In recession, investors seek a different sort of return

News headlines abound on the dire state of our high-street banks, billions of pounds of wealth has been wiped out, businesses are being pushed to the wall and consumers are being hit on multiple fronts – all amidst a calamitous drop in public trust and confidence in institutions.

As government, economists and business debate ways to tackle the economic crisis, one promising model is already emerging: social finance.  While high-street banks are being nationalised, Charity Bank, the UK's only regulated bank that is also a registered charity, is seeing increasing demand from both depositors and borrowers interested in a different model. While government anxiously urges banks to increase lending, ethical bank Triodos announced record lending levels for 2008. And while banks continue to take billions of pounds of state aid, the Co-operative Group is investing over £1 bn in a rebranding campaign underscored by growing demand for financial products with a social reference.

Charles Middleton, managing director of Triodos Bank UK, says “In these tough times, more and more people want to work with an actively ethical and transparent bank, like Triodos.  They can see the financial benefits of investing in the growing environmental and ethical sectors and at the same time want to help organisations making a positive difference”.

Social finance, or more broadly, social investment, bridges the not-for-profit and for-profit worlds by generating both financial and ‘extra-financial’ returns, through social or environmental benefits.

As the Nobel Prize winning economist Amartya Sen wrote eloquently in the Financial Times (11/3/09), we often fail to remember that Adam Smith, the founder of modern economics, did not believe the pure market mechanism to be all that is needed for a healthy market economy. Rather, Smith “wanted institutional diversity and motivational variety, not monolithic markets and singular dominance of the profit motive”. Smith no doubt would have approved of social investing.

What is social investment? Definitions can vary widely.  For example, some philanthropists view their charitable donations as ‘investments’ which bring social rather than financial returns.  Others define social investment narrowly, such as a financial investment in a social business. For the purposes of this Newsletter, Philanthropy UK defines social investment as any type of investment that combines social and financial returns. 

This encompasses a wide range of activities across the financing spectrum (see Figure 1), from lending to charities to investing equity in social businesses to socially responsible investment (SRI).  There is overlap with the capacity-building approach that provides grants and management support to charities and social enterprises (but where the investor does not receive a financial return).

Social investment has existed in the UK in various guises for many years, though a key milestone for the sector was the establishment of the Social Investment Task Force in 2000. Supported by government and chaired by Sir Ronald Cohen, the venture capitalist, the task force’s key recommendations to help “revitalise Britain's poorest communities” helped to accelerate the development of the sector (see Table 1). They also, says Michele Giddens of Bridges Ventures, “helped to give a collection of entities a sense of sector, and to nudge foundations to consider alternative ways to invest their endowments”. 

Government support has also been an important factor, through for example the introduction of tax relief for investments in community development finance institutions (CDFIs), which provide finance and support to businesses and individuals in disadvantaged communities; and support for the establishment of the Community Development Finance Association (CDFA), the sector’s trade body (see ‘The government as social investor’ in this issue).

The sector is still nascent, with a range of approaches at varying stages of development.  For example, the microfinance model has been proven over several decades, and now has arguably become ‘mainstream’, attracting investment from commercial banks as well as the general public. 

Similarly, socially responsible investment (SRI), where the primary aim is a financial return, but with social criteria applied to investments, has grown substantially.  Ethical Investment Research Services (EIRiS) estimates that there is now almost £9 bn invested in Britain's green and ethical funds. 

Another funding model, charity lending, is increasingly being adopted by high street banks, as organisations such as Charity Bank and Venturesome are demonstrating that charities are not inherently risky customers. In its first five years, Venturesome’s default rate, on a risk capital approach, was barely five per cent.  Bridges Ventures, a venture capital firm which invests in companies based in the most deprived areas of the UK and in companies in ‘social impact sectors’ like healthcare, education and the environment, now has had several successful exits, and its second fund, in 2007, raised £75m entirely from private sector investors. Bridges has also recently launched a fund to provide quasi-equity to social entrepreneurs.

Newer models are still being tested. Examples include Breakthrough, a partnership between CAN and Permira which provides established social enterprises with grants and management support to help them scale up and maximise their social impact; Big Issue Invest, whose forthcoming Social Enterprise Investment Fund will provide risk capital to social enterprises and businesses; Socialinvestments.com, which helps to match social businesses with investors; and Social Finance, which is developing products such as the Social Impact Bond to “marry the needs of investors and the sector”. 

The next article, ‘Where to start?’ highlights various organisations working in the sector, including examples of products for social investors.

