Research carried out by CAAS Business School in May 2017 shows that almost all charities expect their business models to shift away from grant funding and towards borrowing and social investment over the next 5-years.
The same research also points to a wide range of opinions amongst charity and social sector leaders as to whether or not this is a good thing. Concerns regarding the use of repayable investment by charities are often driven by deeply held views around what charities should and shouldn’t do. Even some of the most commercially-minded trustees and CEOs are highly reticent about borrowing money, even if it does come under the banner of social investment.
This blog highlights five questions that leaders should think about when considering repayable investment, and it provides some practical advice. The guidance is based on our own experiences as practitioners in this field, and is founded on the overriding principle that social purpose must come first, with finance viewed as an enabling tool to achieve that social purpose.
1. Will the investment lead to greater social impact?
Social impact needs to be considered on two fronts. Firstly, impact is at the heart of why social sector organisations exist, so it follows that any investment should ultimately lead to improved impact. The likelihood of greater social impact can be self-evident in the case of a development in relation to core services, but is often more difficult to assess when building a new head office or developing a purely revenue generating operation that has been designed to deliver new sources of unrestricted funds.
Secondly, impact matters to social investors on the basis that they seek social as well as financial returns on their investments. That said, it is worth noting that some social investors are more focused on impact than others. Social investors can be broadly classified as those that put impact first, and those that care about impact, but tend to be finance-driven in their approach to evaluating lending opportunities.
Charities should assess the impact that any investment will have for beneficiaries, regardless of whether or not this will be a primary focus for providers of social investment. This can form part of an options appraisal process, or can be achieved through a stand-alone impact mapping exercise. Developing performance management systems to measure and report on social impact will ensure that underlying project performance improves over time, based on a management feedback loop.
2. Will the investment improve financial sustainability?
Social investment can be used for a wide variety of purposes, including additional working capital to fund a ‘Payments by Results’ contract, setting up a new trading entity, or to purchase a building or other asset. Regardless of the specific purpose of an investment, leaders should ascertain the extent to which it fits with the overall strategic objectives of the charity, and whether the investment will lead to either new income streams or reduced costs, and ultimately to greater financial sustainability.
As part of an options appraisal, an assessment of whether an investment is likely to lead to improved financial sustainability is often carried out. A discounted cash flow methodology is typically used, comparing the incremental cash flow associated with the planned investment against a ‘do nothing’ scenario. The results can then be adjusted to take into account non-financial factors, including the social impact that the investment is expected to deliver.
3. Is social finance really the only option?
Once the impact and financial sustainability questions relating to an investment have been answered, a useful next stage is to step back from the repayable funding route and ask whether any alternatives exist. The project should by now be sufficiently developed to inform an approach to potential grant funders, especially if attention has been given to the project’s social impact. Similarly, there may be an opportunity to seek funding through a specific donor-focused campaign.
For some charities, free reserves may also be an alternative source of funding that can be applied ahead of seeking repayable finance. Clearly this should be within the context of overall treasury management, and a well-planned reserves policy. If the use of reserves is to be considered, then it may be a good time to review the reserves policy, taking a risk-based approach to ensure that applying free reserves will not lead to a significant reduction in financial sustainability.
4. What is the most appropriate form of investment?
Providers of capital always consider the risk that they may not get their investment back against the returns expected from their investments. The general rule is that the greater the risk the higher the expected rate of return. Social investment introduces a third element: impact. This hybrid type of investor also wants their money to lead to social value. Whilst this is an additional hurdle to clear, some impact-focused investors may be willing to forego an element of financial return if the social impact of the investment can be demonstrated.
There are many types of social finance available. At the low risk (and therefore lower cost end) are loans secured on assets. These typically relate to property transactions, such as new build projects. Terms, including interest rates, on these loans have in recent years become more aligned with commercial loans for all but very large transactions. The market for unsecured lending is more complex, with finance products ranging from traditional overdraft facilities to quasi-equity. Quasi-equity is still debt, but the investor behaves more like a venture capitalist in terms of involvement, and generally requires a higher rate of return to compensate for greater risk.
Choosing which social investors to shortlist requires an initial assessment of the risk profile of the planned investment. If the project is relatively high risk, shortlisting impact-focused investors makes sense, especially those that are able to offer blended grant and loan products.
5. Will repayments be affordable?
An investment might make sense from an economic and impact perspective, but affordability is another matter altogether. Unless financing for the investment is to be ring fenced through a special purpose vehicle, the borrowing charity will need to consider the investment in the context of the organisation as a whole. This typically involves creating an enterprise-level financial model or forecast, taking outputs from the options appraisal and then developing an integrated income & expenditure, cash flow, and balance sheet for the charity.
This approach will drive out a more precise indication of the value and timing of investment requirements, and also allow the charity to assess the extent to which debt can be serviced. It will allow for the inclusion of investor-specific covenant testing, such as debt service cover, and loan to value ratios in the case of secured lending. Finally, modelling provides an opportunity to stress test assumptions to ensure that financial sustainability can be maintained in a worst-case scenario.
For further information contact Jim Brooks 07507 272975