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					                      Mobilising the Right Mix -
        Competing or Complementary Investors?




                                    Peter Hartig
                                     Consultant
                          Draft as of 29 October 2007*

  Prepared for the KfW Financial Sector Development Symposium 2007
“Mobilising Capital for the Poor – What can Structured Finance Contribute?”


   * A final version will be published in the Symposium proceedings (Springer-Verlag)
                  KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



Table of Contents



1     Introduction.................................................................................................................. 3

2     Basic SF Structure and Stakeholders ........................................................................ 4
    2.1      Basic SF Structure ................................................................................................................. 4
    2.2      Major Stakeholders ................................................................................................................ 5

3     Roles, Contributions and Interplay of Various Stakeholders ................................... 9

4     Summary, Conclusions and Open Questions ..........................................................14




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             KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



1      Introduction

Structured finance (SF) seems to emerge as a preferred instrument to mobilise sustainable
capital from a broad range of national and international commercial investors who want to
finance pro-poor asset classes in developing and transition countries. New asset classes and
markets consist of micro and SME loans, low-cost housing portfolios, municipal lending and
loans for environmental investments. Besides improving access to funds for the banks that
are involved, SF offers additional developmental advantages by using limited public
resources to leverage private investors. This contributes to local financial sector and capital
market development and to the integration of domestic financial systems into international
capital markets. Compared to more traditional methods of financing (e.g. plain debt, equity)
SF is considered superior with regard to the alignment of banks’ and private investors’
interests. How this alignment of interests is achieved, what hurdles have to be removed and
what roles the different stakeholders can play is the theme of this paper. A main issue is to
what extent public investors are needed to bridge private investors into markets in
developing and transition countries.

The paper provides a rather simplified categorisation of the different risk-return profiles and
roles of the various SF stakeholders. The types of SF transactions in development finance
and in the market are rapidly changing. This leads to changing behaviour and risk
perceptions by the various players on a deal-by-deal basis. The paper highlights structural
differences between public and private stakeholders’ roles and contributions.

The paper is structured as follows: Section 2 briefly describes the basic structure of a SF
transaction, possible stakeholders and their respective roles and contributions. Section 3
explains the interplay of the various actors in SF based on empirical evidence. Section 4
summarizes the main results, conclusions and open questions.




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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



2         Basic SF Structure and Stakeholders

2.1       Basic SF Structure

Major actors in a simplified SF transaction are the originator, the servicer (often the
originator), the arranger, the guarantor (enhancer) and the investors.1 Examples for different
types of originators in developing and transition countries are microfinance institutions (MFI),
SME banks or banks with environmental and low-cost housing portfolios.2



Figure 1: Basic structure of SF-transactions


                                                         Investors
                           On shore/
    Arranger               Off shore                 Senior tranche
                             SPV                    Mezzanine tranche
                                                     Junior tranche




                                                  Guarantor/ Counter-
    Originator              Servicer
                                                      Guarantor/
                                                   Credit Enhancer



The servicer, who may also be the arranger, manages the asset pool on behalf of the SPV.
The task of the arranger is to structure the deal, negotiate with rating agencies, and find
comparable markets for pricing in order to introduce and establish new asset classes in the
national or international capital markets. Investors provide funds for typically three tranches
according to their individual risk-return profiles. They can include both public and private
investors.

To close the gap between the asset pool and investor’s requirements a guarantor or credit
enhancer may be required in order to introduce new asset classes into new refinancing
markets. Besides the development of new asset classes, the credit enhancer aims to create
sustainable capital market development. The ultimate goal is that the originator will
eventually be able to access funds without third-party credit enhancement.




1
    See figure 1 and Maurer, K.: Session 1: Mobilising capital for the poor – how does structured finance
    fit?
2
    For simplicity the term “banks” will be used for all these different types of financial institutions in
    developing and transition countries, including non-bank microfinance institutions like NGOs or
    finance companies.

