The Investing in Inclusive Finance program at the Center for Financial Inclusion at Accion explores the practices of investors in inclusive finance. Across areas including risk, governance, stakeholder alignment, and fund management, this blog series highlights what’s being done to help the industry better utilize private capital to develop financial institutions that incorporate social aims.

The Council of Microfinance Equity Funds (CMEF) was recently renamed the Financial Inclusion Equity Council (FIEC) in order to reflect both the evolving nature of the industry and Council membership.

In my recent interview with Jim Kaddaras on the landscape of microfinance equity investing in 2003, it quickly became evident that in some respects much has changed over the past decade, while in other ways many of Jim’s comments still ring very true today.

Different Context:

Since 2003, like the expanding industry, Council membership has both grown in numbers and also changed in composition. For instance, a few direct financial service providers have joined the Council as they have now started to invest equity regionally.

Likewise, as impact investing has become far more mainstream in the last decade, some members (e.g. Triodos Organic Growth Fund and responsAbility Fair Trade Fund) have increasingly started to invest in adjacent impact investments. These investments go beyond traditional microfinance to include agriculture, housing, energy, etc. However, microfinance is still by far the majority of most Council members’ portfolio – and also the main proven model for returns.

In addition to the advent of new adjacent impact investment funds, the Council now increasingly has other “beyond microfinance” topics on its agenda, including disruptive technologies and the incredible potential for mobile banking given the now ubiquitous presence of mobile phones.

Similar Issues:

Despite these changes, the overarching focus and purpose of the Council is still very much the same – convening equity investing leaders to take stock of the relevant industry trends, to share knowledge and information to broaden views, and to develop and promote industry standards and best practices.

Council membership is still focused on private social investors with equity investments in financial institutions. This focus and membership, ensures that Council meetings cover topics relevant to all our members and also fosters a sense of trust and a willingness to share openly.

There is still a desire among social investors to share experience and discuss challenges with like-minded investors – be they collaborators, competitors or both. And through these convenings, members still swap ideas, contributing to a shared view of the industry’s future, and walk away with a better understanding of how others are dealing with similar situations – or at the very least with a sense of camaraderie.

Likewise, many of the main topics being discussed by the Council in 2003 – best practices for ensuring effective governance, protecting clients from over-indebtedness, balancing a double bottom-line, promoting a social mission, and coping through times of transition -  are issues that Council members continue to grapple with today.

From Transformations to Responsible Exits:

When the Council was formed, one of the main challenges among the members was the transformation of financial institutions from NGOs to MFIs, and more specifically, the difficulty of getting founders to let go so the institution could move to the next level.

In reference to this transformation, Jim spoke of the difficulty for parent NGOs to let go of their children. This is the same analogy that Daniel Rozas recently used in his blog on responsible exits to describe equity investors. In 2003, investors were pushing for the founders to let go of their NGOs and allow them to transform into MFIs. Now it is equally hard for investors to recognize when the time has come for them to also let go and exit the MFIs in order to, once again, allow the institution to grow and reach the next level.

After all these years, the Council is still convening the leading private investors making equity investments in financial inclusion with the objective of advancing common responsible investment practices. As the industry continues to evolve, we look forward to continuing to foster dialogue and exchange among Council members, helping them to navigate the future of financial inclusion equity investing together.

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The Investing in Inclusive Finance program at the Center for Financial Inclusion at Accion explores the practices of investors in inclusive finance. Across areas including risk, governance, stakeholder alignment, and fund management, this blog series highlights what’s being done to help the industry better utilize private capital to develop financial institutions that incorporate social aims.

In 2003, the Council of Microfinance Equity Funds (CMEF) was formed by a handful of equity investors in microfinance with the goal of sharing, developing, and disseminating industry best practices in equity investing.

I recently had the pleasure of catching up with Jim Kaddaras, who was Vice President of Special Projects at Accion from 2001-2003. He was instrumental in launching the CMEF in 2003, and also led the charge on the creation of Accion Investments. Jim is now a Partner at Developing World Markets, and is still a Council member.

Q: What did the landscape of microfinance equity investing look like in 2003?  

Jim Kaddaras: It wasn’t much of a landscape – it was more of a scatter shot.

