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Voting the Double Bottom Line: Active Governance by Microfinance Equity Investors

Voting the Double Bottom Line: Active Governance by Microfinance Equity Investors

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Published by CGAP Publications
This focus note concludes that the microfinance industry is lagging in applying accepted good practices in governance. Based on interviews with more than 100 microfinance insiders, the study reveals a widely-held perception that equity investors – including private microfinance funds and public international financial institutions – are not doing enough to govern actively and strengthen the oversight of microfinance institutions (MFIs) by their owners.

The study finds that many investors are committed to improving MFI governance and describes recent industry initiatives to identify better practices and promote effective checks and balances.
This focus note concludes that the microfinance industry is lagging in applying accepted good practices in governance. Based on interviews with more than 100 microfinance insiders, the study reveals a widely-held perception that equity investors – including private microfinance funds and public international financial institutions – are not doing enough to govern actively and strengthen the oversight of microfinance institutions (MFIs) by their owners.

The study finds that many investors are committed to improving MFI governance and describes recent industry initiatives to identify better practices and promote effective checks and balances.

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Published by: CGAP Publications on May 31, 2012
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ocially oriented equity investors—particularlythose that take formal roles in the governanceof microfinance service providers and funds—facechallenging situations and decisions.
Equity investingrequires active governance—and this is particularlytrue for value-based investing because value-basedinvestors seek to guide the company so that itbehaves responsibly and creates both financial andsocial returns. Again and again in the course of research, those involved in microfinance institution(MFI) governance have said that most microfinanceinvestors are not taking an active enough role.
Oneexperienced microfinance professional spoke formany when she observed: “Foreign investors mustbe engaged owners, not just sleeping partners.” Thispaper offers evidence from interviews that took thepulse of more than 100 industry insiders to providea self-assessment of microfinance governance today.Corporate governance serves to mediate interestsof diverse stakeholders including shareholders,management, and employees, as the basis fordecisions on a company’s strategy and goals.It provides the framework within which shareholdersoversee operational performance and manage risk toensure the company’s long-term health.
In the case of MFIs, those diverse interests also include protectingvulnerable clients and pursuing a social as well as afinancial bottom line. Equity is of growing importanceto the microfinance sector, and social investors thatprovide equity have expanding opportunities to playgovernance roles. This Focus Note explores the extentto which investors are currently capitalizing on thisopportunity for active and effective governance. Itoffers practical insights, emerging good practices, andreflections on how to address reported gaps.In this paper, we use an intentionally broad conceptof governance. This assumes that while traditionalcorporate governance activities, such as votingone’s shares or taking a board seat, are important,microfinance investors can and should go further byexerting influence throughout the investment cycle,from initial due diligence through to their exit fromthe MFI. Although the focus is mainly on internationaldevelopment finance institutions (DFIs) andmicrofinance investment vehicles (MIVs)
that provideequity, where relevant this paper also considers cross-border lenders and local investors. Interviews withcurrent and former staff of investment organizations,investor-appointed and independent directors of MFIs and funds, chief executive officers (CEOs) andsenior managers of MFIs and funds, researchers, andothers inform this “self-assessment” of governancein the sector and ideas on how to strengthen socialinvestors’ performance in this regard.
Together, theyrepresented at least seven DFIs, 32 MIVs, and 19 MFIs.The analysis also uses CGAP investment data, deskresearch, and preliminary data from a field test of newMIX governance indicators.
Few of those interviewed question that strongerMFI governance is needed and could help improveindividual retail providers and the sector as awhole. While existing guidance and how-to toolsdescribe the ideal of effective MFI governance,practices on the ground are still nascent.
Ourresearch highlights areas for further improvementand reveals promising practices. Raising theperformance bar across the MFI sector will requirestrategy, resources, and staying power. Equityinvestors can play a key role. See Box 1 for asummary of key findings.
