Financial-Hurdle Rate

From a purely financial standpoint, the expected return on an investment must exceed this rate for us to consider an investment. There are currently four components involved in calculating the financial-hurdle rate:

Benchmark Rate

We use the comparable mature U.S. Treasury security as the risk-free rate.

Credit-Risk (Default) Premium

Gray Ghost has developed a simple model to estimate how the required-interest rate must be adjusted to offset the impact of various default scenarios. The model uses two variables: (i) the likelihood of default; and (ii) the amount of original outstanding recovered. Likelihood of default ranges from 2 percent for low risk investments, 5 percent for moderate-risk investments, and up to 10 percent for higher-risk investments.

In exceptional cases, we may use higher likelihoods of default. The amount assumed to be recovered in the event of default is determined by three estimates: (i) the time horizon in which the risk of default is concentrated; (ii) the leverage of the borrower; and (iii) the realizable value of any security.

For example, for longer-term investments in low-leverage institutions which have a low risk of default during the early portion of the payout period, the proportion of the initial investment realized will be relatively high. Whereas, for more highly leveraged investments where the payout is concentrated toward the final maturity, or where the risk of default occurs earlier in the life of the investment, the recovery will be lower.

Country-Region Premium

Country-region premium is developed either by consulting sovereign debt spreads from a source such as DB Emerging Markets (DBEM), or by using an estimated spread for countries with a similar average rating as developed by DBEM. We use judgment to determine whether an individual country spread might be distorted by particular factors and will adjust the market spread when it is viewed that risk premiums are being systematically compressed or exaggerated. Any such overrides are submitted to the Gray Ghost Investment Committe (ICOM) for approval. Each fund's investments are in multi-country funds, so a rough weighted average of the fund's actual or intended exposure is also used. Spreads should be differentiated by tenor.

Liquidity Premium

We assign an additional risk premium to reflect the liquidity characteristics of an investment. If the investment is essentially self liquidating, as in the case of debt, the liquidity risk premium is zero. A pure equity fund would have a premium of 200 basis points. Mixed debt-equity funds would be assigned a weighted premium.

Financial-Hurdle Rate

These four components are summed to get the total expected financial rate of return.

The following two components may be added in the future:

Operating Expenses

The hurdle rate does not yet include any amount to cover our operating expenses. In its 2006 budget, Gray Ghost has set an operating-expense ratio for its microfinance portfolio of 1.75 per cent.

Profit

The financial-hurdle rate also does not include any amount for profit, but in principle, provides only for capital preservation. At some future point, our objectives may be modified to incorporate some net income hurdle objective as well. Furthermore, because Gray Ghost deliberately discounts the risk-adjusted rate account for the generated social value, its pricing model builds in a systematic under-compensation for risk from a financial standpoint.