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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



2.2      Major Stakeholders

2.2.1    Donors

The group of donors include bilateral and multilateral agencies (e.g. BMZ, USAID) providing
official development cooperation assistance and private donors such as foundations and
NGOs (e.g. DOEN Foundation, Cordaid). Donors pursue developmental objectives which
include promotion of financial sector development and extending the frontiers of development
finance, in particular in sectors such as microfinance, SME, low-cost housing, municipal and
environmental finance.

Donors play a vital role in preparing the ground for successful SF transactions in developing
and transition countries, mainly through three instruments: They provide technical assistance
(TA) to promote and upgrade banks and to cover the up-front costs of SF transactions; they
initiate a policy dialogue with governments in order to improve the legal and regulatory
framework conditions for SF transactions; and they are able to cover the most risky part of
SF transactions.



Figure 2: Donor profile

Roles                         TA provider; investor (in junior tranches); initiating policy dialogue

Risk-Return Profile*          Risk-taker, low risk sensitivity

Motivation and                Sustainable impact of SF on financial sector development and pro-
Objectives                    poor finance

Contributions                 Policy dialogue to improve legal and regulatory framework
                              conditions for SF transactions
                              Covering SF up-front and transaction costs
                              TA for MFIs (e.g. governance, transparency, management, fiduciary
                              standards, MIS)
                              Preparing 2nd and 3rd “generation” MFIs for SF (capacity building,
                              formalization, promotion of SF standards, ratings)
                              Covering first-loss tranches


* simplified categorisation




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                   KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper




2.2.2     Development Finance Institutions (DFIs) and International Finance Institutions
          (IFIs)

DFIs are development agencies or banks such as KfW, FMO and DEG, some of them being
governed under the Basel II supervisory regime. They act under the same rules, regulations
and limitations as commercial banks. IFIs include e.g. ADB, IFC and EBRD and have fewer
limitations; thus in principle, they can take higher risks compared to DFIs.3

Bilateral DFIs like KfW play a dual role in development finance: KfW Development Bank acts
as agent for the German government using grants for TA and concessional loans from the
federal budget and guarantees covered by BMZ. In addition, KfW provides loans from its own
resources at market rates in order to leverage limited ODA (overseas development
assistance) funds.

As financial institutions with development expertise, DFIs/IFIs have “the best of both worlds:
detailed knowledge of the financial sectors in developing and transition countries and its legal
and regulatory environment on one hand, and standing and reputation via triple AAA ratings
in the commercial world on the other hand. For example, DFIs have been instrumental in
supporting the microfinance sector through TA-grants, loans and equity, using different
institutional strategies like greenfielding, down-scaling or up-grading. In addition, KfW, for
example, has also vast experience with SF transactions in Germany and elsewhere in
Europe.

DFIs and IFIs can perform the following functions in SF transactions: They take an active role
in structuring risks as the lead or structuring investor by becoming involved in the SF
transaction at its inception; due to their developmental orientation they can take higher risks
compared to commercial investors; for example, they can take the mezzanine tranches,
while offering senior tranches to more risk sensitive investors; they can provide various credit
enhancement instruments such as guarantees to achieve essential triple A-ratings. DFIs and
IFIs are well positioned to act as “honest brokers” with regulators to overcome legal and/or
regulatory hurdles that permit the introduction of SF to a new market or asset class in
developing and transition countries.

DFIs and IFIs facilitate the establishment of microfinance, SME finance, low-cost housing
and environmental finance as well-defined asset classes by active involvement in deal
structuring, credit-enhancement and as investor in subordinated tranches signalling to
commercial investors the credibility of the SF transaction. In that sense DFIs and IFIs supply



3
    For the sake of simplicity DFIs and IFIs will be used as synonyms, neglecting the differences noted.

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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



“seals of approval” from internationally recognized rating agencies and provide comfort for
private capital. In addition, SF transactions are considered pivotal as instruments to develop
local capital markets.