Accion owned stakes in some of their Latin American affiliates and Accion Investments was just launching in 2003. Procredit was a player (they were called IPC back then and their banks had separate names). FINCA had some equity investments and ShoreBank had a smattering of equity holdings.

ProFund had been around since 1995 as the first investment company focused on microfinance equity but it was winding up when the Council started. Africap was just starting, based on the ProFund model. Various other Council members, plus the development finance institutions (DFIs) and several non-profit networks, held a handful of equity investments.

Q: What was the goal of the Council when it was formed?

JK: We felt that by gathering people who had been making equity investments in a one-off way, we could help to develop and disseminate best practices in the field.

Q: Who were the Council members in the early days?  

JK: I believe the founding members were Accion, Oikocredit, Doen Foundation, ProFund, ShoreBank, and Triodos. Other early members were Africap, Andromeda Fund, Calvert Foundation, Citigroup, DID, Deutsche Bank, Open Society Institute, Opportunity, SARONA, SIDI.

Calmeadow in Toronto was also present at the creation. Its founder, Martin Connell, was a Canadian businessman who wanted to do something social and funded a lot of early studies and research.

Q: Where was the first Council meeting? What topics were discussed?

JK: An early meeting was hosted by Oikocredit at their office in Amersfoort, in the Netherlands. The first couple of meetings were focused on getting organized as a Council, discussing who else should be invited to join the Council, and building consensus around the idea of having members pay dues, which was a very controversial topic at the time.

In those early meetings we also focused on setting out the lay of the land as it currently stood so everyone was starting from the same vantage point. And we discussed what type of research and writing the Council should focus on.

Council members represented much smaller organizations back then and we faced issues of how, given our limited capacity, we would cover the world and provide help to MFIs far away. We discussed ways to provide more effective governance in an efficient manner and debated the use of head office staff vs. trusted local directors to serve on boards. We explored the potential for sharing directors among investors in joint investments, and discussed how best to execute this concept of “piggy-backing” off of like-minded investors.

Q: What were some of the early CMEF publications?

JK: The first Council publication was the Characteristics of Equity Investments in Microfinance, which I co-authored with Beth Rhyne. This report looked at where equity investments were in microfinance by region and country, and so tried to quantify and describe the investment landscape in microfinance. The report also examined the role investors were playing at the time – were they active on boards or passive?

The report also focused on effective corporate governance. It focused on how boards should be organized, which committees were important and why, and how to strike the proper balance in terms of a relationship between governance and management—that is, how to ensure that the power wasn’t tilted too much in one direction or the other so the board was in charge of overall strategy and direction, and management was in charge of executing that strategy and managing day-to-day operations.

Q: What were some of the controversial topics when the Council started?

JK: The Council was made up of pretty like-minded investors so there weren’t too many controversial topics among members. But one of the big issues we discussed was what to do when you didn’t have like-minded investors on the board.

All of the Council members at the time were convinced that there should be a double-bottom line and everyone investing was trying to build the field, so making money was not the leading concern. Over time, it was recognized that to build the field, we had to draw other investors in, and to do that, we had to be able to offer a reasonable return. It seems now that some investors feel the social mission can be subordinated to financial returns, but that didn’t exist back then.

We, as equity investors, were also concerned about the role of NGOs in institutions that had transformed from an NGO into a for-profit entity. Often, the non-profit entity would get most of the shares of the for-profit entity in exchange for the microfinance operations it had previously housed, and we struggled with the issue of an NGO keeping up with the capital needs of a growing MFI. Sometimes the original NGO can act as a brake on the growth of the institution, and this is especially true when a strong founder is involved. It can be hard for the founder to let go of his or her “child.” It isn’t always easy from an investor perspective for the founders to be involved. Sometimes the NGO ends up with diluted shares as a minority stakeholder but there can still be complications (i.e. the NGO requires special rights associated with its shares). An NGO refusing to let go can drag the MFI down.

Now, much more diverse shareholdings make it more challenging to have like-minded investors on the board. It used to be like a family sitting at the table and now, sometimes there are strangers.

Q: Looking forward, what do you think will be important issues for the Council to tackle in the future?

JK: The Council has done the industry a great service in terms of supporting pioneer investors and drawing new investors into the field. Now, the Council’s most valuable contribution will be in continuing to promote the best practices in corporate governance, and in striking the optimal balance between the social mission and financial returns.

