International Financial Reporting Standards (IFRS) require that investments be reported at fair value. For microfinance debt instruments, fair value is used pri- marily for informational purposes in the supporting balance sheet notes (see box 1).
On the other hand, determining fair value for microfinance equity investments in the absence of reliable earnings and transaction data can be quite complex.
The purpose of this paper is to identify these challenges and to discuss how KfW approaches these issues on its way to full adoption of IFRS at year-end 2007.
We begin with an overview of the current state of MFI funding and trends, focus- ing on equity and mezzanine funding. Next, we provide a brief background of IFRS, followed by a comparison of standard setters’ fair value definitions. We examine the options for determining fair value, including those based on market prices, and of most relevance to the case of microfinance, methodologies recom- mended for use in the absence of active markets. Finally, we conclude with a brief summary.
Microfinance and Foreign Equity Investment Current MFI Funding Sources
The largest overall source of MFI financing is domestic, including commercial loans, savings deposits for institutions with banking licenses, and retained earn- ings. Yet domestic sources also pose the greatest bottleneck, which is the dearth of long-term domestic funding sources in emerging markets. The lack of developed pension systems and institutional investor funds are the primary missing links.
At the same time, only a small proportion of total MFI funding comes from for- eign investment, defined by CGAP as “quasi-commercial investment in equity, debt, and guarantees, made by private-sector funding arms of bilateral and multi- lateral donor agencies (development investors); and by socially-motivated, pri- vately-managed investment funds financed by both public and private capital (so- cial investment funds).”3
Yet it is difficult to make generalisations about MFI funding sources, as they vary significantly with type of institution and maturity, among other variables.
One way to categorise these differences is through a “tiered” approach. We regard first tier MFIs as those that are sustainable on both a financial and operational basis. The 2nd tier is comprised of promising MFIs on track toward becoming 1st tier institutions. Institutions seeking to retain their primary social objective, or unable to make the leap to financial and operational sustainability for other rea- sons, may prefer (and may be limited to) financing their operations through grants and donations – these institutions would be regarded as the 3rd tier.
3 CGAP FocusNote No. 25. “Foreign Investment in Microfinance: Debt and Equity from Quasi-Commercial Investors.” January 2004. Available online at www.cgap.org.
First tier institutions have the greatest access to domestic and international funding sources. They tend to be more mature and often have banking licenses, allowing them to fund themselves partially through deposits. Their “formalisation”
also subjects them to a higher level of regulatory oversight, in turn requiring a higher level of management, operational and systems competency – all of which decrease their credit risk, which makes them more attractive to domestic commer- cial funding sources. Because of their financial sustainability, the interest of private foreign investors focuses almost exclusively on this group.
We began this paper by stating that one of the reasons 2.5 billion people lack access to financial services is that the institutions that would serve them lack fund- ing – particularly long-term funding. So where are these funding gaps? They lie in the 2nd tier MFIs. Third tier institutions have limited possibilities to attract foreign investment given their lack of operational and financial sustainability. Some may have little interest in taking on quasi-commercial funding as their founders may presume that commercial funding would compromise the institution’s social mis- sion. The prospects for foreign investment in 2nd tier institutions, however, are promising. These institutions, often not licensed to accept deposits and deemed too high a credit risk for commercial loans, may not be attractive to domestic funding sources.
This situation is a challenge for – as well as the duty of – development financi- ers: they may provide support in the form of long-term refinancing as well as technical assistance for institutional improvement necessary to promote a 2nd tier institution to 1st tier status – while retaining the institution’s reach and avoiding
“mission drift”.4 Expanding the 1st tier means more institutions will be able to access private capital, decreasing these institutions’ reliance on funding from de- velopment finance institutions (DFIs).
Tapping International Capital Markets
Determining fair value for equity investments tends to be more complex than for debt investments. The extent to which equity valuation issues will arise is a func- tion of the percentage of equity and quasi-equity funding relative to debt: as MFIs tap international capital markets, what form will this funding take? According to a 2004 CGAP study, debt and equity accounted for 73% and 20% respectively of the USD 167.3 million in foreign investment in microfinance surveyed in the study.5
4 See Doris Köhn and Michael Jainzik: “Sustainability in Microfinance – Visions and Versions for Exit by Development Finance Institutions,” in Ingrid Matthäus-Maier and J.D. von Pischke, eds., Microfinance Investment Funds: Leveraging Private Capital for Economic Growth and Poverty Reduction, 2006.
