Shedding Light on 47956 Microfinance Equity Valuation: Past and Present PERAP Executive Summary ation in 2003, our Low-Income Finance Index has out- performed the Global MSCI World Financials index2 This report is the result of a collaboration between by 238% (and has outperformed this benchmark by CGAP and J.P. Morgan. CGAP is solely responsible for 8% since the Lehman bankruptcy in September 2008). the printing and distribution of this Occasional Paper. LIFIs now trade slightly higher than traditional banks CGAP is not affiliated with J.P. Morgan. Our objective on price-to-book basis (1.9x 2008 book for is to provide benchmarks for valuation of microfi- LIFIs versus 1.5x for emerging banks as of January 28, nance equity, both private and publicly listed. Our 2009). On a 2009 price-to-earnings basis, LIFIs are analysis is based on two datasets: a sample of 144 pri- trading at a 22% discount to traditional banks, as vate equity transactions, which represents the largest shown in Table 2. such dataset gathered to date, and data on 10 pub- licly traded microfinance institutions (MFIs) and low-in- Investors should not value MFIs the same way they come consumer lenders.1 value traditional banks. We highlight five charac- teristics that differentiate MFIs from traditional banks, M FIs will certainly be affected by the financial and justify a slightly different valuation approach: a crisis ricocheting across the globe, but we double bottom line that aims for both social and fi- believe that the sector is fundamentally sound. nancial returns, excellent asset quality, high net in- Larger institutions, especially those with diversified terest margins (NIMs), high operating costs, and funding sources, such as retail deposits, are best longer term funding available from developmental in- positioned to manage the effects of economic and vestors. financial contraction. Valuations may change, but we believe the long-term outlook for equity in- Book value and earnings multiples are the most vestment in microfinance is positive. widely used valuation tools but we also recom- mend the residual income method. Relative value Private equity valuations for MFIs have varied valuation methods, price-to-book, and, to a lesser ex- widely over the past few years. Historical median tent, price-to-earnings multiples remain the most valuations in our private sample have varied between common valuation methods in microfinance equity. 1.3x and 1.9x historical book, and between 7.2x and An absolute valuation method, the residual income 7.9x historical earnings over the four-year period, as method, would also be appropriate for MFIs be- shown in Table 1 on the next page. The considerable cause it combines the current book value with future range of these indicators may indicate the lack of earnings. market consensus on MFI valuation. Microfinance valuations should benefit from a lower OCCASIONAL Publicly listed low-income finance institutions (LIFIs) beta than banks in our view, but they also deserve have outperformed traditional banks. Since its cre- a discount for the limited liquidity of the equity. Be- No. 14 February 2009 1 Because there are few publicly listed MFIs, we considered a group of 10 financial institutions targeting low-income individuals, and note that their business Nicholas P. O'Donohoe models are very diverse. Frederic Rozeira de MarizAC 2 The MSCI World Financials Index is a free-float weighted equity index. It was developed with a base value of 100 as of December 31, 1998. Elizabeth Littlefield Xavier Reille Christoph Kneiding 2 cause of the higher resilience of their business, MFIs' tistical analysis. The following are eight other factors earnings are generally less volatile than traditional that we also view as important: (i) the type of buyer banks. At the same time, valuations merit a liquidity and its possible social motivation; (ii) the country of discount because of the small transaction size in the the MFI; (iii) the legal status of the MFI, in particular microfinance space. Unfortunately, no tools are avail- if it is a fully regulated bank; (iv) operating efficiency; able to quantify this discount. (v) leverage; (vi) the reliance on retail deposits (fi- nancial intermediation); (vii) asset quality; and (viii) Transaction value and net income growth are the profitability (as measured by ROE). main drivers of valuation, as evidenced by our sta- Table 1. Private Transactions: Valuations Rebounded in 2008 Historical P/E Historical P/BV Sample Year Unweighted Average Median Unweighted Average Median # 2005 9.1 7.9 1.6 1.7 28 2006 8.6 7.4 1.5 1.3 37 2007 9.9 7.2 2.5 1.3 37 Sept 2008 10.2 7.9 2.2 1.9 38 Source: CGAP, J.P. Morgan. Valuations rebounded in 2008 mostly due to the high multiples applied to a small number of transactions. Table 2. Public Transactions: Low-Income Finance Institutions Exhibit Higher P/BV but Lower P/E Than Emerging Market Banks P/BV P/E 07A 08E 09E 07A 08E 09E Low-Income Finance Index 2.3 1.9 1.6 10.4 7.6 6.5 Emerging Markets Banks Latin America 2.0 1.9 1.9 8.8 8.6 8.6 Emerging Europe 0.9 1.0 0.9 4.4 5.0 6.4 Africa 1.4 1.2 1.3 6.8 7.2 6.9 Asia NA 1.5 1.4 NA 8.5 8.7 Average Emerging Markets Banks 1.4 1.5 1.3 6.3 8.1 8.4 Source: Bloomberg, Company data, J.P. Morgan estimates. Prices as of January 28, 2009. Notes for the Low-Income Finance Index: The Index is a market capitalization-weighted index that includes six financial institutions offering financial services to the lower income segments of the population, namely Bank Rakyat of Indonesia (BRI), Bank Danamon, Compartamos Banco, Financiera In- dependencia, IPF, and African Bank. We used J.P. Morgan estimates for the stocks covered by J.P. Morgan, and Bloomberg consensus estimates for IPF and Independencia. We reduced to a third the weight of BRI in the Index, as the bank's microfinance portfolio represents only about a third of its total loan book. Notes for the Global Emerging Markets Banks: We show market capitalization-weighted averages of banks covered by J.P. Morgan analysts, repre- senting a sample of 148 banks in all emerging markets. 3 Introduction As we write this paper, we are caught up in an un- precedented financial crisis and a truly global eco- Equity investment in microfinance is small, but nomic contraction. Liquidity shortages, currency dis- growing fast. As of December 2008, there were 24 locations, and global recession will all affect MFIs and specialized microfinance equity funds with total as- their clients in different ways.5 The impact of the cri- sets of US$1.5 billion under management. Institu- sis should become clearer over the course of 2009. tional investors are also showing interest in this In the short run, we expect to see higher costs of new market niche. Leading pension funds, such as funding due to tighter credit and to weaker emerg- TIAA CREF in the United States and ABP in Europe, ing markets currencies relative to dollar denomi- have made microfinance equity allocations of over nated loans. In the medium term we can foresee US$100 million as part of their socially responsible slower growth and lower earnings power. investment (SRI) strategies. Others are researching the field and waiting for clearer market conditions MFIs will have to seek funding from public agencies to invest. Venture capital companies such as Se- and development finance institutions (DFIs) to main- quoia and a few large private equity funds such as tain their liquidity as commercial funders withdraw. Legatum3 are testing the market with small equity They will need to strengthen their asset and liability investments in MFIs, with near-term potential for an management capabilities and be ever more vigilant initial public offering (IPO) in key emerging markets, about credit standards to maintain their outstanding like India. asset quality. The crisis may force some consolidation in the sector, and it will almost certainly put pressure While interest in microfinance equity investments on valuations. We anticipate no new listings in the soars, the actual microfinance equity market is still in short term. As for valuations, we expect multiples of its infancy. Primary issuances are still limited by the private transactions to drop toward 1x book value in small pool of investable MFIs and by the absence of 2009 from a median of 1.9x in 2008. However, the an organized secondary market. A vast majority of strong fundamentals of the microfinance industry transactions are in the form of private placements. To and the commitment of public and private investors date, only two pure microfinance IPOs have taken should bolster pricing