Yet this is a young sector and so the range of products not surprisingly is relatively limited.  For example, there are few ‘equity-like’ products available in a market dominated by debt financing.  The development and testing of more ‘quasi-equity’ products – a model pioneered by Venturesome – will be important for the many organisations for which loans simply are not appropriate.  For instance, Victoria Hornby, Executive at the Sainsbury Family Charitable Trusts, highlights fair-trade organisations, which are inherently highly geared as their model is based on paying 50% up front to their producers, and where a quasi-equity product would be more suitable.

She cites the example of The Ashden Charitable Trust’s investment in Tropical Wholefoods, a fair trade company.  Ashden made an interest-free loan of £100,000 to Tropical Wholefoods, but in lieu of interest payments, the Trust took a 1%, stake (worth £25,000) in the company which it has given to another of its beneficiaries, the Ashden Awards for Sustainable Energy.  The investment has enabled Tropical Wholefoods to grow its business substantially, while Ashden Awards will benefit from future profits or sale of the company.

A related approach, mission-connected investment (MCI), is gaining momentum among trusts and foundations on both sides of the Atlantic.  Margaret Bolton, an independent consultant and author of the report Foundations and social investment, published by the Esmée Fairbairn Foundation, describes MCI as “a particularly strong form of SRI”, where investment activities across asset classes are “actively sought which help the foundation achieve its mission”. 

However, MCI remains a small proportion of total assets, with many foundations arguing that they can be more effective by keeping their investments and grant-making separate, despite the potential for certain investments to run counter to the foundation’s mission.  But a lack of appropriate investment opportunities and structures also remains a barrier. Nigel Kershaw, CEO of Big Issue Invest, a social investor, believes that, “We need more structures such as L³C that can attract patient risk capital to the sector”.  L³C is a new form of limited liability company (LLC) in the US which has social objectives but operates according to ‘for-profit metrics’, and is particularly suited to different classes of investors with different levels of risk.

Meanwhile in the UK a new legal form, the Community Interest Company (CIC), has been introduced to enable organisations to better achieve their social missions.  Another new form, the Charitable Incorporated Organisation (CIO), is currently being considered by government. Arthur Wood, VP Social Financial Services at Ashoka, which invests in social entrepreneurs, commented, “The paradox is that in the for-profit world we are reaping the consequences of over-leverage, but in the traditional not-for-profit world we have no leverage or financial tools – we are operating in an almost pre-modern capitalist world.”

A fundamental challenge is the need for a shift in mind-set by both investors and charities. Malcolm Hayday, chief executive of Charity Bank, commented, “We must get more people comfortable with the concept of doing things other than taking, or giving, grants.”  (See ‘Risky business?’ in this issue for examples of non-grant finance needed by charities.)

However, Nick Wilkie of the charity London Youth, argues that effective funding is “less about mechanisms such as gearing and the space on the ‘capital continuum’, and more about behaviours: such as exercising reasonable levels of control and investing in leadership and logically compelling ideas, rather than focusing solely on quantitative outputs”.

Regardless of source of funding, the difficult economic environment means that “potential fundees must demonstrate more professionalism in being ‘investment ready’ to access these funds”, says Jonathan Jenkins, Director of UnLtd Ventures, which provides business support to social entrepreneurs.  Denise Holle, Social Investment Director at CAN, which provides grants and business support to established social enterprises, agrees: “As most social enterprises have originated from the social or public sector, we find that core commercial skills such as finance and marketing are typically underrepresented on their management teams.”

Social investor Rodney Schwartz, who writes this issue’s ‘My philanthropic journey’ column, observes however, “It takes time to grow a good social business – it is hard, time consuming, gritty and unglamorous – it is much easier, as investors, to just write the cheque.”

Whilst Schwartz has noticed a growing number of individuals interested in investing in social businesses, other intermediaries argue that access to capital is a significant barrier for these organisations. John Kingston, Director of Venturesome, a social investment fund, explains, “We need a greater number of angel investors – those willing to engage directly and take risks with early stage innovations, balancing those risks against social rewards and potential financial returns.”

Demonstrating these returns has undoubtedly been a barrier.  It takes time to prove a new model, and many intermediaries are only now at a stage where they can credibly demonstrate their performance. What little impact reporting does exist is not standardized.  Kingston commented, “To help attract commercial and philanthropic money, we need to demonstrate positive examples of both social and financial returns, as well as offer more clarity about how ‘social returns’ are defined and measured.”

Taking social investment ‘mainstream’ will also require more diversity in products and mechanisms for investors and an infrastructure to support the marketing of these products. As Hayday explains, “For social investment to become a broader-based movement, we need products the public wants and can understand, and we need a range of mechanisms because not everything is appropriate for everyone.”   Sarah McGeehan of NESTA, which provides the sector with direct investment and infrastructure support, added, “Existing social investment products are not available at scale.”