5 Kadaras, James and Elisabeth Rhyne, “Characteristics of Equity Investment in Micro- finance,” April 2004. Cited in CGAP FocusNote No. 25. “Foreign Investment in Microfinance: Debt and Equity from Quasi-Commercial Investors.” January 2004.
Available online at www.cgap.org.
Some pundits have questioned a narrowing of this gap: a 2006 Council of Micro- finance Equity Funds (CMEF) study identified just 199 MFIs as eligible for foreign equity investments,6 underpinning the limited number of potential investees, mak- ing it more important to support 2nd tier institutions.
Other opportunities for equity investment do exist. Two of the most salient are the upgrading of 2nd tier to 1st tier institutions, discussed above, and greenfield investments in newly established MFIs – both of which require equity. The mini- mum capital adequacy requirement (CAR) under Basel I is 8% of risk-weighted assets, though an appropriate minimum capital level may be deemed to be much higher – indeed, as high as 20% in the case of start-up banks in some developing countries. Whether upgrading an existing institution into a bank or establishing a new one, risk capital is necessary, and its most likely source is donors.
Box 1: The MFI Perspective: Relative Advantages and Disadvantages of Equity Investments
Advantages
• Meeting minimum capital requirements: Equity investments provide a capital base for MFIs to meet regulatory capital requirements.
• Cash flow timing: Equity investments do not require regular repayments, simplifying cash flow planning or freeing up liquidity for other purposes.
• No collateral required: Though many MFI loans are unsecured, the lack of collateral is often compensated for through credit enhancement techniques. These considerations do not arise for equity investments.
• Decreased rollover risk: Debt investments are limited to a specific time period and require careful planning on the part of the MFI to ensure that funding is either renewable or that new funding sources will be available after current credit lines mature. Equity investments, in contrast, are not limited to a specific time period.
• Reduction in foreign exchange risk: The vast majority of foreign debt investment in MFIs is denominated in hard currency, creating a currency mismatch for the MFI. This problem does not occur in equity investment.
6 Rhyne, Elisabeth and Brian Busch, “The Growth of Commercial Microfinance: 2004- 2006”, September 2006. Available online at http://cmef.com/CMEF%20Growth%20of
%20Commercial%20MF%202006.pdf. 222 MFIs are defined as regulated, commercial shareholder-owned entities, of which 199 make sufficient information publicly available.
Disadvantages
• Unwillingness to cede control: This may be particularly true of potential profit-maximizing equity investors. An MFI may foresee conflicts between the goal of pure profit maximisation and the MFI’s efforts to balance social and profit goals.
• Greater disclosure: In return for taking on residual risk or ownership, equity investors will require greater disclosure from MFIs.
• “Mission drift”: Profit-oriented equity investors may increase the danger of “mission drift” – that less profitable business segments which benefit the poor may be cut back in favour of more profitable business in other markets.
Financial innovations have made the juxtaposition of debt and equity a false di- chotomy. What lies in between – quasi-equity, or mezzanine investment – may represent the future of microfinance funding. Because mezzanine instruments are often highly customised using structured finance techniques, their flexibility may enable them to best match MFI funding appetite with those of potential investors.
(For a more detailed discussion of structured financing options for MFIs see Glaubitt, Hagen, Feist, Beck: “Reducing Barriers to Microfinance Funding: The Role of Structured Finance” in this book.)
Box 2: The Investor Perspective: Relative Advantages and Disadvantages of Equity Investments
Advantages
• Control: Investors may seek influence or partial control of an MFI’s business. While this is an advantage of equity investments in general, it may be particularly salient in the case of microfinance. First, equity investments may allow investors greater insight into an MFI, improving transparency. Second, taking partial control over an MFI may decrease the risk of the MFI’s business decisions which could adversely affect the performance of the equity investment. Given generally low levels of regulation in the microfinance sector and the perception of microfinance as a “risky” asset class, gaining influence or control may reduce investors’
perceived risk.
