Category Archives: High Impact Businesses

Joining the Crowd

At ClearlySo, we have helped over 50 organisations to raise about £60m in capital since the beginning of 2013.  This has not been easy, and even though more than half has come from institutional investors, it is angel investors and high-net-worth individuals (HNWIs) that have proved an extremely reliable mainstay of our business, funding the bulk of the high-impact organisations we assist.  ClearlySo launched Clearly Social Angels in March 2012, and it forms a small but vitally important element of our individual investor network of over 600 angels.

However, we are limited, due to regulation, to market these high-impact opportunities only to HNWIs and institutions.  As a result, retail investors are unable to play a part in the Impact Investment Revolution.  This was a point made in a recent report by Triodos as part of the G8 Social Investment Task Force, entitled Impact Investing for Everyone.

Crowdfunding is a cost-effective mechanism to gain access to retail investors; we have begun to engage with the sector to provide this access as part of our service to the companies we serve. This source helps to complement the funds our HNWIs can provide and should broaden the market for impact investment.  It is worth noting that crowdfunding platforms have been pursuing us for a few years; the sorts of companies we assist are often the type of company that touch people deeply, and can therefore be more successful on crowdfunding platforms.  We suspect that the crowdfunders also are comforted by the fact that our angels have already priced the deal, made significant commitments and undertaken due diligence.

Our first foray into working with a crowdfunding platform has been with Extremis Technology, which designs a range of revolutionary new shelters specifically for disaster relief.  In this first test case, we are working with the CrowdCube platform.  The entrepreneur, Julia Glenn, has written of her experiences in crowdfunding in a blog.  She notes that crowdfunding is not a replacement for active publicity generation, but rather demands even more of it.  In addition, she makes it clear that having a commitment up front is critical for success – crowdfunders seek to follow the crowd, not initiate.

Although one hesitates to extrapolate too much from a first test, there are a few points to highlight. Joining a crowdfunding platform means two diligence exercises, rather than one.  As this becomes more common, perhaps these processes can be merged.

Whereas we seek to prepare companies for presentations to investors, the wide-ranging questions, which come with a crowdfunding exercise are of a different magnitude.  Crowdfunders ask very detailed, incisive questions through the online forum on the various platforms. In a similar vein, media interest is greatly increased.  Our fundraisings are intentionally discreet; only by exception is publicity generated.  Crowdfunding is exactly the opposite and requires serious attention to keeping the flow of media interest going.  Progress also  takes place in a fishbowl.  If momentum is positive, this can be helpful, but otherwise this transparency can make success less likely.

Nonetheless, for companies that have a “public appeal” (including charities and those calling themselves “social enteprises”), crowdfunding can bring the company to a new audience and forge interesting new connections.

We expect to work more with crowdfunding networks over time, and believe it offers a useful add-on to the services we can provide.  For impact investing to scale, crowdfunding is essential.

First published in Third Sector in May 2015.

All Government Contracts Should Go to Companies Focused on Social Impact

The title is overstated, but there are strong arguments why most contracts ought to be awarded preferentially to bidders who operate primarily for social impact (PSIs).  Jon Cruddas, who is helping write Labour’s Election Manifesto, is to make this point in an upcoming book, reported on by The Telegraph entitled ‘The Common Good in an Age of Austerity’.  This position is based on a hard-edged, practical position that puts taxpayers first.

Governments have a depressingly poor track record in negotiating with purely for profit companies (PFPs).  The Private Finance Initiative (PFI), which brought commercial capital into public services, has been widely judged a disaster, with profit transferred to the private sector, but risk retained by the state.  From aircraft carriers to databases government negotiators have failed to impress.

The most recent scandal involved £16.6bn of bids for alternative energy provision.  Recently, the Guardian quoted Margaret Hodge, Chair of the Public Accounts Committee, in saying, “Yet again, the consumer has been left to pick up the bill for poorly conceived and managed contracts”.  This is similar to a previous report by this committee which was highly critical of G4S, Atos, Serco and Capita.  Serco and G4S were also the subject of an investigation by the Serious Fraud Office.

But let’s not unfairly demonise PFPs.  They have a legal responsibility to act in shareholders’ interests and to maximise profits. In negotiating with governments, PFPs structure contracts to their advantage – they have no legal obligation to act otherwise. We shouldn’t be surprised by this – it’s perverse to expect otherwise! It’s even more perverse that despite this PFPs are awarded nearly all contracts.

