Debt, Equity and Sustainability – Part 3: The great social enterprise lie

I have recently written two blogs with the above title; always intending to write a third, which I have decided to publish in Third Sector Magazine. The series assesses sustainability from the perspective of debt and equity in the economy.  The first piece questioned high debt levels and the importance, as we moved out of the crisis, of encouraging more equity investment. The second analysed the banks and chastised politicians for their criticism of them.  To demand more bank lending while at the same time placing increasingly stringent requirements upon banks which raise their cost of lending, felt unfair and unwise. This third and final piece addresses an ongoing debate around whether social enterprises really need debt or equity.

Whenever the demand for capital in the social enterprise sector is discussed someone proclaims that “what the sector really needs is not equity investment but reasonably/fairly priced debt”.  This statement is normally met with nods all around, but it is highly misleading.

It is true that many social enterprises cannot receive investment in the form of equity. Their legal structures preclude issuing shares. What many therefore seek is debt capital with either a low interest rate or no interest rate at all. Anything exceeding 5% is considered aggressive and beyond the pale. Institutions seeking such “obscene rates of return” are cited as evidence that the evils of the commercial sector are creeping into our beloved social sector.

This is unfair. Most mainstream investors are looking to secure a return that covers their own cost of capital and takes into account the risk of the underlying enterprise. It is in this latter aspect where the problem lies.  Social enterprises (SEs) seem ignorant/unaware of or indifferent to their risk of failure or refuse to recognise that this is a necessary part of the calculation of a fair rate of return. Social enterprises do fail (although research suggests the risk is lower than with conventional enterprises), especially early-stage social enterprises, and social investors need to adjust for this if they are to become sustainable.

The fact is that for small, early-stage social enterprises the likelihood of failure is very high and the required rate of return to compensate makes the cost of the debt seem really high, if not downright “Wonga-like”.  In conventional markets this high risk is offset by the hope for high returns, but typically such investments are structured as equity and not debt, and the return is only realised when the enterprise is exited—not possible for many social enterprises.  Quasi-equity, where the return on a debt instrument varies with the success of the social enterprise, is one answer, but we have found that successful social enterprises can feel “ripped-off”, because their own growth makes the return to investors seem high, after the fact.  They quickly forget that if things had not worked out the investor would have seen zero return, or even a loss of capital (up to 100%).

Thus what we believe SEs are really looking for is for capital which to an investor gives them “equity-like” risk, but at a cost that matches what the highest quality companies pay for debt in the financial markets.  Perfectly reasonable to WANT this; quite different to EXPECT a cost which does not reflect underlying risks.  Social investors agreeing to offer capital at this “wrong” price are playing a valuable role but they will not be sustainable.  For them to become sustainable, their capital base or their returns need to be subsidised by some party valuing the social impact generated by the SEs (Government, foundations or wealthy angels being the most likely candidates), or the risk needs to be reduced (same candidates).  Finding these pots and blending them into the mix to facilitate transactions is a key to social finance.  Being clear and honest about what is really going on is vital.

First Published in Third Sector in November 2013.

How much flirting with the devil is safe in Social Finance?

In September ClearlySo celebrated its 5th anniversary.  By coincidence, it was also five years since Lehman Brothers collapsed, nearly bringing down the entire western financial system.  As someone who spent years writing about Lehman as an analyst, and then six more years working there (I left in 1994), and started fund-raising for ClearlySo the very day Lehman fell, it is fair to say that these reflections have a particularly strong influence on me (see a recent blog).

It is no secret that within the social finance sector we see ourselves as being on the end of the spectrum that is closest to the mainstream.  Some might even say we are not a social business at all, as we operate as a for-profit company (though we have yet to make a profit!) and, although we have a clause in our “Mem & Arts” which stipulates that we exist primarily for social purpose, we have no asset lock or dividend pay-out restrictions.  This has meant that we have been funded differently than many other sector players (most of our capital has come from angel investors) and we one day expect there could be an “exit event”.

Putting ourselves to the side, it is true that of the 20 social businesses we expect to raise capital for this year, most (but certainly not all) will look like ClearlySo—some people call such companies “profit with purpose companies”.  For us to connect with such firms and help them raise capital, feels quite natural—we are advocating a type of company that we ourselves represent.  It is also feels normal for us to reach out more regularly to the investment mainstream.  We expect that, over time, most of the money we raise for social entrepreneurs and impact investment funds will come from angels and mainstream financial institutions, rather than a few dedicated impact investors.

But we recognise that there are notable risks in doing so.  Many in the sector are suspicious of the mainstream and take a dim view of “supping with the devil”.  There are also undeniable dangers for social entrepreneurs considering this path.  How far is one permitted to go?  I was once told by the CEO of A4e that her company was the largest social enterprise in the UK—many feel they went too far down the commercial path.  The Body Shop was highly criticised when it decided to sell out, at a very attractive price, to L’Oreal and Innocent was frequently judged as less than innocent in their commercial approach—a view encouraged by the subsequent sale to Coca Cola.

