The Irrational Case of Microfinance Investing — Latam Edition

Microfinance is overrated. While its mission certainly has merits, the social impact to households is questionable and the risk-return of debt investments in the sector is unbalanced, to say the least. Impact investments generally warrant lower returns, “for social reasons”, but if the impact of Microfinance is limited, does the sector really justify below market interest rates?

The risk-return tradeoff has even become mindboggling over the last few years in Latam. On one hand, Microfinance portfolios across institutions have increased while the market size has not and overindebtedness has reached critical levels in many countries. Despite this scenario, interest rates continue to decrease as a result of high liquidity levels in local markets, the large amount of dry powder in funds and the launch of new funds targeting the sector….Where is finance 101 in all this?

Indeed some fund managers have begun to diversify away from Microfinance, and others are just beginning to consider it, but that said, Microfinance still represents 85% of total impact investments in the region (source: LAVCA). What continues to be the appeal of the sector?

Maybe it is just inertia or the fund managers’ narrow philanthropic mindset believing that Microfinance is the most accessible way to invest for impact. But in any case, it is time to change the game in order to balance the social and financial risk-return. And we could start by:

  • Changing how key leaders in Microfinance behave and think as a way to influence culture and hence promote the transformation of the entire sector’s current undifferentiated business model (talk about an inevitable implosion…).
  • Incentivizing governments across Latam to formalize the sector. This will promote consolidation and economies of scale, and hence improve the quality and profitability of the sector.
  • Educating investors about the dubious benefits of Microfinance, illustrating how social inequality has been worsening across countries instead. This will ultimately open the scope of impact investing, diversifying capital deployment across sectors.

It is now common knowledge that charity is not a solution to social issues, but we continue to be stuck in the mindframe that Microfinance is the Mecca of impact investing. Yet, considering that past actions are the best predictor of future results, we must realize it that Microfinance, as is, is also not a solution for households nor investors, for that matter.