Microfinance Draws Mega Players

Hedge funds, VCs, and other big investors are seeing the huge profit potential in tiny loans

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. "This is not a charitable activity, says Scott Budde, a managing director at U.S. pension colossus TIAA-CREF, which aims to invest $100 million in such outfits. We're looking to produce competitive returns."

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. "Doors will open" once investors have a better sense of the risk, says Gary Kochubka, director of the emerging markets group at S&P, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ).

Some aren't waiting. In May, Morgan Stanley (MS ) 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 (GOOG ) and YouTube (GOOG ), 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 familys monthly income, to $75. Six months ago I didnt even know I could take a loan, Urmila says. Im amazed its brought me this far.

BEAT THE SHARKS

The rush of money into microfinance has raised questions about the hefty profits some microlenders earn. One, Mexico's Banco Compartamos, made a splash in April when it staged an initial public offering and saw its shares jump 22% on the first day. A June 11 report by the Consultative Group to Assist the Poor (CGAP), a consortium of agencies that fund microlenders, faulted the bank for interest rates that reach 100% annually. The report questioned Compartamos 56% return on equity and found an obvious conflict between the welfare of clients and investors. "If you want to attract private capital you have to show high profits," says Richard Rosenberg, the report's author. "But they don't have to be this high." Compartamos says it hopes to lower rates, but adds that high expenses compel it to charge what it does.

Theres 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.

Some say rates, and returns, may fall with competition. Sky-high returns are a temporary phenomenon, says Matthew J. Bannick, who heads Omidyar Network, backed by eBay Inc. (EBAY ) founder Pierre M. Omidyar. Bannick figures even investors who only want to do well for themselves will do good by helping microlenders reach more people. "Is it better to serve 100 million poor people and break even, he asks, or to serve 2 billion poor people and make a modest profit?"

Join a debate about whether SBA loans should continue.

By Keith Epstein, with Geri Smith in Mexico City and Nandini Lakshman in Hyderabad

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