But a commercial approach and structure can offer advantages:

  • Structuring as a Company Limited by Shares enables access to vaster pools of capital
  • Stock options are available to incentivise staff in cash-starved early stage enterprises
  • Commercial structures will be more familiar to counterparties

I believe both approaches have their place and perhaps my own background “in the dark side” meant that this is the course I was destined to take in founding ClearlySo.  And my experience in Chairing Justgiving in the 2003-2006 period was formative in how I came to see the social business world.  But of course I worry that in this pursuit of the middle ground there will be a tendency to veer in a Lehmanesque direction.  I count on colleagues and the sector to keep us honest.

First Published in Third Sector in September 2013.

Angels are a vital component of the social investment ecosystem – and it works

The social investment sector appears to be growing rapidly and holds considerable promise. This is especially important at the current time, as severe cuts in central and local government spending are having serious consequences for the level of public services.  The advent of Big Society Capital (BSC) and a host of governmental actions made it very likely that the social economy will grow rapidly over the next few years. According to a widely read report done for BSC by Boston Consulting Group, the social investment market will grow to approximately £1 billion in 2016, and will expand by 40% per annum in getting there.

What is also true is that despite the rapid pace in fund commitments made by BSC, it will take years for these funds to find their way into the market.  This is because the commitments are done on a matched-basis and each of the fund managers needs to raise other funds elsewhere—and this process often takes a long time. Thereafter, each of the fund managers, if they are doing their job properly, will take years to invest the funds.  Thus it will take quite some time for the institutional side of the impact investment market to form and function effectively.

In the interim, angel investment is essential.  As delayed as the institutional market may be, the retail investment market is years behind that. Financial promotion regulations make it very difficult to offer social investments to individuals.  What remains are thousands of High Net Worth Individuals (HNWIs) and sophisticated investors who are able, and increasingly ready and willing to back social entrepreneurs.  Not only is the capital these HNWIs absolutely critical, but the expertise, contacts and networks they possess make them extremely valuable particularly to early-stage social entrepreneurs.

Next week ClearlySo expects to close its seventh deal this year, raising over £1.5 million for a wide range of social entrepreneurs.  Without this capital and the advice of these angel investors, the entrepreneurial hopes and dreams would remain just that—only hopes and dreams.  Much of this capital has come via our social business angel network called Clearly Social Angels, although of course as these deals were getting done we have also been able to reach out to our broader individual investor network and other contacts from other networks—a social angel ecosystem is emerging.

We look solid to the development of the institutional social impact investment marketplace, and in time the retail one as well, but in the interim and for the coming years we are grateful for the difference these angel investors can make and are making.

First Published in Third Sector in July 2013.

Socents and Ladders

Recently I had the privilege to attend the first anniversary of the launch of Big Society Capital (BSC).  As BSC is ClearlySo’s largest investor many will question the objectivity of what I might say.  So let me just wish them a happy first birthday.

However, the evening prompted me to reflect on the question of what is the purpose of social enterprise, finance and investment—which two consecutive Governments and so many others seem to support as a great idea. This is a debate that has been raging recently which we discussed in a recent blog post. I would like to describe the debate as one between purists and the “ladderists”.

The purists tend to see social investment as something which should be dedicated to encourage a very particular type of highly social organisation. This is not yet a uniform view on exactly what type of organisation ought to be supported, but purists seek to target resources on those fitting a precise definition—those organisations most focused on generating social impact and needing the kind of support their BSC and other governmental initiatives are designed to encourage.  Those businesses which are not so purely focused ought to receive less support or no support, as they are not really social enterprises.  As we see it the world of the purist is black and white.

At ClearlySo we are in a different camp—we see many shades of grey (cue sniggering).  Our aim is to bring the greatest sums of capital imaginable into the sector—and in order to achieve this we might seek to attract mainstream investors with social enterprise opportunities that purists might consider unacceptable.  I am reluctant to try to place BSC on this spectrum, but as an institution formed by an Act of Parliament their remit is legally constrained.

In another debate, during the networking drinks, I confronted another purist—this time on the issue of social impact assessment.  Her contention was that this work is valuable and, in importance, equivalent to the work one might do in assessing financial performance.  Or on a pre-investment basis, she argued that financial and social due diligence were equally valuable.

Philosophically I agree with her.  My problem is that we do not live in this philosophically good world (I wish I did).  In the world that we confront, mainstream investors do not value social and financial analysis equivalently—they value the latter much more highly. If we can get them to start to use social analysis—even a little bit—then my hope is that we get them onto at least the first rung of the latter (hence the silly term I coined, “ladderites”, to describe how we see ourselves).  Over time I hope we can get the mainstream to climb up the rungs—but the hardest bit is to get them on in the first place.  The alternative, I fear, is that we will expend substantial effort to convince them they should jump very high up the ladder—and this will fail.

To be clear, I think the world needs both purists and ladderists—and one is no better than the other.  But I am most definitely a ladderist, and ClearlySo is absolutely focused on getting people on the first rung.  I have undying faith in the fact that once we do, the mainstream will inevitably climb up the ladder.  I think competitive forces and their own desire will drive them.

First Published in Third Sector in May 2013.

What is social investment?

