by Paul DiLeo and Ira W. Lieberman
Significant efforts are underway to stabilize and support the microfinance and related financial inclusion companies serving the poor: NGOs, cooperatives, MFIs, and some small business banks, non-bank intermediaries, credit unions, digital networks and fintechs. To date the scale of losses and whether there will be a significant erosion of equity is not yet clear.
It has been suggested quite reasonably that it is premature to start talking about insolvency and recapitalization now. Rather, we should focus on liquidity and business continuity now and deal with insolvency down the road. While we agree that the current priority is liquidity, we also believe that there are several reasons why it would be imprudent to defer planning for recapitalization and planning how investors and funders can best support the financial inclusion sector through this process.
Among these reasons are the need to ensure that amidst all the demands facing governments, investors and funders resources will be reserved for financial inclusion companies, many of which provide a unique and vital channel to reach vulnerable populations. Second, resources will be stretched thin. It is not too early for each funder and investor to form a view of which companies to prioritize for support and why, and to build collaborative approaches with like-minded investors. Third, decisions being made now by funders and investors that will factor into recapitalization, merger or liquidation if and when any of these become necessary. For example, will new money disbursed since the onset of the crisis receive preferential treatment in any restructuring?
This note addresses a fourth issue: what are some of the issues that will arise in attempting to mount a collaborative effort and preserve insofar as possible a sense of equitable burden sharing.
Nuts and Bolts
The following outlines some of the practical considerations that will arise as companies are recapitalized, merged or dissolved. Not all investors and funders have the same capabilities and responsibilities. Some are in a position to provide new loans or equity, many are not because their funds are fully committed. Many, indeed most, MIV funds cannot assume equity risk. Some investors may be subject to regulatory restrictions on extending new financing under these circumstances. And as noted above, many philanthropies and DFIs are facing multiple requests to address other aspects of the current crisis and do not have the human resources to participate in multiple complex negotiations on a case by case basis.
One advantage of the current crisis is that none of the participants – not sponsors, shareholders, lenders, or MFI managers – can be held significantly responsible for the difficulty facing their institution. So we can skip the stage of assigning blame that can absorb lots of time and good will. Instead, burden sharing can be driven by two considerations: preserving insofar as possible the original seniority of claims and roughly equilibrating the contributions made albeit taking different forms.
One other background factor also needs to be borne in mind. It is not unusual for investors and funders to have exposure to more than one company in a single market. In such a case, a decision may be taken as to which institution will receive support. That decision may not coincide with the choice of other parties. In the worst case, resolution can be deliberately impeded so as to improve the competitive position of the favored company or depress the value of a potential merger candidate. Assuming that this worst case will not arise, however, the choice of one investor to disfavor an institution that other investors are actively endeavoring to recapitalize can pose a significant obstacle to success. To minimize this disruption, it is best that any investor or funder with such a potential conflict disclose it to others, and where appropriate, be recused by other parties from participation in deliberations. While this may not preserve comprehensive burden sharing it may be the second best approach to ensuring that a rescue can be implemented in a timely fashion.
Along similar lines is the more general issue of free-riders: investors who refuse to participate in an equitable fashion, but who will benefit along with everyone else from a successful rescue. Unfortunately, this issue will nearly always arise and bitter as it is, we just have to live with it. Whether they are local banks, government linked-lenders, vulture funds or whoever, they will be a fact of life until Judgment Day. At best, we can aim at some high but not total participation – 75% of creditors – and then move to execution.
In the absence of new money, the resolution of an impairment of equity is relatively straightforward: equity and liabilities are extinguished in the order of seniority and holders of remaining liabilities assume ownership of the institution. One consideration that may cause investors to modify this outcome is that if most or all of the original shareholders are wiped out, remaining investors will need to reconstitute a board, which is not a trivial matter, especially under these circumstances when there will be a premium on having a functioning and effective board quickly in place to navigate the uncertain months ahead. So remaining investors may in fact find it in their interest to allow the original shareholders to preserve some of their interest and maintain their nominee directors so as to provide continuity and oversight. Good governance will be very important as MFIs need to make decisions on rescheduling/ restructuring and, on treatment of clients in arrears, on engaging banking supervisors, new lenders or investors, on dealing with staff issues including those that may be ill as a result of the health crisis and a host of other issues which will arise during the crisis. Preserving some interest of the original shareholders may be more palatable in light of the fact, as mentioned above, that in this case the difficulties facing the institution are not due to lax oversight or poor governance by the original board.
In most cases the goal is to provide the institution with additional resources, including debt and equity and technical assistance support. In order to facilitate access to these resources, it is essential that there be a strong presumption that all new money, debt or equity, is not subject to restructuring unless, of course, all other liabilities have been extinguished. Firm commitment by all parties to this principle is the best way to maximize access to fresh funds; any ambivalence is likely to delay, obstruct and diminish access. Some secondary clarifications will be helpful in building confidence. For example, will disbursements against commitments made before the crisis be considered “fresh money:” and accorded preferential status? What is the “cut-off” date?
As noted above, many investors will not be able to provide new money and for them a variety of alternatives are available depending on their structure, commitments to investors and regulatory or prudential constraints. These are listed below, and are mostly self-explanatory. As a package of contributions to recap is assembled, some approximation of the discounted value of the different instruments might be provided by a neutral third party to provide transparency and maintain a perception of equitable burden sharing among investors in each class of liability.
Haircut: write down of the outstanding principal amount.
Debt to Equity conversion
Senior debt to subordinated conversion
Extension of maturity
Reduction of interest rate / suspension of interest
One further instrument warrants mention, although it is in a category by itself as it would typically be implemented by a consortium of investors and funders rather than individually, and this is some form of “bad bank”. Participation in such a vehicle as part of a consortium may be particularly appealing to investors who are not in a position to actively participate in multiple work outs. The basic idea is that investors create an SPV that purchases NPLs from several companies at a discount, but a price greater than their provisioned value, thereby injecting capital. There are variations, such as HELP, created by Omtrix in Haiti, whereby the originating institution continues to service the loan and has the option to repurchase within several years at a preferential price.
All of us are currently faced with multiple challenges: our own health and that of our families; the health of our colleagues and employees; respecting our fiduciary responsibilities to investors and funders. But as participants in the financial inclusion sector, we have also voluntarily assumed a special responsibility to place particular weight on the well-being of the clients of the companies with which we are engaged. We will face difficult choices in how to balance all these responsibilities but with especial consideration for clients who are particularly vulnerable to the health, food security, domestic violence and other aspects of this crisis. We hope that permanent damage to the financial inclusion sector will be limited. But given the stakes for our clients, hoping is not enough and preparation now will translate into lives and futures saved.
Paul DiLeo is the Founder of Grassroots Capital Management PBC and has over three decades of experience in development finance and 20 years of experience in the microfinance sector.
Dr. Ira W. Lieberman is Chairman and CEO of LIPAM International, Inc. and has over four decades of international development and private sector experience. Ira was the first CEO of CGAP.
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