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Solving the Puzzle of Responsible Exists in Impact Investing

26.03.2018Hannah Dithrich, Research Associate, The Global Impact Investing Network (GIIN)

This blog was originally published on the Center for Financial Inclusion (CFI) website.

A responsible exit lays the foundation for long-term impact, and requires considerations as early as due diligence

Impact investors are motivated by two primary objectives: to generate a financial return and to create positive social or environmental impact. But how do they balance these dual goals throughout the investment process, and specifically at exit? It’s no easy feat.

Investors must consider what happens to impact when they exit an investment. For example, if a company received critical capital and resources from an investor, will it still be equipped to succeed and continue its mission when that investor exits? What if an investor sells her shares to a more commercially-minded buyer who deprioritizes the company’s impactful or sustainable practices?

In financial inclusion investments, the possibility of mission drift after exit can have real implications for impact. For example, if a microfinance institution is acquired by a firm with little experience with underbanked customers, it could increase loan sizes beyond what clients are able to pay back, ultimately leading them into cycles of debt. Impact investors seek to mitigate such risks by exiting their investments responsibly.

A 2014 paper called The Art of the Responsible Exit in Microfinance Equity Sales, by CFI and the Consultative Group to Assist the Poor (CGAP), explored the topic, outlining four decisions that microfinance equity investors can consider: i) the timing of their equity sale; (ii) buyer selection; (iii) governance and the use of shareholder agreements; and (iv) how to balance social and financial factors across multiple bids for their equity. Later this spring, the authors will publish a follow-on paper with guidance for all financial inclusion investors, beyond just those of microfinance institutions.

This year, the Global Impact Investing Network (GIIN) published Lasting Impact: The Need for Responsible Exits, a study that draws insights across sectors and asset classes that can be applied to financial inclusion investments. To produce this report, my colleagues and I interviewed over 30 leading practitioners, and found that investors plan for a responsible exit even before the investment is made. They lay the foundations for long-term impact throughout all stages of the investment process, from due diligence and capital structuring to exit.

During pre-investment due diligence, investors seek out companies or projects that present few risks to mission drift down the line – such as those with inherently impactful business models and those whose founders have a strong commitment to impact. They note that companies with impact ‘baked in’ to their business models face few tradeoffs between financial and impact objectives, so are unlikely to deviate from their mission. The question of ‘whom to exit to’ is key – echoed in CGAP and CFI’s paper – and investors note that they consider this during due-diligence, looking at likely exit options, which often depend on companies’ plans for growth. Annie Roberts of Open Capital Advisors noted that “if the planned exit for a given business is to a large strategic [buyer] that might not share the same impact motives, the investor takes this into account when deciding whether to make the investment in the first place.” CGAP and CFI’s paper also notes that investors typically “plan their exits before they enter”.

Once ready to deploy capital, investors can structure investments to help the company grow sustainably, without jeopardizing impact. Return expectations and structuring aspects like repayment timelines or holding periods and ownership stake in the company can all form part of a responsible exit strategy. For example, while equity investments can allow for more active involvement, they also tend to have relatively short time horizons (a 3-4 year holding period for a typical 10-year fund, for example) and growth expectations that could lead companies to prioritize expansion over sustainable practices. Debt investments, on the other hand, can be structured with flexible repayment schedules that avoid the pressure for rapid growth. Tying some portion of payments to revenue can free up needed cash for companies with variable cashflows, while also enabling investors to participate in a company’s success.

Investors can also use shareholder agreements and other structuring documents to solidify the company’s mission. Grassroots Capital’s concept note on “’Hardwiring’ Social Mission in MFIs” shows how anti-dilution clauses, dual share structures, and golden shares can help preserve a company’s integrity or keep key decisions in the hands of mission-aligned founders. CGAP and CFI’s paper echoes this, with the example of Aavishkaar-Goodwell’s exit from Equitas. Equitas had a majority independent board (which could reject share sales resulting in over 24 percent ownership), shareholder agreements that set a cap on ROE, and commitments to donate 5 percent of its profits to charity. These governance clauses helped create a “self-selecting pool of potential investors”.

During investment, investors can instill positive practices and corporate governance policies that will last through changes in ownership. For example, investors can work with company management to improve governance policies like adhering to SPI4 standards, which assess an institution’s social performance, in the hopes that sound practices will continue through changes in ownership.

The exit itself, of course, is also key. Whether exiting through a strategic sale, to a financial buyer, or through an IPO, investors can seek to exit at a time when the company is at a stable stage in its growth, and can benefit from another investor’s capital or resources. For example, the GIIN’s paper profiles LeapFrog Investments, which felt it was time to exit its investment in a Ghanaian life insurance company called Express Life once it saw the company growing steadily and in need of growth capital beyond what LeapFrog could provide.

When it comes time to exit, though, how do investors know if they’re selling to a follow-on investor that might later take the company in a different direction? CFI and CGAP’s paper highlights the importance of buyer selection, and the GIIN report shows how investors identify buyers that are aligned with the company’s business model or mission. For example, LeapFrog seeks buyers that recognize the commercial value in serving low-income consumers, as well as the impact inherent in these business models. It sold its stake in Express Life to Prudential Plc, which sought to establish a presence in Africa and understood both the value proposition and the impact created by providing critical financial services to low-income consumers.

This research can guide investors – those focused on financial inclusion and those targeting other themes – in sourcing, structuring, managing, and exiting investments to optimize for long-term positive outcomes. As the industry continues to mature, investors will further develop strategies for responsible investments and responsible exits that result in lasting impact.

To read more on the GIIN studies about Africa, you can download the landscape of impact investing in Southern Africa, East Africa and West Africa.