Figure 3: DFI/IFI profile

Roles                         Lead, structuring and anchor investor; credit-enhancer (guarantor);
                              investor (mostly in mezzanine and senior tranches); dialogue with
                              regulators

Risk-Return Profile*          Medium risk appetite

Motivation and                Sustainable impact of SF on financial sector development and pro-
Objectives                    poor finance combined with reasonable return on investment

Contributions                 Risk mitigation by providing guarantees
                              Co-investors in junior notes/subordinated tranches
                              Investment of own funds in senior tranches to signal credibility of SF
                              deals
                              Knowledge of both development finance and private capital markets
                              Covering SF up-front and transaction costs
                              Conducting due diligence on originator and asset pool
                              Preventing mission drift in structured funds
                              Facilitating local currency financing (hedging foreign exchange risk)
                              Providing temporary replacements for international ratings of newly
                              introduced asset classes
                              Facilitating establishment of micro-finance, SME finance, low-cost
                              housing and environmental finance as commercial well-defined
                              asset class


* simplified categorisation


2.2.3    Private Investors

Two types of investors can be distinguished: The commercial investors and the socially
motivated or dual-objective investors. Commercial investors include a vast variety of
actors such as institutional investors like pension funds and insurance companies,
investment banks, hedge funds, oil and state funds, and high net worth individuals (HNWI)
who may also be dual-objective investors.

Commercial investors’ investment decisions are guided by asset allocation strategies that
define the range of possible investments and the proportion of each asset class they will buy
for a given portfolio, weighing risk and return with the objective of obtaining the highest

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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



possible return. Therefore, commercial investors compare different investment options based
on the respective risk-return potentials. A major tool used to determine the comparability of
various investment alternatives are benchmarks and ratings provided by international rating
agencies for different asset classes.

The lack of international ratings and benchmarks for banks, combined with insufficient
information and the lack of confidence of commercial investors unfamiliar with a new asset
class makes this relation a bit precarious. The risk and return profile of commercial
investments are normally compared to an established asset class benchmark (i.e. Standard
& Poor’s 500). Because loans to banks, or loan portfolios to SMEs and low-income
households in developing and transition countries, are not yet a well-defined asset class,
investments in these banks do not fit into the analytical framework governing commercial
investor asset allocation. Benchmarking could also be achieved by ratings from international
rating agencies, but only national ratings for a few banks have been done so far. Moreover,
even international ratings would be restricted by the sovereign ceiling of the respective
country rating. As a consequence, structured development finance transactions in emerging
markets would find it difficult to receive a rating from international rating agencies acceptable
to commercial investors.

Commercial investors represent “unlimited” funds compared to public development funds.
Commercial investors will therefore have to provide most of the bulk for the expansion of
banks in developing and transition countries. Therefore, mainstreaming of development
finance cannot be achieved without private capital. Retailing SF products to private
individuals more broadly through the retail departments of commercial banks will eventually
lead to the “democratisation” of development finance.

Figure 4: Commercial investor profile

Roles                         Arranger and investor (in senior tranches)

Risk-Return Profile*          Highly risk averse; investments in high-grade (triple-A) tradable
                              securities

Motivation and                Maximum returns
Objectives

Contributions                 Expertise in capital market operations and requirements
                              Coordinate/communicate with rating agencies, commercial investors
                              Provide “unlimited” funds for SF transactions


* simplified categorisation



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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



The second group of private investors are socially motivated or dual-objective investors
(e.g. private foundations like the Bill and Melinda Gates Foundation, responsAbility)
emphasizing a reputational return with adequate or marginal financial benefit4. While these
social investors have investment allocation restrictions similar to those of institutional
investors, they also have “...a natural predisposition to consider pro-poor-like investments”5
and do not seek profit maximization.



Figure 5: Dual-objective investor profile

Roles                         Investor (in senior tranches)

Risk-Return Profile*          Highly risk averse

Motivation and                Adequate financial return combined with reputational. “social” or
Objectives                    environmental return

Contributions                 Provide “unlimited” funds for SF transactions


* simplified categorisation



3        Roles, Contributions and Interplay of Various Stakeholders

In development finance to date, true sale securitisation such as asset backed securities
(ABS) and collateralised debt obligations (CDO) together with structured investment funds
have played a major role in SF.6 A common feature of all these closed transactions is the
involvement of public sector stakeholders either as donors and/or as DFIs and IFIs.