Investors acknowledge that the young sector is still “disconnected” and could do more to collaborate more effectively. Toby Eccles, development director for Social Finance, explained, “The pools of capital – such as grant-making, green investing and community development – available to the charity sector are disconnected. Social investment intermediaries need to link them up so that organisations can raise funds in a coherent way.”

In addition to various informal networks, there are a few formal initiatives, such as the Skoll World Forum, which 2009 meeting is this month in Oxford, and the new Global Impact Investing Network (GIIN), founded by the Rockefeller Foundation; Social Finance is establishing the London node of GIIN. Last year Rockefeller Foundation announced that it would provide seed funding for a Social Stock Exchange.  The Exchange, to be based in London but international in scope, is currently in development, and expects to launch a beta version later this year. Mark Campanale, the Exchange’s co-founder, says that it aims to be an authorized and recognized investment exchange: “The Social Stock Exchange is exactly that: an investment exchange for investors pursuing social and financial return from social purpose business, with the goal of creating long-term value in their investment. It is a financial market that enables businesses to raise capital whilst preserving their social mission.”

There is also Schwartz’s Socialinvestments.com (whose new name will be launched at the Skoll World Forum), which is the first website in the UK to enable direct investment into social businesses and social enterprises.

However the sector lacks a formal infrastructure – independent, neutral intermediaries that can act as a clearinghouse for both investors and investees – effectively a corporate finance function. Just like for-profit companies, as social enterprises grow they need different kinds of funding at different stages, but there currently is no objective signposting resource to help them determine what options and providers may be best suited to their needs.

There also is opportunity for a syndication role, taking investment opportunities to investors and intermediaries across the marketplace. Hornby elaborated: “Organisations often need different types of funding simultaneously, and, for example, a foundation might be willing to take a grant position alongside an individual investor seeking a financial return.”  Holle added, “Independent intermediaries can allow a fragmented group of funders to capture economies of scale on due diligence, transaction structuring and investment monitoring.”

Regardless of the structure, there clearly is a need for independent advice. This role is being filled to some extent by financial advisors and investment managers, but there are relatively few advisors actively advising on social investment (See the UKSIF advisors’ panel in this issue).  Geoff Burnand, chief executive of Investing for Good, explains: “The financial services industry is still trapped in a binary view that all capital should be either invested to maximise profit, with little or no consideration for social and environmental effects, or donated. However as the delivery of financial services is going through profound change, advisors have a clear opportunity to develop new services in this area.”  Investing for Good provides specialized advice on social investment, including identifying and evaluating investment opportunities, to wealth managers and financial intermediaries.

Government also has a continuing and important role to play to helping to develop the market, especially in setting frameworks such as through tax policy, legal structures and regulation. Tax relief for social finance, akin to Gift Aid, or guarantees, could attract more private money into the sector.  Wood commented, “There is not enough money in the current ‘for-profit/not-for-profit’ paradigm to do everything on the domestic and international agenda (such as climate change or poverty), so we can only hope to solve these problems by applying subsidies more efficiently through the tax system to leverage additional corporate and private investment into the not-for-profit sector. We also need intermediaries that can facilitate collaboration and ensure an effective margin goes to the social sector.”

Bernie Morgan, chief executive of the Community Development Finance Association (CDFA), also emphasizes that “public policy changes should not mitigate against social investment; financial restructuring should work for social investors too”.

Direct government funding has also been warmly welcomed, and funds such as Futurebuilders and the Adventure Capital Fund have been important in helping to make loan finance a more familiar funding option to charity trustees.  Though a number of the funders we spoke to also expressed concern about the risk, if not managed carefully, of government funding ‘skewing’ the marketplace or crowding out private funders. David Carrington, an independent consultant and chair of the Philanthropy UK Editorial Board, observed, “Short-term political priorities are not always conducive to the objectives of long-term funding programmes.”  Kingston added, “Government funding should not discourage private investors – we need a diversity of funding in this space.”

Social investment today is not dissimilar to venture capital 30 years ago, and many investors argue that government can play a similar catalyzing role, alongside private investors.  Giddens concludes, “London is one of the leading financial centres in the world, and should be so for social finance as well. Social investment is a great lever for government and a great asset for the country.” 

Whilst social investment is not immune to the impact of the economic crisis, the current environment could prove to be a huge opportunity for the emerging sector. There is a growing realisation that there is a more efficient way to fund charities, whose under-capitalization has become woefully apparent under the weight of the recession. Shrunken portfolios are motivating more philanthropists to seek ways to achieve more impact from their giving, while an influx of bright people seeking new roles is helping to expand talent and capacity in the sector. 

The sector is also benefiting from low interest rates, which are making social finance more competitive with commercial products at a time when more people are re-evaluating their relationship with their bank, as well as the returns they are getting from their investments.