This year, I have met many organisations who have taken the liberty to convince me, at length, on their version of what is “social”.  Baxi Partnership has a longstanding commitment to employee ownership, with deep experience in securing the social and financial benefits related thereto.  The John Lewis Partnership is the best example of such a firm.  The Anthroposophical movement and its central tenets lie at the core of Triodos Bank, and inform their activity.  The Coop is committed to the concept of cooperative or customer ownership, and an offshoot it helped to form, Unity Trust Bank, has similar core principles, but with an historical tie to the union movement.

In the UK, a lead is now being taken by Big Society Capital (BSC) which, as a recipient of £400 million in unclaimed assets, has had to define what it can invest in—which partly requires defining what a social purpose business is.  This definition is important, as it guides how BSC may invest its millions.  Yet some BSC professionals have expressed the view that they wish their remit was broader and included certain precluded areas.  But the Act of Parliament which created it is clear, and some deeply social areas are not permissible.

The point is that there are many views on this, and though some have important practical consequences, I find it very difficult to advocate one view over another—they all seem right to me.

It is in this spirit that I am bemused by the recent debate about social finance and investment, kicked off by Robbie Davison’s thorough piece (“Does Social Finance Understand Social Need?”).  It has been followed up by responses from thoughtful commentators such as Nick Temple and David Floyd, and by comments posted on our recent ClearlySo blog post entitled, “Social Finance: The Case for Helping the Least Needy”, by Robbie Davison, Isobel Spencer and Paul Halfpenny.

Lurking here is the presumption than any one of us can “know” what precisely the point of social finance and investment is. I think it would take more than a trace of arrogance to imagine that any of us is in a position to dictate a definition to the sector. Any attempt to do so will falter, as the meaning of “social” (finance, enterprise or investment) is highly subjective.  Devising a common definition will be challenging.

However, I believe there is also a practical risk for anyone to try to proscribe and thereby limit what is included. From our perspective at ClearlySo, the biggest problem for social investment is not the precision of how we define the term, or its deviation from some ideal, but rather the small size of the market. Put simply, we need more investment in social everything.

Thus, we endeavour to bring in more investment from individuals or organisations with capital however they choose to define “social” (within the bounds of decency and legality, of course) and match them with appropriate investments.  By defining the sector broadly, we help to create the largest possible market. I do not believe this will undermine the ethos of the market.  On the contrary, I believe that once investors enter the “social investment tent” they will be attracted by other forms of social investment and more open to diversifying their impact investment portfolios.  By assisting them onto the first rung of the ladder (even if it is highly secure, asset-backed finance for a well-established social enterprise) we make it more likely they ascend.  Low-risk investments are the natural first step in a nascent market.  I am confident that, in time, they will move up the ladder and not destroy the market.

First Published in Third Sector in March 2013.

Social finance: The case for helping the least needy

Conversations with investors, particularly those from a philanthropic background, are often focused on the desire to help those requiring substantial assistance.  The argument goes something like this, “We cannot use our resources to assist those already well on the way to success, better to focus on those really needing our assistance.”

This argument has a certain logic to it, and those with a strong social orientation, in particular those representing charitable foundations, may feel legally or morally compelled to act this way.  A related argument frequently surfaces when foundation investors are asked to participate in structured financings, and assume the riskiest and least remunerative positions.  On occasions they are asked to assume the “first loss”, or take a “capped return”, or sometimes a combination of the two.  A sense of indignation emerges that their capital is being exploited so that those with a market return requirement can profit from social investment transactions they would otherwise not participate in.

I can surely see the point, but would like to suggest a different perspective, one that is based predominantly on the idea of social impact maximisation.  There are times when large financial sums are required and these can only be made available through larger structured transactions—these necessitate access to mainstream players (banks, for example).  By accepting greater risk or lower return, or both, foundation capital can bring in far larger sums than would otherwise be feasible, or are available in the social investment sector.  Society’s needs are so great that even with the £600+ million coming from Big Society Capital, far more is needed.  As mainstream capital still seeks market returns, only social capital or government subsidy can make such deals happen.

An unwillingness to do so just because mainstream investors get their return is akin to “cutting off one’s nose to spite one’s face”.  These foundations would willingly offer grants where 100% loss of funding is assured.  But by using their capital in structured transactions sometimes far more social impact can be generated, AND they might see some return.  Not to do so just because other investors (with very different criteria, beneficiaries and rules) might do well seems odd and reduces social impact generated.

Similarly, by shunning those social enterprises or projects which are close to viable, in favour of the more hopeless, they are reducing both their return and social impact.  Moreover, they are undermining the probability of success of those social enterprises which are just about sustainable, in favour of those which have a very long road still to travel.  And these “nearly there” social enterprises are, by definition, not yet there.  If they fail just near the finish line it is deeply tragic and undermines all the hard work and capital invested by foundations and others which got these social enterprises “nearly there” in the first place.

To get the most out of our money, a critical discipline in today’s capital-starved times, and generate the most social impact, we need to start with the least needy and work our way backwards.  This may seem perverse, but for those who care about substance over form, and making a substantial impact over a huge gesture, it is essential.

First Published in Third Sector in January 2013.