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The cost of money part 2: Too high for the little guy?
In part 1 of an investigation into the cost of money for social enterprise, financiers toiled with finance gaps that leave a large community of smaller social enterprises merely clutching at the fruit of the money tree.
In part 2 find out if this harsh reality will prevail. If social enterprises want a sustainable lender will they simply have to accept the high cost of money?
For Nick O’Donohoe, CEO of the social investment wholesaler Big Society Capital, just as it is important for social investors to understand models of social business, there is also an onus on potential borrowers to improve their understanding of how social investment works.
“It is important for people to look at both sides of the lender/borrower relationship,” he says. “It is, of course, essential for borrowers to have sustainable lenders. The borrowers are going to have to accept that higher risk means higher the rate of borrowing. It is the only way a lender can square this circle.”
But, the issue surrounding the cost of social investment continues to dominate the sector. Seb Elsworth, director of partnerships and communications at Social Investment Business, believes the challenge for social investors remains one of developing the right products at a cost the market can tolerate. “There is a perception that social investment is expensive. I am always hearing people compare social investment products with those offered by this or that high street bank. But our job has always been to finance the unbankable.”
Big Society Capital has return expectations in the region of 5-6%, making it tough for social investors to offer products in the same range– Seb Elsworth, director of partnerships and communications at Social Investment Business
Risk rules
In the past, Elsworth points out, the interest rates of SIB’s funds were set by government, often in the region of 6%. “The point is that this cost was not risk adjusted. The interest rate didn’t vary between organisations with different levels of riskiness,” he says. This blanket approach meant that social investment from these Whitehall regulated funds represented good value for organisations considered high risk, but expensive for those organisations searching for lower risk capital.
But, times have changed. SIB is now in fundraising mode, searching for new investors who are unlikely to share such a relaxed attitude to risk. “We’re working with investors who have more sophisticated requests than government,” says Elsworth. “Social investors in the future will all have clear fund return expectations, as well as impact return expectations. We’ll need to manage our funds in responsible ways, which means there will be variation based on risk. While we’re always going to be more interested in social impact than a High Street bank, we will still have clear responsibilities to our investors.”
While Elsworth is keen to stress that Big Society Capital is “not the only show in town” when it comes to finding investors for its funds, he does concede it is playing an increasingly important role in setting costs in the industry.
“Big Society Capital has return expectations in the region of 5-6%, which obviously means it will be tough for social investors to offer products in the same range,” he says. “When they talk about building a market they want it to be financially sustainable. They clearly need to get the money back, which is why they’re holding this line so firmly.”
Elsworth also wonders if Big Society Capital’s return expectations have anything to do with the returns to banks agreed by the government under the Merlin Agreement. “In a way the Merlin Agreement set the benchmark for the sector,” he says. “It would be good to know what market analysis there was in order to calculate repayments to the banks or whether this was just plucked out of the air.”
But O’Donohoe dismisses this suggestion, claiming his organisation’s return expectations “couldn’t be any lower”. He says: “Yes, of course our return expectations are based on an analysis of the market. If you accept the assumption that we want to preserve our capital you have accept there is a return and a surplus. What is influencing us is the principle not to erode our capital. Everything we do as a financial institution has to have a return because you can’t be right 100% of the time.”
Alternative sustenance for cash hungry enterprise
Indeed, in a response unlikely to fall well with the cash hungry social enterprises that Nick Temple of SEUK referred to, O’Donohoe goes further by suggesting many smaller organisations should look elsewhere for investment. He says: “I do question whether loans are the right product for the smaller organisations out there. The same problem arises across the SME world. If someone is trying to get a small SME up and running they’d be using a credit card or mortgaging their house or borrowing from family and friends etc. The equivalent in the social sector are the pools of grant equity out there."
I have limited sympathy with a social enterprise that says it’s cheaper for an SME to borrow from the High Street. The truth is, so can they.– James Perry, CEO of Panahpur Trust
Controversially, and again in stark contrast to the picture painted by Social Enterprise UK, he adds: “There are a growing number of pools of grant equity available to help social organisations so they can reach the next level where they are more investible for the types of intermediary we’re backing.”
Meanwhile, Perry, in what he describes as a “mismatch between expectation and reality”, also believes many social enterprises have an unrealistic view about the cost of social investment. “I have only limited sympathy with a social enterprise that says it’s cheaper for an SME to borrow from the High Street. The truth is, so can they. The reason they don’t is quite simply the banks won’t lend to them because they have no collateral or capital. Finance is priced according to risk.
“I think BSC capital is very cheap for the risk they are taking. In fact, if anything, I think it’s too cheap. If it were any cheaper it would result in losses. You also have to remember that banks are charging ridiculous margins. Unless you have a very secure proposition you can’t get anything below 6% or 7% which is very high given the base rate.”
But unlike O’Donohoe, Perry does not believe the funding environment is as healthy for the smaller social ventures that Social Enterprise UK says forms the backbone of the sector. He says: “There is an issue at the strategic level of foundations because policy is clearly prioritising social investment. There is a degree to which the rhetoric of politicians has been unhelpful in getting foundations to participate in social investment.
“Rather than encouraging foundations, the rhetoric has been about them not using their money optimally. The suggestion is that this money is just sitting wastefully in the hands of investment bankers and this has angered some foundations because they feel it ultimately undermines their proud history in making grants.”
In the aftermath of the G8 summit, Social Enterprise UK has led calls for politicians and the social investment industry to redouble their efforts to create financial instruments that reflect where the sector is today. Peter Holbrook, CEO of Social Enterprise UK, says: “As cuts continue to bite and traditional sources of finance shrink, connecting cash-strapped social enterprises with suitable finance will be critical to their survival and growth.”
A question for Cameron
But perhaps all this discussion about financial products and costs is clouding a bigger issue. If social enterprises are to survive and prosper in the numbers proudly cited by government, they will need access to market opportunities. It is by presenting these opportunities to potential investors that will get the market moving.
As Perry points out, experience to date suggests the government has a long way to go before it learns how to engage the efforts of those organisations best equipped to tackle deeply entrenched social problems. “As we know most civil society organisations have relied on either government grants or contracts. While these have declined in availability, government outsourcing in key areas like the Work Programme – which many hoped would provide civil society organisations (CSOs) with an income – is going to large companies. The only role for CSOs is to subcontract.
“While CSOs are creating value on the front line, the final value of these contracts is being returned to private shareholders rather than being reinvested into CSOs. The surpluses are being skimmed off by the prime contractors,” says Perry.
Only time will tell if that was who Cameron was referring to when he said, “If you can solve the problem we will give you the money.”