It will be important for the Council to help shape where MFIs end up at the end of the day. Is the future of MFIs to become part of the mainstream banking system, or will they continue to operate separately as specialized institutions?

The Council should also focus on keeping the social mission of the MFI. How can we ensure this social mission remains – or is our job as social equity investors in microfinance essentially now done and we should move on to other things?

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Several years ago the Council of Microfinance Equity Funds (CMEF) created a small booklet containing governance guidelines for microfinance institutions.  The booklet quickly became a minor classic: it was translated into multiple languages and dozens of MFIs used it as a guide to operations for their own boards.

Then came the 2008 global financial crisis and a number of market-specific microfinance crises in several countries. These crises served to highlight the need for strong, mission-led governance by MFIs. Lessons from these events did not alter the core principles found in the original Guidelines, but they revealed a need for greater attention to areas such as risk management and social performance. In response to these lessons, CMEF is releasing a revised version of the guidelines, “The Practice of Corporate Governance in Microfinance Institutions.”

The new Guidelines still address governance basics through topics such as: How to Structure an Effective Board, Effective Board Processes and Board Responsibilities and Decisions.  Among the new or newly expanded topics are:

• Expanded discussion of the board’s role in upholding the social mission side of the double bottom-line (social performance)
• Expanded discussion on risk awareness, management and mitigation
• Incorporation of learning from “Weathering the Storm” on crisis management and from “Aligning Interests” on ensuring that stakeholder interests are properly aligned with institutional interests during times of transformation
• Introduction of the topic of “responsible exit.”

The Guidelines also reflect the increased sophistication of the microfinance industry as it has evolved over the past decade.

Following the Guidelines cannot guarantee good governance, as governance is above all a matter of personal responsibility and interpersonal relationships on the part of every member of a board. But the guidelines reflect the hard-won wisdom of practice from both the microfinance world and the broader financial and corporate sector.  Sincere attempts to fulfill the guidelines will therefore be an excellent strategy for avoiding pitfalls and giving an organization the best possible governance foundation. The guidelines do not propose that “one size fits all” since each MFI ownership structure is different, but they are a map for MFIs to follow.

In an uncertain financial world, sound governance is a constantly evolving process. If we are to emerge from recent crises and avert future crises, addressing governance is a critical opportunity that MFIs cannot afford to disregard.

Seeking assistance: The updated version of the Governance Guidelines will be translated into Spanish and French but if you would like to volunteer to translate the revised Guidelines into another language, please contact CMEF Coordinator Danielle Donza at ddonza@accion.org.

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I once had a roommate who stored her credit cards in the freezer. When I asked her why she was hiding her Visa between packages of frozen peas and ice cream she explained that by “freezing” her credit cards, she would not be tempted to use them.

Unfortunately for lending institutions, many borrowers do not have the discipline (or perhaps the creativity) of my former roommate in confronting the temptation to overspend. In fact, the recently released 2012 “Microfinance Banana Skins: Staying Relevant”, a survey of practitioners, investors, regulators and observers in the field of microfinance, found that overindebtedness among borrowers is now seen to be the most urgent risk in the field of microfinance. Overindebtedness has replaced credit risk, which was ranked as the top concern in the 2009 and 2011 surveys. Although the overindebtedness and credit risk are very closely related, according to authors of the report, the shift to the former reflects new concerns about the state of microfinance.

Survey participants’ responses revealed that the fear of over-indebtedness stems from multiple sources such as;

• MFIs’ failure to conduct adequate credit analysis of borrower
• Inability or inefficiency of credit bureaus to provide information about borrowers’ credit worthiness
• Over-expansion of the microfinance industry
• Rise of competition between MFIs
• Absence of information available to clients
• Overall need for enhanced financial literacy on the part of borrowers.

Although overindebtedness is a ubiquitous concern, a closer analysis of the results reflects the adage: “where you stand depends on where you sit.” Practitioners who run or work in MFIs, were most concerned about overindebtedness. Investors, regulators, and observers also worried about overindebtedness, but listed institutional problems of effective corporate governance and management quality as their greatest concerns.

