Moving on to the next level..we will now try to see how do these Microfinance companies manage to fund their business. This will involve both the fields which I am passionate about- micro & corporate finance :).
Looking at the Indian scenario to find out the answer, one thing that stands out is that in the last two years, the five largest MFIs in India have been beneficiaries of approximately $180mn in private equity investments! and their combined client base during the period grew at an annually compounded rate of 45% .
Now, why do they need private equity after all- Corporate Finance-101 will tell you that a company can’t fund itself solely by debt beyond a certain level. The increasing leverage will increase the cost of capital substantially. So beyond a certain stage the business needs infusion of fresh equity, since the promoters are not in a state to fund it by themselves, they also have not yet achieved the scale to be able to go public- so they turn to the only plausible option left, that is private equity.
The private equity investing in microfinance is mostly in the form of early start-up or growth capital. This is different from the prevalent practices in the developed world in the way that otherwise private equity players are over-leveraged in the pursuit of short-term exit & return. However in the case of investment in MFIs they partner them for a longer duration as still its a long time before these investments will mature giving them an option to exit.
An increase in inflow of such funds will not just help the sector to scale, but will allow greater transparency. The kind of corporate governance requirements of these investors will inevitably result in stronger organizations.
On the contrary, despite the positives such investments, some people still criticize private equity backed MFIs for their rapid growth rates. Their concern is that in the pursuit to scale up fast these PE funded MFIs will compromise the quality of the loan portfolio. To my understanding that is not a problem, as a default ridden portfolio, no matter how large it is, is of limited use to the MFI as well as the PE firm, especially so amidst the current financial crisis. Also people often accuse PE backed MFIs to be driven only by profitability, now that comes from the school of thought that believes microfinance to be just a kind of social service. I will again repeat what I ve already said about microfinance- ‘it is about doing well, by doing good’. No business can sustain & scale up without having a financial business sense to it. We have to understand that grants can’t keep driving microfinance forever, they have to be profitable for them to scale-up & be able to provide the service to a larger base.
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