• Higher risk/reward profile: Equity investors may share in profits only after all claims to debt holders have been paid. Empirical evidence de- monstrating good average MFI performance in repaying debt, combined with strong growth potential given the enormous unmet demand for microfinance services, may encourage investors with higher risk/reward appetites to make equity investments. For example, social investment funds are willing to take greater risk for less reward, ceteris paribus, than an average profit-maximising investor.7 Their phenomenal growth may help shift the trend of microfinance investing toward equity.
Disadvantages
• Difficult investment exit: From an investors’ perspective, the lack of exit opportunities may impede investment. In contrast to the fixed maturities of most debt instruments, equity investments provide no fixed exit date. The lack of a liquid secondary market further limits potential exit possibilities.
• Combination of non-profit and for-profit owners: Profit-maximising investors may hesitate to invest in MFIs with other non-profit owners, fearing that their expected return may suffer as non-profit owners strive to meet social goals rather than profit targets. Non-profit investors may also fear that MFI poverty reduction efforts may be impaired by the pursuit of profit.
Valuing Microfinance Investments
Before discussing the challenge of valuing equity and mezzanine investments according to IFRS, we provide a brief background of IFRS, current standard set- ters’ definitions of fair value, and an overview of accepted methodologies for calculating fair value.
Defining Fair Value
According to the International Accounting Standards Board (IASB), IFRS is com- prised of the standards and their corresponding interpretations adopted by IASB, an independent and privately-funded accounting standards organisation. Standards include International Accounting Standards (IAS), issued from 1973 to 2001 by
7 CGAP FocusNote No. 25. “Foreign Investment in Microfinance: Debt and Equity from Quasi-Commercial Investors.” January 2004. Available online at www.cgap.org.
the International Accounting Standards Committee,8 and IFRS issued by the IASB. Standards and topics range in scope and depth from the presentation of financial statements to financial reporting in hyperinflationary economies.
The standard relevant to valuing investments in MFIs is IAS 39, entitled “Fi- nancial Instruments: Recognition and Measurement.” The objective of IAS 39 is
“to establish principles for recognising and measuring financial assets, financial liabilities and some contracts to buy or sell non-financial items.” It requires that a financial asset or liability be recognised at fair value at initiation, including related transaction costs.9 Thereafter, equity instruments and embedded derivatives10 should be stated at fair value whereas debt instruments are usually held at amor- tised cost depending on their classification into one of the categories defined in IAS 39.9 (see box 3). There is an important exception that is relevant to microfi- nance: “equity investments that do not have a quoted market price in an active market and whose fair value cannot be reliably measured ….”11
Box 3: IFRS and Debt Investments
Debt investments are usually classified as loans and receivables, and according to IFRS are therefore stated at amortised cost. When debt investments are held at amortised cost, the fair value of the investment may be referenced in the balance sheet notes for informational purposes.
In certain circumstances IFRS does allow for the valuation of debt instru- ments at fair value (see IAS 39.9 for more detail). For example, if an investor holds both a debt investment and an equity investment in the same entity, or if the investor holds a convertible bond, it may make sense to report the debt investment at fair value, rather than amortized cost. This approach would treat both debt and equity in the same manner and any changes to the fair value of either the debt or equity investment at remeasurement would flow through the income statement.
Whether held at amortized cost or at fair value, debt investments are subject to impairment tests.
8 The International Accounting Standards Committee is no longer in existence and has been effectively replaced by the IASB. Most of the standards issued by the International Accounting Standards Committee were adopted, either in original or revised form, by the IASB. See the IASB web site at www.iasb.org for more details.
9 IAS 39.43: Transaction costs are excluded in the case of financial assets or liabilities at fair value through profit or loss.
10 IAS 39.11.
11 IAS 39.46 ( c ).
IASB states its mission as “developing, in the public interest, a single set of high quality, understandable and enforceable global accounting standards that require transparent and comparable information in general purpose financial state- ments.”12 Indeed, great progress toward this goal has been made: seventy-four countries, about two-thirds of which are developing countries, require domesti- cally-listed companies to report according to IFRS.13
Standard setters, including the IASB and FASB, have made significant efforts to align standards. A good example of recent efforts is the convergence of defini- tions of fair value, listed below.