Geography, it seems, plays a lesser role. Overindebtedness is of great concern in Latin America, Central and Eastern Europe, the Middle East and North Africa. Notable exceptions are Asia and Africa, where political disturbances and liquidity troubles overshadowed concerns about overindebtedness. But these and other perceived risks, such as management quality and the role of regulation, tended to be more localized risks, whereas overindebtedness is causing apprehension worldwide.

The “Banana Skins” report correctly emphasizes that the survey examines perceived, not actual risks. Nevertheless, the perception that overindebtedness is a threat to the microfinance industry is rising, and this perception has the potential to impact the reputation of the microfinance industry. As more people come to view overindebtedness as a risk in microfinance they are apt to question whether MFIs are more concerned with serving their clientele, or in expanding their client base, meeting business targets and making a profit.

Whether a real risk or merely perceived, the fear of overindebtedness highlights a great irony in microfinance: consumers who once had no access to financial services may now have too many financial obligations. Addressing this dilemma requires understanding the fundamental interdependence of lenders and borrowers. In the increasingly complex financial system, both lenders and borrowers stand to reap enormous gains, but each must play their part. MFIs should be diligent and conduct adequate checks on borrower’s credit history and transparent in educating clients about products and services. Clients should be forthright in providing information about their credit circumstances, and realistic about their respective abilities to pay back a given loan. If necessary, they should take a page from my roommate’s book and find a way to “freeze” their own temptations to use credit for unnecessary spending. Otherwise, the credit MFIs provide could become too much of a good thing.

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The Council of Microfinance Equity Funds (CMEF) and MicroFinance Network (MFN) recently surveyed their members to find out whether MFIs are paying the people who sit on MFI boards– and if so, how much.

Some observers argue that the practice of offering payment to board members will ultimately attract members with the wrong motivations. They believe that the “right” board members are willing to serve on the board for free because of their passion for the microfinance mission. In fact, this is often true: many MFIs don’t pay their board members at all – 40 percent and 25 percent, for CMEF and MFN respectively.

However, as the microfinance industry matures, and the responsibilities of governance increase, MFIs need to be prepared to compensate their directors in order to attract highly qualified board members with the knowledge to govern a financial institution well. So, it is not surprising that among those MFIs linked to CMEF and MFN the majority do provide monetary compensation.

At present, there is a huge demand for board members in the market. Over 2,000 MFIs report to the MIX Market, and boards conservatively have an average of five board members – meaning there are at least 10,000 board seats to fill. Even those MFIs willing to pay honoraria are finding it hard to attract high-quality board members. Principal among the very valid frustrations of MFIs are that:

• Directors often don’t have enough time available for active governance and effective oversight.
• Board members sometimes lack sufficient seniority or qualifications.
• It is difficult to find directors with the requisite microfinance experience and personal skills.
• Some investors fail to ever nominate a director, reflecting a “free rider problem.”

Of the MFIs that reported board remunerations, amounts are still generally modest – US $500 per board meeting is a fairly standard level. Since most boards meet quarterly, board members are usually paid about $2,000 a year (plus travel expenses). Among the 18 percent of MFIs that reported paying an additional annual retainer fee to board members, that amount was generally about an average of $6,000 per year when offered. Thus, a board member being compensated with an annual retainer of $6,000 and a per board meeting rate of $500 would typically receive about $8,000 per year (assuming quarterly meetings).

The maximum that was reported for a per meeting compensation was $3,000 and the maximum annual retainer fee reported was $9,000. So, at the very most, in a very few number of cases, a board member might earn $21,000 for a year’s service on a board (again assuming quarterly meetings).

Some MFIs also pay additional amounts to the board chair and committee members, since those roles often require significantly more time and experience or technical skills. This additional compensation is usually not large – between $1,000 to $2,000 per year (or roughly $250 to $500 per board meeting). And approximately 60 percent of MFIs reported covering some of the travel expenses for their board directors, most often airfare followed by hotel expenses and rarely a per diem.

Clearly, there is a disconnect in the industry between the large demand for good governance, and the lack of qualified candidates to meet this need. Reaching back to econ 101, when demand outstrips supply, the price usually goes up, and it seems inevitable that the Invisible Hand will slowly start to push the price of good board directors up. Some regions, such as francophone Africa, may already see this; MFIs in that region offer some of the highest board compensations reported in the survey.

