Securitization and Intermediation in Microfinance: Access to the Capital Markets
Financial intermediation is a dicey proposition these days, and ‘asset securitization’ a downright dirty word in a world in which securitization allowed the obfuscation of risk – purses from sows’ ears, but actually just fancy looking sows’ ears, it turns out, everywhere you looked. Nonetheless, one of the important longterm issues for microfinance (and for the whole, newly emerging ‘venture philanthropy’ sector that links for-profit and nonprofit together) is whether nonprofit enterprises such as microfinance can or should seek to access capital in the regular global capital markets; how that might happen as a financial, legal, and regulatory matter; and who might play the role of intermediary and securitizer.
Is it possible for nonprofits to access the capital markets? Nonprofits have been going to the regular capital markets for a long time – schools, hospitals, universities, and so on, have long accessed the capital markets through bond issuances. But there have always been limitations on this, in the United States and usually even more restrictively elsewhere. First, as a practical matter, nonprofit bond issuance – since nonprofits don’t have shareholders, stock issuance is not an option – is done by institutions that have one of two things, and almost always both: real estate as collateral and a reasonably dependable and steady stream of income, whether through tuition, patient fees, or something else. If you are just Joe Nonprofit Organization, engaged in some worthy activity (such as advising low income teens on how to lose weight and avoid obesity; I just finished reading the WP great but scary series on this) but don’t have land and don’t charge fees for services, bond investors won’t lend you money because they won’t see how you have the possibility to pay it back; the nature of your nonprofit is always going to be grant funding, not loans.
Second, nonprofit bond issuance typically takes place through municipal bond markets, with local government authorities giving approval to the bond issuance – if your law school or university has done some capital construction recently, the bonds were almost certainly issued via some local government agency to allow access to tax exempt muni bond markets. As a consequence, nonprofits that do not fit this model – and this includes most international nonprofits – have not been able to access the regular capital markets. Their funds come from a combination of foundation and other private giving, government agency, and international organization funding; those funds might be all grants, or they might include some amount of loans from those agencies – but the funds do not ultimately come from the public capital markets. They come from what is sometimes called the nonprofit capital market.
There have been some tiptoes into the public capital market by nonprofits that otherwise would not fit the traditional criteria. Often – nearly always, I would say – these efforts have been undertaken by or in collaboration with social responsible investment funds, such as Calvert Group. But the fundamental financial question remains the same – if you don’t have an income stream, even leaving aside the collateral question, it really doesn’t make sense for your organization to seek funds in the capital markets in which the whole point is that you pay a market rate of return. Public capital markets are not money for free; a nonprofit goes there because it has outstripped the capital available to it in the nonprofit capital markets at zero or negative rates of return, and in search of capital it is willing to pay market rates. But that only makes sense if the organization has an activity that produces an income stream at or exceeding market return rates (all that NPV stuff I was pooh-poohing in my last post!)
My own organization, the Media Development Loan Fund, has gone to the US capital markets with the assistance of Calvert Fund. That is, we have available to investors an instrument (under securities law exemptions) called Press Freedom Notes that pay SRI rates of return, meaning that you buy them as a regular security, but they pay less than full market rate. What has been the response among the public? Practically none, alas. That includes the regular investing public as well as the socially attuned socially responsible investor community. The problem, to be brutally frank, is that to sell these kind of bonds, you need a very attractive – i.e., very sad – story, preferably about small children with big sad eyes, or baby seals. Trying to sell regular old SRI investors on something as antiseptic and remote and abstract as the importance of a free and independent and transparent press as a crucial element of human rights, development and poverty reduction in the world – it’s not just a tough sell, it’s a no-sell.
