71310 FOCuS NOTE Voting the Double Bottom Line: Active Governance by Microfinance Equity Investors S ocially oriented equity investors—particularly those that take formal roles in the governance of microfinance service providers and funds—face In this paper, we use an intentionally broad concept of governance. This assumes that while traditional corporate governance activities, such as voting challenging situations and decisions.1 Equity investing one’s shares or taking a board seat, are important, requires active governance—and this is particularly microfinance investors can and should go further by true for value-based investing because value-based exerting influence throughout the investment cycle, investors seek to guide the company so that it from initial due diligence through to their exit from behaves responsibly and creates both financial and the MFI. Although the focus is mainly on international social returns. Again and again in the course of development finance institutions (DFIs) and research, those involved in microfinance institution microfinance investment vehicles (MIVs)4 that provide (MFI) governance have said that most microfinance equity, where relevant this paper also considers cross- investors are not taking an active enough role.2 One border lenders and local investors. Interviews with experienced microfinance professional spoke for current and former staff of investment organizations, many when she observed: “Foreign investors must investor-appointed and independent directors of be engaged owners, not just sleeping partners.� This MFIs and funds, chief executive officers (CEOs) and paper offers evidence from interviews that took the senior managers of MFIs and funds, researchers, and pulse of more than 100 industry insiders to provide others inform this “self-assessment� of governance a self-assessment of microfinance governance today. in the sector and ideas on how to strengthen social investors’ performance in this regard.5 Together, they Corporate governance serves to mediate interests represented at least seven DFIs, 32 MIVs, and 19 MFIs. of diverse stakeholders including shareholders, The analysis also uses CGAP investment data, desk management, and employees, as the basis for research, and preliminary data from a field test of new decisions on a company’s strategy and goals. MIX governance indicators.6 It provides the framework within which shareholders oversee operational performance and manage risk to Few of those interviewed question that stronger ensure the company’s long-term health.3 In the case of MFI governance is needed and could help improve MFIs, those diverse interests also include protecting individual retail providers and the sector as a vulnerable clients and pursuing a social as well as a whole. While existing guidance and how-to tools financial bottom line. Equity is of growing importance describe the ideal of effective MFI governance, to the microfinance sector, and social investors that practices on the ground are still nascent.7 Our provide equity have expanding opportunities to play research highlights areas for further improvement governance roles. This Focus Note explores the extent and reveals promising practices. Raising the No. 79 to which investors are currently capitalizing on this performance bar across the MFI sector will require May 2012 opportunity for active and effective governance. It strategy, resources, and staying power. Equity offers practical insights, emerging good practices, and investors can play a key role. See Box 1 for a Katharine McKee reflections on how to address reported gaps. summary of key findings. 1 This paper uses the terms “social,� “socially oriented,� and “double bottom line� investor interchangeably. 2 This paper uses “MFI� in its broader sense to refer to specialized providers of financial services to lower income customers. 3 See, for example, OECD (2004). Traditional corporate governance focuses mainly on the “principal–agent� problem, i.e., how owners can oversee and protect their interests after delegating operational roles to management. 4 DFIs are bilateral (e.g., the Netherlands Development Finance Company [FMO]) or multilateral (e.g., the International Finance Corporation [IFC]) entities that fund development activities and have majority or full public ownership. MIVs include microfinance funds, networks, holding companies, and other entities that fund MFIs directly or through funds/structures. 5 See Annex A for a complete listing of those interviewed. 6 The survey with draft governance indicators received 162 responses from the MFIs that reported to MIX in 2010. 7 See, for example, Council of Microfinance Equity Funds (2005), Cerise-IRAM (2006), BBVA Microfinance Foundation (2011), Promifin (2011), and Goldberg et al. (2011). 2 Section I summarizes findings and brief analysis some more purely commercial investors. Section V of factors contributing to increased attention to provides a thumbnail sketch of current governance- governance across the industry. Section II describes related initiatives and closes with an analysis of the growing influence of microfinance equity challenges and recommended next steps. investors and their opportunity to strengthen MFI governance. Section III describes the most common I. Findings and Drivers “hot button� issues in the board room. Section IV outlines key findings on the reported behavior A recent study described the mainstream corporate and effectiveness of equity investors; it also governance ideal as “creation of competent boards explores implications of an investor marketplace capable of objective and independent judgment and that is increasingly segmented and has attracted thus likely to exhibit the expected authoritative and Box 1. Key Findings Further progress on financial inclusion will demand 4. The research found that equity investors are strong, adequately capitalized, and responsible not fully capitalizing on the opportunity to providers. This self-assessment by industry insiders found strengthen MFI governance. The specific areas a mixed governance picture, with bright spots and many for improvement include the following: weaknesses. Respondents reported that the norm is • Actively engaging in and beyond the board still far from the ideal: that is, boards are well-informed, room guide strategy, and challenge management as needed • Ensuring adequate qualifications, time without micromanaging. While other sectors also suffer commitment, and continuity of investors’ from governance deficiencies, the microfinance industry nominees is lagging in applying accepted good practices. Many • Addressing director passivity and reticence to respondents noted recent improvements, however, as question management proposals a result of increased awareness, specific reform efforts, • Aligning shareholder interests MFI growth, and regulation. It also found important progress on tools to The most important findings from the research are strengthen social performance that could be as follows: applied more effectively in governance. 1. Social investors that provide equity to MFIs, 5. The MFI sector is relatively young, and many funds, and other MIVs have ample opportunities institutions are still led by charismatic founders. to contribute to improved governance, including Managers are often reluctant to accept the need to the right to fill at least 325 board seats. They can give up some control in the interest of achieving more help encourage MFIs to adopt good practices and balanced governance and a stronger double bottom model active ownership themselves. line. Reportedly too few investors have the intention or focus to take on cases of management capture, 2. The standard roles of corporate governance— where the CEO or management team dominates the addressing the principal-agent problem that board and the board’s oversight of the MFI is weak. is created when owners delegate day-to-day operations to management, setting mission and 6. MFI governance practices overall exhibit some strategy, overseeing operations and management, common weaknesses. These include the following: and ensuring the company’s long-term survival— • Clarity on the respective roles of management, are relevant for MFI governance. The vulnerability the board, and shareholders. of clients and trade-offs that may arise between • Policies on conflict of interest and what the financial and social bottom lines are additional information must be disclosed to the board common concerns. • Establishment and use of board committees • MFI-specific dimensions of social governance, 3. Currently, the reported hot button issues in risk, and human resources management MFI governance are growth, product/segment diversification, client protection, pricing and 7. As the microfinance investment market gets profits, executive remuneration, and major more diverse and segmented, including a rise in changes in financing and ownership structures. more purely commercial financing, governance MFI crises and failures have strained governance structures and processes will need to adapt to and exposed weaknesses, as well as underscored ensure adequate alignment of shareholders’ how strong boards help MFIs survive tough times. preferences and time horizons. 3 challenging behavior� (Geneva World Microfinance governing bodies will need to strengthen their Forum 2010). The global financial crisis revealed skills and oversight capacity. The sector’s need for the gap between this ideal and reality. Large capital also brings MFI governance into sharper financial firms suffered obvious governance failures, relief. Fast-growing providers in some markets including lapses in ethics, poor risk management, have tapped capital markets, including through and misalignment of executive remuneration with bond issues or initial public offers (IPOs). This can long-term shareholder value. Current reform efforts bring in investor types that are new to the sector, seek to solve the problems observed, such as such as private equity (PE) firms and traditional management capture, conflicts of interest, board institutional investors. New financing can trigger passivity, and inadequate disclosure of information changes in governance, such as renegotiated legal from management to board, regulators, and the agreements, board seats, or targets. These changes public.8 Most experts agree that if these good are sources of governance stress in themselves. governance measures succeed, they should improve Current owners and MFI managers would do well to firm performance.9 assess prospective owners carefully for compatibility of the different parties’ overall goals, targets, and Adding to this general attention to governance time horizons. of financial institutions, microcredit crises and high-profile MFI failures in several countries— Recent responsible finance initiatives also focus largely attributed to unsustainable growth—have on governance as the main process that ensures heightened concerns about MFI governance. adherence to good practice and aligns MFI Analyses of these cases revealed that ineffective strategy and operations with mission.10 Hundreds governance was an important contributing factor, of MFIs have joined the Smart Campaign, often with one study concluding that “. . . an institution’s with strong encouragement from funders. Fifty- governance structure proved to be the primary five investors have endorsed the UN-backed differentiating factor between those entities that Principles for Investment in Inclusive Finance (PIIF).11 overcame a crisis and those that did not� (Marulanda Translating these commitments into practice will 2010). Most of the MFIs that survived a crisis did so require active governance; indeed, the codes and because of a timely and well-honed response by their standards implicitly oblige MFI directors to observe board chair and directors, including mobilizing fresh a higher “duty of care� than those in conventional capital from lenders and shareholders, overhauling financial institutions (although many now argue that the mission and strategy, strengthening or changing bank directors have a duty of care to depositors, which management, and rebuilding the confidence is established by regulation in some jurisdictions). of clients, staff, and regulators. Sometimes the board moved out of the traditional oversight role, Together these factors are spurring recognition that temporarily stepping in to take on key management MFI governance needs to catch up. Respondents to responsibilities. the 2011 Banana Skins survey, for example, ranked governance as the fourth highest perceived risk; they Building a successful MFI in any young, dynamic also ranked three other risks—credit risk, reputation, market is challenging, as the provider seeks to and competition—as greatest and rising most quickly scale up and boost efficiency while managing new (Lascelles and Mendelson 2011). Governance plays a operating risks. With MFI business models becoming central role in managing each of these risks. Investors more complex and product lines diversifying, MFI are uniquely positioned to provide and improve MFI 8 Most mainstream corporate governance reforms are embodied in law and regulation. However, industry initiatives, such as the 2010 uK Stewardship Code, also seek to promote active governance and tackle directors’ passivity and overly short-term orientation. 