• IAS 39: The amount for which an asset could be exchanged, or a liability settled, between knowledgeable, willing parties in an arm’s length trans- action.14
• International Private Equity and Venture Capital Valuation Guidelines (IPEVCVG): The amount for which an asset could be exchanged between knowledgeable, willing parties in an arm’s length transaction.15
• Global Investment Performance Standards (GIPS): The amount at which an asset could be acquired or sold in a current transaction between willing parties in which the parties each acted knowledgeably, prudently, and without compulsion.16
• Financial Accounting Standards Board (FASB): An estimate of the price that could be received for an asset or paid to settle a liability in a current transaction between marketplace participants in the reference market for the asset or liability.17
In a November 2006 press release, the International Private Equity and Venture Capital (IPEV) Valuation Board reported that changes to its guidelines “will en-
12 From IASB’s web site, www.iasb.org.
13 See Deloitte and Touche’s IAS Plus web site: www.iasplus.com.
14 IAS 39, IN18, IAS 32.11.
15 IPEVCA were developed by the Association Français des Investisseurs en Capital (AFIC), the British Venture Capital Associate (BVCA) and the European Private Equity and Venture Capital Association with input and endorsement from numerous international private equity and venture capital associations. 1 January 2005. Available online at http://www.privateequityvaluation.com/documents/International_PE_VC_Valuation_
Guidelines_Oct_2006.pdf.
16 Global Investment Performance Standards. Revised by the Investment Performance Council and Adopted by the CFA Institute Board of Governors. February 2005.
Available online at www.cfainstitute.org.
17 Financial Accounting Standards Board. Fair Value Team. Minutes of the June 29, 2005 Board Meeting – Definition, Transaction Price Presumption, and Hierarchy. Available online at http://www.fasb.org/board_meeting_minutes/06-29-05_fvm.pdf.
sure full consistency of the IPEV Guidelines with both FASB and IASB stan- dards.”18 Moreover, in the amended version IPEV explicitly notes that their defini- tion of fair value is “…congruent in concept with alternately worded definitions such as ‘Fair Value is the price that would be received for an asset or paid for a liability in a transaction between market participants at the reporting date’.”
Yet much work remains: alternative accounting standards, such as U.S. GAAP, continue to be used around the globe. Though differences in standards are not as large or numerous as they once were, differences remain, and they create ambigu- ity for those responsible for financial reporting. The fair value case provides a salient example: while standard setters share similar views of the definition of fair value, the recommended methodologies which may be employed to calculate fair value for investments which lack an active market are inherently subjective and are specified differently among standards. These are discussed in detail below.
Market Prices and Microfinance Investments
Determining fair value at investment initiation – when the first funding transac- tion is made for a de nove entity – is usually a simple task: according to IFRS, the transaction price is normally considered the fair value of an investment. The initial transaction price for a debt, equity or mezzanine investment in an existing microfinance institution or the subscription price for an equity stake in a greenfield transaction would be considered fair value. At remeasurement, the determination of fair value can be more complicated and a fair value hierarchy, discussed below, must be applied.
Market prices, when available, are considered the best gauge of fair value. Ac- cording to IFRS, “The existence of published price quotations in an active market is the best evidence of fair value and when they exist they are used to measure the financial asset or liability.”19 Usually the current bid price in the most advanta- geous market is used as a basis, adjusted for necessary considerations such as differences in the credit risk profile of the counterparty.
Yet market prices require active financial markets, which creates a problem in valuing MFI Investments. Markets for MFI investments are neither active by any definition, nor do transactions occur on an arm’s length basis. (See below for more detail on microfinance secondary markets.) According to IFRS, “A financial market is quoted in an active market if quoted prices are readily and regularly available from an exchange, dealer, broker, industry group, pricing service or regulatory agency and those prices represent actual and regularly occurring market transactions on an arm’s length basis,”20 this term referring to independent third-party transactions.
18 International Private Equity and Venture Capital Valuation Board Press Release,
“Valuation of Private Equity Investments: Changes Ensure Consistency with Recent Fair Value Standard”, Brussels, November 15, 2006. http://www.privateequityvaluation.com/.
19 IAS 39.71.
20 IAS 39.7.