By Edmund Higenbottam, Managing Director of Verdant Capital, and Raj Domun, Director and Fund Manager of the Verdant Capital Hybrid Fund
In recent years, the Inclusive Financial Institution sector has grown significantly in Africa and elsewhere, driven in part by growth in the global specialist investor base supporting the sector, and in part due to the growth of local debt markets. In Africa, this growth has stretched the equity capital bases of many institutions – and of the sector as a whole – due to the narrow range of equity and equity-like capital sources and instruments available to these institutions.
One solution to this problem is hybrid capital, an intermediate capital type that sits between debt and equity while meeting the regulatory capital requirements of financial institutions. In Africa, hybrid capital can provide funding that can be leveraged by both specialist global (debt) investors and local debt investors, thereby achieving a multiplier of developmental impact: “crowding-in.”
The term “Inclusive Financial Institution” describes financial institutions with broader developmental impact than traditional banks, including those that serve previously unbanked populations and smaller companies. In contrast, the impact of African commercial banks on broad-based economic development can be narrow, due to their tendency to focus on lending to multinationals and the largest local corporations as well as investing in government bonds and bills.
Inclusive Financial Institutions are active in segments such as “traditional microfinance”, (microloans for individual traders and other microentrepreneurs), simple savings products, lending to SMEs (often described as the “missing middle”), housing finance, education finance, health finance and agri-value chain financing. Some of these lenders specialize in asset classes that disproportionately appeal to small and medium-sized enterprises, for example leasing, invoice discounting and merchant credit advances. Fintechs can be considered Inclusive Financial Institutions, especially if their core technology is used to reduce transaction costs and enable services such as borrowing, savings or payments on a micro scale. The term “microfinance” is often used as a catch-all to describe the full range of such institutions, and the global specialist investor base is typically described as “microfinance investment vehicles” or “MIVs.”
Over the last decade and a half, Inclusive Financial Institutions have experienced tremendous growth, and many have undergone transitions to acquire full banking licences. Perhaps the most famous example is Equity Bank in Kenya. More recent examples include Ghana Home Loans as well as Letshego, which is registered as a bank in many of the 11 countries it serves. The growth in the sector has been driven in part by the growth of the MIV community. According to the “2018 Symbiotics MIV Survey,” the global microfinance asset class totals USD 15.8 billion, approximately eight times larger than it was 10 years earlier.
The community of MIVs has established itself as a niche asset class in the global investment universe. The growth of this asset class is testament to the strength of its financial performance, including a positive return every year since 2006, coupled with much lower volatility than other fixed-income benchmarks such as the JPMorgan Global Bond Index.
The growth of MIVs has been matched in many markets by growth in local bond markets. Institutions such as afb in Ghana and Madison Finance in Zambia, both of which first issued bonds in 2015, are blazing a trail for other Inclusive Financial Institutions to follow in their home markets.
Meanwhile, this growth in debt funding has exacerbated the imbalance between the availability of equity and debt capital. Another factor is that many IPO markets in Africa are highly illiquid. Most Inclusive Financial Institutions are too small to tap the IPO markets effectively, i.e. to offer an IPO large enough to create meaningful liquidity in the secondary market. In this respect, the contrast between Africa and other markets is stark. According to Caspian Impact Adviser, a leading Indian MIV, 72 Indian microfinance institutions have launched IPOs since 2011, compared with only 17 on the African continent.
Hybrid capital includes a range of instruments – from subordinated debt to preferred equity – which are popular in the banking sector globally, but rarely available to financial institutions in Africa. Hybrid capital instruments enable regulatory capital to be tiered according to factors such as tenor, degree of subordination and loss-absorption capacity. They also allow for fixed redemption, exit and other contractual terms, which can help balance the requirements of regulators with the needs of investors. Finally, and perhaps most importantly, hybrid capital can bring into play new investors, which otherwise might not have invested in the sector.
Typical Inclusive Financial Institutions leverage their regulatory capital four or five times with senior debt. In other words, their regulatory capital typically represents 20 to 25 percent of their total assets. Thus, an investment of USD 100 into hybrid capital instruments can facilitate a loan of USD 400 to USD 500 to a small or medium-sized enterprise, a school, or a family buying a home.
Verdant Capital recently launched the Verdant Capital Hybrid Fund, which will invest hybrid capital in Inclusive Financial Institutions in Africa. The fund is a limited partnership, established under the laws of Mauritius, with a 12-year life and a targeted size of USD 80 million. The fund has secured initial approval for a commitment from its anchor investor, a leading European development finance institution. The Verdant Capital Hybrid Fund is scheduled to close in 2019.
This sponsored content was written by Edmund Higenbottam, Managing Director of Verdant Capital, and Raj Domun, Director and Fund Manager of the Verdant Capital Hybrid Fund. Verdant Capital is a leading specialist financial advisory firm that operates on a pan-African basis.
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