9 A 2327-firm survey found stronger performance in better governed firms (Brown et al. 2010). However, it should be noted that less than 1 percent of governance studies focus on emerging markets or developing countries (Ararat et al. 2011). 10 Responsible microfinance consists of client protection (for all providers) and social performance management (for those with a specific social or development mission). See McKee, Lahaye, and Koning (2011). 11 For more information, see www.smartcampaign.org and www.unpri.org/piif/. 4 Figure 1. Illustrative: Different investor segments and objectives Low-beta, Grant/quasi-equity Social/impact Momentum commercial providers investors investors investors Focus • Mission • Social + �nancial • Financial returns + • Financial returns returns Corporate Social Responsibility Risk-Return • No principal back • Protec on of principal • Risk-adjusted • Higher risk/higher Expecta ons • No �nancial return • Range of return market-rate returns return pro�le (MFI transforma ons expecta ons (from • Pa ent capital; • Returns through capital special case) modest to near-market) longer-term orienta on apprecia on (e.g., steady dividend) Investment • Grant • Time horizon varies • Micro�nance small part • Shorter me-frame Characteris cs (5–10+ yrs) of overall por olio common (e.g., 1–5 years • Invest in retail MFIs, • Minimum deal size vs. 5–10) holding companies or rela vely high • Exit through IPO or sale MIVs • Typical indirect investor of shares Examples • Founda ons, • DFIs, MIVs, other • Insurance companies, • Late-stage venture bilateral funders private investors pension funds capital and private equity (PE) �rms, some MIVs governance, in their roles as directors and sources of $1.7 billion in microfinance equity, a gain of 13 percent new equity. over 2009. MIV data are less complete; year-end 2010 estimates are in the $500 million to $900 million range. II. The Microfinance Investment As a result of these ownership stakes, investors have the Market is Segmented; Investors right to appoint at least 325 board seats—representing Have Ample Opportunities a major opportunity for active governance. to Govern Actively in MFIs Figure 2 shows seats held by holding companies Figure 1 shows a stylized segmentation of an and international networks (such as Advans, increasingly diverse microfinance equity market. This FINCA International, and MicroCred), MIVs that segmentation affects MFI governance arrangements are not holding companies (such as Developing and governability. Technically, grant funders, such as World Markets and Oikocredit), DFIs, and other foundations or bilateral agencies, are not investors, investors. Holding companies and some networks although they have capitalized start-up and growth take full ownership or controlling stakes in their of many MFIs. Each of the three investor groups MFI affiliates. As a result, typically they fill multiple has distinct return, risk, and time preferences. board seats and appoint the MFI board chair. One Institutional investors in the “low-beta� category international network alone fills 50 board seats. Most might invest if the sector can offer stable dividends other investors take seats on boards when entitled and positive social benefits. “Momentum� investors (typically with a 10–20 percent stake), and some aim typically have a shorter time horizon and seek to to invest stakes large enough to secure a seat by the maximize profits; they tolerate higher risk in exchange law under which the MFI is organized. Investors may for higher returns through capital appreciation. negotiate for a seat even when their stake is below the threshold, generally with support from larger Socially motivated investors are providing increasing investors.12 Surprisingly, a handful of investors do amounts of microfinance equity and hold hundreds of not always take the seats to which they are entitled. board seats on MFIs, funds, and other MIVs. Among Others negotiate for a seat but do not fill it or delay public funders, at year-end 2010, the 10 largest DFIs had nomination of their representative. Either situation 12 For example, the Omidyar-Tufts Microfinance Fund was allocated a seat on one board with an ownership stake of only 6 percent. 5 Figure 2. Governance opportunity for social and development investors Number of board seats 350 300 24 325 93 250 Social and 200 116 development equity investors 150 hold at least 325 board 100 seats 92 50 0 Holding co’s MIVs DFIs Other MIIs Total (n = 5) (n = 24) (n = 19) (n = 4) (n = 52) Sources: 2010 CGAP MIV and funder surveys, Symbio cs can hinder governance, as in the cases reported III. Hot Button Issues in where unfilled investor seats made it difficult for Microfinance Governance boards to achieve a quorum for important decisions. Not filling seats may have to do with the challenge Across the diverse pool of interviewees, the of finding the right candidate, associated costs, short list of these hot button strategic decisions director liability worries, or philosophical concerns in the board room was surprisingly consistent. about “northern� funders dominating “southern� Respondents were asked which were the most institutions. No matter the reason, the end result is a difficult or controversial decisions that arise in the lost opportunity to provide expertise and guidance. governance process. Many of the identified issues involve trade-offs that arise between social and Investors often provide partner MFIs a combination financial performance, at least in the short term.13 of debt, equity, and technical assistance (TA). One expert observed: “The double bottom line is Sometimes they fund the MFI’s holding company a live issue, not just rhetoric.� The first half of the as well. Networks, funds, and MIVs, such as Incofin, list appears to cover relatively more established Africap, Equator Capital, and Oikocredit, pursue a “finance-plus� approach with dedicated TA funds. Accion provides management support (including Box 2. Which Decisions are Reported to seconded CEOs) as well as equity investment and Generate the Most Controversy in the Board Room? active governance support. IFC combines substantial MFI capacity-building support with its funding in • How fast to grow and where • Which new products to offer and which client sub-Saharan Africa. The French DFI PROPARCO segments to prioritize receives TA and capacity-building funds from the • How to price products and ensure long-term French development agency AFD. Senior investment client protection officers stressed the value of this model for young • What profit targets are appropriate and how should profits be allocated companies in fast-changing markets. However, • What level of executive remuneration is playing multiple roles of lender, shareholder, and appropriate TA provider can raise conflicts of interest that need • How to handle capital increases, entry of new owners, and responsible exit to be managed through governance policies and • How to handle crisis process. 13 An example of the view that there are no significant trade-offs between social and financial returns is found in J.P. Morgan (2010), whereas other analyses identified both synergies and trade-offs (MIX 2010 and Guarneri et al. 2010). For a useful synthesis, see Di Leo (2011). 6 debates whereas the second half describes emerging “heavily debated� as they can raise concerns about concerns. mission drift as well as capacity and market potential. Managers may be tempted to reach growth targets Growth by increasing loan size. One fund manager described how an MFI board required specific risk management The majority of respondents raised this issue, and social performance measures as a condition which comes up as boards approve and oversee for a major proposed increase in average loan the business plan, annual budget, and portfolio size. Support for expansion into consumer lending performance. Several directors reported cases is also controversial, with different DFIs and MIVs where the board has reined in management’s having sharply divergent views on the reputational growth plans year after year. As one pointed and mission drift risks involved. Seasoned directors out, if managers are not themselves significant stressed that it is critical for the board to ask tough shareholders, they tend to focus more on market questions about diversification proposals since share than profits. Others described cases where young and mature MFIs alike have stumbled due to managers proposed moderate growth and boards inadequate planning and overly rapid expansion into pushed for more aggressive targets. In several new market segments. MFIs that failed, insiders reported that although one or more directors voiced concerns about Product pricing and client excessive growth, management was bullish, the protection measures overall market seemed strong, and it ultimately proved too difficult to “lean against the wind� and Boards set responsible lending policies and monitor chart a more conservative strategy. “Governance MFI business conduct. The recent microcredit crises needed to come in—otherwise there was no one have raised funder, media, regulator, and politician in the driver’s seat who would cool down the concerns about nontransparent pricing and how it growth,� explained one fund manager. Investors contributes to borrower debt stress. Pricing debates such as KfW are putting in place internal growth have sharpened,15 and respondents report this guidelines, tailored to the MFI and market context issue as now more prominent in board rooms and (for example, acceptable growth rates for start-up shareholder agreements. Investors reported due and younger firms are higher than for larger and diligence analysis of prospects’ all-in pricing and peer more established providers). comparison. More MFI boards now do the same in reviewing pricing policies. Respondents reported Product diversification and service to several cases where boards have turned down price new client segments or geographies reductions proposed by directors or management. In contrast, the shareholders of FIE in Bolivia agreed These issues raise board concerns about demand, by policy that prices to clients would be reduced capacity, risk, and competition. Some directors also when return on equity (ROE) hit 15 percent. One described divisions between more “finance-first� and fund manager reported winning over directors who “social-first� investors as MFIs considered business represented more commercial investors to the MFI’s lines with high social value but profitability only in policy of periodic rate decreases by citing the sector’s the longer term, if at all. 14 Investors committed to reputation risk from its relatively high margins. serving rural areas or small depositors, for example, Many pointed to the need for clearer guidance on described the challenge of building sufficient responsible pricing. shareholder support for these activities. Management proposals to serve new market segments, such as Boards and investors also are focusing on other small-to-medium enterprises (SMEs), tend to be dimensions of responsible finance, such as 14 See Monitor Institute (2009) for first use of these terms and Di Leo (2011) for further discussion of microfinance implications. 