Small Loans Attract Big Players

Stephen DeAngelis

July 18, 2007

Last April I wrote a post based on a Nicholas Kristof column that discussed how average people can get involved in providing microloans to entrepreneurs in the developing world [Financing the Poor]. Keith Epstein reports that hedge funds, venture capitalists, and other big investors are now finding big profits from tiny loans [“Microfinance Draws Mega Players,” BusinessWeek, 9 & 16 July 2007]. Epstein writes:

“If you think microfinance is the exclusive domain of do-gooders seeking a free-market cure to global poverty, think again. While much of the money flowing into loans for the working poor is indeed ponied up by people with high-minded goals, these days its coming increasingly from those with a sharp eye for the bottom line—raising new questions over how to balance the altruistic mission of microfinance with the pursuit of profits.The high interest paid on microloans makes the operations surprisingly profitable. So hedge funds, venture capital firms, and other big investors are angling to get into the business.”

High interest rates are normally associated with high risk loans. Microloans, especially those provided to women, have proven to be anything but high risk (with many microlenders reporting that over 90% of the loans made to women are repaid in full). The repayment rate for Kiva.org — the focus of my earlier blog — is 99.78%. Not all people desiring microloans, however, are good credit risks — and there is a growing demand for such loans.

“Theres no shortage of demand for microloans. Consultancy McKinsey & Co. estimates that as many as half of the globes 3 billion poor people may be eligible for loans—typically just a few hundred dollars at interest rates that average 31% a year. A June 19 report by Standard & Poors notes that the $15 billion-plus in microloans currently on the books pales next to the potential of some $150 billion in lending. Microfinance ‘is emerging out of the acne phase and getting ready for the junior prom,’ says Brenton Kessel, president of Abacus Wealth Partners, which has funneled about $6 million into the $23 million Unitus Equity Fund, one of nearly 100 investment funds now focused on microfinance. Even more money may soon start pouring into the sector. By September, Standard & Poor’s aims to establish global standards for the business and expects to rate some 20 microlenders, a move sought by retirement funds and others eager for the high returns the segment can offer. Although defaults are rare, without some indicator of credit quality, many won’t invest.”

Thirty-one percent interest rates seem incredibly high for loans whose primary aim is to help people emerge from poverty. Although Kiva.org doesn’t charge interest to its Field Partners, its Field Partners are free to charge interest. Kiva.org, however, will not partner with an organization that charges exorbitant interest rates. As Kiva.org notes on its web site, “Self-sustainability is critical to creating long-term solutions to poverty and charging interest to entrepreneurs is necessary for microfinance institutions to achieve this.” Kiva.org requires its Field Partners to fully disclose their interest rates. It goes on to note:

“Microfinance is an expensive business, which is essentially the reason small loans are not provided by large banks. While Kiva.org’s Field Partners do not bear the cost of capital or the cost of default, they do bear transaction costs and currency risk. Charging interest to entrepreneurs enables our Field Partners to bear these costs and achieve self-sustainability.”

To understand why 31% interest rates can be charged, one must understand that interest rates from local “lenders” can average as high as 80%. At those rates, 31% percent looks like a bargain. The average rate for Kiva.org partners, on the other hand, is 18%, less than many Americans pay on their credit cards. Getting back to Epstein’s article:

“In May, Morgan Stanley packaged small loans worth $108 million from a dozen for-profit lenders into a tradable security with yields of up to 7.7%. Two other industry heavyweights are planning to jump in this year, offering a total of $500 million in securities, S&P says. And TIAA-CREF in September bought a $43 million stake in Frankfurt-based ProCredit Holding, which controls microlenders in 20 countries, from Ecuador to Sierra Leone. ProCredit promises investors a return on equity of as much as 15%. Some expect even richer returns—perhaps as high as 35%—which is luring big names in venture capital. In March, Sequoia Capital, known for backing the likes of Google and YouTube, snapped up an $11.5 million stake in SKS Microfinance, based in Hyderabad, India. Since it was founded in 1998, SKS has made loans at rates of 24% to 30% to 731,000 Indians. In the village of Bhongir, Gandavola Bhagyamma has used SKS loans to buy two water buffalo. Fellow villager Yellakandula Urmila bought a loom to weave silk for saris with her $150 loan, tripling her family’s monthly income, to $75. Six months ago I didnt even know I could take a loan, Urmila says. I’m amazed it’s brought me this far. … There’s little agreement on what a reasonable rate is, since lenders costs vary dramatically. For poor people with scant access to credit, though, microlenders are preferable to borrowing from loan sharks, who often charge far more.”

If your motives are altruistic, then I still recommend you place your money with an organization like Kiva.org. Currently, Kiva.org cannot pay lenders interest on their money (although they hope that changes in the future). If your interests are altruistic, that shouldn’t matter. Microloans, even those with higher interest rates, have proven to be a boon in the developing world, proving once again that commerce is generally better welfare. Get involved.