going forward. MFIs with a place (Compartamos in Mexico and Equity Bank in solid funding base and strong asset quality should Kenya), and current market conditions are not fa- emerge stronger from this turbulence, and we can vorable to new ones. expect valuations to bounce back in 2010. The scarcity of information on microfinance valuation Our ambition is to provide a benchmark for valua- is a major challenge to establishing microfinance eq- tion. In this paper, we intend to address some of the uity as an investment niche. Investors and MFIs are key questions facing microfinance investors and MFIs: looking for reliable and accessible market references What is unique about the microfinance sector that may to improve equity pricing. However, little research justify an original valuation approach? What are the has been done on microfinance equity valuation, valuation methodologies used? What are the key val- due to the difficulty in accessing private data.4 uation drivers for private placement in microfinance? What is the performance of microfinance on the pri- This paper is an attempt to offer some useful bench- vate and public markets, in both absolute and relative marks to investors, microfinance managers, and an- terms? What are the challenges ahead for this new alysts and to help build market transparency. market niche in the context of the financial crisis? 3 Sequoia invested US$11.5 million in SKS, a leading Indian MFI, and Legatum invested in Share, another microfinance leader in India. 4 Barclay O'Brien, Valuing Microfinance Institutions, Savings and Development, Quaterly Review Issue 3-2006, Milan. 5 See CGAP Virtual Conference: "Microfinance and the Financial Crisis," November 18­20, 2008. 4 This paper consists of four parts. In the first part, we Table 3. Our Sample Represents the Largest underline what makes MFIs different from traditional Available Dataset to Date banks. We then describe commonly used valuation Transactions (#) Transactions (US$) methods and their applications in the context of 2005 28 107,969,182 MFIs. In a third part, we look at data from our sam- 2006 37 19,905,978 ple of 144 private transactions and discuss the key 2007 37 61,440,959 determinants of valuation. Finally, we look at the 2008 38 103,893,011 performance of publicly listed low-income finance in- stitutions and analyze the impact of listing on the NR 4 3,307,321 franchise performance. Total 144 296,516,451 Source: CGAP. NR: not relevant. This report is the result of the collaboration be- tween CGAP and J.P. Morgan. CGAP is bringing its deep microfinance market knowledge and J.P. Mor- gan its equity research skills and emerging markets expertise. Methodology & Sample for the Study Our analysis is based on two original samples: a private CEO had access to the underlying data. CGAP was re- transaction dataset on the performance of 60 MFIs and a sponsible for quality control of the data and preliminary sample of 10 publicly traded low-income finance institu- analysis. Only aggregated benchmarks based on at least tions (LIFIs): five data points were shared with J.P. Morgan. These ag- gregated data are available on CGAP's Web site, at Data on private equity transactions were collected by www.cgap.org. J.P. Morgan had no access to the underly- CGAP in a strictly confidential survey conducted in summer ing database. 2008. Four development finance institutions (DFIs), 13 mi- crofinance investment vehicles (MIVs), and 14 MFIs pro- The sample of publicly traded LIFIs was put together by vided data on their transactions from 2005 to September J.P. Morgan analysts.6 We identified 10 listed LIFIs with a 2008. Some of the survey participants are acknowledged broad microfinance focus. They include two publicly listed in Appendix III. The sample consists of 144 equity trans- MFIs (Compartamos and Equity), four banks with an em- actions, with 60 MFIs in 36 different countries. This is the phasis on small- and medium-sized enterprises (SMEs) and most comprehensive dataset on private equity placements microenterprise lending, and four consumer lenders. We in microfinance to date. We estimate that it represents recognize that these institutions present a different risk close to 50% of primary transactions and 70% of second- and return profile for investors than traditional MFIs. They ary transactions over the 2005­2008 period. CGAP fol- do not necessarily have an explicit social agenda, and their lowed strict procedures to ensure full confidentiality of the loan portfolio is less concentrated on microenterprise lend- data reported. This includes confidentiality agreements ing and more exposed to economic shocks. However, with all survey participants and restricted access policies to these institutions provide interesting valuation compara- the database. Only four CGAP staff authorized by CGAP's bles for MFIs because they operate in the same market. 6 CGAP, Microfinance Investment Vehicles (MIV) Disclosure Guidelines for Reporting on Performance Indicators - Microfinance Consensus Guidelines, 2007, http://www.cgap.org/gm/document1.9.3140/MIV%20Disclosure%20Guidelines%202007.pdf 5 Microfinance Equity Market As of 2007, there were 397 banks and nonbank financial in- On the funding side, DFIs such as IFC, KfW, and EBRD have stitutions reporting to MIX--the reference database for mi- been early equity investors in microfinance. Their aggregate crofinance performance--with an aggregate equity base of microfinance equity portfolio was valued at US$900 million roughly US$5.2 billion. Eighty-five percent of the equity in- as of 2007 and growing very fast. The second group of in- vestment is concentrated in the largest 100 MFIs. Eastern vestors consists of 24 specialized funds with an equity fo- Europe and Latin America account for almost two-thirds of cus, private equity funds, or holding companies of microfi- the microfinance equity. New share issuance is also in- nance banks. These funds are still relatively small in size, but creasing rapidly and passed the US$1 billion milestone in growing very rapidly. Their total assets under management 2007.7 were estimated at US$1.5 billion in December 2008.9 MFIs have built an impressive track record, and their fi- Since 2007, large private equity firms, such as Sequoia and nancial performance has been documented by MIX since Legatum,10 have made equity investments in select micro- 1995. In 2007, the average asset size of microfinance banks finance markets such as India. We estimate that the total grew by a notable 40%.8 Returns are solid with a median amount invested by these institutions is in excess of ROE of 14.1% in 2007. Asset quality remains high, with a US$200 million. Finally, leading pension funds with an SRI median portfolio at risk over 30 days (PAR30) of merely focus are making asset allocations in specialized microfi- 1.4%. However, MFIs are being affected by the global cri- nance equity funds. sis, and the performance of the microfinance industry is likely to deteriorate in 2009. 7 According to Adrian Gonzalez; analysis based on MIX 2007 data. 8 Adrian Gonzalez et al., MIX, based on microfinance banks reporting to MIX in 2007. 9 Based on CGAP MIV survey 2008 and CGAP estimates for growth projection in 2008. 10 Blackstone, Carlyle eye microfinance firms, The Economic Times, India, October 12, 2007. 6 1. Microfinance versus A. Double Bottom Line Traditional Banking Most MFIs emphasize both their financial profitabil- Do MFIs deserve a premium over traditional banks? ity and their social impact. The emphasis on this In this section, we assess the key differences and sim- double bottom line varies greatly among MFIs. How- ilarities between mainstream banks and MFIs from a ever, it is a unifying feature of MFIs to recognize the financial analysis perspective. positive benefits that access to financial services brings to clients and the need for responsible lend- What Makes Microfinance Financials Different? ing practices. Mainstream financial ratios and other factors used in A double bottom line helps MFIs attract soft lend- analyzing banks remain relevant when looking at ing and investments from public and socially re- MFIs. However, we believe MFIs are a unique type of sponsible investors--a positive factor in the evalua- financial institution because of their business model tion of risk.11 However, from an equity perspective, and clients. In this chapter, we introduce five major a double bottom line justifies a discount to valua- characteristics of microfinance that differentiate MFIs tions. A socially motivated business may undertake from traditional banks, which are summarized