The role of donors and DFIs and IFIs depends on the stage of structured finance and on the
contributions of private capital and public actors. In the initial phase of establishing new asset
classes or markets, donors and DFIs and IFIs are strategically important in the process of
creating and testing structured finance facilities. Donors and DFIs and IFIs are prepared to
accept a higher level of risk, while private capital is almost always risk-sensitive7. DFIs and
IFIs have a different risk perception through a better knowledge of new asset classes such
as MFIs and their difficult markets and environments, while commercial investors are less
familiar with banks and their environment thus overestimating risks. The function of public


4
    Goodman: Microfinance Investment Funds: Objectives, Players, Potential. In: Matthäus-
    Maier/Pischke (2006), p. 22
5
    Sousa-Shields: Commercial Investment in Microfinance: A Class by Itself? In: Matthäus-
    Maier/Pischke (2006), P. 91
6
    Glaubitt, Hagen, Feist, Beck: Reducing Barriers to Microfinance Funding: The Role of Structured
    Finance, pp.9
7
    See figure 8

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                KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



stakeholders is to match (perceived) investment risk with the risk tolerance or appetite of the
commercial investors. This can be generally accomplished by constructing hierarchical
divisions or “risk-ladders” with different types of risks and corresponding returns.

Depending on clients, markets and structures, donors and DFIs and IFIs can play different
roles in initiating and complementing commercial investors. Donors like BMZ can provide
public grant funding for first loss cushions thus taking the highest risk portion based on
developmental objectives. Donors and DFIs and IFIs assist banks in meeting the high
governance, transparency and reporting standards of international capital markets and
investors by providing TA. In addition, donors can offer TA or other grants to cover the up-
front cost of establishing SF vehicles and DFIs and IFIs are using their own resources and
personnel to bear administrative costs. There is a wide consensus that public investors are
usually the first movers and invest where no private investors are able or willing to do so.
When an asset class is eventually established, donors and DFIs and IFIs can focus on new
asset classes.

DFIs and IFIs like IFC, EBRD or KfW can act as structuring/lead or anchor investor,
actively designing or structuring the deal from the beginning and assisting the originator and
arranger. As structuring investor, DFIs and IFIs not only take some risk in the deals in which
they participate but also mitigate risks8. This is done e.g. by bringing in legal expertise, by
conducting thorough due-diligence on the originator and the asset pool, by later monitoring
the transaction and by early dialogue with rating agencies and other counterparties.

In addition, banks involved in securitisation transactions for the first time very often need
advice. In these cases DFIs and IFIs can play the role of an honest broker, because they
are trusted by the banks due long lasting relationship. In addition, DFIs and IFIs are not
considered potential competitors. Finally, they have the expertise and TA to assist banks on
legal and regulatory issues.

In the BRAC Micro Credit Securitisation, the first on-shore securitisation of a microloan
portfolio, KfW provided substantial technical input to the arranger, RSA Capital, and actively
lobbied for the deal with Bangladesh authorities.9 As the legal and regulatory environment in
developing and transition countries often inhibits the development of local capital markets
and especially securitisation transactions, donors and DFIs like KfW have the political
potential to initiate policy dialogue with government and regulatory and supervisory agencies
to create an enabling environment for SF development. In addition, they can co-finance legal



8
    IFC (Lee Meddin): Foreword – Establishing new market for securitisation: The value-added of the
    credit enhancer
9
    For more details see Hüttenrauch and Schneider, p.42

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              KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



and regulatory feasibility studies. These activities are important especially for initial SF
transactions in new countries and/or markets and cannot be carried-out by private investors.

In addition to several risk mitigating features, the Credit Agency of Bangladesh rated this first
local ABS issue in Bangladesh AAA. FMO purchased one third of the securities. Citibank
Bangladesh and two other local commercial banks invested in one-third of the assets. The
remaining third were also purchased by Citibank Bangladesh, backed by a guarantee from
FMO and a counter guarantee from KfW covering timely payment of interest and principal.

