By Hamlin Lovell, NordicInvestor
Microfinance is one of the fastest growing impact investing and alternative credit strategies, and a range of different approaches can be pursued. We interviewed SEB Portfolio Manager of Microfinance, Hetal Damani, to find out what differentiates their microfinance strategy – both from an investment perspective and in terms of ESG.
The microfinance investment vehicle (MIV) market has grown by around 20% per year since 2006 and the fastest growth at 27% CAGR has come from private institutional investors. Assets are now USD 15.8 billion, according to the 2018 Symbiotics MIV Survey, which surveyed 92 funds globally. The total market for microfinance is larger because banks and other financial institutions are also active in the space, but the quantum of their lending is harder to measure. The concept became widely known in the 1970s by Bangladesh’s Grameen Bank, which in 2006 jointly received a Nobel Prize with its founder, Muhammed Yunus.
Sweden’s SEB (which should not be confused with an Indian company based in Tamil Nadu called SEB MICRO FINANCE) has since 2013 pioneered microfinance funds in Scandinavia, launching one fund every year, including the second local currency fund in Europe. SEB has the largest microfinance assets in the Nordic region – around SEK 7 billion (EUR 700 million) – which also places it in Europe’s top ten microfinance managers.
SEB’s microfinance funds cater only for institutional and professional investors; some other MIVs do accept retail investors. The SEB funds are marketed in Sweden, Norway, Finland and Denmark. The investor base includes pension funds, insurance companies, foundations, and municipalities.
Sweden is now ranked as the fifth largest microfinance centre, behind Switzerland, the Netherlands, Germany and the USA. Microfinance funds are almost entirely European, according to the Symbiotics survey, and this is partly because local fund structures, such as certain Luxembourg ones, are well suited to private debt strategies. SEB is investment manager of its funds and has partnered with Symbiotics – a firm in Switzerland, which is providing SEB with market access to microfinance institutions. Switzerland is where most of the largest microfinance managers are based and is home to managers such as Blue Orchard and ResponAbility. The origins of this lie in Geneva being a major centre for inter-governmental organizations such as the UN, as well as charities like the Red Cross, and being a centre for private banking.
But the destinations for microfinance lending are naturally outside developed European countries. Eastern Europe and Central Asia, Latin America & the Caribbean and sub-Saharan Africa, are the largest regional exposures microfinance funds with India, Cambodia and Ecuador the biggest country buckets together making up 24% of MIV exposures. Microfinance takes place in at least 96 countries, and different managers have preferred areas. “SEB’s strategy currently has a larger focus on Eastern Europe & Central Asia, South America and South Asia”, says Damani.
SEB is exposed to around 160 MFIs in over 50 countries. “The parameters that we assess with respect to country exposure include country stability with political and economic variables, financial sector risk and currency pressures”, says Damani. “Other factors we assess include AML (Anti Money Laundering), KYC (Know Your Customer) or counter-terrorist financing” she adds.
Target and realised investment returns
“SEB microfinance investors are seeking portfolio diversification in terms of countries, currencies and borrowers, and low financial risk: the loans are small, with frequent amortizations and low default rates, contributing to stable returns”, says Damani.
To decompose microfinance returns, we need to start with interest paid by millions of borrowers and look at the stages in the process. “The average portfolio yield in microfinance is around 24%, which may sound high for those in European markets but this has to be seen in the context of operating costs of the microfinance institutions (which are much higher than commercial banks) and local inflation and interest rates (which are often much higher than in developed countries)”, explains Damani.
“Roughly half of the gross yield is taken up by operational costs, which reflects the labour intensiveness of maintaining many branches; visiting clients and carrying out credit risk assessments in rural areas; and collecting frequent payments, which are in many cases cash”. Technology is becoming useful to lower the cost structures through mobile e-wallets, and in some countries such as Colombia, more people have mobile phones than have bank accounts.
The next largest component of the yield – at around one third or 8% on average – is the microfinance institutions’ funding costs, which is where the SEB strategy comes into play. “The SEB funds are not lending directly to millions of borrowers, but are lending – sometimes as part of a syndicate with development finance institutions (DFIs) – to the microfinance institutions (MFIs), which need to satisfy financial and ESG criteria”.
The strategy is paid to take credit risk, and non-performing loans are typically around 2.5% of the MFI’s gross loan portfolio. Losses in SEB’s first fund, lending to the MFIs, have averaged c.0.4%. From an SEB perspective the loans are unsecured. The loans made by MFIs could be either secured or unsecured.
The MFIs would generally need to experience quite severe defaults from their own borrowers, before they defaulted on their funding sources. This does sometimes happen. “Reasons for MFI defaults can include forex related defaults (linked to hard currency shortages), credit losses (weak underwriting standards, natural disasters, brutal changes in regulation) and fraud”, says Damani.
Microfinance funds can be evergreen or limited life, and they can be open ended or closed ended. Equity microfinance funds can have longer investment horizons of six or seven years or more, while fixed income funds tend to be shorter term.
SEB’s Luxembourg SICAV funds are fixed income, limited life, closed end funds. “Stale pricing” or out of date pricing is not really an issue for SEB’s series of closed end funds, which return capital to investors after five years. Loans are not marked to market as no real secondary market exists. They are effectively marked to model – at nominal value plus accrued interest. If repayments are late, the loans will be written down according to Luxembourg accounting standards.