in less profitable activities to achieve its social goals, Table 4. such as expanding to remote areas or working with Table 4. Key Characteristics of MFIs What is specific to microfinance? Rationale Key Indicator 1 Double bottom line Most MFIs take pride in having a double bottom line Average loan balance per (i.e., both financial and social). The level of emphasis on borrower as a % of GDP the social mission varies among institutions. per capita Average cost per customer 2 High net interest MFIs often have higher net interest margins than their Net interest margins margins mainstream peers, because of the higher rates they charge. Intensity of competition in the country or region 3 Strong asset quality The quality of the loan portfolio is a key driver of profitability Past due loans over 30 days and requires different ratios than traditional banks, because + renegotiated loans of the specific nature of MFIs' loans. divided by gross loan portfolio Write-off ratio 4 High operating cost The relative smaller size and shorter maturity of loans drives Cost per borrower ratio transaction costs higher for MFIs. Operating expenses to assets 5 Longer term funding Leverage of mature MFIs is only slightly lower than that Duration of liabilities and of traditional banks. The main difference is in the liquidity assets position: MFIs have a favorable asset/liability maturity gap Public funding /Total (average maturity of liabilities is larger than the average liabilities maturity of assets). Because of their social agenda, MFIs Debt/equity are able to attract long-term funding from public institutions and SRI investors Source: CGAP, J.P. Morgan. 11 The association of European SRI investors estimated the size of the World SRI market at Eur4.9 billion in 2007 (Eurosif SRI study 2008). 7 clients who require training before they can become potential to generate high returns, which enables customers. These efforts may be reflected in a clients to pay higher interest rates to MFIs.13 higher cost structure for the business, although in 3.The macroeconomic explanation: limited com- some cases, this may also be rewarded with higher petition. Despite the rapid growth of microfinance yields. in most markets, there are still relatively few fi- nancial institutions that serve low-income people, B. High Net Interest Margins Driven by and competition on lending rates is limited. High Lending Rates Additionally, the sector lacks some clear standards MFIs have much higher NIMs12 than commercial for the disclosure of interest rates charged to clients. banks in emerging markets. This is because of the For example, some MFIs express their interest rate relatively high interest rates charged to microfinance as a flat rate using the beginning balance of the clients and limited competition for their business. In loan. Common disclosures would likely benefit both 2006, the average worldwide microfinance lending clients and investors. rate stood at 24.8%. We believe that there are three main reasons to justify the level of interest rates in Effects of the crisis on NIMs microfinance: The financial crisis is having a significant effect on MFI NIMs. MFIs report increased liquidity pressures to 1.The financial explanation: higher costs (espe- CGAP and funding cost increases between 200 ba- cially operating costs) justify higher rates. Mi- sis points (bps) to 500 bps since September 2008, be- crolending incurs relatively higher costs than tra- cause of tighter credit conditions in the local inter- ditional lending, with higher personal and bank market and from foreign lenders.14 To preserve administrative expenses because of the location of their margins, MFIs are increasing their lending rates, clients, small transaction size, and frequent inter- but some are experiencing difficulties in passing the action with MFI staff. full cost increase onto their clients. These measures 2.The microeconomic explanation: microenter- are unpopular in the context of the economic down- prises are profitable. Microenterprises have the turn and may conflict with the MFI's social agenda. Figure 1. NIMs Are Higher for MFIs, as of 2007 68.5% 28.2% 24.4% 20.2% 20.8% 17.7% 17.3% 18.7% 14.2% 6.1% ProCredit Equity Bank MiBanco ACLEDA Compar- SKS Banco BancoSol Top 45 MFIs EM Banks Bank Serbia tamos Solidario Source: Mix Market, 2007 when available. NIM is the net interest income divided by average total assets (defined as the financial revenue ratio on the MIX Web site). Under the TOP 45 MFIs, we show the unweighted average for all the MFIs with total assets above US$150 million (according to MIX, as of 2007). EM Banks include a cross-section of banks covered by J.P. Morgan analysts for emerging markets (except Asia). 12 The median NIM for MFIs reporting to the MicroBanking Bulletin is 22%, while the average for emerging markets banks covered by J.P. Morgan analysts (Asia was not included) stands at approximately 6%. 13 Research in India, Kenya, and the Philippines found that the average annual return on investments in microenterprises ranged from 117 to 847%. Helms and Reille, "Interest Rate Ceilings and Microfinance: The Story So Far," CGAP, 2004. 14 In early 2008, most foreign lender under priced country risks (see Reille and Forster, Focus Note 25, CGAP). 8 Not all MFIs will be affected by credit scarcity. MFIs ing Bulletin have demonstrated high asset quality, with a large share of demand and savings deposits with an average portfolio at risk over 30 days (PAR30) depend less on bank borrowing. Also, MFIs with ac- consistently below 4%.15 cess to government funding or concessional funding from development investors should fare better and PAR30 shows the value of all loans outstanding (prin- maintain comfortable NIMs. cipal and interest) that have one payment past due for more than 30 days. It is important to look at C. High Asset Quality Is Driven by PAR30 in conjunction with the write-off ratio, to en- Original Collection Method sure that the MFI is not maintaining a low PAR30 by writing off delinquent loans. Historically, MFIs have had stronger asset quality than mainstream banks in emerging markets. MFIs Effect of the crisis on asset quality have developed original lending technologies. These As of January 2009, the effect of the current financial include good knowledge of customers, supported by crisis on asset quality is not yet apparent. Microlend- frequent visits to clients' businesses; nontraditional ing has proven to be resilient to economic shocks in guarantees, such as group guarantees; and excellent the past, such as during financial crises in East Asia and information systems that track arrears weekly or even Latin America. This is because microfinance customers daily. MFIs also have strong incentives for perform- tend to operate in the informal sector and to be less ance: clients who repay loans can build a good credit integrated into the global economy. They also often history and get access to larger loans and better provide essential products, such as food or basic serv- terms. MFI loan officers also have strong financial in- ices, that remain in high demand even in times of cri- centives to ensure repayment, because the variable sis. However, the current financial crisis and the triple part of their salaries depend on portfolio quality. All effect of economic downturn, fall in remittances, and these factors translate into high asset quality. Over higher food prices have not been experienced before. the past 10 years, MFIs reporting to the MicroBank- It may well translate into lower asset quality for MFIs. Figure 2. PAR30, as of 2007: Solid Asset Quality 8.1% 4.2% 3.7% 3.2% 2.7% 1.5% 1.8% 2.0% 1.0% 0.1% 0.2% ProCredit Equity MiBanco ACLEDA Compar- SKS Banco BancoSol Top 45 Micro- EM Bank Serbia Bank tamos Solidario MFIs finance Banks * Banks Source: Mix Market. J.P. Morgan. Data as of 2007. Sample of 10 largest MFIs focusing on loans to microentrepreneurs. BRI and Grameen Bank, respectively the largest and 3rd largest MFIs in the world according to MIX, are not included in our sample, because PAR information is not available. Under the Top 45 MFIs, we show the unweighted average for all the MFIs with total assets above US$150 million (according to MIX, as of 2007). Data for Microfinance Banks are an unweighted average for all microfinance banks, according to MIX. EM Banks include a cross-section of banks covered by J.P. Morgan analysts for emerging markets (except Asia). * For EM Banks, we show the ratio of nonperforming loans to total loans, which typically shows the ratio of loans that are 90 days past due. Therefore the ratio for banks is not directly comparable with PAR30, but gives an indication of relative asset quality. 