15 See, for example, Muhammad Yunus’ statements on acceptable returns, debates on Compartamos’ pre-IPO pricing strategy (including Rosenberg 2007), and documents on the Smart Campaign’s “responsible pricing� principle. The Social Performance Task Force (SPTF) is now addressing this issue within its universal standards of social performance (http://sptf.info/sp-standards). 7 transparency, redress, and collections practices. A few Interestingly, some promoters also are limiting are building these into MFI managers’ incentives. MFI profits (Equitas in India reduces prices if ROE One director stressed that the board “. . . must check hits 20 percent) and screening potential investors that each aspect of the strategy—growth, pricing, to ensure they agree with these limits. In its last products—is consistent with responsible finance capital-raising round, Ujjivan in India limited its and make management prove that the targets are entry price to attract the right investors and reduce sustainable.� Another advised boards to “insist on valuation pressure. ESG [environment, social, and governance] issues even if management doesn’t see it as important While many respondents were skeptical that boards at the time—they must come to see it as in their would or should act to rein in “excessive profits,� self-interest.� Respondents said that endorsing the some voiced frustration that the incentives for Smart Campaign was not in itself controversial—and many managers and shareholders seem to be such indeed, investors have spearheaded management that “the financial bottom line will always win.� As buy-in to these initiatives. Not surprisingly, however, an example, one fund manager described how a key players do not always agree on implementation sustainable rural African MFI was turned down for specifics, such as how much to invest in staff training funding because other social investors found the or which upgrades to prioritize. For example, some internal rate of return to be too low. Others shared nominee directors wished their peers would push similar cases of what they considered “misalignment� MFIs harder to report and use credit bureau data. among owners on the profits–mission balance. Directors also noted the need to be pragmatic and Section IV(d) discusses this issue further. phase in client protection measures over time. Executive compensation and incentives Profit targets and allocation The global financial crisis has resulted in many Some investors have placed the “balanced returns� efforts to realign executive pay in mainstream issue on MFI board and shareholder agendas. Others financial institutions to reward safer and more stable are crafting internal guidance on acceptable profit performance.16 One relevant lesson for the MFI sector ranges, levels, or allocation (among dividends, could be that the composition of compensation retained earnings, and other designated uses, such (including bonuses and shares as well as base salary) as MFI “social funds�). For example, a DFI senior is as important as its overall level. The pay issue for manager stated that ROE exceeding 25 percent, or MFI CEOs and fund managers is just surfacing in growth projections above 100 percent, would attract investor processes and board rooms. Sometimes close scrutiny, especially for an established MFI. Many shareholders agree on this issue upfront in articles urged investors to analyze what is driving some MFIs’ of incorporation. For example, Equitas MFI in India relatively high ROE. A fund manager cited this as a caps CEO pay at 40 times that of the lowest paid field factor in turning down three or four deals, including an staff’s pay. Some investors have internal guidance for MFI that “had a moderate interest rate environment, analyzing total pay; they report using the benchmarks was overcapitalized, and the investors were still making either to screen out investments upfront or to pursue close to 38 percent year in and year out.� better compensation policies and practices once invested. For example, CEO remuneration at some One fund manager described a case where the large Indian MFIs raised eyebrows and deterred some board set specific rural outreach targets and MIVs from investing. Elsewhere an MIV decided to allocated funding for them instead of capping invest in an MFI, despite executive pay it considered ROE. Some questioned investors’ focus on ROE excessive, but insisted on creation of a committee of per se and advocated analysis of other factors, such the MFI’s board to gather data and gain broad buy-in as customer benefit from past efficiency gains. for changes. New international accounting standards 16 See, for example, Winter (2010), Brown et al. (2010), and Calmeadow (2009) on aligning incentives in MFI transformations. 8 mandate disclosure of executive compensation, which Most of those interviewed believe that the sector will could also affect views and practice in the sector. need commercial capital and hope it will be possible to “crowd out the short-term investors with the long Financing strategy, ownership term ones� that seek stable companies and steady changes and “responsible exit� dividends. Realistically, institutional investors are more likely to come into funds and MIVs than directly The board shapes an MFI’s size and diversification into MFIs, but growth financing from more patient of its assets by overseeing its long-term financing institutional investors could replace or complement strategy. Respondents reported heated debates direct equity from PE firms. Many acknowledged, around taking on substantial new debt (especially however, that it will not be easy to tap this source. if it comes with forceful covenants) and increasing One fund manager cautioned “. . . we want capitalization to bring in new shareholders. Some institutional investors to come in for 20 years and be criticized MFIs that they perceived had sought out satisfied with returns of 6–7 percent per annum. This mainstream commercial lenders and equity investors might seem reasonable but our deals are small, it is with excessive return expectations. New investors’ hard for them to select well, and right now there is a time horizons were also a common concern. A holding lot of reputation risk.� company manager cited cases where PE firms were seeking to exit in two to three years through A special case: MFI crisis and failure an IPO or secondary sale, a “time horizon that is in no way consistent with what needs doing.�17 He Recent research shows how the MFI crises and continued, “. . . some funds say ‘We are committed the prospect of big financial losses created huge to return 20 percent to our investors,’ but how can additional strains on governance (Marulanda you do this and be in development?� MIV and fund 2010 and Rozas 2011). Many insiders stated that managers reported turning down big investments more effective governance could have mitigated when return expectations appeared unrealistic or the the impact or even averted failure of MFIs, such time frame too impatient. as BANEX in Nicaragua. The holding companies and networks were reported to respond more Respondents also noted more focus among social quickly in a crisis than others. Few microfinance investors on how to achieve “responsible exit.� While investors had experienced MFI work-outs, losses, most social investors are likely to sell their shares to or sector liquidity crises. Directors experienced a more commercial buyer, many would prefer to serious tension between their nominating investor’s find buyers that have a sound understanding of the interests and loyalty to the MFI. Crises also microfinance business and can at least be counted exposed differences in shareholders’ and creditors’ on to maintain responsible practices. Some investors time horizons and flexibility. Some respondents are seeking to ensure ongoing mission orientation described the harm to clients and others investors by crafting language in agreements and working that resulted from rigid covenants and unreasonable with like-minded investors. A DFI manager reported work-out expectations. that reputation concerns had led his DFI to block entry of certain new investors. Fund managers also Lenders close to pay-off were tempted to “cut said that they do and will take considerable care and run� rather than cooperate on a long-term at exit, since reputation will play a key role in the solution. Respondents reported that financial success of their future funding rounds. However, to survival trumped social value for some owners, date there have been few MFI exits, and whether whose behavior seemed to reflect an attitude that socially oriented equity investors are actually willing “we paid a lot for our shares and now we need to to compromise on sales price in favor of social goals earn it back.� One CEO said, “You see how social is not yet clear. your investors are only in the hard times.� Many 17 The telescoping of investor time horizons reflects a broader trend worldwide. Bolton (NYSE Index 2010) reports that the average holding period for a stock on the New York Stock Exchange had decreased from around eight years to less than a year within a lifetime. 9 commented on investors’ unrealistic expectations microfinance governance is still distant from that boards could mediate competing and best practices in many cases� (Guarneri, Moauro, conflicting interests. One industry insider remarked and Spaggiari 2011). This is consistent with our on “our ‘romanticism’ around financial institutions interview findings. Respondents cited frequent created to pursue a double bottom line—since we examples of investors appearing to underestimate are all double bottom line it is so hard to imagine what it takes to be a responsible owner and failing power being used in a self-interested way. We to approach governance roles with adequate demonstrated a real naiveté in our illusion that all strategy and resources, which in turn negatively the things we see in normal financial institutions affected the overall effectiveness of the MFI’s could never happen here.� governance. Ongoing debates around responsible finance The research suggests five areas for improvement and commercial investment suggest the need for in social investors’ governance strategy and further clarification and guidance. Investors are behavior; it also revealed promising developments developing internal guideposts on issues such as in each of these areas. We address each of these growth, returns, and executive pay. Consultations in turn: on the PIIFs and SPTF universal standards are progressing.18 Yet consensus is elusive for some 1. Governance requires engagement beyond difficult areas, such as defining returns that balance participating in shareholder meetings or filling the interests of clients, providers, and investors. a board seat. Respondents reported that many Convergence around a single global standard for equity investors should play a stronger role in acceptable growth or profitability is unlikely. Nor governance-related activities throughout the life is it advisable. But investors can and should play a of their investment. key role in the sector’s efforts to build consensus 2. Social investors should carefully consider who on tough issues, where possible and appropriate. they nominate to represent them on the board Guidance that emerges can inform internal investor and monitor how the person performs in this role. processes and external assessments, such as 3. Opportunities exist for investors to strengthen ratings. It can also help shareholders with diverse MFI governance structures and processes. preferences better align within MFI ownership 4. With the advance in social performance metrics, structures and the boards to which they delegate respondents highlighted the opportunity to decision-making to better navigate the hot button improve social governance. issues of the future. 