There should not be a liquidity mismatch problem as the vehicles’ five year lock up is longer than the tenor of the loans to microfinance institutions. In turn, most of the underlying loans are also shorter than five years
Hard or local currency
SEB lends in a range of local currencies (unhedged), which include US dollars for dollarized economies. The rationales for this are both financial and ethical.
The key argument is essentially to capture the risk premia embedded in emerging and frontier currencies. SEB expects that the yield premium in various currencies should more than compensate for their long-term pattern of depreciation. A Symbiotics study found that over a 10-year period the effect of higher net yields adjusted for currency movements is positive 75% of the time with an unhedged strategy compared to a hedged strategy, which underscores the longer-term nature of the investment.
Being exposed to multiple currencies also diversifies currency risk.
“The ethical reason is that lending in hard currency would pass the FX risk onto the institutions, which may find that currency hedging is expensive, complicated or unavailable”, explains Damani.
Even so, some investors cannot take on currency risk at the level of the investment vehicle, and some MIV managers who lend in local currency do still hedge returns back to the fund’s currency, which might be Swedish Krona, Swiss Francs or Euros. Hedging emerging to developed currencies has nearly always involved some costs and these have grown due to negative interest rates in Sweden, Denmark, Switzerland and the Eurozone. Therefore, hedging is expensive, and it has reduced returns down to a range of around 1-3%. In 2017, returns in EUR fixed income funds fell as low as 0.3%, according to the Symbiotics survey. Of course, this could still be attractive, at least compared with shorter term government bonds and some bank accounts in these countries.
Partly as a consequence of lower developed market interest rates, some MIV funds have used leverage at the fund level to enhance returns – to an average of 4.8% in USD per the Symbiotics survey. SEB does not employ leverage on its microfinance funds.
The SEB strategy has delivered high single digit, unhedged returns. “The first fund, which matured in 2018, made a total return of c.53% (annualized 9%). The return was a little above the target of 6-8% net yield. The yield of the loans was the main contributor to performance but the currencies also contributed to performance as the basket appreciated against the Swedish Krona”, says Damani.
The majority of MIVs, including SEB’s, are targeting both social and financial returns, and not prepared to accept “below market” financial returns, per the Symbiotics survey.
The purpose of microfinance is to provide access to capital to entrepreneurs excluded from the mainstream financial system and the goal is to improve social and economic development in lower-income economies where financial markets would otherwise not go. In addition, SEB needs to get comfort on the countries and institutions being lent to, in terms of client protection, governance and financial inclusion. Symbiotics, which is guided by its Social Charter, has teams of analysts, and a strong network of contacts, which helps with both credit risk ratings and social responsibility ratings.
“Social performance is measured across multiple dimensions, in a multi-stage process, which contributes to a final score. Firstly, are we lending to a responsible financial institution with good governance, social and development objectives, able to serve low income and under-served clients, and offering fair client protection in terms of preventing over-indebtedness; transparent pricing; and community engagement. Secondly, we look at impact outreach: are we channeling capital to where it is needed the most? We track whether the funding is reaching markets with the lowest banking penetration rates and how many end clients and borrowers are reached. Our first fund reached 6.1 million entrepreneurs and all of our funds currently reach out to 25 million entrepreneurs. We also look at the split between men and women – over 50% of loans in our first fund were to women – and types of activities such as agriculture, trade, production and services. Thirdly, we try to look at outcomes; this is difficult to measure since many exogenous factors affect end-clients’ daily lives and socioeconomic progress. However we have identified impact proxy measures that would allow us to understand how the SEB Microfinance Funds have influenced: the availability of non-credit products, like savings, insurance, payment, and non-financial products to help entrepreneurs better manage their economy; the employment sustained through microfinance as a key tool in bridging the financing gap for micro-, small and medium enterprises (MSMEs); and the availability of financial products catering to households needs such as goods of first necessity, education and housing”, says Damani.
SEB has produced a video highlighting some case studies, such as a woman in Africa who was able to use a loan to start two butcheries.
Broadening out SDG focus
“In 2015, the United Nations adopted a set of 17 international development goals to end poverty, protect the planet and ensure that all people enjoy peace and prosperity. Known as the Sustainable Development Goals (SDGs), these include areas such as climate change, economic inequality, innovation, sustainable consumption, peace and justice, among other priorities. The SDGs are set to be achieved by 2030, and require action from all public and private players worldwide, particularly in developing countries. The UN estimates the gap in financing to achieve the SDGs at USD 2.5 trillion per year in developing countries, which cannot be bridged through increasing tax revenues alone and thus requires investments from the private sector.”, explains Damani.
“Galvanized by this global call to action, socially responsible investors have shifted from pure microfinance to financial inclusion, and more broadly to impact investing with the aim of contributing to the SDGs to the greatest extent possible. Even among MFIs, the products offered are being diversified to touch on a number of SDGs beyond financial inclusion. According to the 2018 Symbiotics MIV survey, 25% of MFIs in the MIVs direct portfolio already offer “green loans” and many are investing in agriculture, housing, energy and SMEs alongside microfinance portfolios. Some of the aforementioned criteria for SEB’s microfinance funds have already contributed to several SDGs through such MFIs”, she continues.
A new fund – SEB Impact Opportunity – launched in December 2018 seeks to address a range of global challenges such as climate change mitigation, access to education and gender equality, explicitly incorporating the SDGs in its investment philosophy through an evergreen mandate.
Investors should watch this space because Impact Investing is set to become a megatrend.