Edmund HIGENBOTTAM, Verdant Capital
This panel session discussed innovative financing structures to Inclusive Financial Institutions (IFIs) and was moderated by Ralf KASTENHOLZ who heads KfW Development Bank's division for global Direct Equity and Fund Investments in Financial Institutions, managing an investment portfolio of more than EUR 1 billion in direct equity, sub-debt, and fund investments. The division deals with first loss and pari-passu investments in debt, and equity funds as an anchor investor. The aim is to support the global microfinance industry, foster MSME growth in developing countries, and be a leading catalyst for making SDGs investible.
According to Kastenholz a more resilient financial system is needed to deal with challenges ahead. The microfinance industry has changed a lot, and financial inclusion remains a key challenge. In addition, large differences between and in regions still exist, and ‘hard to reach’ markets are still underserved. Kastenholz invited Edmund HIGENBOTTAM from Verdant Capital to discuss the instruments that will be invested in IFIs through the Verdant Capital Hybrid Fund (VCHF), which has a pan-African investment mandate. Instruments include subordinated debt and preference shares, and for regulated institutions, AT1 Capital and LT2 Capital and will help ‘crowd-in’ senior debt from other sources.
Higenbottam explained how MIV funding in terms of assets under management has grown by about eightfold over the past ten years. Also funding deployed in Africa has grown in terms of absolute amount of capital allocated. However, on a relative basis it is still massively underrepresented. This indicates that other regions receive significant MIV allocation, disproportionate to its population.
Verdant Capital conducted a survey in 2019, asking MIVs around the world what their key reasons were for not investing in Africa. Investors’ biggest reasons were that NPLs is too high (88%). Interestingly, solvency or capital adequacy or equity to assets rations being too low is the second most important factor. Other factors, such as poor skills on the part of MFI’s management or governance issues, and too low profitability rates were also mentioned.
Higenbottam continued by listing several innovative instruments that may make MFIs in Africa more attractive to invest in. One solution mentioned is greater solvency/capitalisation. For instance, the VCHF helps MFIs increase capitalisation, crowding in more senior debt funding from other sources. Another solution mentioned was greater scale. This is important in terms of costs to give investors individual investments amount; the bigger the scale, the easier it is to raise money. Also, broader access to liquidity (especially local) is important. Investees having a range of options is important to help crowd additional capital. Currency risk management and supporting technical assistance activities were also mentioned as instruments making Africa more attractive to invest in.
Regarding greater solvency/capitalisation, Higenbottam continued explaining that 3 out of 5 MFIs said to raise new equity funding in early 2021, using it to grow their fund loan portfolios. Nevertheless, Verdant Capital has not seen a rush of equity deals closing in 2021. This means that there is still a lot of equity missing on the market, making for interesting opportunities for funds like VCHF.
Besides senior debt, other capital tools available are private equity, hybrid funding and IPO. In the short-term, Verdant Capital therefore looks at private equity and hybrid capital. In the long term, Higenbottam argued, listed equity is the way to build a vibrant banking sector in Africa. Still, there is limited IPOs from the MFI sector, as it needs a minimum size to justify listing cost and achieve aftermarket liquidity. For MFIs to grow their scale, Higenbottam continued, capitalisation is needed, regulation, cross-border growth, better adaption of technology and more mergers and acquisitions to share best practices and build scale.
Jerome PIROUZ then presented the work of TCX, which has supported frontier capital markets through provision of currency hedging over the past 15 years and in 110 currencies. Pirouz pointed out that significant depreciations have occurred frequently on a global level. At any given moment, a decent share of the world’s currencies is in ‘crisis’. That is why focusing on local currency and on de-dollarizing economies has clear advantages both in terms of profitability, risk management and market development.
The advantages are manifold. First, focussing on local currency improves a lender’s reach and impact. It helps serve more clients that require local currency financing rather than USD. Also, the development impact is greatest in local currency sectors (examples: microfinance, SMEs, off-grid). Other pluses are that it contributes to capital market development and takes advantage of higher local currency spreads. Second, it supports offering the right product for the end-client. It takes out currency mismatches between debt and revenue and provides predictable cash flows. Also, it allows for better credit risk (NPL) and protection from sudden depreciations as the transmission mechanism between FX risk and credit risk is broken. Lastly, focusing on local currency helps reduce systemic risk, argued Pirouz. It improves resilience to external shocks by decreasing the dollarization of local markets. It also breaks the destructive cycle of currency risk fuelling high local currency interest rates, and the propensity to borrow even more in USD.
Pirouz continued sharing the latest innovation of TCX, which is a jointly achieved with the European Commission and KfW. TCX has launched a facility where it offers lenders the possibility to provide local currency financing at a cheaper rate. The facility follows a specific timeline, which needs to be respected by investors. The process starts with an Information period where investors connect with potential investees, followed by a submission period where investors submit their requests to TCX. Then TCX proceeds to rank the requests, followed by the allocations which are granted while agreeing on the price reduction. This is followed by the investment process itself of about 3 months. Then, final negotiation takes place, where at execution the reduction is applied to the pricing. Lastly, the deal is executed as per standard trading procedure. In case delays occur, TCX has the right to revoke the allocation and consider the next eligible deal (as per the ranking).
Lastly, Olamipo OGUNSANYA from the Africa Local Currency Bond (ALCB) Fund was given the floor to discuss the contribution of local bond markets to the funding mix available to the sector in the Africa. ALCB Fund’s mission is the mobilisation of domestic resources into high impact sectors (benefiting MSMEs/households), increasing private-sector resilience through reduced FX exposure and contributing towards more efficient allocation of domestic savings and greater financial self-reliance in African economies. Its strategy is to promote the primary issuance of bonds and other transparent capital markets instruments by providing anchor investment, technical assistance, and handholding, making it easier and cheaper to come to the capital markets. Uniquely, ALCB Fund prices to market and requires local co-investment and arrangers.
The ALCB Fund has made investments in over 45 companies and 18 countries. The fund benefits from geographic and sector diversification of the portfolio, with the primary sectors being MSME finance, housing, micro-lending, infrastructure, and agriculture.
Ogunsanya shared a case study about their investment in LAPO Microfinance Bank. This MFI is Nigeria’s largest microfinance bank and provides pro-poor financial solutions through its 406 branches to over two million clients. LAPO’s portfolio is composed of group loans largely catered to female entrepreneurs as well as products catered to SMEs, education, solar lighting, and incremental housing finance. LAPO actively tried to reduce its exposure to foreign exchange risk by accessing the domestic debt market.
The Fund invested a total of USD 5 million in LAPO’s 5-year bond issuance in 2017, and another USD 2.7 million in 2020. ALCB Fund has been engaged with LAPO since the inception of the bond, providing technical assistance for ratings, accounting, and legal services. An important part of ALCB Fund’s work was also to engage with local counter parties. Ogunsanya added that they can only operate as investor in the market with the hedging support of institutions like TCX.
Kastenholz closed the session by pointing out that each of the presented instruments are perfect examples of what is needed to make the market more resilient. The key message here is that it is not about re-inventing the finance industry. Innovations need to be brought to all markets, for which scale is needed. “Let’s push this forward and have a successful future together for our clients, partners and customers.”