Recognizing Two Approaches to Balancing Returns in Microfinance

Currently the microfinance industry is working to define and operationalize the idealistic concept of “balanced returns” included in a number of statements of principle or codes of conduct including the Principles for Investors in Inclusive Finance (PIIF) and the Social Performance Task Force (SPTF) Universal Standards. The annual meeting of the SPTF in early June featured discussions of how different stakeholders defined “balance” and how this dynamic heterogeneity could help build the industry. For its part Grassroots has been focusing on how to best articulate social goals, “hardwire” social priorities into MFIs, and then mobilize well-aligned capital to support this investment proposition.

Private enterprise workers from Huynh Khang drying fish for export. Rach Gia City, Kian Giang Province, Vietnam.

These discussions and initiatives force us to confront distinct views of what microfinance can accomplish and how. Is microfinance effective by accelerating the entry of the poor into mainstream markets, specifically markets for financial products, where market forces will ultimately deliver improved lives to the bottom of the pyramid through “financial inclusion”? Or can microfinance directly benefit the poor by enlisting private capital and market incentives in targeted, pro-poor interventions not available in the mainstream? And how do we weigh the potential of “mainstreaming” to provide access at scale against the more comprehensive transformation of lives and opportunity offered by carefully targeted efforts?

Each of these distinct views cites evidence and research. Each is enjoying renewed energy and dynamism: from financial inclusion efforts on the one hand to pro-poor efforts on the other. And each defines “balanced returns” somewhat differently, with those focused on financial inclusion emphasizing synergies between financial and social objectives while the pro-poor camp is more apt to point to trade offs and the need to prioritize client benefit and social goals.

Three recent industry efforts have moved the question of what returns are responsible and appropriate – and what is “appropriate” may differ depending on the approach -- into sharp relief:

First, in response to actual or alleged abuses in recent years, major efforts have been made to strengthen the “do no harm” infrastructure of the microfinance industry. The Smart Campaign, codes of conduct, and other efforts to increase transparency and financial education can all be seen as meaningful efforts to ensure that financial inclusion does not harm the vulnerable clients targeted by microfinance.

Second, efforts are underway to develop a framework for ensuring that the financial relationship between poor borrower and MFI lender allows borrowers to retain a sizeable proportion of the fruits of their initiatives. These frameworks require MFIs to achieve high levels of operating efficiency and set interest rates at levels determined with the client’s well being in mind, rather than simply what the market will bear. This framework is still developing and needs to be elaborated to encompass loans for non-productive activities and non-loan products, like savings and insurance.

Third, initiatives such as the Pro Poor Seal of Excellence, now called Truelift, seek to return microfinance to its roots such that the MFI serves as the nexus of a coordinated web of financial and non-financial interventions with the objective of demonstrably impacting a particular social ill, be it poverty, gender inequity, youth unemployment, etc. These initiatives share tools and metrics through “communities of practice” to help MFIs refine and enhance the effectiveness of their poverty interventions, and better communicate their results.

Each of these interventions pushes returns “below market”. The fact that all three may also reduce some risks or build client loyalty to a brand can allow us to avoid setting clear priorities. But the more ambitious the concept of “balance” – the more decisively client benefit is prioritized -- the greater the likely reduction in ROE. How much greater, we don’t yet know. But if we take some of the initial guidance for “acceptable” ROEs emerging from discussions about appropriate interest rates, the implications for investors are significant. Chuck Waterfield of MF Transparency has proposed a “green zone” for microfinance investors at an ROE at MFI level between 6-15%. Running a portfolio of such investments through Grassroots’ investment fund model yields returns to equity investors in the neighborhood of 5%, well below “market” for emerging market private equity.

This recalibration of the microfinance investment proposition is taking place within the context of the development of the broader impact investing industry. If microfinance is to rely on impact investors to fund its future growth, it is crucial that it build credibility with both its financial-first (two-thirds of the total, according to JPMorgan) and below-market investors. For financial first investors, this means delivering the targeted financial returns with acceptable levels of reputation and political risk.

For impact-first investors, this means placing in the forefront how microfinance differs from other impact investing sectors and making appropriate adjustments in investor expectations. For microfinance, which exclusively targets the poor, every dollar extracted from clients through interest rates or fees is taken from the pockets and mouths of the poor and put in the bank accounts of the relatively wealthy: it is a wealth transfer from the bottom 40% to the top 5%. This is not necessarily the case with other “social” companies who seek merely to transfer wealth from the top 15% to the top 2%.

As financial-first investors we will point out that this is the way the world works, and high priced money can be better than no money at all. But for impact first investors this hard-nosed answer doesn’t really get us off the hook. Is bringing poor people into a more or less conventional system of financial products enough to position them for improving lives? Or has the mainstream financial industry failed to earn our trust as having the best interests of poor clients at heart, which would in turn require us to build an alternative industry designed and dedicated to serve and benefit the poor?

Acknowledging these different views is important because without clearer and more accurate investment propositions, microfinance will progressively alienate all its investors: those financial-first investors who believe that social and financial goals can be mostly synergistic and impact first investors who believe we must be prepared to forego some financial return to enhance microfinance as a force for bettering lives. Microfinance can both join the mainstream and be an alternative to the mainstream, but only if investment managers and MFIs are clear and specific about the investment proposition they are offering in each case and then deliver.

Read SPTF members' top 10 lessons learned about the implementation of the standards

--------The author is the President and Founder of Grassroots Capital.