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About the Author

Hannah Dithrich conducts research at the Global Impact Investing Network (GIIN) to fill critical knowledge gaps in the industry and improve practitioners’ approaches. Hannah is a former Fulbright Scholar to Malta where she worked with the United Nations Refugee Agency, and has extensive background in microfinance at Grameen America and in research at a boutique fund of funds focused on emerging markets. She holds a Bachelors of Arts degree in International Relations from Pitzer College.

Islamic Microfinance: Financing model for economic growth in Côte d’Ivoire

13.03.2018Mohamed Agrebi, Senior Operations Officer, MFW4A

At the crossroads of conventional microfinance and the principles of Islamic Finance is Islamic Microfinance, a concept that is rapidly growing and which enables millions of disadvantaged people, be they Muslims or otherwise, access innovative financial services aimed at assuring their well-being.  The principles of Islamic Finance are simple and clear, and based on the fundamental belief that money does not have any intrinsic value and that all risks should be borne by both parties ; the lender and borrower. Islamic Finance is an economic system which lies on five core principles, namely ; i) prohibition of interest rates ii) prohibition of uncertainty, iii) prohibition of investing in illegal activities/industries, iv) profit and loss sharing, v) prohibition of using tangible assets as collateral.

Islamic Microfinance differentiates itself from conventional microfinance systems by the simple fact that it offers accessible and adaptable financial products to all sectors of the economy. The concept contributes to financing viable products through participatory financing which expands the possibility of implementing investment projects and favouring economic growth.

Today in Côte d’Ivoire, there are two distinct sectors that are directly linked to economic growth; the agricultural and small-and-medium-sized (SME) sectors. These two sectors contribute to the tune of 25%  and 18%  respectively towards the national GDP and employ more than 70% of the working population.

As regards the agricultural sector, producers are mainly in the northern part of the country, a predominantly Muslim region. In recent years, Côte d’Ivoire has proved itself as one of the  world’s top producers of several agricultural products such as cocoa, cashew nuts, kola nuts to mention but a few. Yet, only 13% of conventional microfinance institutions are present in these regions, and where Islamic microfinancial institutions are yet to set up businesses.

In terms of agricultural finance, Islamic finance offers products such as Salam, which is well adapted to the sector.  Salam is a forward financing transaction where the seller is obliged to deliver specified goods/assets to the buyer on a pre-agreed date in exchange for payment made out in full at the singing of the contract. Salam has a number of advantages especially for agricultural producers, notably, the absence of interest rates, profit and loss sharing with the financer, in addition to direct financial contribution to cover overhead expenses such as salaries and taxes. In this regard, Salam is an ideal financing model for activities like agriculture, handicrafts as well as SMEs.

The SME sector makes up 80% of the economic fabric of Côte d’Ivoire and contributes upto 18% of the country’s GDP . Looking at these statistics it can easily be said that Côte d’Ivoire’s economy is mainly run by the SME sector.

Financing businesses is at the heart of Islamic Finance. Islamic microfinance institutions have an array of participatory financial products such as Mudaraba and Musharaka, which easily adapt to the needs of SMEs. In the case of Mudaraba, the financing bank can take full responsibility for funding the entire investment project as a business associate. This kind of funding is suitable for startup SMEs looking for initial capital. Musharaka, on the other hand, is a contract between two or more parties and is mainly used to fund projects where profits or losses are shared on a prorata basis depending on the capital contributions of the concerned parties. The Musharaka financial instrument aims to essentially fund an investment project that is considered profitable while remaining compatible with the principles of Islamic Finance. The investment using Musharaka is a contribution from parties who are supportive of one another in the event of loss and who share the profits if and when the venture is profitable.

As such, Islamic Microfinance has a great potential to respond to the needs of several economic sectors through the use of innovative and participatory financial instruments. Nonetheless, the sector is still in its nascent stages in Côte d’Ivoire. The Ivorian Islamic microfinance market is mainly made up of two players, notably, Raouda Finance based in the economic capital, Abidjan and Al-Barakat, in Daloa, a town in the mid-west region of the country.

In addition to the issue of geographical distribution in the country, (for example Raouda Finance has only 4 branches in the southern part of the country) these microfinance institutions face a number of major challenges such us the lack of a governing framework which takes into consideration the specificities of Islamic Finance, and insufficient resources as well as lack of skilled workers in the domain.

The operations of Islamic Microfinance institutions are generally impeded by the governing framework which does not take into consideration their particularities, despite the fact that Ivorian authorities have up until now tolerated their operations. The temptation to go back to conventional financing options is real given the insufficient resources of islamic microfinance institutions. There is also a lack of skilled personnel particularly with regard to certain complex aspects of Islamic financial concepts such as the profit and loss sharing (PLS). Financial solutions based on PLS require a good understanding the principles of risk management. Furthermore agents working in MFIs have been trained in conventional financing models and therefore end up using inappropriate terminology such as « we can give you a loan to the tune of…. » «…. the interest rate is….. ».

Islamic microfinance is a financial paradigm capable of triggering a buzz in the Ivorian financial landscape especially with regard to sustainable economic growth for the country. However, its development highly depends on the political and economic will of the country’s decision makers.

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About the Author

Mohamed Agrebi is the Senior Operating Officer at Making Finance Work for Africa (MFW4A), hosted by the African Development Bank (AfDB). Since 2010, he has been working for MFW4A. Mohamed also leads on MFW4A' Islamic Finance-related activities. He holds an executive master degree in Islamic Finance and Banking from “Ecole Superieure des Sciences Economiques et Commerciales de Tunis”. In 2017, he authored a research paper on the prospects of Islamic Microfinance in Côte d’ivoire.

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