Should micro-equity replace micro-loans?
As Voices on Society readers are well aware, microfinance is growing steadily. Since Muhammad Yunus, the founder of Bangladesh’s Grameen Bank, won the Nobel Prize in 2006, it has almost become a household word. Countless organizations have invested in microfinance, both in the for-profit and not-for-profit sectors. Kiva, the nonprofit online lending platform, has issued hundreds of millions of dollars in loans, as has Grameen, which recently opened up a branch in the United States. Many foundations and organizations, such as the Clinton Global Initiative, have also embraced microfinance and the impact it can provide.
Despite this success, there is one striking shortfall: microloans fail to consistently live up to their full promise. In most cases, they fall short of truly creating sustainable businesses, significant job growth, or lasting improvements in household income.
The reason lies in the nature of using debt to finance growth. In traditional microfinance, poor people who have no other option for raising capital borrow very small amounts of money. The loans allow them to create micro-enterprises and increase their income. Although borrowers generally lack a formal education and have limited access to basic infrastructure and resources, the industry-wide repayment rate is over 95 percent. Interest rates typically exceed 20 percent.
While microfinance has succeeded in providing access to capital for people at the base of the pyramid, most microfinance lenders are structured and capitalized to take an entrepreneur only so far. Microbusinesses frequently take out several rounds of loans; the same micro-entrepreneurs may take out loans from other microfinance lenders to repay their initial loans, or even take out loans for personal use, pay it back, and then take out another loan again in the future. As a result, the vast majority of entrepreneurs served by microfinance loans still lack the ability to scale their business, add real value in the supply chain, and steadily increase their profitability. The continued reliance on loans, which often feature strict repayment dates and at times exorbitant interest rates, precludes true sustainability.
At the Micro Equity Development Fund, we believe the answer lies with micro-equity. A strong micro-equity market potentially opens up a dual opportunity: for micro-enterprises currently funded via microloans, access to a new, robust, and flexible source of equity capital would fuel growth and help them develop into small-to-medium-size companies. And micro-equity offers greater benefits for investors as well.
Micro-equity seeks to overcome the obstacles to sustainability by giving entrepreneurs larger sums of capital than would be available through loans without requiring them to devote a large share of revenues to interest payments. The micro-entrepreneur would have more time to use the capital and develop the business.
The sparseness of investment capital is one reason developing countries often lack successful midsize employers. Another is the absence of publicly available resources such as a domestic private-venture-capital industry to invest in firms, university-based business incubators, peer-to-peer business networks, or the equivalent of the US Small Business Administration. Micro-equity could help fill those roles.
On the investor side, micro-equity would provide an equally important opportunity. In return for funds, investors would receive a small equity stake in the microbusiness. They would have safe, socially responsible alternative investments to add to their portfolios.
This new investment vehicle will also attract new investors. An emerging trend in recent years has been the integration of socially conscious business practices with the efficiency and sustainability of the private sector; the goal is to create enterprises that can deliver both social and financial returns in a balanced manner. Micro-equity will appeal to an evolved, hybrid investor, one who is socially minded but also believes that generating returns on invested capital will enhance the opportunities to alleviate poverty. If the model is successful in helping medium-size enterprises develop and grow, it will also improve the overall business climate in emerging markets. That, in turn, will create a multiplier effect, spurring economic growth, additional investment opportunities—and, most important, job creation.
From a logistical standpoint, implementing this new model could be less complex than one might expect. Microfinance organization could easily adapt to micro-equity, making minor changes in their existing infrastructure to teach skills such as basic accounting. “Maintenance” fees might offset their costs; alternatively, they might share in the profits investors receive in return for providing oversight. Since micro-equity should be viewed as a long-term investment, it has the potential to provide greater overall returns for microfinance organizations, especially as profits increase and these businesses grow.
Lastly, a system of checks and balances is needed to ensure that both investors and the microbusiness are protected. Under the model we have developed at the Micro Equity Development Fund, for example, micro-equity investments will be sold in tranches to safeguard the investor. They will be tied to assets such as machines and equipment, which can be collateralized and recovered in the event of default.
To protect the micro-entrepreneur, investors can never own more than a small percentage of the microbusiness. In the event of liquidation, the micro-entrepreneur has first opportunity to repurchase the equity at a fair price based on our valuation parameters. Micro-entrepreneurs also must have the freedom to develop as their owners see fit, so we will limit the outside influence of investors. That will also help ensure that micro-equity can contribute to growth and social benefits in developing societies.
The impact should be quickly observed. Micro-equity will bring a substantial amount of new capital to entrepreneurs at the base of the pyramid in emerging markets. They will find it easier to scale their businesses and become more profitable. And although this model is intended to deliver financial returns to the organizations and investors who back the micro-entrepreneurs, the largest returns may ultimately be social.
A version of this article originally ran on www.nextbillion.net on June 5, 2012.