5. There needs to be more attention paid to how the microfinance sector will handle tensions IV. How Effective are Social that can arise as investors become more Investors in Fulfilling Their diverse Governance Role and What Is the State of MFI Governance? a. Governance over the life of the investment— entry, legal agreements, monitoring, and exit There is a strong consensus that microfinance equity investors can improve the performance Gaps in DFI and MIV due diligence. Funders have of retail MFIs by offering more consistent considerable leverage at this point, before deciding and proactive governance support. A recent whether to invest, how much, and on what terms. Microfinanza report found that “[d]espite the Improved due diligence will strengthen provider key role of governance for the sustainable incentives, especially if funders are willing to defer achievement of the social mission and institutional funding until deficiencies are fixed and even say risk management, the current state of the art of no, as respondents from a diversity of investment 18 http:sptf.info/sp-standards 10 organizations reported having done. Due diligence provide fresh capital if needed. Deciding upfront also lays the base for active governance once who will take leadership and how investors will invested. Three areas are reported to need more cooperate in the case of a crisis is also emerging as attention: social goals, responsible finance issues, an important focus for due diligence, since timely and expectations of other owners. action is essential. Most equity investors have strengthened the Legal documents and reporting requirements. process of getting comfortable with the vision Investors can describe goals and preferences and quality of the institution and its leadership, in articles of incorporation and shareholder or as well as screening ESG factors, including client subscription agreements. Provisions in legal protection. 19 Examples of progress include the documents offer a basis for addressing trade-offs following: that arise, including around responsible finance, and anticipating how future problems will be • Tailored due diligence scorecards (e.g., Blue addressed. They also help ensure alignment of Orchard, Triodos, Oikocredit, Incofin), joint the parties around mission, strategy, and targets. due diligence missions (European Microfinance While not yet standard practice, diverse investors Platform 2011), and in-depth due diligence (e.g., Aavishkaar Goodwell, Agora Microfinance, analyses that are also available to other investors Equator Capital, and the European Investment (BBVA Microfinance Foundation) Bank) reported including specific provisions on • Public reports by third parties on MFIs’ compliance MFIs’ mission adherence, client protection, or with codes of conduct (commissioned by the State social performance reporting in shareholder/ Industrial Development Bank of India to support its subscription agreements and some loan covenants. lending and equity processes) 20 KfW instituted a responsible finance clause and • A common protocol for assessing client protection recently added new language in fund manager (the new Smart Campaign certification tool) agreements to ensure MFI adherence to client • Increased attention to MFI governance in ratings protection. KfW, FMO, and CDC (the British processes DFI) built client protection and risk management • Internal benchmarks on acceptable practice (e.g., provisions into a new fund in India. Incofin term Dutch and German DFIs, Triple Jump’s “red light� sheets have standard language covering social tool, Oikocredit’s analysis of pricing, executive pay, performance and client protection; for example, profits, and dividends) one partner MFI was required to join the industry association and report to the credit bureau. Several One due diligence gap cited frequently is the investors urged that indirect investors, such as need for investors to better size up the profile institutional funders of funds, also step up due and expectations of the other investors and diligence around responsible finance. One stated, lenders that are in the MFI or fund. Investors are “They need to build in the right incentives for direct now more aware of reputation risk and scrutinize investors, fund managers, and holding companies, fellow owners, creditor agreements, and covenants through contracts and management compensation more carefully. For example, a new due diligence formulas.� Many look to the PIIF process to help questionnaire at KfW assesses funds’ governance define good practice for institutional investors. and responsible finance profile and the fund managers’ qualifications and remuneration. Many Agreements can strengthen governance, for example, stressed the need to assess fellow investors’ time by stating minimum professional qualifications for horizons, as a proxy for their likelihood to help build directors and clarifying which decisions require the company over time, respond to problems, and board or shareholder approval. Specific provisions 19 A recent CGAP Technical Guide advises investors on steps for integrating client protection throughout the investment process and emerging good practices from diverse DFIs and MIVs (CGAP 2011). See also European MF Platform 2011 publication. 20 Small Industries Development Bank of India Web site (http://www.sidbi.in/micro/). 11 on work-outs and future financing are also appearing will exit through sales to current shareholders, new in agreements, including the types of new partners buyers, or occasionally management. This is the final that can come in and on what terms. An Agora point at which a social investor can influence the Microfinance partner asserted that “the shareholder MFI’s governance and direction. One fund manager agreement has to be watertight on complete described it as “always a bit painful� to try to find adherence to mission.� In response to expectations the right buyer(s) who will balance shareholder from retail investors and new standards, MFIs and financial and social value with helping ensure the MIVs also are providing more detailed reporting on company’s continued double bottom line success. social and financial value creation. The European These issues are getting more attention from both Investment Bank, for example, drew on the KfW sellers and continuing owners. Exit provisions could clause in designing its social performance reporting help ensure commitment to mission, protect minority requirements for MIVs and will make them more shareholders, or maintain a bloc of like-minded specific over time. owners. Most of those interviewed believe that specific legal To date microfinance exits have been few and provisions help strengthen governance by setting reportedly consensual, so the effect of such provisions clear expectations with management and other is largely untested. The Aavishkaar Goodwell MIV owners. They acknowledge, however, the difficulty shared a recent case where exit provisions came into of foreseeing future issues and providing guidance play. An MFI that the MIV had helped start increased that is actionable but not micromanagement. One its capital, diluting the MIV’s stake to the point that director said it will boil down to whether there is it lost its board seat. The fund decided to exit, but “enough trust and common values to deal with only after extensive consultations with managers what will come up, which is largely unpredictable and its own retail investors. The senior staff member and cannot be anticipated in agreements.� Since who had served on the board described the fund’s agreements are not always legally enforceable, concern about how to exit responsibly and avoid investor incentives also matter. A recent report on the perception of being “a vulture investor.� To this responsible governance concluded, for example, that end, the MIV screened prospective buyers carefully “social principles do not necessarily resolve typical before selling its shares (not to the highest bidder) tensions (cost of rural outreach vs. risk, for example) and recycled the funds into early stage companies in and shareholders’ profit expectations. . .. [I]n a very Africa. In this case and others, executing a satisfactory competitive market, investment managers of equity exit required anticipating key issues up front in the funds may be reluctant to apply strict conditions to legal agreements. shareholder agreements. Some may prefer to help MFIs improve their practices through monitoring� b. Making the most of board representation (European Microfinance Platform 2011). Nominating individuals to serve on boards of MFIs or It is important to note that covenants may give lenders funds is equity investors’ most direct opportunity to considerable direct influence as well, for example, exercise active governance. Social investors’ policies by requiring that they approve key decisions. Many and practices vary widely. While most nominate staff investor staff and directors voiced concern that the such as investment officers, it is also becoming more number and rigidity of lender covenants sometimes common to nominate outside individuals (either local increase MFI risk, rather than reduce it. Lenders may or international). There is also a debate underway have more forcing power than owners on certain about the value and practicality of appointing issues, may lobby the board on specific matters, and independent directors—that is, persons who do may also influence MFI governance through TA or not represent any single shareholder. Respondents informal advice to management. reported that while, in general, directors nominated to fill board seats for social investors bring useful Exit. While IPOs are possible in a few larger and expertise and perspectives, gaps are often evident, more developed markets, most equity investors including in director skills and qualifications. Another 12 weak spot is directors’ time commitment, consistency, and outside experts so that we can be the hands-on and continuity. And a third is nominee directors’ investors that we want and need to be.� The CHF duty of loyalty (particularly if they are investor staff) and Opportunity International networks sometimes and their willingness and ability to be objective and appoint MFI CEOs from one country to serve on assertive. This section explores current practices, the board of an affiliate in another country. Several factors contributing to observed weaknesses, and respondents stressed the useful role of strong local promising developments. directors in managing reputation, regulatory, and political risks. Deciding whether to take a board seat and how to fill it. An equity investor with a controlling interest As MFI business models, product lines, and operating may have the right to fill two or three seats and environments become more complex, the skills mix appoint the chair. Most other investors negotiate needed by boards evolves. Few board members have for a board seat if entitled to one by their stake. direct operational experience. One fund manager Sometimes, however, after insisting on a seat, an echoed a common theme: “MFIs should reach out investor does not nominate a director or does so beyond their silos and recruit directors from the only after long delay. Reasons for this may include commercial world—business people, accountants, capacity, cost, concerns about conflict of interest lawyers. . . .