Microfinance – previously seen as an area bound to make perennial losses - is rapidly growing into one of the important asset classes that investors  are hunting for.

Even though there have been no dramatic developments since Parliament enacted the Microfinance Act two years ago in Kenya, it is turning out that this is one of the most lucrative areas of investment for both equity and debt investors.

On the whole, it may turn out that it is not philanthropy that will eliminate poverty in Kenya and many other parts of the world but business that exploits opportunities presented by poverty – however unpalatable that may seem to some people.

And microfinance business could turn out to be just that remedy even though there are those who say the high returns are irreconcilable with the stated “mission” for banking the unbanked.

It is apparent that microfinance is globally a high-growth and high return area and has good asset quality and returns that do not show continental or geographical bias.

For a long time, it was thought that the poor were a particularly bad investment as it was taken for granted that they could not repay their loans.

Phrang Roy, an official at the Department for International Fund for Agricultural Development, wrote a few years back that society “was wrong in believing that poverty and lack of collateral meant that poor people were not creditworthy.

This belief was simply our social prejudice.” Experience showed that microfinance combined with savings, loans, investment opportunities, insurance options among other financial services operated in the framework of group solidarity proved that poor people were a manageable risk and efficient users of credit.

As a result of the perception that the unbanked are very risky, conventional investors have shunned this area such that only development finance institutions and social investors (including NGOs, multilateral agencies) have traditionally put their money in microfinance. In short, it has appeared that this investment is more of philanthropy than business.

Research done by MicroCapital – a US-based news and research firm on international microfinance – focusing on nine MFIs chosen from nine countries found out that average returns were about 27 per cent compared to emerging markets listed stocks’ return of 19 per cent.

In fact, global comparative returns for firms in Bangladesh and Mexico were over 100 per cent – an extraordinarily high return on equity (RoE).

The firms surveyed included ASA of Bangladesh, Compartamos of Mexico, Equity Bank of Kenya, MiBanco of Peru, Al Amana of Morocco, XacBank of Mongolia, ACLEDA of Cambodia, Bancosol of Bolivia and SHARE of India.

The survey, based on 2005 data, looked at the return on equity both locally and adjusted this to compare them globally.

It turned out that the Mexican firm returned 180 per cent and the Bangladesh firm had 124 per cent similar return on equity. Equity Bank had 29 per cent RoE.

It took many years for even financial analysts to discover that MFIs were profitable. Even local MFIs were not thought to be as profitable as they turned out to be.

Indeed, in recent years MFIs business has grown faster at 38 per cent than was previously the case where the three-year average was 34 per cent.

But this growth was necessarily a reflection of the institutions reaching poorer sections of the population.

It appeared that growth in portfolio was an indication of customers seeking increasingly higher amounts with more experience with their lenders while credit officers concentrated on higher loan amounts and less on the poor.

In this scenario, can MFIs help reduce poverty? Interestingly, this research did not include Bangladesh’s Grameen Bank, whose founder Prof Muhammad Yunus won the 2006 Nobel Prize for Peace, because this particular one was found to have one of the lowest financial revenue ratio as it charged the lowest interest rate, but still remained profitable.

Therefore, compared to its peers, it did not appear to be in the bracket of institutions that investors would be impressed with.

A major reason that investors may be interested in this area is the fact that it is still highly under-leveraged compared to other types of financial institutions.

That means that it has a lot of room for more growth.

A major downside of micro-credit is the high expense ratios although experts advise that it is proper to compare this with revenue ratio to get a good indicator of the overall yield on the portfolio.

It is noted, for example, that most institutions are charging lower over time even though expenses may not come down by the same ratios. 

The high returns are also having impact on valuations especially for firms that want to go public.

The high Compartamos IPO valuation with price to book value of 12.8, price to earnings or PE of 26.3 and as well as price to loan portfolio of 5.7 will push other MFI valuations upwards for mature and profitable companies.

With such valuations, private equity, institutional investors as well as high networth individuals may soon find that it is better to buy a stake in a Kenyan MFI than to go to the stock exchange or the primary auction for bond or treasury bills.

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