15 Because of the short maturity of the loan (often less than one year) and frequent installments for repayment (often weekly), we look at loans that are past due after 30 days, as opposed to 60 or 90 days, which is common for traditional banks. 9 Well-managed MFIs that have a conservative credit In terms of indicators, the ratios of operating ex- policy and a focus on microenterprise lending should penses to total assets or operating expenses to total remain resilient. MFIs with weak credit standards loans appear to be the most relevant. Other popular and large exposure to small and medium-sized en- measures are the cost per borrower (Operating Ex- terprises (SMEs), housing, and consumer lending are penses / Average Number of Active Borrowers), staff likely to be affected the most. productivity (Number of Active Borrowers / Total Staff), and the loan officer productivity (Number of D. High Operating Costs Are Driven by Active Borrowers / Number of Loan Officers). Small Transactions Effect of the crisis on operating costs The costs of providing microcredit are high because MFIs have seen their operating costs increase in of the small size of loans, the location of clients, and the first half of 2008 as a result of inflation and the high level of interaction clients have with MFI higher input costs. Staff costs and transportation staff. Efficiency is a key concern because MFIs require costs have been affected the most, with a spike of much more staff and administrative efforts per dol- over 30% reported in Latin American countries. In lar lent than mainstream banks. As can been seen in 2009, we expect inflation to return to lower levels, Figure 3, MFIs exhibit much higher operating costs thus reducing the pressure on wage increases and than mainstream banks. transportation costs. However, operational effi- ciency, as measured by operating expenses to However, the cost structure of MFIs tends to im- loans, may decrease as a result of slow or even prove over time as a result of economies of scale, negative growth in the microfinance portfolio. better loan technology, and an increase in the aver- MFI staff productivity might also suffer as credit age loan size. Competition also can put pressure on agents allocate more time to loan monitoring and MFI margins and drive efficiency improvements. collection. Figure 3. Operating Expense to Gross Loan Portfolio Is Higher for MFIs Than for Traditional Banks, as of 2007 34.2% 24.0% 15.4% 16.2% 11.5% 12.8% 14.3% 13.7% 14.0% 12.3% 11.5% 7.0% ProCredit Grameen Equity MiBanco ACLEDA Compar- SKS Banco BancoSol Top 45 Micro- EM Bank Serbia Bank Bank tamos Solidario MFIs finance Banks Banks Source: MIX, J.P. Morgan. Data as of 2007. For ProCredit, the percentage indicates operating expenses to total assets. Averages for the top 45 and for EM Banks are unweighted. EM Banks include a cross-section of banks covered by J.P. Morgan analysts for emerging markets (except Asia). Data for microfinance banks are an unweighted average for all microfinance banks, according to MIX. 10 E. Longer Term Funding Figure 4. Breakdown of Funding for Microfinance Banks In some markets, the credit squeeze is affecting MFIs by making funds more difficult to obtain, more costly, Equity and available in shorter maturity. Therefore, in our 21% analysis, we paid special attention to the liabilities side of MFIs' balance sheets: equity, deposits, and other funding. Microfinance exhibits three major dif- Borrowings ferences vis-à-vis traditional banks. 42% MFIs have overall lower leverage than Deposits traditional banks 37% Overall, MFIs tend to have lower leverage (mea- sured as total equity to assets) than traditional banks. Source: MicroBanking Bulletin data for all banks (2007). Deposits com- Our unweighted average leverage for the 45 largest prise demand, savings, time deposits, and deposits from banks. MFIs (with assets above US$150 million) stands at 19%, significantly lower than the J.P. Morgan emerg- Deposits are not necessarily a more stable and less ing markets benchmarks.16 expensive source of funding The cost of funding through retail deposits (in par- However, leverage is increasing over time, and ticular, demand deposits, which typically are not re- large and older MFIs are reaching equity leverage munerated) is not necessarily cheaper than other levels comparable to traditional banks, as shown in funding sources. This is because capturing and serv- Figure 5. Figure 5. The Largest MFIs Have Similar Leverage to Traditional Banks. However, on Average, the Equity-to-Assets Ratio Is Lower at Banks, as of 2007 44.8% 28.1% 19.4% 15.7% 7.8% 9.1% 11.0% 10.7% 11.6% 9.9% 10.9% ProCredit Grameen Equity MiBanco ACLEDA Compar- SKS Banco BancoSol Top 45 EM Bank Serbia Bank Bank tamos Solidario MFIs Banks Source: Mix Market. Leverage information for BRI is not available. Sample of 10 largest MFIs focusing on loans to microentrepreneurs. Data for BRI are not available. We also show the average for all the MFIs with total assets above US$150 million (according to Mix, as of 2007). For this extended sample of the 45 largest MFIs, we use the broad definition of microfinance. Averages for the top 45 and for EM banks are unweighted. EM banks in- clude a cross-section of banks covered by J.P. Morgan analysts for emerging markets (except Asia). 16 Those benchmarks represent a wide selection of banks covered by J.P. Morgan analysts across emerging markets (except Asia). 11 icing small deposits is costly and requires a more ex- and often unhedged foreign exchange exposure. pensive physical infrastructure. MFIs exposed to hard currency debts have already suffered severe exchange losses since September As with traditional banks, some types of MFIs' de- 2008 as a result of the depreciation of emerging posits are less stable than others. Large institutional markets currencies vis-à-vis the U.S. dollar. Un- deposits and interbank deposits can move quickly, hedged currency exposure will likely be a key theme whereas retail deposits (both demand and savings) for MFIs in 2009. tend to be more stable. Overall, we think MFIs with access to public funds, Borrowings: Key feature is longer maturity and with a strong retail savings base and covered for- Because of their social agenda, MFIs are able to at- eign exchange risk exposure, will better weather the tract longer term funding from public agencies, mi- current financial crisis. crofinance specialized funds, and development in- stitutions.17 This provides MFIs with a favorable tenor There are five major characteristics that differentiate mismatch between liabilities (longer tenor) and assets MFIs from traditional banks. But the question re- (typically less than a year). mains, do MFIs deserve a premium or discount over banks? There are both pros (higher NIMs, higher Effect of the crisis on the liquidity position of MFIs growth outlook, access to long-term funding from Large MFIs should not face a major liquidity developmental investors, and higher resilience in squeeze in 2009 because of their favorable maturity economic downturn) and cons (social agenda, small gap and access to emergency liquidity facilities of size, lower efficiency, and reputation risks of lending public investors and governments funds, such as to the poor). A premium or discount should be eval- IFC, KfW, and IDB. However, most of this foreign in- uated case by case, based on the MFI characteristics vestment is in hard currency, leaving MFIs with large and market environment. 17 The average maturity of loans from microfinance investment funds is 36 months, and the average maturity of loans from DFIs is 60 months. CGAP MIV Survey, 2008. 