Over the years, microfinance has emerged as a profitable business opportunity and a way to build local economies. When Dutch pension giant ABP, the scheme for civil servants, placed €5m in the Dexia Micro-Credit fund last year it was a sign of growing interest in this type of investment among institutional investors.

Peter Johnson, partner at US-based investment advisory group Developing World Markets (DWM), believes there are plenty of opportunities in microfinance for pension funds.

He says: “Four or five US pension funds have already invested in our product and so far all of them are pleased. The European institutional investors include banks, mainstream asset managers and an insurance company but there are a number of pension funds
in Europe actively considering microfinance.”

He says that from a social point of view, pension funds are bullish towards microfinance. However, although pension funds have started to understand the market rates of return that are available, they remain concerned about the volume of investments. They worry about how much to invest to make it worthwhile and this is holding them back a bit.

But Johnson thinks this attitude will change. “The fact that a number of them have already invested shows their willingness to take on even the limited volumes available and this is a good starting point.”

DWM has closed microfinance transactions of around $250m (€189m) to date. The microfinance assets it has placed with investors include: ProCredit Holding, MicroFinance Securities XXEB, Unitus Equity Fund (first closing), Balkans Financial Sector Equity Fund first closing, the Pro Mujer Loan Fund, BOMSI (first and second closing) and Global Partnerships Microfinance Fund 2005.

DWM links investors to microfinance and microfinance-related organisations through innovative financial instruments and investment opportunities, for example through a collateralised debt obligation (CDO).

Johnson says the CDO is used to pool together loans for microfinance institutions (MFIs) and then issue notes back to investors.

“In the case of fixed income investments we create a senior subordinated structure, which can reduce the risk for pension funds. The structure contains senior notes and several layers of subordinate ones such as mezzanine and junior notes and equity. Pension funds have invested in the senior notes - which are designed for typically risk-averse investors - and also in one layer of mezzanine.But principally, pension funds
like the senior ones as they are the safest and structured to have the least risk of loss of capital,” Johnson says.

Diversification of portfolios contributes to risk reduction, while a very low default rate is also attracting investors to the sector.

Investment in the sector should be encouraged by the conclusion of a New York University study (‘The systemic risk of microfinance’) that MFIs perform better than banks during an economic downturn - plus the implied reduction of volatility in emerging markets portfolios compared with traditional assets like banks.

But to attract more institutional investors to microfinance, good corporate governance, transparency and expertise is needed. Because of this it is difficult to say whether microfinance will remain a niche or move into the mainstream.

Johnson says: “I think the volumes will always be relatively limited but they may be large enough so that microfinance is no longer considered a niche affair. It could be just one of a number of alternative asset classes that are social in nature.”

According to Johnson, pension funds should become involved in microfinance firstly because there may be an alignment between their constituents and the investments.

In the case of TIAA-CREF, for example, the constituents are academics, who typically have a concern for social justice in the world and who see microfinance as a very appropriate type of investment to address that.

Secondly, the fact that microfinance investments - even if they are small - have a very low correlation with world markets such as traditional equity and fixed income markets can help in terms of the overall performance of the fund. In addition, Johnson says, investing in the equity of MFIs can be highly rewarding as the returns can be extremely attractive.

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