In the BRAC securitisation deal FMO and KfW not only provided necessary credit-
enhancement but KfW acted as structuring investor and provided substantial input to the
design of the final structure of the securitisation deal. In addition, FMO‘s investment in one
third of the securities signalled to commercial investors their confidence and trust in this new
asset class, acting as catalyst for commercial investors.

A similar contribution is the Microfinance Loan Obligations 1 (MFLO 1) – Opportunity
Eastern Europe Securitisation.10 The deal structure shows the complementary role of the
European Investment Fund (EIF). EIF acted as co-arranger and guarantor of the timely
payment of interest and principal for the senior notes. As the originating banks had never
been rated by an internationally recognised rating agency, KfW calculated the average rating
of the total pool as B+ at closing. Given the subordination structure and first loss tranche, the
senior notes would have been assigned a BB rating. Through the guarantee of the EIF, itself
AAA-rated, the guaranteed senior notes were assigned a triple A-rating. In addition, KfW
invested almost EUR 20 million in senior notes, signalling to commercial investors the
credibility of the investment.

Similar credit enhancement has been provided by DFIs and IFIs in other micro-finance deals.
BlueOrchard Microfinance Securities I was the first securitisation of microfinance assets.11
The US government’s Overseas Private Investment Corporation (OPIC), a development
finance institution, issued fully guaranteed Certificates of Participation to institutional and
private investors (senior note holders), effectively guaranteeing their investments in micro-
finance, lending credibility to the transaction.12 JP Morgan Securities was responsible for the
distribution of the securities to institutional and private investors.13

In a subsequent transaction, BlueOrchard Loans for Development 2006 (“BlueOrchard
II”), the senior notes, were not enhanced with a guarantee by a DFI. This time, Commercial


10
   For more details on the following deals, refer to the Joint Annex (profiles of SF transactions)
11
   Details see Goodman, Microfinance Investment Funds: Objectives, Players, Potential, In: Matthäus-
   Maier/Pischke (2006), p. 25 and Hüttenrauch and Schneider
12
   For more details see Glaubitt, Hagen, Feist, Beck
13
   Brugger: Microfinance Investment Funds: Looking Ahead, In: Matthäus-Maier/Pischke (2006), p.241

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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



investors were already more educated about the new MFI asset class and pure
subordination via waterfall payment structure was sufficient.14

Securitisation of ProCredit Bank (Bulgaria) was led by Deutsche Bank as arranger in
2006. The partial securitisation of ProCredit Bank’s loan portfolio (micro, small and medium
enterprise loans) was the first true sale securitisation in Bulgaria. The transaction was
facilitated by a credit enhancement provided pari passu by KfW and the EIF. By
guaranteeing principal and interest payments for the senior notes, the rating of the pool was
raised from BBB to AAA. Only with triple A-rating the notes qualified for the Deutsche Bank
asset backed commercial paper program. The guaranteed senior tranche was sold to
commercial investors. EIF and KfW acted as credit-enhancer and were able to qualify the
deal for a triple A-rating thus fulfilling an important precondition for commercial investments.

These deals also demonstrate the role of DFIs and IFIs as initial substitutes for
international ratings. The lack of international ratings and benchmarks for the originator’s
asset class quality creates information asymmetries between originator and private investors,
and consequently lack of confidence of commercial investors. Therefore, DFIs and IFIs act
as substitutes for rating agencies for MFIs or SME banks. This is achieved by structuring SF
deals as structuring or lead investor, through credit enhancement in the form of guarantees
and through investment of their own funds. Together with their triple-A ratings by reputable
international rating agencies DFIs and IFIs are the perfect interim substitute for international
ratings.

A main market entry barrier for private investors is the comparatively high start-up cost of
structured finance vehicles and the risk of transaction failure. DFIs and IFIs are generally
prepared to assign a significant amount of time, manpower and financial resources to
establish structured finance facilities, preparing the ground for attracting private capital.

Furthermore, donors and DFIs and IFIs are instrumental in increasing the demand for SF and
the SF market by developing and graduating the second and third tier of banks and other
financial institutions in developing and transition countries.