12 2. Technical Overview of institutions or comparables transactions at other in- Valuation Methods stitutions. This section addresses commonly used approaches Table 5 summarizes four approaches and highlights to equity valuation. The three most widely used val- their relative advantages and limitations. Investors uation techniques involve two types of multiples tend to rely on both absolute and relative valuation and future cash flows. Multiples can be based on his- methods. We recommend residual income analysis as torical values (trailing multiple) or future estimates a sound absolute valuation method; we also advise (forward multiple) of prior transactions of the same investors to cross-check valuation with multiples of Table 5. Summary of Pros and Cons of Commonly Used Valuation Methods Method Pros Cons Multiple: Price to Book · Simple and most widely used in the industry · Comparison with other transactions is · Book value being a positive number, P/BV is difficult because of differences in context, always meaningful accounting standards, tax treatment, and · Looking at multiples is an alternative way to different leverage of the institutions (no true address the issue of premium / discount comparable) · Book value does not indicate future earnings power of the institution · Book value could be subject to impairments · Multiples comparison is subject to market exuberance (bubbles) Multiple: Price · Simple and widely used in the industry · Comparison with other transactions is to Earnings · Looking at multiples is an alternative way difficult because of differences in context, to address the issue of premium / discount accounting standards, and tax treatment (no true comparable) · Cannot be used if earnings are negative; mostly used in the case of a stable and predictable earnings stream · Historical earnings do not indicate future earnings power of the institution · Multiples comparison is subject to market exuberance (bubbles) Discounted Cash · Detailed valuation method · Not appropriate for young MFIs, for which Flow Analysis · Conceptually sound method, because future assumptions may be unrealistic investor should be willing to pay for the · Valuation is very sensitive to terminal value present value of future cash flows and discount rate used in the valuation, which by nature are subject to error · Not the best method in the case of minority shareholders, because only majority shareholders can decide the use of future cash flows Residual Income · Detailed valuation method · Valuation is very sensitive to discount rate · Conceptually sound method, because it · Not appropriate if the capital structure of adds the present value of expected the MFI is expected to change significantly future residual income to the current book value · Conceptually sound method, because it includes a charge for equity capital · Terminal value represents a smaller portion of total valuation, if compared with discounted cash flow method · Appropriate for young MFIs that may have no earnings in the short term Source: J.P. Morgan. 13 comparable transactions and companies, which Two types of P/E measures are commonly used: the stand for the relative approach. trailing P/E and the forward P/E. The trailing P/E compares the current market price to the EPS of the Relative Valuation: P/BV Multiple four most recent quarters of the company. This meas- ure is commonly quoted in newspapers. The for- The price-to-book value (P/BV) multiple is the ratio of ward P/E compares the current market price of the the market price per share to the book value per stock to an estimate of future EPS. The driver of the share of the company. To find book value, we sub- P/E multiple is the estimated EPS growth of the in- tract total assets from total liabilities. Since we are stitution. looking for the value of common stock only, we also subtract the value of preferred stock. Book value, be- The main advantage of the P/E multiple is that earn- ing a balance sheet item, is cumulative in nature (un- ings power (EPS) is the chief focus of analysts and in- like earnings per share, which is a flow item) and rep- vestors. As such, it is widely used and recognized. resents the investment of shareholders in the firm over time. The driver of P/BV is the return on equity The main limitations of the P/E multiple rest in the (ROE) of the institution. fact that earnings can be volatile, or even negative, in which case P/E becomes meaningless. This is par- Finance companies typically hold a large share of rel- ticularly true for young MFIs. Also, companies can atively liquid assets, making P/BV a widely used and have different accounting rules, which make in- relevant valuation measure for the financial services tertemporal and intercompany comparisons difficult. industry. Book value is meant to reflect the net mar- In particular, different provisioning policies for loan ket value of assets. For nonfinancial firms, the balance losses and tax credits may have a significant effect on sheet often reflects historical values for assets. In the net income reported by the company. As in the the case of financial institutions, book value is also re- case of book value, analysts are expected to adjust ferred to as net asset value (NAV). net income figures for variation in accounting policies to reflect the actual earnings power of the company. One of the main limitations of this ratio is that book value ignores some assets that may be critical to the A key point to keep in mind with the P/E multiple is company, such as the value of human capital. In most the potential dilution of earnings caused by the con- cases, MFIs tend to have little to no intangible assets version of options, warrants, and convertible bonds or goodwill. However, investors should look at write- to common stock. off policies (which vary among MFIs) and unhedged foreign exchange exposures to adjust book values, be- Absolute Valuation: Discounting Future Flows cause those two items can significantly impair capital. Defining future earnings flows and discounting them The P/BV multiple is by far the most commonly used to the present is another common valuation method. methodology in microfinance. The main advantage of this valuation method is that it is more detailed than the multiples analysis. It re- Relative Valuation: P/E Multiple quires the analysis to make explicit company revenue forecasts over a number of years (most often, fore- The P/E multiple is the ratio of the market price per casts are for 5­10 years). On the other hand, because share to the earnings per share (EPS) of the company. it is so detailed, it is also a complex methodology 14 that requires understanding assumptions underly- and mature financial institutions that have a defined ing projections of revenues. dividend policy. The discounted cash flow (DCF) valuation is appro- FCFE priate for young MFIs that are growing rapidly. In our FCFE starts with the cash flows available to equity private transactions study, the DCF method was used holders in the firm. It consists of the sum of the op- by less than 10% of respondents, while all investors erational cash flow (net income plus any noncash reported using P/BV multiples and most also used items, such as provisions), the investing cash flow, P/E multiples. and the financing cash flow. Because they represent the cash available to equity holders only, they are dis- Different types of earnings flows can be dis- counted at the cost of equity. counted. These depend on the definition of cash flows chosen. The purpose of this method is to de- Residual income analysis fine the earnings power of a company and there- Unlike the pure DCF techniques, which forecast fu- fore the amount of cash it will generate for in- ture cash flow values and discount them back to the vestors. Some analysts may choose dividends as a present, the residual income model is a hybrid that good proxy for cash, while others may look at free starts with the current book value and adds the pres- cash flow to the firm (FCFF), free cash flow to eq- ent value of expected future residual income. Resid- uity investors (FCFE) described below, or residual ual income is the difference between net income and income (described below). At the end of the ex- the opportunity cost to shareholders to invest in the plicit forecast period, a terminal value is calculated MFI's equity (calculated as the cost of equity multi- assuming a constant growth rate for earnings into plied by book value). The main advantage of this the indefinite future. Once defined, those future method over pure DCF is that the terminal value rep- cash flows are discounted to the present using a resents a smaller part of the total valuation. discounting factor--in effect, these various calcu- lation approaches find the present value of a future It is particularly useful in situations where the firm is stream of cash. either not paying dividends or is paying them in an irregular pattern. Also, for young, growing MFIs that The difficulty of DCF valuations lies in their depend- will start generating a positive free cash flow only in ence on two inputs: (i) the terminal growth rate of the future, it is easier to use the current book value earnings and (ii) the discount rate used (the cost of as a base for valuation. However, the method may equity). An important limitation of DCF valuations is not be appropriate for companies that will see their that a sizeable part of the final value of equity comes capital structure change