Why not award most contracts to PSIs?  Their raison d’etre is about social impact – and their constitutional documents reinforce this. Their approach is not about maximising profit, but about charging fairly and looking after beneficiaries.  Often they are innovative in their approach and genuinely care about the outcomes they achieve—their key stakeholders are beneficiaries, not shareholders.

If contracts with PSIs were priced too low, the taxpayer would get good value for money and PSIs gain painful lessons.  If too high, then PSI’s extra surpluses grow enabling more social impact – again the taxpayer wins.  Given this win-win “game” it’s astonishing PSIs don’t win all contracts.

One issue is scale.  There is no denying that private sector providers are larger.  Commissioners must be able to establish that PSIs can do the work – but this should be the only test. Instead, civil servants put in place pointless hurdles that have the effect of eliminating PSIs from the competition.

This was evident in the MoJ’s recent initiative-turned-fiasco “Transforming Rehabilitation”.  PSIs were told they could play a large role in the programme and the impact investment sector, led by Big Society Capital, helped some PSI-led consortia to qualify despite the unfairly tilted playing field.  Some well-run and large PSIs were involved such as Catch 22, Turning Point and Changing Lives.   In the end, all the contracts are led by PFPs, although some PSI “bid candy” also featured.  This was cynical and Chris Grayling and the MoJ were rightly excoriated by Antony Hilton.

A key issue was the need for parent company guarantees to ensure contract fulfilment, and the sums involved (£13-£74 million) meant few PSIs qualified.  But let’s unpack this criteria.  The parent companies that offered such guarantees are lowly rated – in each case far lower than RBS before the crisis began, leading to a state rescue.  How good a “guarantee” is this really? And SEUK research on PSIs found they are actually less likely to go under than private firms over the past 30 years.  People tend to value what PSIs do and work to rescue them if they encounter difficulties – would G4S be protected in a similar way if it encountered difficulties?

The lobbying efforts of large companies help put in place criteria that made bid processes complex which they then have an advantage in winning.  Don’t taxpayers’ interests demand we take the benefits PSIs offer into account? The Social Value Act was meant to help ensure this—it doesn’t.

Government ministers and civil servants are either lazy, illogical or excessively influenced by business, not to weight these factors more heavily in favour of PSIs—let us hope it is laziness, which can be most easily addressed.

First published on Pioneers Post in February 2015.

Moral Decency and £1,000 per Day

At a recent conference on impact investment, I got talking to someone from a well-known funder over lunch. The conversation soon turned to whether it had used the services of impact investment intermediaries. He said it had and wished to use more, but he believed intermediaries to be “incredibly greedy”. In the past, it had been charged up to £1,000 per day – a sum he considered indecent.

As my own company ClearlySo is an impact investment intermediary, I need not bother to declare an interest — and I saw his point. It is challenging to justify payments of this magnitude in a world where so many people are living on less than $2 a day.

The figure of £1,000 per day is also relevant as many government-related contracts directly impose such limits.  It seems eye-popping amount and how many people really deserve £200,000 a year, and if so, should they be in this sector?  But let’s look a bit deeper.

Nobody is “billable” 100 per cent of their work day.  If we assume that a professional does client work 60 to 70 per cent of their time, then expected annual revenues amount to about £130,000 a year. Behind each professional is a team who do HR, administration, finance, legal and so on but who you don’t bill for their time. In addition, there are sales teams which generate costs, and do not win every pitch, and even if successful, cannot bill that time to the client.  Nearly half of the £1,000 a day is eaten up this way.

This leaves £65,000, which means you can pay about £50,000 in salary after adding around 30%  for national insurance, pensions, training and other staff benefits.  This leaves no surplus, which the organisation requires to be sustainable and invest for growth.

To become sustainable the intermediary must charge more, become more efficient, or pay less.  Now £50,000 a year feels a decent wage, and is nearly twice the national average, but unfortunately, most intermediaries are based in London, where most deals are transacted, and costs are substantially higher than in the rest of the UK.  Furthermore, financial transactions in the impact space are no less complicated than in the mainstream—they need to accommodate standard financial trickiness and the added complexity which comes with social impact tweaks.  These skills demand individuals with significant financial acumen and their alternative market value is many multiples of the figures above.

