Risks of Investing

Below are some of the risks identified by Gray Ghost.

Repayment Risk

Since microfinance institutions (MFIs) loan money, they face repayment risk. To the extent that an MFI's default rate rises, the MFI will see a decline in profitability, which will increase the chance that it, in turn, cannot pay interest or principle due to a lender on a timely basis. Investment funds that provide equity to MFIs are susceptible to a greater degree of capital loss, compared with debt funds, in the event an MFI defaults. In recent years, there have been few instances of default, and none by larger, professionally managed MFIs.

The quality of portfolios managed by MFIs, reflecting payment delays and write-offs of their loans to micro-entrepreneurs, are generally in the 3 percent to 5 percent range, which compares favorably with the portfolio quality of other financial institutions. One important factor behind borrowers' impressive repayment rates historically has been the prevalence of a group-lending model, where borrowers cross-guarantee each others' loans. But even where an "individual lending" model is used, repayment discipline is generally quite strong, evidence of the strength of the relationship between the micro-entrepreneur and the lender.

Foreign-Currency Risk

Many MFIs operate in countries that have experienced volatility in exchange rates in recent decades, and while macroeconomic management has generally improved relative to the 1980s or 1990s, adjustments in exchange rates can be expected. Over a given time frame, such exchange rate changes will not always be compensated for by local currency yields. Many loans to MFIs by debt funds are denominated in dollars or euros, which in principle transfers the foreign-exchange exposure to the MFI.

However, there has been increasing recognition in recent years, that, at best, this transforms a lender's foreign-exchange risk into credit risk, which potentially exposes the MFI to large losses. Increasingly, lenders are looking for ways to provide local currency loans to MFIs and either manage the foreign exchange risk themselves, through a widely diversified portfolio of loans, or work with financial institutions that can assume the risk for a fee.

Even without any loss to investors related to foreign-currency translation, an MFI's access to capital — and, in turn, growth prospects — could be severely curtailed by currency devaluation. That deceleration in growth would likely impair the value of equity investments in that MFI held by a microfinance fund.

Country Risk

Aside from foreign currency, there are other country-specific risks such as political and regulatory risks. Historically, microfinance was too small to attract much attention from governments or regulators, but as microfinance becomes a more important part of many financial systems, political and regulatory scrutiny increases.

As a general rule, regulatory changes have been to the benefit of MFIs, clarifying their authorities and legal standing. However, there are countries where prolonged uncertainty concerning the regulatory framework for microfinance serves as a drag on growth. In addition, because microfinance charges interest rates that look high in the context of the formal financial system, in order to cover the higher costs often associated with smaller borrowers, consumer protection and usury laws can invoke ways that can disrupt the operations of MFIs.

As for macroeconomic trends within a country, there is some evidence that MFIs are much less affected by economic downturns than mainstream financial institutions. In some cases, observers have even found an increase in demand for microfinance when recession or disruption of the formal economy pushes more people into the informal economy. Notwithstanding these possibilities, an investor should probably expect that an MFI investment will be perceived as losing value or facing higher risk as the overall macroeconomic performance and risk rating of a country deteriorates.

Commercial Bank Downscaling

Commercial banks are increasingly looking to offer microfinance services as they recognize the large pools of under—served and creditworthy borrowers that MFIs have revealed. Commercial banks may enjoy operating and funding expense advantages that enable them to offer lower loan rates, relative to MFIs, which will force down the portfolio yields for MFIs. Our view, however, is that much of the microfinance market will prove unattractive for commercial banks, who will find it too poor a fit with their overall market positioning.

That said, the commercial banks will continue to explore microfinance over the near to intermediate term and their penetration of the market will increase. Their entry will put pressure on financial results for MFIs that are most directly affected.

Liquidity Risk

We typically invest in funds that have intermediate to longer-term investment horizons with limited, if any, avenues for the fund investor to redeem debt or equity holdings in the interim. Today, no public market exists for such securities, and the private transfer of microfinance investments is often restricted by shareholder agreements.

Liquidity in microfinance securities may also be affected by changes in interest rates on alternative-investment classes, for example, U.S. Treasury bonds. Microfinance securities typically offer fixed rates. To the extent that interest rates offered on alternative fixed income securities were to rise sharply, that could diminish the attraction of microfinance securities.

We suggest you thoroughly investigate the risks associated with each investment considered.