majority of its management attention to these specialized financial services. Microfinance Bonds and Securitization: A Primer
15 Blended Value Investing: Capital Opportunities for Social and Environmental Impact Microfinance Bonds and Securitization: A Primer Johnson and his colleagues have learned to communicate with fund managers like BlueOrchard or Global Partnerships as well as potential investors. In structuring these securities, they have become experts in creating financial models of cash flows from MFIs and understanding the risks associated with those cash flows. DWM has learned the needs, concerns and interests of its potential investors, who include high net worth individuals and their private wealth managers, foundations, socially responsible investment funds, other institutional investors, and international development banks���each with their own needs, concerns and interests. Johnson and Roger Frank, DWM managing director, suggest that it is not easy to segment these investors whose appetites for investment risk and reward and those whose understanding of the microfinance sector vary widely. The new dimensions of microfinance securities and the awakening of the investment community to them make DWM���s expertise all the more valuable. Orrick, Herrington & Sutcliffe LLP (Orrick) As Mulhair planned to launch a securitization deal to meet the demand he saw in Central America, he also turned to international law firm Orrick, which had provided legal advice for the BlueOrchard Microfinance Securities. For Global Partnerships, Orrick was instrumental in structuring the entity that would manage the securitization fund. Without careful planning, managing an investment fund would make GP appear to have extremely high overhead on its financial reports. Such a condition would not interfere with GP���s legal and responsible management of the funds instead, it would make GP unappealing to donors (the equivalent of dramatically reducing the net margin percentage of a for-profit corporation). GP could not afford to hamper its ability to raise donations, which fund various microfinance projects that are not appropriate for commercial financing. Orrick���s solution for GP appears to be a replicable model for organizing an American non-profit microfinance fund management organization. In essence, Orrick and GP created a limited liability corporation called Global Partnerships Microfinance Fund 2005, LLC (GPMF) in which GP is the only member. All activity and cash flows associated with the securitization pass through the LLC. Specifically how this corporate structure resolves GP���s financial reporting concerns is beyond the scope of this paper, but it also resolves some investors��� concerns. Mulhair expressed that indeed it is important to create an investment vehicle that is familiar for investors, and the LLC serves that purpose. Whereas ���investing��� in a non-profit may be a foreign or confusing concept for some investors, the LLC is common to many private investments. Screening Potential MFI Investments Mulhair developed a distinct profile for potential MFI investees. He focused primarily on MFIs growing at 20-40% per year and that would likely continue to do so for several years. All of the funds under consideration for participation in the offering had to demonstrate that they were profitable on a sustainable basis. For funds in this category, growth comes from three sources: ��� They are making more loans in the communities where they are operating ��� They are making larger loans to established customers ��� They are expanding into new geographic markets. The first and particularly the last means of growth require the MFI to invest additional resources in initiating those new loans. In order to be eligible for GPMF���s consideration, the MFIs had to be sufficiently well run and have the systems in place to scale with their growth in lending. Finally (and related directly to the last point), Mulhair only considered MFIs that had a track record of rapidly deploying their capital. He did not want his investors��� money sitting idle he wanted it working immediately for poor entrepreneurs. This profile is remarkable in that it does not target the lowest-risk, first-tier MFIs (which have better access to capital than do the institutions GPMF targeted). The profile likely increases risk to some extent, as growth can hide problems. Nevertheless, the exhaustive due diligence process, the loan agreements��� covenants, and the post-investment monitoring allow GPMF to understand and manage the risk. Mulhair reports: ���These MFI���s are the most rapidly growing providers of capital to the poor, and they are doing it with sustainable business models. They are the future leaders of the microfinance industry.���