When I explained this to the funder, he was not impressed.  He accepted the maths, but he still felt the figures too high.  I asked him what it pays its lawyers a day, and he said, “Well, that’s different”.  “OK,” I said, “what about your accountants?” He argued that too was different.

Maybe transactions will become simpler, or London will become cheaper—but these seem unlikely.  Admittedly, intermediaries need to better articulate and demonstrate the value they add, and funders, investors and entrepreneurs should be transparently explained the maths above.  As an alternative, these three groups need to better explain to intermediaries why impact investing is so unlike mainstream financial intermediation, and that their skills are worth significantly less than those of lawyers and accountants in the impact domain.

It would be utterly indecent for impact intermediaries to earn the packages rampant in the City, but this is far from the case today.  If we want the sector to “work” we have to first talk about and second, try to tackle this challenging issue.

First published in Third Sector in December 2014.

Externalities: When the long term meets the short term

In late November, KLP, Norway’s largest pension fund ($70 billion), announced it would blacklist companies which generate more than 50% of their revenues from coal-based activities.  This follows similar moves by asset managers in Sweden, Australia and the USA and hundreds of others worldwide.

Recently coal-related stocks came under selling pressure as a result of executive actions undertaken by President Obama.  This was among a list of factors which has seen coal share prices fall by 50% over the past three years, thereby underperforming the rising market by roughly 80%, a disaster for which pensioners ought to hold their highly paid fund managers to account.

Steps such as those undertaken by KLP are laudable, but they do feel like shutting the barn doors well after all the horses (well, at least 80%) have bolted.  They would have done their beneficiaries a far greater service if they have been more farsighted in their thinking and taken externalities into account.

Externalities are a term used in economics to describe real costs or benefits passed on to society, which are external to the core actions of economic agents.  Those in the coal industry mine coal to generate energy which harms society by polluting the atmosphere and depleting the planet’s ozone layer.  The pollution is external to their core activities (mining and energy production); an unfortunate by-product.  This engenders real costs and is thus a negative externality, but some firms generate positive externalities.  ClearlySo, which works only with firms generating high social impact, works with many of these.  London Early Years Foundation, which provides nursery education, is one example.

The key point regarding externalities is that they do generate real costs or benefits.  One might consider them as taxes or subsidies which are passed on to society without political involvement or democratic accountability.  In the case of positive externalities we tend not to mind as things we want are provided for free, but when costs are transferred to society by firms profiting at the public’s expense, we are not pleased.  In today’s fiscally challenging times we are outraged.  Political leaders are responding by making firms pick up these costs—the externalities are thereby “internalised”.

We will see much more of this, and investment managers who fail to appreciate the externalities generated by their investees will suffer as a result.  Until recently, firms seemed able to get away freely with the harm they caused; obesity, lung cancer, water pollution—fund managers behaved as if the long term costs generated would never have any consequences.  But as governments step in to internalise these costs, such factors gain short term significance—and penalise lazy fund managers.  On the other hand, some progressive investors, such as AXA Investment Managers, use the analysis of such factors to gain a performance edge over rivals who ignore these factors.

Governments are also just beginning to reward enterprises generating positive externalities, or beneficial social impacts.  This is at a very early stage, but momentum is gathering, as rewarding such firms reduces demands on the public purse.  All this means that the social impacts of firms are emerging as an important third dimension (alongside perceived risk and return) for investors to consider.  Failure to do so will mean underperformance for some fund managers, as the beneficiaries of KLP have learned to their misfortune.

First published in Third Sector in November 2014.

What’s in a Word? The continuing debate about what is a social/impact enterprise

Recently I posted a blog applauding the G8 Social Impact Investment Taskforce (SITF). It published reports that dramatically advanced the development of a global social economy.  However, hidden beneath the pages of well-argued text rages an interminable debate: what do we call those endeavours generating social impact?

Writers have used “social enterprise” since the 70s, and “social investment”  since the 90s.  The SITF reports contain all these terms – plus “impact entrepreneur”, “impact investment”, “social impact investment” and many tortured derivations of.  At the core of this wordplay is American discomfort with the word “social”.  I cannot explain the intensity of this aversion, but it may help explain why in 2007 the Rockefeller Foundation felt it had to devise new terms.  Ever since, resources have been wasted on this debate.

Such arguments would be amusing if we were not approaching a time when naming begins to have significance.  After the SITF launch, Chi Onwurah, the Shadow Social Enterprise Minister, announced she would create a legally binding definition of a social enterprise.  The intention is a positive one, to favour social enterprises in government contract bidding.  I suppose the thinking goes, “to favour one class of enterprise, we have to be precise about who they are”.