dramatically, in particular in from the terminal value, and this terminal value is very the case of an MFI that increases its leverage or is ex- sensitive to changes in those two assumptions. pected to make acquisitions. Changes to these estimates lead to large variations in the price calculated. Remarks on the Cost of Equity For MFIs, the most appropriate DCF methods are the The cost of equity (COE) is the return that the FCFE model and the residual income analysis. Divi- providers of equity capital expect in return for their dend discount models are more relevant for stable funds. The most commonly used method of finding 15 COE is the capital asset pricing model (CAPM), disburse small loans, shorten maturities, keep a where COE is the sum of the risk-free rate (rf) and a large client base, maintain intimate/direct knowl- premium for bearing the stock's risk. This premium is edge of customer, use dynamic incentives by con- the product of the stock's beta () (sensitivity of the ditioning new loans on full repayment of a previous stock price to changes in the market return) and the ones, require borrowers to deposit a percentage market risk premium (MRP), which is the expected of the loan at a bank, and sometimes rely on peer market return over the risk-free rate. group knowledge of a borrower's repayment ca- pacity and social pressure for repayment. Based on COE = rf + * MRP historical delinquency data, it seems that these techniques more than compensate for the ab- The risk-free rate is calculated as the yield on long- sence of collateral. term government bonds. Investors commonly use 2.Their client base operates in safer sectors. Mi- the 10-year U.S. government bond as a proxy for the crofinance customers tend to operate in the infor- risk-free rate and add to it a country risk. MRP is the mal sector and be less integrated into the formal expected return of the market (in this case, the eq- economy. They provide small-ticket items and of- uity market) over the risk-free rate on the long run. fer essential products, such as food or clothing. Be- We follow convention and consider an MRP of 5%, cause they serve the needs of their close commu- on average. Following a historical approach, the nity, microborrowers are also less dependent on analysis suggests that the equity risk premium grav- imports and currency fluctuations. itates around 5­7%.18 3.MFIs' funding tends to have a longer maturity than their assets. As mentioned previously, we be- Remarks on beta and Diversification Effect lieve that MFIs, on average, have a favorable du- The main unknown in this CAPM equation is there- ration mismatch. The main reason for this is that fore . As already noted, beta represents the sensi- they are able to attract lines of credit from public tivity of the stock price to changes in a specific eq- agencies, DFIs, and social investors, which tend to uity market. A beta of 0.9 indicates that the stock have long tenures. price of the company moves by 0.9 when the bench- mark index moves by 1. This suggests that adding a Empirical evidence tends to suggest that MFIs fare stock with lower beta could help minimize the over- relatively better than other financial institutions in all volatility of a portfolio. the event of an economic recession, in particular for asset quality. The resilience of microfinance to eco- We believe that in the long run, MFIs should have a nomic shocks has been documented in numerous lower beta than traditional financial institutions and country case studies (including Indonesia, Bolivia, therefore should offer diversification benefits to port- and Mexico).19 In 2001, a U.S. deceleration affected folio managers. We see three main reasons to support the traditional banking sector in Mexico but had lit- our assumption on the counter cyclicality of MFIs: tle effect on Compartamos' operations. Microfi- nance banks in Indonesia fared much better than 1.MFIs have original risk management techniques. mainstream banks during the 1999 crisis, in particu- The following characteristics of microfinance can lar when looking at asset quality. Two recent econo- be seen as effective risk management techniques: metric analyses also found no strong and statistically 18 Dimson, Marsh, and Staunton, Triumph of the Optimists, Princeton University Press, 2002. 19 Glenn D. Westley, Microfinance in the Caribbean: how to go further, Inter American Development Bank, 2005, Technical paper. 16 significant correlation between GDP growth and Our view is that relative valuation methods (compa- the financial performance of MFIs, although data rable transactions and companies) allow investors availability is still too scarce to draw solid conclu- to go around the problem of liquidity discounts (and sions.20 other discounts for that matter) and, therefore, should be used in conjunction with the absolute At the same time, we recognize that MFIs are more methods described above. exposed to regulatory risks. Change in banking reg- ulations, such as caps on interest rates, can under- Valuation Methods Complement Each Other mine the profitability of microfinance. MFIs lending to the poor with relative high interest rates also are In some cases (mostly for Indian MFIs), we came exposed to political pressure and media scrutiny. across more original valuation tools, such as multiples of price to loan book or price to number of clients. Overall, however, our view is that MFIs tend to pres- They remind us of multiples used to value Internet ent a lower operational risk than traditional banks, companies (before the bubble burst). The rationale which in turn justifies a lower beta. behind those is that an MFI should be able to extract value from its loan book and each of its customers. Remarks on Liquidity However, we find those multiples of limited use, be- cause investors have no benchmark to draw conclu- Most investors in the microfinance space would re- sions from them and eventually will want to look at duce normal valuation by some liquidity (or illiquid- current book value and future earnings power. ity) discount, reflecting the absence of a liquid mar- ket for MFI shares. Based on our conversations with Valuation models based on an absolute approach market participants, we believe that reasonable illiq- (DCF, residual income) or on a comparative transac- uidity discounts would range between 10% and 30% tion approach are all useful frameworks. When the of the normal value of the MFI. The value of the dis- assumptions in the models are consistent, those dif- count would depend on a series of factors, such as ferent approaches should give similar values. In prac- the liquidity on the local stock exchange where the tice, it may not always be possible to forecast every MFI would be traded, the percentage of free float, variable with the same degree of accuracy. and shareholding structure. In the case of a young, fast-growing MFI, the residual Academic research has tried to apply concepts of op- income model may prove more useful because pro- tion pricing to the problem of liquidity, by valuing liq- jecting future cash flows could be difficult. For estab- uidity in a similar way as an option to sell a share (put lished MFIs with a stable earnings stream, the DCF option).21 We believe this approach is interesting model is more appropriate. As for most companies, conceptually, but gives limited empirical guidance to looking at the multiples of comparable companies or investors, because of the limitations of the model's comparable transactions in the past is an important assumptions. and necessary cross-check in the valuation process. 20 Adrian Gonzalez, Resilience of microfinance institutions to national macroeconomic events: an econometric analysis of MFI asset quality, MIX discussion paper No 1, Washington DC, 2007; Nicholas Krauss and Walter I., Can microfinance reduce portfolio volatility? NYU Stern School of Business, Working paper, New York, 2008. 21 Dyl, Edward and George Jiang, "Valuing Illiquid Common Stock," Financial Analysts Journal, vol.64, Number 4, pp. 40­47. 