� Yet many observed the tendency for and fiduciary responsibility, or the assumption that managers and boards to “mystify� microfinance as others will take on this task. This behavior reflects a unique and specialized activity and to be almost a serious weakness that some call “the free rider suspicious of expertise from other sectors. problem.� Time commitment, consistency, and continuity. While many investors devote considerable care to Respondents reported that investors’ directors finding strong directors, respondents reported that often have too little time available for active MFI boards often lack the skills they need, and some governance and effective oversight. Director nominees lack sufficient seniority or qualifications. One constraint is the limited pool of senior staff to fill multiplying board mandates. Investors typically Box 3. The Special Case of MFI nominate current or retired senior staff. Sometimes “Owner-Operators� a more junior investment officer serves as alternate. Typically when investors fund MIVs that take (Younger staff may be cheaper and closer, but controlling stakes in MFIs (e.g., holding companies they can lack sufficient experience and credibility and certain international networks), they expect the sponsors to lead on governance. Respondents drew to serve in the lead role, and senior staff may be a clear distinction between “operating� owners and better able to raise sensitive issues and make other more “passive� shareholders. The sponsor commitments. Weighing the trade-offs, one MIV often recruits all initial directors. As new equity is recently decided to nominate only over-40 staff as raised, shareholders may even grant the sponsor sufficient voting rights so it stays in the driver’s seat. directors.) KfW has strict qualifications criteria, and A common example is “greenfields� banks financed only senior staff can fill its board and committee by DFIs, MIVs, and sometimes local investors. positions on MFIs, funds, or holding companies, A fund manager experienced with start-ups sees with up to five “mandates� per person. Oikocredit the sponsor’s governance role as “the most powerful tool for value creation.� Another advocate nominates a mix of local and international staff, to for this model explained: “We are more than active optimize time availability, capacity-building, and investors because we are major shareholders—and representation costs. FMO prefers outside experts, someone has to be in the lead because otherwise management can take advantage of a scattered but when senior staff serve, they are limited to two board.� However, this model of strong ownership mandates. By policy, IFC now nominates outside and control could have drawbacks, such as less experts as its directors. An officer at a smaller MIV vigorous oversight by others of the operating said: “As early-stage investors, we play a big role owners’ proposals. Conflicts of interest can also arise upon exit of shareholders with equity at both in governance, which is embedded in our business the fund and MFI levels. model—we bring together a team with local staff 13 absence or turnover strains board work, especially awkward cases where “some DFIs appoint themselves, that of building effective double-bottom-line represent themselves, and get their marching orders accountability or dealing with major problems. 21 from the DFI management.� As an example of potential Accordingly, investors such as Accion and FMO conflicts a director cited a case of suspected MFI have strict rules on participation, including in-person fraud, where the board chose to conduct a thorough board meeting attendance. Africap requires a investigation but the investor might have preferred two-year commitment from directors and three knowing the situation earlier. Conflict of interest can months’ notice for resignations. Building capacity also arise as an investor exits from an MFI, since the and a strong governance culture requires director ideal timing for the MFI and the investor may differ. continuity, leading some to stress the advantages of well-qualified local directors. Appointment, orientation, and support of nonstaff Overcoming the fixed-income mindset. Several directors. Time demands on directors, the limited respondents described a specific gap they see in pool of appropriate staff candidates, and conflict of MFI directors. Many microfinance equity funds have interest concerns help explain the trend of investors been started up by successful fixed-income fund nominating outsiders to represent them. This is managers, with investments often growing out of not always easy, however. IFC and others reported prior debt relationships. Yet the worldview and skills difficulties in finding MFI and fund nominees with required for success in equity are different than the requisite time, experience, and personal skills. those required for lending with its natural focus Furthermore, some countries hold corporate directors on credit risk. Effective equity investing demands personally liable. A board member to several a longer term view and willingness to invest in younger, smaller MFIs described the governance systems, innovation, and strong governance. capacity-building challenge: “The idea is to create the One fund manager has found the focus of many right genetic code that will eventually enable them to investment officers with whom he serves on attract the right people, but it is quite difficult—why equity fund boards too bank-like and oriented to would a really experienced person want to stick her cash flow stability, and suggested that funds may neck out and take on the considerable responsibilities need to overcome the “fixed-income mindset� by and liabilities of this?� nominating experienced outside directors from other sectors. He continued, “. . . it seems like the When relying on nonstaff directors, the investor [funds] read in a rule book that you should ask for must also provide an adequate orientation so the a board seat but don’t really have the experience, nominees grasp the investor’s worldview and goals time, and resources to do it right.� and are able to represent its interests well. Several provide substantial guidance, including appointment Conflict of interest. When staff serve as directors, letters detailing directors’ roles. CHF International most investors go to great lengths to avoid real or has a strategy for recruiting, developing, and perceived conflicts of interest between loyalty to the compensating local directors (ideally, three per MFI and to their employer. 22 Indeed, respondents MFI), including orientation for new directors on their described cases where investor-nominated directors board roles and ongoing training on microfinance upheld their duty of loyalty to the MFI impeccably operations and social and financial performance. as they voted multiple times against their employer’s Some networks provide specific guidance to narrow self-interest. However, tensions can arise, and directors on how they prefer to achieve the double there are gray areas around the director’s fiduciary bottom line, seeing this as an important way to help role. One experienced DFI staff director reported ensure consistent and effective representation. 21 For the sample of 162 MFIs in the MIX governance dataset, most boards met at least three times per year. In the case of recent MFI crises and failures, many international directors found it hard to step up their time commitments. 22 For example, by IFC policy nominee directors must maximize the MFI’s interests over IFC’s. IFC does not share all its internal information on the MFI or internal deliberations about IFC’s interests. IFC votes directly on shareholder-level issues. 14 Investors may require outside directors to submit that nominate senior staff to fill their allotted seats periodic briefings on key board deliberations or also advocate for independent directors. Many annual reporting. Investors including Equator argue that independent directors should chair Capital, KfW, IFC, IADB/MIF, Incofin, Oikocredit, the board and certain key committees, such as Triodos, and SIDI organize director training or Audit, Nominations, and/or Human Resources and convene nominee directors regularly to exchange Compensation. experience and discuss governance and other challenges. Others were skeptical about the value of independent directors for the MFI sector at this Covering representation costs. Whether they time. One concern is the small pool of suitably nominate staff or outside experts, it is expensive qualified (and unconflicted) people in many for investors to provide high-level expertise in the countries to serve in this capacity, even with right amount and at the right times to a portfolio of honoraria (which are uncommon). Another is far-flung investees with diverse and changing needs. whether it is realistic to expect an independent Smaller funds may find it particularly challenging to director to be more willing than others to stand up balance budget realities with an optimal level of MFI to a strong-willed CEO and if these directors would representation and governance capacity-building. have the necessary focus and diligence without Budget constraints also limit the use of compensated “skin in the game.� 25 Respondents described outside directors. Many voiced concerns that troubled MFIs with apparently “blue-ribbon but the fee expectations of newer, more commercial in the dark� boards. Another barrier might be institutional investors (and even some DFIs) are shareholder preference: a person who has served unrealistic. They argue that it is inappropriate to on many boards observed, “My experience is benchmark microfinance MIV fees against those that MIVs and DFIs don’t want to compensate typical for mainstream private equity funds that board members, and they really want to represent have much larger portfolios and developed-country their own institutions’ interests on the board.� investees. One holding company director asserted, 23 A senior DFI manager said, “One of the reasons “. . . equity in microfinance should be more that I believe some institutions like independent expensive than private equity in general because directors is because they cannot be blamed when the amounts are small and governance and TA are there is a problem.� Section IVc describes policies more needed.� and governance procedures that might offer additional paths to achieve the benefits ascribed Pros and cons of independent directors. While to the use of independent directors. interest is growing in independent MFI directors (that is, where shareholders agree as a group Board member passivity and “management to appoint individuals without ties to any single capture.� Governance requires the board to investor), the practice is not yet widespread perform a delicate balancing act that avoids both nor without those who question its value and micromanagement and passivity. Many CEOs set practicality at this time. This practice is now in the agenda and control information and decisions favor in mainstream corporate governance as a that come to the board. Respondents focused on means to achieve more balanced governance by the challenge of creating a distribution of power promoting independence, challenging behavior, that is balanced rather than concentrated in one and a longer term perspective by boards. 24 or two individuals. Our research suggests that it Sometimes regulation requires it. Certain investors is much more common for MFI boards to be too 23 A $50 million equity fund with a 2.5 percent fee would generate only $1.25 million in annual revenues, for example. Budgetary provision for representation and travel costs is subject to negotiation and varies widely. 24 While many advocate for independent directors as a best practice, Ararat et al. (2011) found the evidence to be inconclusive. 25 More than one observer has commented on the role played by management capture in the India crisis and observed that having well-known people as independent directors on MFIs was insufficient to ensure independent behavior. 