Introduction to Microfinancing

Introduction

An Entry to Microfinance: What is it, who invests in it

Microfinance, also known as microcredit, refers to financial services targeting low-income populations with limited to no access to conventional banking products, such as loans and financial aid. In doing so, microfinance is able to deliver significant impact potential, through financial inclusion, while also delivering returns to investors and microfinance institutions. Government subsidies and debt capital are the most common sources of capital for microfinance institutions, however these return and impact potentials are drawing in an increasing number of equity investors each year – in turn allowing microfinance institutions to perform at their fullest potential.

Microfinance: A Brief look

The primary function of microfinance is to extend the scope of financial services, limited by post-GFC banking regulations, to the low-income, unemployed, or otherwise disadvantaged individuals and groups. Equitable small business loans, following ethical lending practices, are the most common form of microfinance.

The full range of microfinance products and services are much larger, however. From basic banking services to individuals, such as savings and checking accounts, to start-up capital for small business entrepreneurs and educational programs, microfinance is aiming to bring equitable access to financial products and address the demand untapped by conventional banking institutions across geographies. For example, many microfinance institutions focus on providing women with financial aid, addressing gender imbalances in access to credit and grants. The United Nations declared the year 2005 as the International Year of Microcredit considering their role in the battle for the eradication of poverty.

Though gaining prominence in finance over the past two decades, the roots of microfinance can be traced back to the self-help and solidarity schemes of savings and cooperative banks over the lasts two centuries. People, whose low-income status deem their financial needs uneconomical to be serviced by conventional financial systems, have always existed, after all. Microfinance today is a continuation of decades of efforts to provide financial independence and a higher quality of life, through loans and services, to these marginalised sectors of society.

Microfinance Products: Increasing in variety

The methods employed by microfinance institutions today to fulfil the financial services needs of the unserved and underserved populations are very wide in range, increasing every day with new initiatives and start-ups. The common factor among these is the intent and effort to treat individuals of diverse economic and social backgrounds equally. The most common forms of microfinance products and services include:

Micro savings – Eliminating minimum balance and/or minimum deposit requirements, micro-savings services deliver long-term returns on savings regardless of income levels.

Microinsurance – Extending insurance options to low-value assets, limited-time processes, and small employee pools, microinsurance provide health and property protection to entrepreneurs regardless of the size, revenue, and sector of their businesses.

Micro leasing – Allowing the leasing of equipment, plots, vehicles, mobile phones, and a wide range of other low- to mid-value assets, micro leasing reduces startup and digitisation costs of small business owners.

Individual business loans – With more flexible terms and wider range of principal amounts, microfinance business loans allow small entrepreneurs to grow their businesses to their full potential.

Money transfers – Lower or no transaction fee money transfer options allow individuals and businesses to safely enter into transactions, send remittances, and conduct business across cities, regions, and countries.

Microfinance Investments: Returns, impacts, and investors

In the initial phase of microfinance, international funding and investments came from donor organisations, such as public development agencies and private foundations. As the sector grew and commercialised, however, microfinance institutions outgrew the supply of philanthropic and public capital, turning to private and institutional investors to fund their operations. As a result, the sustainability and long-term success of the microfinance model today is deeply dependent on its ability to deliver returns. A variety of Microfinance Investment Vehicles (MIVs) were developed to allow investors to capture these returns, while increasing the capital supply for microfinance services to expand substantially.

The creation of these MIVs has allowed an ever-growing number of international and regional entities to invest money in well-established microfinance activities and institutions. Funds managed by non-profit organisations, commercial banks, and investment firms now often make microfinance investments with the intent to capture stable returns, fulfil impact mandates, and diversify their portfolios.

Investors who focus on return-oriented schemes are responsible for a significant portion of microfinance investments. To name one of the many examples out there, Morgan Stanley issued a microfinance backed tranched bond, and was rated “AA” by S&P. According to study of Micro Banking Bulletin reports, 63 of the world’s top MFI’s have an average return rate of about 2.5% of total assets – a rate of return that varies wildly across MFIs, geographies, and investment mandates. Though local and regional banks integrated microfinance investments into their portfolios to capture returns first, today, large international banks have a much larger presence in financing MFIs and NGOs with microfinance activities.

Though return-oriented investors have a large presence in the microfinance investment space, the role of impact investors in financing MFIs is far from trivial. Especially significant for Social Impact Investors, microfinance offers a direct avenue towards fulfilling financial inclusion mandates. The real impact of microfinance investments can be much greater and more varied, however, extending to healthcare accessibility, food security, gender equality, adoption of green technologies, and much more. MFIs are, and will continue to be, a mainstay of impact investments.

Private equity investments also provide a pathway to microfinance. Here, microfinance can act as an alternate investment class, offering a stable and low market correlation investment opportunity. The expansion of the microfinance sector, as a result of increasing digitisation, internet and mobile device penetration, and increased debt investor interest, indicates a growing opportunity for private equity investors. The role of venture capitals in the expansion of the sector, through funding start-ups leveraging digital technologies to access new market segments, is especially significant.

Crowdfunding is also one of the easiest ways to raise capital for Microfinance institutions. Investment crowdfunding allows a company to source money by asking many backers to each invest a relatively small amount in it, allowing MFIs to offer multiple microfinance products within a single process.

Today, capital and expertise are increasingly flowing into microfinance. There are many benefits associated with microfinance institutions that extend beyond the direct effects of financial inclusion. Increasing in prominence since the 70s, microfinance is ever-increasing in relevance to investors, finance professionals and individuals.

Written by: Akın Deniz Heper | Investment Analyst at Helicap

‍