17 3. Valuation of Private Equity multiples dropped in 2006 and 2007, but recovered Transactions--Microfinance in 2008. The peak in 2008 might be explained by the Institutions relatively strong fundraising by microfinance funds in 2007 and a shift from debt to equity. The large pool In this section, we analyze a sample of MFI private eq- of investible funds applied to a relatively small num- uity transactions. Our sample covers 144 transactions ber of transactions that drove up valuation multiples. that occurred between January 2005 and September 2008 and with an aggregate value close to $300 mil- Our analysis is based primarily on median multiples lion (see Table 6). As explained earlier, transaction data (P/BV and P/E) to compensate for the effects of out- were collected and processed by CGAP, and commu- liers, but we also present unweighted averages (see nicated to J.P. Morgan in the form of aggregates. This Table 7). Table 8 breaks down median historical mul- was done to preserve the confidentiality of the under- tiples by region. lying data and the anonymity of survey participants. CGAP tables with aggregated data on equity valuation The data were collected during summer 2008 (i.e., are available on its Web site (www.cgap.org).22 before the credit crisis hit the financial markets). Our historical multiples are based on the latest book Our analysis focuses on historical multiples (i.e., his- value or the latest 12-month earnings available for torical price to earnings and historical price to book the MFI.23 We recognize that earnings and book value multiples, which are also called trailing multiples). value can be distorted by different treatments of Although forward multiples are also available, we con- taxes and provisions across MFIs.24 sider our analysis more robust when based on past au- dited data rather than projected earning estimates. The current financial crisis will inevitably affect mi- crofinance. Planned microfinance IPOs for 2008 were We conducted a statistical analysis on the dataset postponed, and it has been increasingly difficult for and explored the influence of 16 variables on the val- MFIs to raise new equity (as well as debt), with the uation of MFIs. Although the dataset is limited, our exception of a few notable transactions. The financial analysis provides insights on market benchmarks for performance of MFIs may well deteriorate in 2009 as private equity transactions and valuation drivers. a result of adverse macroeconomic conditions, in particular the higher cost of funds. Some MFIs could Valuation Between 1.3 and 1.9x Historical face losses and equity write-downs on the back of ris- Book; 7.2 and 7.9x Historical Earnings ing past due loans and foreign exchange losses. Eq- uity valuation will be affected given that valuations The median P/BV multiples over the past four years for listed emerging market banks are down roughly ranged between 1.3x and 1.9x for P/BV, and be- 50% since Lehman's bankruptcy. We also think that tween 7.2x and 7.9x for P/E. As Table 7 shows, these fewer transactions will take place and that distressed Table 6. Number and Value of Transactions, by Year 2005 2006 2007 2008 NR Total Transactions (#) 28 37 37 38 4 144 Transactions (US$) 107,969,182 19,905,978 61,440,959 103,893,011 3,307,321 296,516,451 Source: CGAP. 22 CGAP will continue to maintain and update its confidential database on equity pricing and provide market benchmarks for private transactions. 23 The book value we used in our calculations of P/BV multiples is generally the book value as of the end of the year preceding the transaction. 24 See MicroBanking Bulletin, which attempts to normalize results for differences in accounting policies. 18 Table 7. Valuations Rebounded in 2008 Historical P/E Historical P/BV Sample Year Unweighted Average Median Unweighted Average Median # 2005 9.1 7.9 1.6 1.7 28 2006 8.6 7.4 1.5 1.3 37 2007 9.9 7.2 2.5 1.3 37 Jan­Sept 2008 10.2 7.9 2.2 1.9 38 Source: CGAP. Valuations rebounded in 2008 mostly due to the high multiples applied to a small number of transactions. Table 8. Breakdown, by Region: Eastern Europe and Asia Exhibit the Highest Historical P/BV in 2008 Median Historical P/E Median Historical P/BV 2005 2006 2007 2008 2005 2006 2007 2008 Africa 5.6 6.2 17.1 11.8 0.9 1.2 1.6 1.7 Asia NA NA NA 6.0 1.7 2.0 7.0 2.4 ECA 9.3 8.6 13.8 9.3 1.8 1.3 1.0 2.0 LAC NA 6.7 5.6 7.8 1.4 1.2 1.1 1.2 Source: CGAP. NA = less than 5 transactions. deals to rescue failing MFIs may bring down the av- plotting ROE against P/BV and net income growth erage multiple of transactions. However, we do an- against P/E, using country and regional averages.25 ticipate that well-managed MFIs will demonstrate im- pressive resilience to the crisis. No link between profitability and valuation In the case of the P/BV multiple, a higher ROE, which We expect valuations for private transaction to move is a measure of profitability, should coincide with a toward a median of 1.0x book value in the next 12 higher multiple. But to our surprise, this is not the months, mirroring the drop of approximately 50% in case for microfinance transactions. Table 9 shows the valuation of traditional banks since September no relation between the current profitability of an 2008. But the business fundamentals of microfinance MFI and its value.26 The wide disparities between re- remain strong. We expect valuation to bounce back gion and country averages indicate the immaturity of in 2010­2011 as economic conditions and credit the microfinance private equity market and the lack markets improve. of market consensus for MFI valuation. Back to Basics: Drivers of Valuation Are Usually India is a clear outlier, with an average P/BV of 6.7. This Profitability and Income Growth canbeexplainedby(i)thelargemarketandgrowthpo- tential for microfinance in India, (ii) the strong demand Profitability and earnings growth usually drive valu- for Indian equity investments from leading private eq- ations. We tested this assumption on the dataset by uity funds, and (iii) the lack of market benchmarks. 25 We present country data only when our sample includes 5 or more transactions (for more details, see methodology of the study at the beginning of this report). 26 An analysis of disaggregated data confirms this finding. 19 On the other hand, Africa commands a relatively the skyrocketing growth in the supply of capital high P/BV valuation (1.5x), despite a negative median (+100% in 2007) from DFIs and social investors for ROE. This surprising result might be influenced by microfinance equity deals in Africa. the dearth of MFIs with strong return in Africa and Table 9. Historical P/BV Multiples and Median ROE Average Median P/BV ROE (%) P/BV ROE (%) Africa 1.9 3 1.5 1 Asia 3.3 3 2.1 13 ECA 1.7 15 1.7 16 LAC 1.5 23 1.2 21 Ghana 2.3 8 1.7 13 Uganda 1.5 6 0.9 4 India 6.7 9 7.0 17 Cambodia 2.1 23 1.9 23 Mongolia 1.8 19 1.8 18 Tajikistan 1.4 3 1.4 3 Bolivia 1 22 1.1 23 Nicaragua 1.7 26 1.3 29 Peru 1.3 21 1.2 21 Source: CGAP. Figure 6. Scatterplot Reveals No Correlation between P/BV Multiple and Current Profitability (ROE) 8 7 India 6 5 4 P/BV 3 Asia Mongolia Cambodia 2 Africa Tajikistan Ghana 1 ECA Bolivia Nicaragua Uganda LAC, Peru 0 5% 0% 5% 10% 15% 20% 25% 30% ROE Source: CGAP. Median numbers are shown in this chart. Numbers correspond to medians. LAC: Latin America and the Caribbean; ECA: Eastern Eu- rope and Central Asia. 20 Positive Correlation between Income Growth and P/E multiples were not available for Indian transac- Valuation tions, which explains the relatively low reading for For P/E multiples, higher earnings growth should Asia as a whole on a P/E basis, versus the high P/BV command a higher multiple. This relationship is evi- for the region. Also note that this analysis does not denced in Figure 7 and Table 10, though Asia is a clear take into account the variation in the number of outlier.27 In our view, investors are assigning a premium shares and the effect of equity dilution. to MFIs with strong earning growth prospects. Table 10. Historical P/E Multiples and Net Income Growth Average Median Income Growth (%) P/E Income Growth (%) P/E Africa 1 11.8 16 10.9 Asia 126 6.5 64 4.2 ECA 53 11.6 35 9.4 LAC 60 7.9 20 6.8 Uganda 6 8.1 22 6 Cambodia 57 7.4 53 4.5 Mongolia 51 10.2 33 9.5 Tajikistan 61 17.9 75 13.8 Bolivia 22 5.7 27 6.2 Nicaragua 19 6.7 20 5 Peru 64 9.1 22 6.8 Source: CGAP. Figure 7: Scatterplot of Historical P/E and Earnings Growth Shows Some Correlation 16 14 Tajikistan 12 Africa 10 ECA 8 Mongolia Bolivia P/E Uganda Peru 6 LAC Cambodia 4 Nicaragua Asia 2 0 0% 10% 20% 30% 40% 50% 60% 70% 80% Net Income Growth Source: CGAP. P/E multiples for India are not available, which is why the country does not appear in this chart. Net income growth corresponds to the net income growth projected at the time of the transaction by the participant to our survey. Numbers correspond to medians. LAC: Latin America and the Caribbean; ECA: Eastern Europe and Central Asia. 27 This is also confirmed by an analysis based on disaggregated data (see correlation analysis below). 