I find this problematic and expect numerous unintended adverse consequences, but here I challenge the very nature of the term social (or impact) enterprise as a unique thing in itself.  Over the past two decades we have had extensive debates about what the taxonomy should be based upon.  Legal form?  Geographical HQ?  Beneficiaries served?  Types of employees or employee ownership Dividend caps/asset locks?  The intentions of the entrepreneurs/investors?  On it goes … and we have debated all of these at ClearlySo.

These categorisations come in and out of favour and the latter few have been in ascendance – partly due to the growing importance of Big Society Capital (BSC), which has legal limitations proscribed in law.  It makes sense for BSC to adhere to the conditions of its charter; it does not mean the entire sector must follow.  Surely these factors should be secondary to the impact generated.

Whatever the form/structure/intention, I would argue that we should weight our judgement (or dole out tax credits and bidding preferences) towards those firms generating the greatest impact.  Society is not helped if we restrict contract winners only (for example) to CICs and charities if a Limited Company were better able to deliver the sorts of results governments desire – such as reducing reoffending rates or helping NEETs find long term employment.

I am also not sure intentions should matter in this equation.  They are nearly impossible to divine, change frequently, and may well be irrelevant.  I am happy for a business that dramatically reduces CO2 emissions, or generates low-cost renewable power to prosper are receive state benefits even if the entrepreneur is mainly interested in getting rich.  Society is better off and in certain instances, such a model might prove the most ‘socially’ impactful.

I can see the risks of such a position, and can already hear the arguments around how this will lead to the abolition of the welfare state.  This is not my intention and I am confident it would not be the outcome.  Private sector contractors like Capita are in it for profit; maximising social impact is far lower on their agenda – and the existing system is absurdly stacked in their favour.  Such changes as I am proposing would harm, not aid, them in their efforts.   Unlike the Shadow Minister, I would award all contracts on this basis – not just a few.

First published in Third Sector in September 2014.

Social Impact Investment Legends

I tend to consider what to write in this column only as deadlines approach. Quite a bit has been going on the sector, offering an array of potential topics for discussion. However, the recent death of my good friend and colleague, Stephen Lloyd, whom I have described as the social impact investment sector’s leading legal light, means that at this point in time my mind is frankly on him and people like him. I wrote a piece to honour Stephen on the ClearlySo blog so I will not repeat myself. However, he was so significant that it would do him a disservice to neglect him in this piece.

On writing about Stephen and his life I felt a depressing sense of déjà vu. I recalled having written also after the death of two very different but also significant individuals in the sector: Sarah Dodds and Anita Roddick. As founder of The Body Shop, Anita needs no introduction and her influence on the sector has been enormous. The Body Shop, together with Ben & Jerry’s ice cream, were the first two “big hits” of businesses that generate significant social impact. Also, each fundamentally changed the way we thought about consumption.

Sarah Dodds, like many of the hundreds toiling away in the social investment space is less well known but equally loved and admired by those who knew her well. The Canadian born Dodds spent years here in the UK working in particular with early-stage ventures that had scalable potential. She spent much of her career here in the UK at UnLtd running their ventures arm and dedicated herself tirelessly to helping many early stage social entrepreneurs achieve scale.

I feel a sense of rage at the premature passing of these three great people, but I also thought it might be worthwhile to explore some of the characteristics common to them—I have come up with three I thought were worth sharing.

First, the most noticeable trait all three of these people shared was a deep abiding faith and conviction in what they were doing. All three believed, almost as a matter of faith, that the endeavours on which they were embarked had the potential to change the world for the better. Each chose their own path to achieve this although, like any who are cut down before their time, there was much more still to be done. But this sense of dogged determination is something I admired in all three.

Second, all three seemed incapable of doing anything else. It was as if they had received a custodial sentence and were legally required to commit to community service to the sector for society’s collective benefit. They all seemed to have no choice in the matter and I could not imagine them doing anything else.

A third characteristic was an inability to do things the way they were supposed to. They each drove people around them a bit crazy with their desire, commitment, drive and work rate. Although loved by many this did not mean that their colleagues always found them easy to work with. We should recognise and accept that when people are embarked on world-changing ventures, their single-minded focus, their inability to easily say no, or to be told “no”—all of these qualities which contribute to their success—can mean they can be frustrating at times.