An interesting example of changed roles and contributions of public and private stakeholders
is the db Microfinance-Invest Nr. 1 deal, which closed in September 2007.




14
     A similar “waterfall” payment structure without further external credit enhancement is applied in
     EFSE, a structured investment fund for South East Europe; see attachment(profiles of SF
     transactions)

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                 KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



The deal has unique and innovative features:

           •   A private commercial investor (Deutsche Bank) took on the entire unrated junior
               tranche for the first time;

           •   Private commercial investors invested in the mezzanine tranche;

           •   First time investments by private (ultra high net worth) individuals;15

           •   First time rating of subordinated loans.

The role of KfW in this transaction was to co-initiate the deal, and to act as structuring and
lead investor. By optimizing the structure of the securitization and by investing its own funds
in the mezzanine and in the senior tranche, KfW signalled to private investors its confidence
in the deal. Further enhancements were not necessary to attract private investments. The
dual role of KfW as bank and development institution helped to convince private investors
that the deal was attractive in financial as well as ethical terms (twofold seal of approval by
KfW).

A simplified summary of the different roles and contributions of the various SF stakeholders
is shown in figure 6.




15
     Subsequent securitizations are planned to be offered via the retail department of Deutsche Bank
     AG.

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                   KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



4        Summary, Conclusions and Open Questions

SF seems to be an appropriate vehicle for improving the access of banks in developing and
transition countries to local and international capital markets. In addition, SF is instrumental
in developing local capital markets. To fully develop its potential, SF transactions need
donors and DFIs and IFIs to crowd-in commercial investors. Presently, crowding commercial
investors into new asset classes such as MFIs, SMEs or low-cost housing can be
accomplished by complementary approaches such as reducing the preparation and
transaction costs of SF, mitigating risks through active deal structuring, shouldering some of
the transaction risks through credit enhancement, and generally signalling the commercial
investors that pro-poor portfolios can be dependable asset classes.


Figure 6: Roles and contributions of different stakeholders



                                                      Commercial
                                                       Investors /
                                                      Investment
                             DFIs/IFIs                                                   Social
        Donors                                           Banks
                                                                                       Investors



          TA,                                                Investments
     Structuring,
        Policy
       dialogue                                                                         Credit
                                                                                     enhancement,
                                                                                      guarantees
                                                               Senior


                                              On
                                             shore                                       DFI/IFI
    Originator /          Arranger             /                                       Investments
     Servicer
                                              Off
                                             shore           Mezzanine
                                             SPV
                                                                                        Donor
                                                                                      Investments
                                                               Junior



Empirical evidence indicates that commercial investors are not yet ready to invest in SF
vehicles without facilitating instruments and measures provided by DFIs. As structured
finance vehicles for development finance become more mature and commercial investors
more confident, donors and DFIs can start to phase out of this asset class and look for new

                                                     14
             KfW Financial Sector Development Symposium 2007 – Session 3 Keynote Paper



challenges. One promising example is the recently closed db Microfinance-Invest 1 deal,
where for the first time, commercial investors invested in unrated first loss, without additional
credit enhancement.

However, only subsequent SF deals with less involvement of DFIs and IFIs will prove that
microfinance or any other asset class in development finance has successfully been
established in international capital markets.

But open questions remain:

       •   What roles should or must DFIs and IFIs play in future transactions, assuming
           changes in SF structure and developing market context, e.g. buyer of last resort
           to make securities more liquid?

       •   Is the facilitating and complementary role of DFIs and IFIs in the medium-term
           perspective only temporary or permanent, e.g.

                 what is the exit strategy in structured funds like EFSE?

                 how stable are private commercial investments in case investments with a
                 better risk/return profile are identified or in the event of financial crises)?

                 Will there always be new, more risky or more costly territories of DFIs and
                 IFIs to conquer

       •   Will the exit of DFIs and IFIs and donors from structured funds like EFSE lead to
           “mission drift” of such managed investment vehicles?




                                                15

				
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