One of the most tense situation an investor in microfinance and financial services face is when looking at an opportunity in a market that is overheating.
On one hand you have your prospect or client requiring a large line of credit, and on the other hand, you have been reading those reports that the market is almost fully saturated. And the situation of course is further form being all black, otherwise the decision would be easy to make and substantiate.
The bank or micro-finance institution, along with the competition, is doing very well. The portfolio quality is adequate. It might be worsening a bit but nothing worrying and it might be a very temporary increase in defaults. All in all, noting dramatic, but it might turn into a drama soon. It MIGHT.
Why don’t wait and see?
Waiting and see how the “market develops” is the first reaction of any conservative investor, but there are few problems with such response: i) you need to be ready to probably wait a long time and skip many opportunities with nothing happening ii) your partners (co-investors, clients) might lose trust in your capacity to respond and support them when needed iii) you are not able to substantiate your decision with specific facts and figures (as all you have are “signals”) iv) you might send the wrong signal to the market and accelerate the issue you wanted to avoid in the first place.
These issues clearly grow with your size as investor and the role you have been playing in that market.
Calm down and do your homework
The first step is to better understand what is happening (obviously?). Investment decisions usually only get better with more data and less information asymmetry. Hire an independent auditor to go on the field, interview the end clients, and form a more educated opinion. The situation might not be as bad. The saturation might be in some areas and not in others. Strong mitigants might be in place to improve the selection of new clients and the monitoring of existing ones.
If the first step has not raised any bigger concern, it might be time to just go ahead with your investment while making sure to put as many conditions and mitigants as possible (assuming the institution itself meets your other conditions regarding systems, governance, capitalization, provisioning etc.)
– Shorter tenor: reduce the tenor to the shortest possible, as you don’t want to be involved for 5 years in an overheating market. Compare the US market in 2005 and 2010…
– Covenant on the gross NPL: you need to be able to monitor the real quality of the portfolio (with no provisioning). Require reporting on all buckets so you can monitor the development of the portfolio very closely
– Monitoring of the credit and collection policy: require to be in the loop of any change of the credit policy. Any change is relevant at this stage; why is the institution becoming stricter? More flexible? Understand the triggers of any changes.
– Negative list: This is more of a discreet signal to the market than a strong mitigant. Money is fungible but you can require that the proceeds of your investment should not be used in a list of specific areas deemed saturated.
Don’t forget about the competition
While the market might be better than expected and your client very responsible and cooperative, the picture can get quickly nasty because of what other lenders are doing in the market. You client might grow at 5% a year, over-indebtedness can be provoked by less conservative competitors, growing at 100% over-leveraging the whole market. Proactive engagement with the sector is therefore paramount. Push for better exchange of data, for better practices, for better regulation – when you can. Unfortunately, no one wants to stay still before the music stops. Classic.
It is not about the outcome
Focus on doing the process right. You should trust your appraisal framework and the data you have at this stage. You should evaluate your decision on the process you followed. If you decide to skip the investment, and “nothing” happens, then let it be. Very likely, you made that decision for the right reasons at that time and with the best interest of your stakeholders in mind. Your process and standards are your best protector against endless debates and blaming games.