I offer these observations above because I wish to remember my friends and because their passing away before their time raises existential questions I do not attempt to address in this piece.  But also, these three great individuals from the social impact investment space serve as role models for many actively engaged in the sector, and also for those considering social impact investment careers.  I think we could not ask for better models.

First published in Third Sector in August 2014.

Amusing tales from the mainstream

At ClearlySo we perceive ourselves as being at the outer edge of the social impact investment marketplace. We are focused, in particular, on the place where mainstream investment and social impact investment connect. So we will speak regularly to the foundations and impact investment funds that have been pioneers in the sector, but we spend a relatively high proportion of our time working with traditional mainstream investment organisations. The reason is simple, that’s where most of the money is.

Similarly, and certainly a related point, is that the social entrepreneurs we assist exist along a very broad spectrum. Most would meet the investment criteria of Big Society Capital or other impact investment intermediaries, but in addition we work with companies which would be excluded from such lists, but we judge to deliver substantial social impact. A good example of this could be Weedingtech, a firm which uses foam bubbles of extremely hot water to kill weeds. We recently assisted them in a £750k round of investment capital, but many might judge the environmental impact of this firm as merely a by-product of their main focus, which is to create a successful business, and thus they would not be deemed worthy of engagement.

Recently we have had a series of amusing encounters with mainstream investors which underscore what real life is like in the trenches for social impact investment intermediaries like us. The first comes from a series of discussions I had with Nordic fund managers about impact investment. It was clear that they were seeing a number of clients were focusing on impact investing solely as part of what could be described as a “box ticking” ESG exercise. One of the executives I spoke with was a bit irritated by such practices as he felt they were not particularly genuine. My view is that if box ticking was required to get people interested in considering social impact investments it was certainly worth the price. Such a view could be seen as cynical, but to my mind is eminently practical.

Another series of recent meetings concerned funds that delivered high returns but also notable social impact. We noticed that in marketing such funds that the very notion that a fund might deliver social returns to any extent makes prospective investors suspicious about the fund’s ability to offer superior financial performance. This can be the case even be despite an impressive track record of successful financial performance, as if the very words “social impact” required an obligatory sacrifice. We do not believe this to be the case and a respected professional from the European Investment Fund, Uli Grabenwarter, has written a terrific paper on the subject suggesting that social impact and investment performance are positively correlated. We concur with his view.

Nevertheless when it comes to marketing, perceptions can be even more important than reality. Thus glossing over the fact that a fund delivers important social impacts perversely makes it more likely for those social impacts to be realised, as it increases the fund’s chances of raising capital. Conversations we have had recently with leading fundraisers in the mainstream suggest that this is the case. At a recent lunch such an expert shared with us that when marketing a client’s funds they will not even raise the point about social impact for fear of scaring off investor prospects. Of course, if investors are interested, they will engage in this discussion.

So engaging with the mainstream is tricky and an awareness of perceptions is critical. Nevertheless, in the long run we think the effort is eminently worthwhile, even if we leave some piece of the story “off to the side”. And if in the meantime limited partners of funds inadvertently achieve social impact that they weren’t even aware of, there is certainly no harm done! Quite the contrary.

First Published in Third Sector in July 2014.

Taking the long term view in seeking social investment

Practitioners like us in the social finance sector spend a significant part of time explaining to business which generate social impact the advantages of securing capital from social investors.  We argue that they are the sort of investors who are more willing to take a long term and client-centred view.  Furthermore, because they are positively motivated by the social impacts generated, they have greater alignment with the goals of socially-oriented enterprises than conventional investors, which can lead to many tangible and intangible benefits.

The fact that social impact investors value these non-financial outcomes is what underpins social finance.  In conventional finance, investors seek to maximise risk-adjusted rates of return over an increasingly short time horizon.  Increasing “short-termism” and the obsession with profit and return maximisation at all costs has been seen by many to be the underlying cause of the financial crisis.  Social investors value social impact and are keen to support the businesses which generate this.

This unsurprisingly resonates with many enterprises generating social impact.  Their reason for being is not about profit maximisation, but driven by a set of social objectives combined with a need for sustainability.  Thus businesses oriented towards impact, often described as social enterprises, share their ethos with emerging social impact investors.   They also express distaste for the ethics of conventional finance, and a frustration with banks and their short- term behaviour.

