There has been a swelling debate around the original intent of microfinance organizations centered around social good, and the recent “commercialization” of the model as evident in private fund raising, and promoters and PE funds making windfall gains in public markets.

The article here by Elisabeth Rhyne seems to advance a great argument for the golden mean. Let social and governmental efforts push the frontier and take risks that private capital will not take today (that is where the market failure exists) and let private capital deal with everything that is inside the frontier. Over time, for a sustainable structure to exist, more and more of the space should get folded within the frontier, and that would be a great development for the sector.

There has also been a perception amongst regulators and some microfinance players on the non-profit side that promoters and investors are making huge gains at the cost of poor people who are being charged exorbitant rates. The argument seems to be flawed on various counts.

First, worldwide data available on credible sources such as MIX market show that privately funded microfinance organizations are operationally more efficient compared to non-profit ones. This efficiency is being created by great management teams that are being attracted to the sector by a combination of social good and personal value creation potential. This efficiency creates value that gets shared between the poor customers (in form of lower interest rates) and the promoters/shareholders (in form of profitability).

Second, influx of private capital actually allows the sector to grow at a much faster pace than is possible otherwise. Hence more poor people get the benefit of such services.

Third, private equity is a very fragmented space, and genuine competition exists amongst PE firms. When some of the PE firms invested in this space years back, the risk perception of the sector was very high, and that risk has played out in the right direction. Because of that, the risk perception now is lowered, and capital is available at a lower cost (read, high valuations.) This capital formation allows newer MFIs to raise capital at much more attractive terms. In other words, it is erroneous to judge today’s returns against the risk perception today – it needs to be judged against the risk perception that existed when the money was invested. As a corollary, going forward, the relative returns on standard MFIs will be lower, because the risks are somewhat mitigated. In Rhyne’s words, the standard MFI play has been folded into the frontier, and the frontier is now pushing for newer markets and newer products.

Its ironical, but the greatest service that regulators can do to the sector, and to poor customers of MFI companies, is to provide regulatory clarity around the sector, so that risk perceptions reduce further, and poor people can realize the gains from availability of even cheaper capital.