Another trend that will likely affect board compensation practices is the use of independent board directors who are unrelated to any shareholder and are totally un-conflicted. Best practices suggest that at least 25 to 30 percent of a board should be independent, but this is a difficult role to fill, given that these directors have the same board responsibilities as other members without having any “skin in the game.” Why would independent board members spend large amounts of time on their board responsibilities and take those responsibilities seriously if not for some additional compensation? Yet, over 60 percent of the MFIs reported paying independent directors the same amount as the other directors. And 87 percent of the CMEF respondents reported using only or mainly fund employees (that is, fund manager investment officers) to serve on boards.

Ultimately, if MFIs are expecting high-caliber, highly qualified, senior people to commit a significant amount of time to their governance duties, sometimes with personal liability, often with extensive travel, then they need to be willing to compensate directors for their time and efforts. The role of a board director needs to be seen as a responsibility, not an honor, and remuneration underscores the importance of that role.

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For publically traded retail banks, valuations are at historic lows. In the microfinance industry, 2011 also saw the continued compression of valuation multiples from 2009 highs, according to the recently released Global Microfinance Equity Valuation Survey, Volume Growth and Valuation Contraction. CGAP and J.P. Morgan, with support from the Council of Microfinance Equity Funds (CMEF), publish this report annually to address the scarcity of valuation data available in the public domain.

Including valuation data for both MFI private equity (PE) transactions as well as Lower Income Finance Institutions (LIFIs), which are publically listed companies providing financial services to lower-income clients, but not necessarily having a stated social mission, this report aims to provide benchmarks for the valuation of both private and publicly listed microfinance equity, promote market transparency and identify industry trends.

This year the survey finds a “wider trend where LIFI and microfinance valuations in the public and private markets are beginning to converge toward those of traditional financial institutions in emerging markets, and are probably closer to their true value.”

MFI asset quality began to recover from a crisis of client over-indebtedness and unsustainable growth in India, Bosnia, and Nicaragua toward the end of 2010. This recovery helped the microfinance private equity market experience stronger deal flow in 2011, with almost twice the number of transactions, and the largest flow of equity capital into microfinance to date, reaching US$292 million across 68 transactions, as reported by 29 investors.

Latin America continues to be the leading region, accounting for more than half of the amount of investments in private equity, followed by Asia. Notably, Peru and India account for around 70 percent of the total volume globally.

The report concludes that this strong growth in transaction numbers and overall volume in 2011 was driven by:

• Several large transactions (mainly in Latin America),
• Expectations of an improved regulatory environment in India, and
• Lower valuations, which continued to decline in 2011 (except Europe and Central Asia), having a positive effect on the number and size of transactions.

Valuations contracted in 2011 are measured by the forward book value multiple. The forward book value multiple, the key benchmark for equity valuation in the microfinance private equity market, dropped to an average of 1.4x book value from a high of 1.7x in 2009. Likewise, the price-to-earnings (P/E) ratio, a measure of the market price/share relative to the annual earnings/share, dropped to an average of 11.4 from the 2010 highs of 20.1.

So why did 2011 see the continued compression of valuation multiples for MFIs? Well, this is likely due to lingering uncertainties about asset quality in some markets and continued public scrutiny.

As for the public equity market, the comparables also declined with a drop in the average valuation of the Lower Income Finance Institutions (LIFIs) Index. The report found that the expected return on equity (ROE) of institutions included in the LIFI Index has been relatively stable around 27 percent, but book value contracted from 4.2x in last year’s edition to 2.7x using most recent data.

For 2012, the report concludes that microfinance equity valuations are not expected to decouple significantly from the valuation of emerging market banks. It predicts valuations will be stable in most markets, with the exception of Africa and certain countries of Latin America, which could see some increase in valuations.

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How do you recognize or quantify the time and effort that a non-profit’s founder has poured into an organization? Do you reward a non-profit’s board members for their countless hours donated to shaping the institution’s mission, and if so, how? What role does the staff have in determining the success of an organization? What skills and qualities are necessary in a manager, and what should be done if his skills set no longer meets the needs of an institution?

Such questions normally circulate beneath the surface at any operating non-profit. However, they truly come to light during periods of institutional transition, for example, during transformation to a for-profit or a merger of organizations. As these questions are often intensely personal, they have the potential to become, on the one hand, a bitter point of contention or, on the other, an opportunity for frank discussion and collaboration.