15 passive rather than too overbearing. Respondents as more urgent. As one microfinance expert said, observed that some directors seem to view their “Too many managers and boards think ‘we don’t appointment as an honor or an opportunity to have a problem’—we must help CEOs see the make a social contribution and lack the necessary ‘upside’ of good governance, versus seeing dealing toughness and rigor as a result. Many investor with the board as a nuisance.� Stronger evidence on nominees were reported to be too consensual and the long-term business case will help, as will greater hesitant to scrutinize management submissions client voice, capability, and insistence on quality. carefully. Describing the pressure from peers and MFI leaders are also concerned about retaining their managers, one experienced director emphasized mission in the face of market pressures. At a recent “You must be willing to risk the wrath of the CEO.� governance retreat for senior Latin American MFI Some speculated that DFI staff might have weaker leaders, one CEO reportedly said, “We need to incentives to be proactive than their MIV peers, due protect the mission that gave birth to our MFI, to to disbursement pressure and less accountability to avoid being victims of our own success.�26 Reform shareholders for losses. As one fund manager put processes also are more likely to succeed if they it, being held accountable for losses and benefiting directly address managers’ fears of losing control. It is from gains “concentrates the mind.� encouraging that more CEOs are adding their voices to the call for reforms and working with shareholders Charismatic founders still lead many MFIs. Some to create balanced leadership. Funders can exercise serve as both CEO and board chair. Respondents saw their leverage in a united front to multiply these management capture—where management controls examples. many seats or appoints directors with close (and even family) ties—as fairly common. Some investors require Not surprisingly, respondents report that crisis the separation of CEO and Chair roles as a condition further tests the management–shareholder power for investment or set an asset threshold by which it will balance. Before one recent MFI failure, some occur. New directors also reported that longstanding directors questioned the CEO’s expansion and owners may be hesitant to challenge “their� CEO. An diversification plans. When the CEO pushed back, MIV director described the challenge of “promoting however, others were hesitant to insist on steps change when senior management, including often such as independent review of management’s the founder, is resistant.� These factors can further market assessment and projections. Directors limit the board’s independence and backbone. reported that they found it difficult to push for When they feel unable to bring about change, some more conservative plans when times seemed good directors resign. As in other sectors, director passivity and the MFI was profitable and growing fast. is exacerbated by fragmented ownership, divergent In hindsight, they wished they had asked more shareholder goals, and board members with too little questions and built support from other directors to time, experience, or incentives to rock the boat. On take a firmer stance. the other hand, one CEO reported on the benefits of reforms: “I had the board captured but was smart No category of investors or type of nominee is enough to cede control—the new board has held me immune from the weaknesses described. Yet all accountable and instilled a lot of rigor.� agree that the investor community as a whole could do better in finding well-qualified directors Improving governance requires buy-in by that will serve with the necessary assertiveness management and motivation of many individuals and effectiveness. The next section looks beyond to change. Smaller MFIs tend to see governance the qualities of individual directors to policies, reforms as relevant only to their larger peers, the procedures, and structures that can help strengthen managers of which in turn often see other priorities MFI governance. 26 As reported by Juan Vega, from workshop organized by Promifin, Calmeadow Foundation and Center for Financial Inclusion. 16 c. Strengthening board procedures, structures, and Setting the agenda. The agenda itself can strengthen accountability the governance culture by structuring meetings well and allocating significant time for committees, which Active governance is aided by workable mechanisms should lead on performance monitoring, vetting for goal-setting, decision-making, and oversight. of management proposals, and supervision of the There are various MFI governance tools, guidance, control structure. Some boards create a committee and emerging good practices. Yet effective translation to improve social governance or regularly build in into practice is uneven. The research highlighted five discussion of related topics, such as new product key building blocks: design or findings from client satisfaction surveys. One idea to improve risk governance is for the 1. Adopting board policies and codes of ethics board to define risk categories and put risk analysis/ 2. Improving meeting agendas mitigation as a standing item on the agenda, so 3. Ensuring full and timely disclosure to the board management will come to see this as normal rather 4. Creating an effective committee structure than intrusive. A standing executive session for 5. Using external assessments and board board-only discussions also reinforces the division evaluations of board–management roles and permits handling of sensitive matters. Some boards create a process Many identified social governance as a cross-cutting for directors to submit concerns to management priority in need of improved procedures and structures. before the board meeting. Many respondents also pointed out the value of advance consultation Establishing policy and procedures. Governance among directors: “It’s what goes on with like-minded policies formalize expectations about rights and investors before the board meeting that matters— roles of board and officers, individual directors, you need to be an organized alliance.� This practice is management, shareholders, and others as relevant. also reported to help counter management capture. The three priorities cited were clear delineation of management, board and shareholder roles; While in many MFIs the same person serves as information disclosure and flows between the parties; both CEO and board chair, good practice calls for and conflict of interest procedures.27 The research separation of these roles. The board chair helps identified several strong practices. For example, ensure effective board meetings by acting as a Africap Fund’s governance charter and the BBVA counter-balance to senior management and an Microfinance Foundation code and guidelines treat honest broker for diverse stakeholders’ interests. these issues comprehensively. Both funds also expect One expert characterized the chair role as “giving and support their portfolio MFIs to comply. The life to the board� through “the right combination of MFIs that responded to the MIX governance survey soft people skills and technical acumen.� An effective identified recent upgrades in policies on internal chair can make sure that long-run strategic issues controls, client protection, regulatory compliance, get on the agenda and guide the membership to and sources of capital. One seasoned director noted consensus. Recruiting new directors and appointing that “having formal rules helps a lot in terms of the committee chairs are other important tasks. Some diversity of individuals and their effectiveness—when described the ideal chair as an independent director you create the culture and norms for the board, who is senior and commands respect. Over time newcomers quickly adapt.� In contrast, several MFIs and owners likely will need to find a way to respondents described boards that operate too compensate board chairs to attract the right people informally, with no-objection decision making. In one and ensure they can devote sufficient time to the job. case, a director said, “All the real decisions were made outside the board meetings, which seemed to Disclosure of information and analysis to the board. be held just to satisfy the regulatory requirements.� Inadequate information flow from management to 27 Earlier referenced guidelines from the BBVA Microfinance Foundation, Cérise, CMEF, and Promifin cover these bases well. 17 board—described by one director as “the life-blood social issues are discussed between the senior of good decision-making and supervision�—is a management and Board members on a one-to-one common problem. Board packets often arrive too basis, no agenda of social significance figures during late for thorough review and do not have adequate the formal Board meetings.� In response, Ujjivan breadth and depth of information to paint a total created a Social Performance Committee with its performance picture and inform strategic decisions. managing director and two investors (Sequoia Capital A good practice is standing agreement on the and the Michael and Susan Dell Foundation). MFI “dashboard� of key performance analytics to be funds and boards are increasingly putting in place generated for the board from the management stronger social governance and this area needs information system and supplemented by direct continued attention.29 reporting from nonmanagement sources, such as internal auditors. Inputs from multiple sources can Outside information, third-party reviews, and help create a consistent flow of information from board assessment. Outside information gives boards clients to board. Respondents noted that while the a more independent view on management analysis quality of social performance reporting tends to lag and proposals. Sources of outside information behind financial analysis, the gap is narrowing in include financial audits, which are common, and many institutions. financial ratings, which are somewhat less common. More MFIs are getting social audits and ratings, Improving board committees. A half-day board which can help the board ensure adherence to client meeting does not allow for diving deeply into specific protection and social performance policies. Directors topics or critically assessing a management proposal. also reported significant benefits from meeting with This is a major factor in director passivity. Having clients and staff. (One CEO pointed out that this committees carry out this work for the board is an practice also “keep[s] the manager guessing, so he important response to the problem. Many noted will be more forthcoming.�) that while mainstream corporate governance sees committees as the “work horses� of effective boards, Respondents reported that boards are hesitant to they are underdeveloped in MFIs. Among MFIs, the commission independent reviews of portfolio quality most common committee is Audit/Finance, which or key management proposals. Among the reasons specifies what management must report to the cited are cost, the need to get buy-in from all board, oversees the external audit, and develops directors, fears of micromanaging, negative reactions and oversees internal controls. Other committees from management, and the inherent challenges an that are becoming more common include human outsider will face in coming up with high-quality resources and compensation, risk management, and data and independent analysis. Several interviewees nominations and board development.28 Respondents agreed with findings from the studies on MFI failures: cautioned against overburdening small MFIs with too if boards had been willing to require independent much structure, however. review of the risks, they would have done better in anticipating and handling the crises. Should the Interviewees also stressed the need for more board practice of seeking outside reviews become more attention to and clearer, more explicit expectations common, it will be an important marker of the about social performance. A recent study found that maturity of MFI governance. boards tend to devote little focus and few resources to this area. For example, an EDA Rural Systems Another good practice is periodic assessment of study (2009) of the Indian MFI Ujjivan found that individual directors and the board overall (see, for “the board has hitherto concentrated mostly on the example, the Incofin board evaluation tool and the financial performance of the company and although Promifin assessment tool). 