Though equity investment in microfinance is a small market niche, it’s growing fast. But just what criteria are investors using to make their decisions? Both investors and microfinance institutions (MFIs) need reliable and accessible market references to improve equity pricing; yet, information on microfinance valuation is scarce, and private data are hard to access. Indeed, little research has been done on microfinance equity valuation – until now.
CGAP and JP Morgan have teamed up to tackle the challenge of valuing equity investments in microfinance – and the result is the first-ever set of benchmarks for the valuation of microfinance equity.
Equity investment: In its infancy
There is no question that equity investment in microfinance has been on the rise. There were 24 specialized microfinance equity funds with total assets of US$1.5 billion under management by the end of 2008. And institutional investors, like the leading pension funds TIAA CREF and Dutch state pension ABP, have made microfinance equity allocations of over US$100 million as part of their socially responsible investment strategies. Meanwhile, venture capital companies like Sequoia and a few large private equity funds like Legatum are testing the waters, and there’s near-term potential for initial public offerings (IPOs) in key emerging markets, like India.
“On the other hand, primary issuances are still limited by the small pool of investable MFIs and by the absence of an organized secondary market,” says CGAP’s Xavier Reille. “A majority of transactions are in the form of private placements, and so far there have been only two pure microfinance IPOs (Compartamos in Mexico and Equity Bank in Kenya). With the current turmoil in the market, it’s unlikely we’ll see new ones any time soon.” Despite strong investor interest, there is still work to be done to help spur interest in equity investment in microfinance
The main drivers of microfinance valuation statistical analysis showed that transaction value and net income growth are the main drivers of valuation. And there are eight other important factors: (i) the type of buyer and its possible social motivation; (ii) the country of the MFI; (iii) the legal status of the MFI, in particular, if it’s a fully regulated bank; (iv) operating efficiency; (v) leverage; (vi) the reliance on retail deposits (financial intermediation); (vii) asset quality; and (viii) profitability (as measured by return on equity).
Promoting market development
To support the development of this new market, and to address the lack of reliable market data, CGAP and J.P. Morgan set out to establish benchmarks to help microfinance investors, managers, and analysts value MFIs. They analyzed two datasets: a sample of 144 private equity transactions, which represents the largest such dataset gathered to date, and data on 10 publicly traded MFIs and low-income consumer lenders.
What CGAP and J.P. Morgan found was that, while publically listed microfinance lenders have outperformed traditional banks by 238% since 2003, private-equity valuations for MFIs have varied widely over the past few years. “Historical median valuations in the sample have varied between 1.3x and 1.9x historical book, and between 7.2x and 7.9x historical earnings over the four-year period. The broad range of these indicators might indicate the lack of clear market agreement on MFI valuation,” says Reille. And publicly-listed low-income finance institutions (LIFIs) have outperformed their country indices, though, over the past 12 months, they have performed in line with traditional banks.
CGAP and J.P. Morgan also identified five characteristics that differentiate MFIs from traditional banks: a double bottom line that aims for both social and financial returns; excellent asset quality; high net interest margins; high operating costs, and longer-term funding available from developmental investors. As a result, microfinance requires a slightly different valuation approach.
“While book value and earnings multiples are the most widely used valuation tools, we also recommend the residual income method when valuing microfinance equity,” says Reille. Relative value valuation methods, price-to-book, and, to a lesser extent, price-to-earnings multiples, remain the most common valuation methods in microfinance equity. “An absolute valuation method, the residual income method, would also be appropriate for MFIs because it combines the current book value with future earnings.”
Despite the financial crisis, the outlook is good. According to Elizabeth Littlefield, CGAP’s CEO, microfinance will certainly feel the effects of the current economic and financial contraction in the short term. Liquidity shortages, currency dislocations, and the global recession will all affect MFIs and their clients in different ways, but the impact of the crisis should become clearer over the course of 2009. In the short run, the cost of funding will most likely rise due to tighter credit and to weaker emerging markets currencies relative to dollar-denominated loans. “Growth rates will need to slow and asset and liability management will need to improve,” says Littlefield.
However, Littlefield says that the microfinance sector is still fundamentally sound. Larger institutions, especially those with diversified funding sources, such as retail deposits, are best positioned to manage the effects of economic and financial contraction. Valuations may change, but strong fundamentals and the commitment of development finance institutions and private investors should bolster pricing going forward. “MFIs with a solid funding base and strong asset quality should emerge strongly from the financial crisis,” says Littlefield, who expects valuations to bounce back in 2010. Ultimately, the long-term outlook for equity investment in microfinance is positive.
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CGAP Private Transactions Benchmark – 8 MB file
Contains data regarding microfinance valuations and transactions worldwide.