 Voting the Double BottomLine: Active Governance byMicrofinance Equity Investors
1 This paper ses the terms “social,” “socially oriented,” and “doble bottom line” investor interchangeably.2 This paper ses “MFI” in its broader sense to refer to specialized providers of financial services to lower income cstomers.3 See, for example, OECD (2004). Traditional corporate governance focses mainly on the “principal–agent” problem, i.e., how owners canoversee and protect their interests after delegating operational roles to management.4 DFIs are bilateral (e.g., the Netherlands Development Finance Company [FMO]) or mltilateral (e.g., the International Finance Corporation[IFC]) entities that fnd development activities and have majority or fll pblic ownership. MIVs inclde microfinance fnds, networks,holding companies, and other entities that fnd MFIs directly or throgh fnds/strctres.5 See Annex A for a complete listing of those interviewed.6 The srvey with draft governance indicators received 162 responses from the MFIs that reported to MIX in 2010.7 See, for example, Concil of Microfinance Eqity Fnds (2005), Cerise-IRAM (2006), BBVA Microfinance Fondation (2011), Promifin(2011), and Goldberg et al. (2011).
No. 79May 2012Katharine McKee
   F   O   C   u   S   N   O   T   E
Section I summarizes findings and brief analysisof factors contributing to increased attention togovernance across the industry. Section II describesthe growing influence of microfinance equityinvestors and their opportunity to strengthen MFIgovernance. Section III describes the most common“hot button” issues in the board room. SectionIV outlines key findings on the reported behaviorand effectiveness of equity investors; it alsoexplores implications of an investor marketplacethat is increasingly segmented and has attractedsome more purely commercial investors. Section Vprovides a thumbnail sketch of current governance-related initiatives and closes with an analysis of challenges and recommended next steps.
I. Findings and Drivers
A recent study described the mainstream corporategovernance ideal as “creation of competent boardscapable of objective and independent judgment andthus likely to exhibit the expected authoritative and
Further progress on financial inclusion will demandstrong, adequately capitalized, and responsibleproviders. This self-assessment by industry insiders founda mixed governance picture, with bright spots and manyweaknesses. Respondents reported that the norm isstill far from the ideal: that is, boards are well-informed,guide strategy, and challenge management as neededwithout micromanaging. While other sectors also sufferfrom governance deficiencies, the microfinance industryis lagging in applying accepted good practices. Manyrespondents noted recent improvements, however, asa result of increased awareness, specific reform efforts,MFI growth, and regulation.The most important findings from the research areas follows:1. Social investors that provide equity to MFIs,funds, and other MIVs have ample opportunitiesto contribute to improved governance, includingthe right to fill at least 325 board seats. They canhelp encourage MFIs to adopt good practices andmodel active ownership themselves.2. The standard roles of corporate governance—addressing the principal-agent problem thatis created when owners delegate day-to-dayoperations to management, setting mission andstrategy, overseeing operations and management,and ensuring the company’s long-term survival—are relevant for MFI governance. The vulnerabilityof clients and trade-offs that may arise betweenthe financial and social bottom lines are additionalcommon concerns.3. Currently, the reported hot button issues inMFI governance are growth, product/segmentdiversification, client protection, pricing andprofits, executive remuneration, and majorchanges in financing and ownership structures.MFI crises and failures have strained governanceand exposed weaknesses, as well as underscoredhow strong boards help MFIs survive tough times.4. The research found that equity investors arenot fully capitalizing on the opportunity tostrengthen MFI governance. The specific areasfor improvement include the following:
Actively engaging in and beyond the boardroom
Ensuring adequate qualifications, timecommitment, and continuity of investors’nominees
Addressing director passivity and reticence toquestion management proposals
Aligning shareholder interestsIt also found important progress on tools tostrengthen social performance that could beapplied more effectively in governance.5. The MFI sector is relatively young, and manyinstitutions are still led by charismatic founders.Managers are often reluctant to accept the need togive up some control in the interest of achieving morebalanced governance and a stronger double bottomline. Reportedly too few investors have the intentionor focus to take on cases of management capture,where the CEO or management team dominates theboard and the board’s oversight of the MFI is weak.6. MFI governance practices overall exhibit somecommon weaknesses. These include the following:
Clarity on the respective roles of management,the board, and shareholders.
Policies on conflict of interest and whatinformation must be disclosed to the board
Establishment and use of board committees
MFI-specific dimensions of social governance,risk, and human resources management7. As the microfinance investment market getsmore diverse and segmented, including a rise inmore purely commercial financing, governancestructures and processes will need to adapt toensure adequate alignment of shareholders’preferences and time horizons.
Box 1. Key Findings
challenging behavior” (Geneva World MicrofinanceForum 2010). The global financial crisis revealedthe gap between this ideal and reality. Largefinancial firms suffered obvious governance failures,including lapses in ethics, poor risk management,and misalignment of executive remuneration withlong-term shareholder value. Current reform effortsseek to solve the problems observed, such asmanagement capture, conflicts of interest, boardpassivity, and inadequate disclosure of informationfrom management to board, regulators, and thepublic.
Most experts agree that if these goodgovernance measures succeed, they should improvefirm performance.
Adding to this general attention to governanceof financial institutions, microcredit crises andhigh-profile MFI failures in several countries—largely attributed to unsustainable growth—haveheightened concerns about MFI governance.Analyses of these cases revealed that ineffectivegovernance was an important contributing factor,with one study concluding that “. . . an institution’sgovernance structure proved to be the primarydifferentiating factor between those entities thatovercame a crisis and those that did not” (Marulanda2010). Most of the MFIs that survived a crisis did sobecause of a timely and well-honed response by theirboard chair and directors, including mobilizing freshcapital from lenders and shareholders, overhaulingthe mission and strategy, strengthening or changingmanagement, and rebuilding the confidenceof clients, staff, and regulators. Sometimes theboard moved out of the traditional oversight role,temporarily stepping in to take on key managementresponsibilities.Building a successful MFI in any young, dynamicmarket is challenging, as the provider seeks toscale up and boost efficiency while managing newoperating risks. With MFI business models becomingmore complex and product lines diversifying, MFIgoverning bodies will need to strengthen theirskills and oversight capacity. The sector’s need forcapital also brings MFI governance into sharperrelief. Fast-growing providers in some marketshave tapped capital markets, including throughbond issues or initial public offers (IPOs). This canbring in investor types that are new to the sector,such as private equity (PE) firms and traditionalinstitutional investors. New financing can triggerchanges in governance, such as renegotiated legalagreements, board seats, or targets. These changesare sources of governance stress in themselves.Current owners and MFI managers would do well toassess prospective owners carefully for compatibilityof the different parties’ overall goals, targets, andtime horizons.Recent responsible finance initiatives also focuson governance as the main process that ensuresadherence to good practice and aligns MFIstrategy and operations with mission.
Hundredsof MFIs have joined the Smart Campaign, oftenwith strong encouragement from funders. Fifty-five investors have endorsed the UN-backedPrinciples for Investment in Inclusive Finance (PIIF).
 Translating these commitments into practice willrequire active governance; indeed, the codes andstandards implicitly oblige MFI directors to observea higher “duty of care” than those in conventionalfinancial institutions (although many now argue thatbank directors have a duty of care to depositors, whichis established by regulation in some jurisdictions).Together these factors are spurring recognition thatMFI governance needs to catch up. Respondents tothe 2011
Banana Skins
survey, for example, rankedgovernance as the fourth highest perceived risk; theyalso ranked three other risks—credit risk, reputation,and competition—as greatest and rising most quickly(Lascelles and Mendelson 2011). Governance plays acentral role in managing each of these risks. Investorsare uniquely positioned to provide and improve MFI
8 Most mainstream corporate governance reforms are embodied in law and reglation. However, indstry initiatives, sch as the 2010 uKStewardship Code, also seek to promote active governance and tackle directors’ passivity and overly short-term orientation.9 A 2327-firm srvey fond stronger performance in better governed firms (Brown et al. 2010). However, it shold be noted that less than1 percent of governance stdies focs on emerging markets or developing contries (Ararat et al. 2011).10 Responsible microfinance consists of client protection (for all providers) and social performance management (for those with a specificsocial or development mission). See McKee, Lahaye, and Koning (2011).11 For more information, see www.smartcampaign.org and www.npri.org/piif/.

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