Thus it has caught us by surprise recently when a number of successful social enterprises balked or hesitated at financing possibilities from social investors when mainstream banks seemed to offer slightly better rates than social investors.  Suddenly quaint concepts like “values-alignment” were quickly jettisoned in the pursuit of the lower interest rates; even from the “evil high street banks”.

There can be times when social investors are more financially attractive to social enterprise borrowers than banks—as they value the social impact and make an implicit or explicit trade of risk-adjusted return for social benefit.  Some recent ethical bond issues would fit into that category, such as the well-publicised Scope bond.  Socially-oriented businesses like the Ethical Property Company (EPC) make it very clear that equity investors are very unlikely to do as well, from a purely financial perspective, purchasing EPC shares than buying stocks in conventional property companies.  EPC shareholders explicitly trade off returns for the important social impacts generated.

But there is not always such a funding advantage.  Sometimes banks offer very attractive terms.  Housing Associations, even the most ethically oriented of the lot, find the current glut of very cheap bank debt hard to turn down.  Other large socially oriented enterprises we know also find it tempting.  But we would urge them to try to resist temptation (unless the gap is ridiculous).

As we have seen over the last few years banks do literally come and go.  Even those which have not gone under will enter and exit lending markets at speed.  SMEs up and down the country have learned that “relationship banking” was more of a slogan than a genuine approach—at least for most commercial banks.

To build a new financial market means supporting investors who take a long term, values-oriented and client centred view.  This might be necessary even when there is some short term cost to be paid.

First Published in Third Sector in April 2014.

Impact investment approaches: proving what you are and what you are not

At ClearlySo the question we are asked most by the clients we are helping to secure social investment is, “what sorts of returns or impact are your investors looking for?”. We urge them not to think this way and just to focus on just building their enterprises, being innovative in how they achieve their social impacts and then working with us to see what type of financial model and instrument best suits.  Investors can be found for pretty much any inspiring social enterprise in the increasingly rich and broad investment ecology that is emerging.  Social entrepreneurs find this answer unsatisfying.  They seem to want a number – if they persist, I tell them “42”, in homage to the Hitchiker’s Guide to the Universe.

The fact is there is no single number.  Our sector is only just emerging and investor behaviours and preferences are still developing.  The importance of social impacts means that values play a big part in the investment decision making process; values shift, are challenging to measure and the trade-offs investors are prepared to make change constantly.

This is very common with angel investors, such as those in our Clearly Social Angel network.  An individual may be willing to accept even a negative return to achieve a social impact they really value (such as educating young girls in Africa), but seek market returns for the rest of their portfolio.  Then we might find they have been inspired by a health-sector social entrepreneur and are investing a substantial sum with a relatively low return.  These ever-changing desires make social finance fun and are part of the self-discovery process in which we are all collectively engaged.  Individual motivations, at a very deep level, play a vital role.

Motivational factors seem to be important to institutions as well.  In my view, one of the most interesting and amusing oddities lies not with individuals but with institutional investors in the impact investment space. This came to light magnificently with a client we were advising.  In order to establish potential demand for social investment into our client’s project, we sought the opinions of investors in advance of an offering.  This is a time-consuming process but makes it much easier to feel confident in levels of demand and appropriate rates of returns investors will seek for a given project.

At the conclusion of the interviews, my colleague summed up brilliantly by saying, “Well one thing is clear: the impact funds are more demanding than the mainstream investors”. The client and I looked at each other, and then at my colleague, assuming he had misspoken – but he hadn’t.  In fact, he was right in saying that, for this investment, conventional investors would accept a lower rate of return than those funds established to target social impact.

This seeming anomaly may be case-specific, but I doubt it.  It also may have to do with deep-seated motivations that are somewhat surprising.  From some of our enquiries it appears as if mainstream investors undertake impact investment for CSR reasons, or because they are experimenting to see if there is client demand, or because of employee pressure, or a combination of the above.  They rarely do so, at least at this stage, to make a lot of money or as a core part of their business.  By contrast, for impact investment funds (IIFs) this is the core business.  They are trying to prove to sceptics that a fund that generates social impact can deliver solid returns.  At this early stage in the history of IIFs this is particularly important.  One could say that the mainstream is trying to prove how social it can be, whilst the IIFs are demonstrating their commercial viability.  This may be an over-simplification, but only a bit of one.  Our sector is indeed fascinating!

First Published in Third Sector in February 2014

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.