Big thoughts on little loans through mezzanine tranche of microfinance CLO structure

In early july we received confirmation that we are receiving full repayment on time in respect of DWM Microfinance Securitization (XXEB) 7.117 11. Oh right… yes, interesting… but what does that mean?!

This is a fixed income investment in the microfinance fund Developing World Markets (DWM) that we made for Henderson Global Care Managed five years ago. We were one of the first institutions to invest in an instrument like this and, although it has been a hair-raising ride, in the end it has been a success. We have been repaid the amount that we originally lent, and have made a decent return on top of this, whilst also having a positive social impact and learning a great deal along the way.

When we first looked at the microfinance market it was in a pretty immature phase. This was our second investment in a microfinance security, a step on from the first which benefitted from the substantial cornerstone investment of a quasi governmental agency in the US, which helped the fund to reach critical mass and attract other investors. I don’t think many other funds like ours were willing to get involved, when the instrument was unproven and we knew it would lack liquidity.

For these reasons we kept our investment quite small in the context of the fund, but at $1,000,000 still meaningful in the impact that it could have. The fund used the money it raised to lend to more than 20 different microfinance institutions around the world in countries as diverse as Peru, Bosnia and Indonesia. In turn these institutions would lend very small amounts (hundreds rather than thousands of dollars) to individuals as start-up capital for small businesses. Examples of customers from the last newsletter include a musician in Mongolia who set up a business producing dobros, a banjo-like instrument sold in the local market, and a teacher in Azerbaijan, who made silk tapestries to supplement her salary.

The microfinance industry has run into some difficulty over the last couple of years, as allegations of poor practices by some have led to political and reputational problems for the sector. The issues have been most high profile in India, where some microfinance institutions (MFIs) were accused of heavy handed tactics in recovering loans and some borrowers had reportedly committed suicide as a result of repayment difficulties. Part of the role of a fund manager such as DWM is to scrutinise the lending policies and practices of those MFIs that it lends money to, giving us some comfort not just from an ethical perspective, but also from a commercial viewpoint given the negative impact that this kind of allegation has had on the industry. Political pressure can be less predictable. After a bout of political unrest in Equador and Bolivia just over 5 years ago, this fund was set up explicity to avoid exposure to these two countries (hence the name XXEB – ex Equador and Bolivia). In the event these countries would probably have been relative havens of stability over the last five years, especially when compared to the problems experienced in Nicaragua, where the president had led a populist “no-pay” movement against the microfinance industry and corruption problems were uncovered.

As a collateralised loan obligation (CLO) structure, our interest was in the so-called ‘mezzanine tranche’ of debt security - meaning that in the event of inadequate cash-flows, other investors with junior debt and equity holdings ranking below us in the capital structure would be most at risk. Ultimately, the problems in Nicaragua were enough to damage those investors that ranked beneath our security, but our investment was unharmed, although at one stage it looked like it would be quite a close run thing.

So what have we learnt? First, that not all microfinance creates positive social benefit, so a robust research process is critical to ensure that benefits will be achieved. Second, that the social responsibility of the lending process is an essential check in reducing financial risk and delivering more sustainable financial outcomes. Third, that diversification is critical, as so much relies upon the political climate - something that can change dramatically with every electoral cycle. Despite all this, however, we have seen this industry and its financing mature over the last five years. The options for investing in this sector are now much broader, and are increasingly becoming available to a range of specialist and mainstream investors.