The less-known entrepreneur

Most people, even micro finance experts, consider that the micro finance industry is dedicated to providing financial access to the bottom of the pyramid (BOP) through credit or lending technologies similar to bank loans.

In my mind, nothing could be further from the truth: I consider most of the work done by micro finance institutions to be more related to equity investing than anything else.

This is a topic that could be covered in a series of books based on a lot of real interesting research that hasn’t yet been carried out, but let me try to do it some justice.

Time frame: the GAAP periods in traditional businesses (month, quarter, semester, year) work well because a company’s cash ebbs and flows in tune with these time frames; thus, the calendar (which permeates our lives) is more or less synchronized with our expectations of the business cycle we’re examining. We expect that whatever management does, it’ll take a month or a quarter to show up as net income. It is reasonable for us to wait two or three years to see an investment develop meaningful returns. Banks usually lend in year terms.

This is not the case with BOP entrepreneurs, who can easily have four or five different businesses in a calendar year, some of which will survive from year to year, perhaps due to seasonality, while others will rise and fall as a business opportunity presents itself, is capitalized, and liquidated as a normal course of business, in scant weeks or months!

Repayment: many people who are not familiar with micro finance are surprised to find out that a micro finance portfolio has a natural tendency to perpetually grow, even if its MFI stops acquiring new clients (ceteris paribus). I still can see the face of an investor who exclaimed in surprise after he finally got it: “…but that’s an evergreen scheme!” Yes it is.

This is due to the fact that micro entrepreneurs never pay the principal back; sure, they make periodic payments (some call them capital amortization and interest, I call them dividends) weekly or monthly, but, at the end of each “loan” cycle (as little as weeks and as long as months), most of them are looking to get the principal back and then some.

This is one of the methods used to ensure that they pay the MFI its cut: they borrow say $50 for 16 weeks, pay it back with the promise that they will be able, if they prove their worthiness, to borrow say $60 immediately after (or the same $50 for longer). More like a new round of financing with a capital gains payout (indulge me).

The only exception to this arises from a liquidity event or a liquidation, both of which happen surprisingly frequently in the BOP.

Guarantees: most MFIs have figured out how to work with “social guarantees”. These aren’t real or tangible assets, or if they are, not very useful in recuperating much of the amount in default, but rather anchors in the entrepreneur’s psyche that formalize his or her commitment to abide by the terms of the disbursement. More of a “my word is my bond” kind of thing – very similar to the “informality” mostly seen in angel investing and definitely far from the boilerplate contracting that is the norm in credit operations.

Concluding, a BOP entrepreneur starts and finishes business opportunities in the matter of months, can cover “debt” service from the turnover of her entire business, and takes micro finance on little more than her word. Thus, MFIs behave more like traditional equity players than like loan givers because they cover the entire lifespan of the enterprise, get paid from real or virtual liquidation of the business, are involved in additional rounds of financing, do not base the bulk of their risk management on legal contracts, but rather on relationship management, and defaults are largely written off (after some due effort building and maintaining default disincentives).

Some corollaries (another post):

• Eradicating informality in the BOP would require extensive rewrites of most codes of commerce and the institutionalization of incredibly agile bureaucracies (an oxymoron?).
• Banks can’t do micro finance.
• Successful BOP entrepreneurs (serial micro entrepreneurs), by the very nature of their success, will have trouble growing beyond the BOP – they’re more like arbitrageurs than business managers.
• “Do you have any financial statements?” is a silly question.