28 MIX data; forthcoming guidance on risk management from CMEF. 29 Imp-Act/MicroSave (2011). See also Guarneri et al. (2011), Lapenu et al. (2011), and Simanowitz (2011). 18 out that of more than 300 Indian PE firms, only a few Box 4. Some Smaller Shareholders and chose to enter the sector while many did not, finding Individual Directors “Punch Above Their Weight� the valuations and growth rates unrealistic and fearing a bubble. Other people interviewed for this In the owner–operator governance model promoted research found the quality of momentum investors’ by entities such as ProCredit, Opportunity International, and the BBVA Microfinance representation to be uneven. Foundation, the locus of responsibility for building governance is clear. But since many MFIs have While recognizing potential benefits of more more fragmented ownership structures, it is less commercial investors to MFIs’ governance culture, obvious who should take the lead. Some minority shareholders received kudos for prioritizing many respondents voiced concerns about their governance and engaging with a deliberate focus, entry into the sector and cited stresses when the strategy, and resources. These include Accion, new shareholders’ performance expectations—in Equator Capital, Grassroots Capital, Incofin, Oikocredit, ProFund, SIDI, and Triodos. Regional terms of the type, level of, and time horizon for MIVs, such as MIV ACP-Peru, Africap Holdings, financial returns and the social bottom line (if any)— and India’s Lok Capital, also earned praise for diverged from those of current owners. This concern their governance work and high-caliber directors. underscores the importance of screening prospective Interviewees cited the personal effectiveness of these investors’ directors and their commitment equity investors for compatibility and taking steps to to be present before, after, and between board socialize them to the MFI’s overall goals, strategy, meetings and to help management translate and business practices. board guidance into action. Sometimes they lead coalitions of like-minded shareholders. Their capacity-building work includes director training Some respondents found DFI-nominated directors and committee development. They are reported overly “commercial� and asked if DFI staff incentives to help shareholders forge consensus around favor volume over mission or quality. On the other mission, strategy, and performance metrics, and their active engagement benefits other owners hand, many acknowledged the inherent value of the and stakeholders as well as giving them out-sized patient funding model of most DFIs, many of which influence. are able to “stay in the deal� longer than close- ended funds, as long as inflexible targets did not d. Aligning interests as the microfinance investment force an early exit. One CEO appreciated how “they market becomes more diverse [the DFI] stuck around when a hard-core commercial investor might not have.� Others described DFIs that What has happened as more mainstream commercial provided important capacity and know-how to build investors have entered the sector? On the one hand, MFIs and their governance. respondents observed that the new investors can enhance MFIs’ adherence to mainstream corporate Recent studies confirm the widely held impression governance standards and help professionalize that many investors prioritize financial performance systems, control structures, committees, and over social performance.30 Goldberg et al. (2011) reporting. Several informed observers questioned the describe how “some owners are more sensitive to dominant narrative that commercial investors in India loss of financial or physical assets, and others to loss played a major role in the crisis. One director reported of reputation, developmental goals, or institutional that PE firms seemed to respect others’ knowledge mission.� The 100 plus interviews revealed a striking of the microfinance business and in fact prioritized consensus about where different investors fit along consolidation and efficiency as much as growth. While the social–financial spectrum and agreement on another acknowledged the short-term orientation of which investors, as one fund manager put it, “serve PE firms, she continued, “I don’t buy the story that sectors and provide products that aren’t the fastest they drove irresponsibility—management is always growing and don’t earn the highest profits.� These in the driver’s seat.� Another fund manager pointed preferences do not align neatly by public versus 30 See Lapenu et al. 2011 and Guarneri et al. 2011. 19 private status. Even those MIVs that are perceived including the implications for responsible finance— as more socially oriented stressed that they urge and the case for better practices, tools, and metrics. partners to adopt an adequately commercial mindset Many now expect more active governance from MFI and a disciplined focus on profitability. They also equity investors in the future. reported framing responsible finance proposals to appeal to the broader risk and financial concerns of There is no single approach to filling board seats more commercial owners of the MFI. that is best in all situations. Each investor needs to consider whether it is doing the best it can to Many stressed how new codes, minimum standards, nominate people with the right skills, leadership and performance metrics can “give investors greater qualities, experience, the time to serve, and the confidence that co-investors, directors and managers inclination to be informed, objective, and active. are fully aligned in the pursuit of the same set of Failure to do so burdens the MFI and other priorities.� Improved metrics could better differentiate shareholders. As MFIs upgrade boards, they will MFIs by their specific financial–social preferences, need to balance director skills, independence, and enabling investors to select MFIs (and other investors) accessibility. Many stressed that boards are more that best meet their goals.31 Many MIVs described the likely to achieve robust and balanced strategies if pressures of running closed-end funds that typically directors bring diverse but complementary skills invest in an MFI for only five to seven years.32 They and perspectives. Looking forward, the sector may reported that the fixed term and investor-return targets well need and be able to attract paid independent can make them push MFIs to achieve higher growth directors, including experienced individuals from and returns; they can also weaken the incentives to other sectors. Measures to promote this (for invest in long-term capacity building. example, cost–share for governance reforms such as those provided to encourage microfinance ratings) In response, some are proposing innovative financing and director training and certification should be structures. While most investors prefer the certainty explored. Nominee directors have a responsibility of closed-end funds, for example, they also praised to be sure they understand the investor’s overall the open-ended funds of Oikocredit, responsAbility, goals before they step into the board room. Triodos, Triple Jump, and others that permit a longer Well-designed orientation of new directors and term MFI relationship and avoid artificial return annual consultations and training are emerging as targets and premature exits. Other ideas included good practices. new legal forms, such as MFI “social businesses,� “benefit� or “common good� corporations, or a class Good governance requires patience, resources, of preferred shares where investors could voluntarily and a united front. Unless investors leverage their accept lower returns, effectively “monetizing the opportunity by insisting on reforms and demanding financial–social trade-offs.� more over time, good governance will stay on the back burner for many MFIs. Rather than accepting V. Industry Initiatives and management capture and promoter syndrome (where Next Steps the founding MFI promoter is the dominant decision maker) as insurmountable, investors need to roll up Section I included a summary of seven key research their sleeves and recognize, as one fund manager findings. What is the evidence that MFIs and their put it, that “we are entering imperfect institutions investors will take action on this agenda? Across and trying to make them better.� Promising practices the sector, there are encouraging signs of growing are emerging to promote effective checks and awareness about governance shortcomings— balances and authoritative, challenging behavior by 31 Di Leo (2011) distinguishes between social first (SF) and financial first (FF) MFIs and their specific impact models. SF MFIs prioritize social outcomes with a floor on financial returns while FF MFIs do the reverse. SF MFIs would have more sophisticated social performance management systems, so boards could decide in advance how to handle future social–financial trade-offs. 32 Investors put capital in a closed-end fund for a fixed time, within which the fund invests in and then exits from MFIs. 20 boards, and many investors now seem committed to Box 5. Governance Initiatives in the improved MFI governance. Additional social investors Microfinance Sector need to communicate clearly to MFI partners the • Indicators and research. New analysis is governance improvements they expect, so reforms underway on current governance practices. have broad ownership, with all shareholders agreeing MIX, SPTF, Promifin, and others are testing standardized governance structure/process on what needs doing, crafting a workable plan with indicators for MIX reporting. Complementary case managers, supporting the process, and taking action studies and other qualitative analysis (including when progress is inadequate. action research) are planned to develop and test hypotheses about how governance affects MFI performance. Important insights about the case We need a candid conversation about what stronger for active governance (and the consequences of MFI governance will cost and whose job it is. As passive governance) come from recent research.a an industry, we have probably underestimated the • MFI tools and capacity. MFIs and their directors investment and patience required for effective can draw on tools and guidance from the BBVA Microfinance Foundation, CMEF, Cerise, IFC, and governance while overestimating the sector’s growth others. Peer exchanges and director training (and and resiliency without it. An experienced director possibly certification of directors) are also underway estimated that putting even a basic governance or planned by the BBVA foundation, CAF, Center for Financial Inclusion, IADB/MIF, and Calmeadow. structure in place takes two years. This is particularly The Promifin initiative is a multi-year action challenging for MIVs that must balance investor return research program to conduct detailed third-party expectations, relatively thin margins, and a clock assessment of partner MFIs’ governance, provide ticking relentlessly toward exit. As the DFIs, funders in-depth capacity building, and monitor results on MFI governance and overall performance. of funds, and indirect investors finance new equity • Ratings and investor tools. Specialized raters funds, they must put in place subscription agreements assess MFI governance (as part of financial ratings), and management compensation formulas that create and social governance structures, data, and systems the right incentives and enable MIVs to govern (as part of social audits and ratings). Some advocate for an incentive fund to encourage MFI governance actively. Over time good governance, particularly reviews. Investors reported paying more attention high-quality board representation, must become a to governance in due diligence, agreements and core cost of doing business for most retail providers. reporting frameworks. Recent studies by the European Microfinance Platform (2010, 2011) One experienced director made the case for DFIs and describe investor actions, including new tools and MIVs to cover these costs in the meantime: “Spending investment officer training. Investor associations $10,000 a year to strengthen governance can really are updating guidance on key issues such as increase the value of your investment so much over responsible finance, board compensation, and risk. • Policy and regulation. Many respondents the longer term—it really pays off.