BlueOrchard aims to create new CDO asset class

Specialist investment manager BlueOrchard Finance and Morgan Stanley are hoping to kickstart a new sector of the structured finance market with the launch of the first public CDO of loans to microfinance institutions.

The two-tier cashflow structure is backed by a static pool of loans to 22 microlenders, emerging market banks that make very small business loans to the poorest sections of society. Its backers are hoping that BlueOrchard Loans for Development (Bold) 2006-1 will whet mainsteam investors' appetites for an asset class that offers diversification, stability of returns and a decent yield.

Despite the low income of their clients, microfinance lenders typically have very low delinquency rates. Furthermore, studies suggest that their performance is uncorrelated with any other asset class. These institutions even seem immune to economic crises in their own countries, perhaps because their borrowers are so far removed from the formal economy. BlueOrchard says none of the loans it has invested in have ever defaulted.

Typically, microlenders raise their funding from development banks, donors and supranational agencies - often on generous terms. It may seem surprising, therefore, that loans to this sector can offer decent returns.

However, as the sector has grown, it has begun to turn to private sources of funding, such as local debt markets and specialist international funds. "The largest, most sustainable microfinance institutions are growing at between 30% and 70% a year, and many smaller institutions are growing much faster," says Jack Lowe, chief executive of Geneva-based BlueOrchard. "Their need for funding is enormous. And with the public sector and donor community looking increasingly to earn commercial rates of interest, the traditional sources of funding are not sufficient to meet their needs."

BlueOrchard already manages two funds that invest in the microfinance sector on an unleveraged basis. The biggest is a Luxembourg Sicav sponsored by Dexia which currently has a value of $77 million. In addition, the company acts as manager on an earlier CDO, BlueOrchard Microfinance Securities I, which was distributed privately to institutions already involved in the microfinance industry.

The new deal, by contrast, will target a range of mainstream investors, as well as funds dedicated to socially responsible investment. Although it is not rated, officials involved in the transaction believe there is the potential for a rated deal in future. Ultimately, direct securitisation of the microfinance loans may also be possible.

A key benefit the CDO brings to microfinance institutions is that it allows them to borrow at longer maturities. The loans in the Bold transaction largely match the five-year tenor of the CDO. "Reliable longer-term funding is really what is missing in the market today," says Lowe. "We hope to be able to do a series of CLOs in future which will meet the institutions' needs for longer-term funding as they arise."

BlueOrchard acts as servicer of the static portfolio. It selects the loans and will monitor them and deal with any payment problems. The CDO consists of a $76 million class A tranche and $30 million class B equity piece in which Dutch development bank FMO and BlueOrchard are investing. "We wanted to use a simple structure and the highest quality portfolio possible for this landmark deal," says Desiree Fixler, capital markets specialist at BlueOrchard in London, who previously worked in credit derivatives at JP Morgan. "Although the universe of microfinance institutions is as large as 10,000, we are selecting 22 of the best."

Loans to the micro lenders are made in three emerging currencies as well as dollars and euros. This currency risk is hedged with a cross-currency swap that Morgan Stanley is providing. "It is quite a feat to structure a CLO involving local currency loans," says Fixler. "Thanks to the swap provided by Morgan Stanley, we have been able to include assets in Mexican pesos, Colombian pesos and Russian roubles - another reason why this deal is groundbreaking."

The 22 microfinance institutions in the portfolio are from 13 different countries: Mongolia, Bosnia, Colombia, Peru, Bolivia, Mexico, Nicaragua, Ecuador, Azerbaijan, Albania, Georgia, Russia and Cambodia. The largest single exposure is 10%.

The yield on the portfolio - that is, the average interest rate BlueOrchard charges for the loans - depends on a number of factors, including an assessment by BlueOrchard's analysts of the credit quality of the institution and the availability of competitive sources of financing. The weighted average interest rate of the portfolio is expected to be 8.7% in dollar terms.

BlueOrchard's 10-strong staff come mostly from the mainstream international finance industry rather than the public or voluntary sector. "The profile of our people is quite important," says Lowe. "They are not the typical people who work for an NGO. They are all people who have their training from large organisations who have then made the personal decision to move into microfinance."

Michael Peterson