MDLF has also done something unique and exciting (exciting, anyway, if innovative nonprofit financing is your thing) by issuing what we believe is the first publicly traded derivative – a swap note traded on the Zurich exchange – issued by a nonprofit. This was facilitated by a leading Swiss private bank, Vontobel, and a leader in the SRI innovation community in Europe, ResponsAbilite. In addition, liquidity in trading was guaranteed by a Swiss government agency. This was very, very cool as a concept, but even though Vontobel presented it as an SRI investment to its wealthy clients, and although we sold a lot, it didn’t sell out, and the reason appears to be, once again, that even among sophisticated wealthy clients, baby seals count for a lot. Possibly – I’m not being cute here, but quite serious – if we had thought to somehow get Natalie Portman to sign on with MDLF rather than FINCA, we might have had more sales traction.
So, yes, under some circumstances nonprofits outside the usual mold can access the capital markets. Whether it is realistic or prudent to do so is another question, and that is mostly a matter of whether it can get cheaper or subsidized capital out of the nonprofit capital markets, and whether it has an income stream sufficient to service the cost of capital from the capital markets. It is, in fact, a limited set of organizations that fit those criteria.
Problems of intermediation. One group of organizations that might conceivably have the income stream to make capital markets feasible is microfinance. It is not very clear to me that this is needed now – my sense of microfinance as a worldwide activity is that it actually has more than enough capital to undertake its work. That is, the task of breaking down blocks of capital into tiny, tiny loans, the making and supervision of those loans, and the monitoring of those loans is a fantastically involved process – far more time and resource consuming that for profit lending typically. It is worth keeping that in mind when you read comparisons of loan repayment rates for microfinance versus commercial lending – microfinance typically involves a back end monitoring program that, if translated into either interest rate or additional risk, would significantly shift those figures. The nonprofit capital market, so far as I can tell, is willing to supply any amount of capital that the sector needs; lending capital is not the issue. But it might become an issue in the future. Moreover, if you accept, as I do, that the more important problem for most developing countries is not the individual entrepreneuer, but instead what, in my previous post, the New Yorker’s Surowiecki calls the “missing middle” – the small to mediumsize firms that, in places like China and India, employ people – those firms have far greater difficulty getting money, or sufficient money, from the nonprofit capital markets. Again, a bit of the baby seal problem. So those kinds of firms – crucial to economic development – need access to capital, and in larger chunks than hundred dollar loans.
The examples I gave earlier involved the use of SRI experts in order to do the highly technical and legally demanding tasks of accessing the capital markets. In addition, however, eventual access to capital markets requires intermediaries, not just experts to help navigate the process. The reason is that whether in microfinance or ‘the missing middle’, in most cases it won’t be economically sensible for individual firms or nonprofit organizations to seek to access those markets. It made sense for MDLF because we are, relatively speaking, large with large loans in our portfolio.
But in most cases, the best approach appears to be one in which a specialized nonprofit acts as intermediary, taking on the portfolios of individual nonprofit agencies, securitizing them, and then reselling them to access capital in the markets. That intermediary can add value through (1) expertise, (2) risk spreading and diversification, (3) reputation, and (4) a guarantee from its own resources in order to reassure capital markets. That last requires a strong financial commitment from some large nonprofit or government agency, as well as strong discipline to ensure that nonprofit does not mean ‘bust’ downstream where the income stream ultimately derives from. It also makes no sense whatsoever unless the capital is genuinely usable at market rates of interest. It is the sort of thing that an Open Society Institute could undertake, and in fact is, in part, through its economic development funds. But there is a lot of work to be done in this area. One exciting thing, however, is the way in which the SRI community has drawn in quite extraordinary talent from the private investment sector – MDLF is working with some SRI folks with backgrounds any private equity firm would envy, who are willing to take a big pay cut in order to bring their finance skills to the nonprofit sector.
This is, obviously, a bad moment to be launching new forms of securitization. But it is not a bad moment to be planning for the future of nonprofit securitization, and for entities that have the expertise and capital to act as intermediaries between nonprofits with decent income streams but not traditional collateral – especially in the international NGO sector – and the capital markets.