� suggested the value of regulation to reinforce good governance. Yet little is known about Governance of social performance and risk whether the rules in place for MFIs in some needs more attention. Outcome-focused social countries are effective. The World Bank is beginning to survey current practice and consider performance metrics are improving, including development of MFI governance diagnostic and in the important area of service quality. Many reform tools for governments. MFIs could benefit from adopting these metrics • Coordination. Many players are joining forces to improve industry awareness, practice, and and translating them into more rigorous targets, knowledge in this sphere. Work is underway to analysis, controls, and decisions about how people create a platform to make guidance, tools, and and money are to be allocated. Ultimately, the research findings more accessible and useful to board and the broader governance process MFIs, boards, and funders. must hold management accountable for client a Topics include governance, client protection, and MFI outcomes and core business standards. In parallel, performance linkages (Gonzalez, Guarneri); MFI failures more comprehensive risk concepts are emerging and incentives (Marulanda, Rozas, Lieberman); large bank governance failures (Pugliese); and risk management and value that redefine the central role of governance in creation (Goldberg). protecting an MFI’s assets and ensuring its long- 21 term survival. Weak governance is cited as a diligence processes, standardization of covenants, factor in recent crises and MFI failures. Investors and over-indebtedness prevention are beginning to can help boards mainstream emerging good risk yield results. management practices, drawing upon the new tools and improved ratings methodologies. Value-based investing requires active governance. For those public and private investors with the The question is not “whether� the sector needs inclination and resources, this is an area ripe for commercial capital to meet unmet demand for focused capacity-building, stronger tools and quality financial services but what type. While practices, and evidence-based analysis of which acknowledging that profit-maximizing investors with improvements result in better financial services for relatively short time horizons could contribute to the poor. responsible market development, many of those interviewed suggested that in light of the sector’s References business models and clientele, when there is a choice MFI boards should instead try to crowd in more AMK (Cambodia). 2010. “Annual Report: Finance at patient investors that see the long-run potential in your Doorstep.� Phnom Penh: AMK. financial inclusion and seek stable earnings rather than large, fast cash-outs. This can include local Ararat, Melsa, and George Dallas. 2011. “Corporate individuals and institutional investors; indeed some Governance in Emerging Markets: Why It Matters international social investors prioritize the objective to Investors—and What They Can Do About It.� of supporting a more locally-owned ownership Private Sector Opinion #22. Washington, D.C.: Global base over time. Improved MFI governance can Corporate Governance Forum and International help create a virtuous circle—making the sector Finance Corporation. more attractive for these investors while creating a stronger framework for mediating diverse (but Bédécarrats, F., S. Baur, and C. Lapenu. 2011. hopefully not incompatible) shareholder interests “Combining Social and Financial Performance: within MFIs. A Paradox?� Valladolid: Microcredit Summit. http:// www.globalmicrocreditsummit2011.org/ Our research suggests three factors that will shape investors’ inclination to govern actively and Brown, Lawrence D., and Marcus L. Caylor. 2006. effectively. First, investors’ own incentives need to “Corporate Governance and Firm Operating be well-aligned. Since most investors are fairly liquid Performance.� Social Science Research Network now, disbursement and earnings pressures could Working Paper Series weaken their incentives to screen potential partners carefully and insist on MFI governance reforms once Calmeadow Foundation and Center for Financial invested. One MIV manager said, “It is hard to ask the Inclusion at Accion. 2011. “Aligning Interests: tough questions and push on governance when our Addressing Management and Stakeholder Incentives competitors are less demanding in requiring difficult during Microfinance Institution Transformations.� structural changes.� Governance work by DFI and Washington, DC: Accion and Calmeadow Foundation. MIV staff might also need more recognition and support. Second, better social metrics and industry good-practice benchmarks will help investors to Calmeadow Foundation, Center for Financial better match up money with mission. This in turn Inclusion at Accion, and Citi. Forthcoming. “Running should make effective governance easier to achieve. with Risk.� Washington, D.C.: Accion. Collective action among investors at the MFI and industry levels is a final success factor. 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The UK Amsterdam: Duisenberg School of Finance. http:// Stewardship Code. papers.ssrn.com/sol3/papers.cfm?abstract_id=1652137 25 Annex A: List of Interviewees Interviewees included current and former staff and – Participatory Microfinance Group for Africa Directors of the following: (PAMIGA) – ProCredit Holdings • DFIs – responsAbility/PlaNis – European Bank for Reconstruction and – International Solidarity for Development and Development (EBRD) Investment (SIDI) – European Investment Bank (EIB) – Swiss Microfinance Holding, – Inter-American Development Bank/Multilateral – Triodos Investment Management Investment Fund (AIDB/MIF) • Microfinance Service Providers – International Finance Corporation (IFC) – AMK-Cambodia – KfW – Arohan Financial Services (India) – Netherlands Development Finance Company – Banco Solidario (Ecuador) (FMO) – Cashpor (India) – Overseas Private Investment Corporation – Centenary Rural Development Bank (OPIC) (Uganda) – PROPARCO – Compartamos (Mexico) • MIVs, including networks and holding companies – Equitas (India) – ABN-AMRO – MiBanco (Peru) – Accion Frontier Fund – MiBospo (Bosnia-Herzegovina) – Advans – NRSP Microfinance Bank (Pakistan) – AfriCap Microfinance Investment Company – Opportunity International Banks of Malawi and – Agora Microfinance of Serbia – Aavishkar Goodwell – Pride Tanzania – BBVA Microfinance Foundation – Pudhuaaru KGFS (India) – Blue Orchard Finance and Investments/Bamboo – SEWA Bank (India) Finance – SogeSol (Haiti) – CHF International – Tameer Microfinance Bank (Pakistan) – Concern Worldwide – Uganda Finance Trust – Deutsche Bank – Ujjivan (India) – Developing World Markets • Other experts including representatives of investor – European Fund for Southeast Europe (EFSE) and microfinance associations, development and Finance in Motion (FiM) agencies, researchers, and consultants – Equator Capital – AccessIndia – Ethos – Center for Financial Inclusion – Grassroots Microfinance Equity Fund – Cérise – IFMR Rural Finance – CGAP – Incofin IM – Council of Microfinance Equity Funds (CMEF) – MicroCred – EDA Rural Systems (India) – MicroVest – IFMR Trust and IFMR Rural Finance (India) – Oikocredit – Imp-Act Consortium – Omidyar Network – International Association of Microfinance – Omidyar-Tufts Microfinance Fund Investors (IAMFI) – Omtrix/ProFund – Microfinance Institutions Network (MFIN, India) – One Planet Investments – Michael and Susan Dell Foundation – Opportunity International – MicroRate 26 – MicroSave – Aude Flogny-Catrisse – MIX Marketplace – Stephanie Geake – SEEP Network – Samit Ghosh – Symbiotics – Geeta Dutta Goel – World Bank – Emile Groot – World Microfinance Forum Geneva – N. Gurunath • Interviewees (alphabetical listing): – Stefan Harpe – Matthias Adler – Darrin Hartzler – Motoko Aizawa – Eric Heinen – Leticia Alvares Alonso – Miguel Herrerra – Veena Yamini Annadaman – Martin Holtmann – Rashid Bajwa – Nadeem Hussain – Monika Beck – Irina Ignatieva – Cecelia Beirne – Kathryn Imboden – Alexander Berg – Michael Jainzik – Els Boerhof – Tor Jansson – Pierre-Marie Boisson – Davit Karapetyan – Kea Borann – Mathias Katamba – Bob Bragar – Frank Kennedy – Karla Brom – Amy Klement – Edvardas Bumsteinas – Jean-Pierre Klumpp – Deborah Burand – Cécile Lapenu – Lauren Burnhill – Kate Lauer – Gail Buyske – Jean Laville – Giovanni Calvi – Marten Leijon – Fernando Campero – Ira Lieberman – Anita Campion – Laura Fernandez Lord – Carlos Danel Cendoya – Tim Lyman – V. Chandrachudan – Asad Mahmood – Renee Chao-Beroff – Rashid Malima – Greg Chen – Beatriz Marulanda – Anne-Marie Chidzero – Klaus Maurer – Arjuna Costa – Elissa McCarter – Lisa Davis – Rebecca McKenzie – John Ddumba-Ssentamu – Ann Miles – Jorge De Angulo – Tomas Miller – Loic de Canniere – Rochus Mommartz – Dominiek Deconinck – Nejira Nalic – Jean-Philippe de Schrevel – Henk Nijland – David Dewez – Justin Oliver – Paul Di Leo – Geert Peetermans – Pasquale Di Benedetta – Pete Powers – Deborah Drake – Alok Prasad – Sebastien Duquet – Steve Rasmussen – Tilman Ehrbeck – Larry Reed – Tryfan Evans – Xavier Reille – Claude Falgon – Elisabeth Rhyne – Todd Farrington – Michael Schlein – Mark Flaming – Christian Schmitz 27 – Shubhankar Sengupta – Joan Trant – Moumita Sen Sharma – Bill Tucker – Vipin Sharma – Marilou van Golstein – Alex Silva – P. N. Vasudevan – Anton Simanowitz – Juan Vega – David Simms – Niraj Verma – Frances Sinha – Massimo Vita-Damian von Stauffenberg – Pete Sparreboom – Rodger Voorhies – Brad Swanson – Jayshree Vyas – Vidhi Tambiah – Graham Wright – Olga Torres No. 79 May 2012 Please share this Focus Note with your colleagues or request extra copies of this paper or others in this series. CGAP welcomes your comments on this paper. All CGAP publications are available on the CGAP Web site at www.cgap.org. CGAP 1818 H Street, NW MSN P3-300 Washington, DC 20433 USA Tel: 202-473-9594 Fax: 202-522-3744 Email: cgap@worldbank.org © CGAP, 2012 This Focus Note was researched and written by Katharine McKee with their time and insights. The paper also benefited from review of CGAP, with additional interview support from Antonique Koning by the following individuals: Pasquale di Benedetta, Karla Brom, (CGAP) and Mark Flaming (independent consultant) and investor Megan Chapman, Deborah Drake, Tilman Ehrbeck, Kate Lauer, Laura research by Symbiotics and CGAP. The author wishes to extend deep Fernandez Lord, Mark Flaming, Antonique Koning, Cécile Lapenu, appreciation to the more than 100 interviewees who were so generous Ira Lieberman, Elisabeth Rhyne, Jeanette Thomas, and Juan Vega. The suggested citation for this Focus Note is as follows: McKee, Katharine. 2012. “Voting the Double Bottom Line: Active Governance by Microfinance Equity Investors.� Focus Note 79. Washington, D.C.: CGAP.