“Aligning Stakeholder Interests in NGO Transformations: Emerging Good Practices,” the new report released by  the Council of Microfinance Equity Funds (CMEF), continues the difficult process of getting to the heart of these questions. The report, which represents the consensus of the majority of CMEF members, was drawn largely from investors’ direct experiences and the practices that they employ and/or have witnessed over the course of man institutional transformations and transitions.

“These guidelines will be useful for both investor and NGO executives alike,” said CMEF Coordinator Deborah Drake. “The issues addressed in this document have served as significant stumbling blocks to transformations and mergers in the past, and this is one of the first times that the challenge is being recognized and discussed in an open, transparent manner.”

The Council of Microfinance Equity Funds (CMEF) recently responded to the Reserve Bank of India’s invitation to comment on the Malegam Committee Report.

Sixteen members of CMEF, which brings together the leading private entities that make equity investments in MFIs in the developing world, have invested Rs. 8.1 billion (813 crores; US$178 million) of equity in Indian microfinance institutions, and other members are in negotiations with potential investee institutions. As direct investors in MFIs, CMEF members place great importance on their corporate governance role as board directors, shareholders and guardians of the double bottom line.

The CMEF concern is that “Although implementation of many of the proposed recommendations would indeed add to a sustainable development of the sector — through the enhanced institutionalization of transparency in pricing, client protection and corporate governance — it is our opinion that several recommendations could seriously set back the clock for microfinance in India.”

“The recommendations would severely limit the capacity of MFIs to reach and provide the level and quality of financial inclusion that poor clients need and deserve,” states the CMEF. “The restrictions on MFI lending rates, especially in the absence of measures to address the availability and cost of MFI debt funding, may well endanger the viability of many institutions.”

The CMEF further comments that “many proposed recommendations are likely to result in a sharp drop off in access to credit, hurting poor clients and impeding progress toward financial inclusion achieved over the last two decades.  We anticipate, furthermore, that these recommendations are likely to have a very negative impact on future flows of equity investment, even from the socially responsible investor community; these funds are critical to fuel the growth and continued outreach of the microfinance sector.”

In proposing a way forward, the CMEF strongly suggests “that the [Reserve Bank of India] acquaint itself with the experiences of other countries. There are now many examples worldwide of creative and efficient regulatory frameworks including Peru, Uganda, South Africa with its Microfinance Regulatory Council as a self regulator, and Cambodia.”

In concluding, the CMEF states that “the Malegam Committee Report represents a short-term response to a serious regional crisis which will result in intensive regulation of a very small subset of credit only institutions, in our opinion.  While this approach may quell political tensions in the short term, it is likely to have negative consequences for the industry and its clients in the long run. The CMEF would like to thank the [Reserve Bank of India] for providing us this opportunity to comment on the recommendations and we urge the RBI to consider a more holistic view of financial inclusion and the most appropriate strategy to achieve it.”

The Microfinance Banana Skins report, now in its third year, reflects changing perceptions of risk in a dynamic and fast-moving industry. This year’s report shows that microfinance has come of age, and with that, new issues have arisen. In an increasing number of markets, the rapid rate of growth and outreach means that microfinance is confronting the same forces of competition, credit cycles, and consolidation seen in other sectors.

This survey explores the risks facing the microfinance industry at a time when hard questions are being asked about its future, prompted by growing doubts about its effectiveness as a source of small-scale finance for the poor.

One of the respondents summed up the significance of these doubts, saying they could “dissipate the fairy dust that has historically coated everything related to microfinance.” Many of the risks explored in this report reach the heart of the debate about where microfinance goes next.

For the third year in a row, the Council of Microfinance Equity Funds served as one of four members of the Banana Skins Steering Committee.  The Council, represented by Deborah Drake, played a significant role in providing input to the survey’s design and content, compiling and expanding the list of survey participants, and planning the dissemination of the report. The report’s findings will be discussed at a series of roundtables to be held in different regions throughout the year.

The survey was conducted by the Centre for the Study of Financial Innovation (CSFI) and sponsored by Citi and the Consultative Group to Assist the Poor (CGAP) with support from the Council.