Microfinance: Investing in Human Potential

Lenders providing relatively small loans have helped more than 59 million of the world’s poorest people improve their communities.¹ This unusual combination of philanthropy and investing remedies economic disparities in underserved areas and as a new branch of socially responsible investing, it can generate competitive returns.

Microfinancing is more than an investing buzzword. With more than $33 billion in total assets,² microfinance institutions (MFI) have become a potent force worldwide. MFIs are also creating an emerging asset class of microfinance investment vehicles such as certificates of deposit from community development banks, equity and debt funds, or loans to MFIs.

To be sure, microfinance has been around since the Marshall Plan, but it received renewed attention in the mid-1970s through the innovative microcredit projects of 2006 Nobel Peace Prize winner Muhammad Yunus in Bangladesh. In its entirety, microfinance encompasses the full range of banking services for the poor — not only lending but also savings, insurance and funds transfer services. More commonly, the term is applied to lending very small amounts — typically anywhere from $100 to $1,000 — to people who have no other access to credit.

These microloans often allow recipients to start small businesses they would otherwise not be able to get off the ground. For instance, a farmer in Cambodia may borrow a few hundred dollars from his local microfinance organization to buy more seeds and fertilizer in order to grow a cash crop. The farmer could use profits to repay his loan, expand his farm, and cover his children’s education and health care.

The loans that MFIs make are definitely not handouts to the borrowers, who are responsible for repayment just as any other debtor is. In fact, MFIs have traditionally experienced repayment rates over 99%,³ and they generate annual yields of between 1% and 4%.

Its role in your portfolio
But those yields aren’t the only factor when you are considering how MFI investments fit into your broader investing picture. "Microfinance falls under the umbrella of values-based investing," explains Elliot Berger, Director of Foundations and Strategic Philanthropy at the Merrill Lynch Center for Philanthropy & Nonprofit Management. With this offshoot of socially responsible investing, investors can meet their social and financial goals without having to pay what Berger refers to as the conscience penalty — lower returns for socially directed investments.

Investors who prefer to give back may choose to forego any interest, allowing the MFI to use those earnings to fund more loans and increase the impact of the initial participation. Investors who would like their MFI participation to contribute growth to their portfolios can select instruments with higher interest rates, matching their desired returns with MFI vehicles related to social causes that interest the investor. Organizations often guarantee the principal and allow investors to set their own rate of return within a predefined range. “It all depends on how you want to participate," Berger says, noting that most MFI investments are structured to meet a wide range of financial goals.

Rates of return above the 1%–4% range are available, but investors seeking those higher returns should investigate the MFI involved and understand how MFIs generate their returns. MFIs charge borrowers interest rates that seem excessive to banking customers in the developed world — 36% is not unusual.

However, these rates are necessary to cover the MFI’s overhead, including cost of capital, reserves for losses and transaction costs. And they are far more reasonable than those of informal lenders with much higher costs, such as savings clubs or local wealthy community leaders.

But an MFI’s ability to keep costs low affects its viability as well. As more MFIs attract commercial capital, investors seeking returns without compromising social goals will want to look into the operating costs of institutions in which they’re considering investing.

Getting involved
There are several ways to get involved with MFIs, such as making an outright donation, loaning capital directly to an MFI or entering a microfinance investment fund, which is fast becoming a popular option.

"Microfinance investment funds can be an excellent solution for many investors already familiar with the fund structure," Berger says. These instruments pool investor assets to target specific social issues or regions, such as supporting women’s microfinance initiatives in South America or Gulf Coast recovery efforts.

Investors can often choose the length of the loan and the desired rate of return, from 0% to 4%. They can also decide whether they want to participate in noncommercial or commercial funds. Some funds can offer returns on par with more traditional fixed-income investments. Most organizations also give investors an idea of the social return on their investment, such as how many jobs an investment of, say, $3,000 for five years could finance through the resulting microenterprises.

Those looking for a more hands-on approach and little to no financial return on investment may want to check out Kiva (www.kiva.org), Berger says. The social-networking-style Web site lets users lend to specific entrepreneurs in the developing world in amounts of $25 or more. Although Kiva does not guarantee repayment or a return on your loan, the site gives a 0.1% default rate for the more than $6 million in capital for which it has so far completed loan terms.

Finding the right fit
As with any other investment, Berger cautions, investors must exercise due diligence. To understand exactly how the MFI you are considering selects recipients and manages loans, check with organizations such as the United Nations Capital Development Fund⁴ to ensure that the MFI meets best-practices standards.

Then, be clear about your own expectations. “Microcredit does not work for everyone who needs help," Berger says. “It may be part of a path out of poverty, but it is not always the total solution." According to Berger, there is often a fine line between pulling people out of poverty and pushing them in deeper by adding debt without providing additional resources to help stabilize their lives. “You need to make sure you aren’t expecting too much or doing too little to meet those goals," Berger says. Some projects, such as the Women’s Empowerment Program in Nepal and Accion in Latin America and Africa, include funding for programs to reduce domestic violence, increase literacy, develop local infrastructure such as roads and drinking water, or improve health care and housing. Consider microfinancing in light of your own investment and philanthropic goals. It can be one more way you give back to the community, locally or far from home.

¹Microfinance Information eXchange (MIX), “Selected Microfinance Indicators—2006." Updated on May 5, 2008; Adrian Gonzalez, Lead Researcher. http://www.mixmbb.org/Publications/001-IND/02-IND.DATA/MFI%20INDUSTRY%20DATA%20SETS/Selected%20MF%20Indicators.pdf.
²Microfinance Information eXchange, MicroBanking Bulletin, Issue 15, Autumn 2007. Annual data for 2006 (the most recent year available) on write-offs as a percentage of average growth loan portfolios for 1,200 surveyed microfinance institutions. http://www.mixmbb.org/Publications/001-IND/01-IND.ANLS/01-IND.ANLS.MBB/MBB15%20Final.pdf.
³Village Welfare Society, www.villagewelfare.com/financials.php; “Why Do MFIs Charge High Interest Rates?" About Microfinance, 2007. http://www.cgap.org/portal/site/CGAP/menuitem.1bbcacde5ab5216067808010591010a0/.
⁴Visit the Evaluations page of the United Nations Capital Development Fund’s Web site for more details on measuring the performance of microfinance institutions: http://www.uncdf.org/english/evaluations/index.php.