21 Transaction Size and Net Income Growth Are · Only significant correlations are considered (these the Main Drivers of Valuations are all values marked with one or more asterisks). · The sign of the correlation measure indicates the We selected 16 variables, including geographic distri- direction of the correlation. A + stands for a posi- bution, deal features, and MFI characteristics, and con- tive correlation, while a - stands for a negative ducted a statistical analysis to identify valuation drivers correlation. for private transactions in the microfinance space. · The closer the indicator is to zero, the weaker the correlation; the closer the indicator is to 1, the First, we looked at correlations between each indi- stronger the correlation. vidual variable and the valuation of the institution measured through either P/E or P/BV (see Table 11). Overall, we observe more significant correlations of The indicator we use measures the strength of a lin- the selected variables with P/E than with P/BV. Three ear correlation between the two variables and is in- variables show significant correlations with both terpreted in the following way: multiples: Table 11. Bivariate Correlations · Leverage. The evidence on leverage, measured as the ratio of debt-to-equity, is inconclusive. While it P/E P/B is negatively correlated to P/E, it is positively cor- Leverage 0.29 ** 0.53 *** related to P/BV. Operating Expense Ratio 0.29 ** 0.07 · Net income growth. The indicator clearly has a PAR30 0.15 0.13 moderate positive effect on valuation, either meas- Net Income Growth 0.46 *** 0.46 *** ured as P/E or as P/BV. ROE 0.32 ** 0.14 · Transaction value. It has a low, but significant cor- Avg. Loan Balance 0.08 0.12 relation with valuation. Larger transactions lead to higher valuations. Avg. Savings Balance 0.06 0.03 Savings/Assets 0.08 0.18 In a second step, we conducted a regression analy- Age 0.41 *** 0.1 sis testing the influence of a subset of variables28 on Gross Loan Portfolio ($m) 0.20 * 0.12 valuation, controlling for the influence of other vari- Legal Type: Bank 1.84 1.96 ables. Table 12 summarizes the regression outputs. Avg. Loan Size (GNI) 0.08 0.12 The results corroborate our findings from above: net Transaction Value ($m) 0.21 * 0.25 ** income growth and transaction size exert a signifi- Market Capitalization ($m) 0.37 *** 0.54 cantly positive effect on valuation. As in the case of Buyer is DFI 5.54 * 0.53 bivariate correlations (see Table 11), we find more significant effects on P/E than on P/BV.29 We also con- Source: CGAP. Operating expenses ratio is calculated as operating expenses divided by gross loan portfolio. ducted an analysis on the impact of each variable on Note: * significant at 5% ** significant at 1% *** significant at 0.1% Correlations are measured through the Pearson Correlation Coeffi- historic P/E and P/BV (see Appendix II). cient r. Its values are interpreted as 0$2m 14.0 12.2 3.5 2.5 21 Source: CGAP. Table 23. Market Capitalization Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <$5m 8.9 6.2 1.7 1.5 61 $5m­$10m 11.1 9.1 1.5 1.3 28 $10m­$20m 7.4 6.9 1.6 1.3 31 >$20m 11.6 9.7 3.6 2.3 23 Source: CGAP. Table 24. Buyer Type Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample MIV 9.2 7.2 1.9 1.3 71 IFI 14.3 8.6 2.4 1.8 36 Other 7.8 7.4 1.8 1.5 28 Source: CGAP. Table 25. Scale: Number of Borrowers Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample Small 10.9 8.2 1.6 1.3 31 Medium 11.5 7.8 1.8 1.4 27 Large 8.0 7.3 2.3 1.5 66 Source: CGAP. Small=<10,000 borrowers, medium=10,000­30,000 borrowers, large=>30,000 borrowers. 37 Table 26. Age of the MFI Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample New 14.7 13.0 1.9 1.7 38 Young 8.7 8.1 2.6 1.5 36 Mature 7.1 5.8 1.6 1.2 51 Source: CGAP. New=0­6 years, young=6­10 years, mature=>10 years Table 27. Legal Status Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample Bank 10.6 9.3 1.8 1.4 59 Non-Bank FI 8.8 6.4 2.1 1.4 81 Source: CGAP. Table 28. Efficiency Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <10% 6.6 6.8 5.8 5.1 6 10%­20% 8.6 7.3 1.8 1.4 76 20%­30% 8.9 9.3 1.4 1.1 10 >30% 13.1 11.3 2.0 1.5 22 Source: CGAP. Operating Expense / Period Average Gross Loan Portfolio. Table 29. Asset Quality: PAR 30 Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <1% 9.9 8.3 2.5 1.7 51 1%­3% 7.0 6.8 1.4 1.2 41 >3% 10.9 7.5 1.9 1.4 29 Source: CGAP. Outstanding balance of loans (principal and interests) with at least one payment > 30 days overdue / Gross Loan Portfolio. 38 Table 30. Financial Intermediation: Savings to Total Assets Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample Non FI 8.3 6.5 2.5 1.3 36 Low FI 9.5 6.0 1.9 1.6 35 High FI 10 8.2 1.7 1.4 52 Source: CGAP. Non FI = Voluntary Savings / Total Assets=0, medium FI = Voluntary Savings / Total Assets > 0 and <20%, high FI=Voluntary Savings / Total Assets>20%. Table 31. Leverage: Debt to Equity Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <3 13.3 11.1 1.9 1.6 30 3 to 6 9.8 7.9 1.7 1.3 45 >6 7.2 6.6 2.3 1.4 49 Source: CGAP. Total Liabilities / Total Equity. Table 32. Outreach: Average Loan Balance Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <50% 8.6 6.6 2.7 1.5 37 50%­150% 9.3 7.9 1.8 1.6 40 >150% 10.1 7.8 1.6 1.3 45 Source: CGAP. Average Loan Balance per Borrower / GNI per capita (Gross National Income). Table 33. Outreach: Average Savings Balance Historical P/E Historical P/B Unweighted Average Median Unweighted Average Median Sample <50% 12.6 6.6 2.5e 1.8e 22 50%­100% 8.9 8.9 1.6 1.4 37 >100% 8.6 7.4 1.5 1.3 25 Source: CGAP. Average Savings Balance per Borrower / GNI per capita (Gross National Income). 39 Appendix III: CGAPs Private Equity Transaction Survey, Survey Participants CGAP's private equity transaction survey was completed in summer 2008. Thirty-one organizations partici- pated, including 4 development finance institutions (DFIs), 13 microfinance investment vehicle (MIVs), and 14 MFIs. CGAP is grateful to these organizations for their support of CGAP's public research on microfinance valuation. The survey is strictly confidential, but the following organizations have authorized CGAP to list them as survey participants. DFIs BIO FMO PROPARCO MIVs ACCION INTERNATIONAL ADVANS SA AKAM INCOFIN INVESTISSEUR ET PARTENAIRE POUR LE DEVELOPPEMENT (I&P) MECENE INVESTMENT, ADVISOR OF AFRICAP MICROVEST OMTRIX OPPORTUNITY INTERNATIONAL RESPONSABILITY SHORECAP MANAGEMENT SIDI Financial Institutions BANCO DEL EXITO (BANEX) CENTENARY BANK COMPARTAMOS BANCO FUNDATION D-MIRO MISION ALIANZA-ECUADOR UGANDA FINANCE TRUST XACBANK No. 14 February 2009 Please share this Occasional Paper with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org © CGAP, 2009 The authors of this Occasional Paper are Nicholas P. O'Donohoe and Finally, the authors are thankful to Adrian Gonzalez from the Microfinance Frederic Rozeira de MarizAC, both with J.P. Morgan, and Elizabeth Littlefield, Information eXchange; Deborah Drake and other Council of Microfinance Xavier Reille, and Christoph Kneiding, with CGAP. This report is the result of Equity Fund members; Alex Silva and Brian Busch of Omtrix; and Clay Obrian a collaboration between CGAP and J.P. Morgan. of Opportunity International for sharing their views on the microfinance sector and for their support. The authors would like to acknowledge the contribution of Christina Leijonhufvud, head of the Social Sector Finance team at J.P. Morgan and Mia The authors remain responsible for the opinions expressed in this report and Feldman of the Social Sector Finance team; Neil Gupte, analyst in Equity for any inaccuracies. Research for Asian Financials; Thomas Anduze-Acher, analyst in Equity Research for Latin American Financials; Richard Rosenberg, senior advisor at CGAP; Suggested citation for this Occasional Paper: Barbara Gahwiler and Mathieu Lebegue, microfinance analysts at CGAP. O'Donohoe, Nicholas P., Frederic Rozeira de Mariz, Elizabeth Littlefield, Xavier Reille, and Christoph Kneiding. 2009. "Shedding Light on The authors also acknowledge the contributions at J.P. Morgan of Sunil Garg, Microfinance Equity Valuations: Past and Present." Occasional Paper 14. head of Equity Research for Asia; Aditya Srinath, head of Equity Research for Washington, D.C.: CGAP and J.P. Morgan, January. Indonesia; Victoria Miles, head of Emerging Markets Corporate Research; Paul Formanko, head of Equity Research for Banks in Emerging Europe and CGAP is solely responsible for the printing and distribution of this Occasional Central Asia; Mervin Naidoo, senior analyst for South African Banks; Saul Paper. CGAP is not affiliated with J.P. Morgan and is not a broker/dealer. Martinez, senior analyst for Latin American Financial Institutions.