Sources of finance – a culture of change
Philip Kirkpatrick and Sarah Cannings take an opportune look at the revised CC14 guidance to review the various social investment options
KEY POINTS
- Social finance or social investments are investments which seek both a social and a financial return
- New Charity Commission guidance confirms that charities can engage in social investment – although trustees need to consider their justification carefully
- Social investment has the potential to play a part in the development of the sector more widely
- A variety of social finance models are available including revenue participation agreements, social loans, equity and social impact bonds
The world of social finance is opening up and there is much talk of social impact bonds, revenue participation instruments and social loans.
But what is all this and how can charities provide or use it? Social finance is (at least by our definition) investment which seeks to obtain a social return, by advancing social purposes, as well as a financial return. It is different from grant funding, which seeks only social return, and commercial lending and other investment, which seeks only a financial return.1
Finance by the sector, for the sector
Those charities wishing to make social investments should be delighted with the release of the Charity Commission’s revised guidance, ‘Charities and Investment Matters – CC14’ which, we understand, has been approved in principle by HMRC.2 The guidance explains in detail – and with greater confidence than previous guidance – the freedom charities have to engage in social investment. It runs through the spectrum of investment aims in this area, distinguishing helpfully between ‘mission-connected investment’, which seeks proper financial return from investments aligned or connected with charitable mission, and ‘programme-related investment’, which is made principally to advance charitable purposes, with little or no regard to financial return.
Blended investments
But the great leap forward is the Commission’s recognition of charities’ ability to make ‘mixed purpose’ or ‘blended’ investments; in other words, engage in social finance. This has the potential to act as a catalyst for a wider culture change in charity investment practice and to play a significant part in the development of social enterprise and the growth of the social investment marketplace. There have been some notable pioneers in this field, for example Charity Bank and CAF’s Venturesome Fund, but trustees in general have always been held back by the Commission’s and HMRC’s previous stance on this type of investment.
Charities providing social finance need to consider their justification carefully; this type of investment can only be justified if the trustees seek an appropriate balance between the financial and the purposes (of the investing charity) for which it is made. In particular, how far does the activity go towards furthering the charity’s purposes and, on this basis, what proportion of the charity’s resources is it reasonable to commit? Having worked through this, trustees need to think about whether it is also reasonable to make the balance of the investment, namely the part which is intended to deliver a financial return. The key question will be whether the expected return from the investment as a whole can be justified in this context.
Social finance models
So, what options are available for charities wishing to take advantage of a more innovative form of investment in line with the draft guidance?
Loans
Charities with appropriate charitable purposes and powers can invest in charitable projects via loans. These vary from fully secured loans on commercial terms to much softer loans with little or no interest or security. The new guidance should give charities greater confidence to make loans anywhere along the spectrum between these two objectives, by lending money with the expectation of a blended social and financial return. For instance, such a return might comprise a sub-commercial interest rate return alongside obligations to meet specified social impact targets.
Revenue participation and social loans
While in the commercial market investment in shares is the norm, charities able to issue shares which yield financial returns to investors are very rare beasts.3 At least, that is, outside the world of industrial and provident societies where there is heated debate about the charitability of such structures. So making (or attracting) an equity investment in a charity is very rarely possible. Charity Bank, which is an FSA-authorised bank is perhaps the only example of a registered charity with such capability. This is a problem for those charities that seek capital but are not ready for the risk of fixed-interest payments typically made on loan capital. However, an equity-like result can be achieved via a revenue participation agreement or ‘participating’ loan. Figure 1 sets out an example of a ‘social loan’ scheme in action.
Under such arrangements, charities with trading income can link loan interest payments to the success of their revenue generation rather than on the basis of fixed rates. In this way a loan behaves more like equity in that it takes more of a risk as to return on investment but also takes advantage of higher rates of return if the revenue generation is successful. Note that these loans calculate interest on the basis of revenue (income) and not profit. Charities cannot distribute profit other than for their own charitable purposes.
Note, however, that that tax treatment of these arrangements is complex and, as with all novel investments, requires specialist advice.
Equity
While it is very rare for charities to be able to issue equity in order to attract investment, various non-charitable vehicles are able to issue equity. This includes straightforward private companies and social enterprises which are constituted as industrial and provident societies or community interest companies limited by shares. Where the company is carrying out work that furthers the investing charity’s purposes, an investing charity may be able to acquire shares, with the mixed purpose of achieving a financial return and advancing charitable purposes.
This type of investment may be subject to financial limitations; for example, an investment in a community interest company limited by shares would be subject to a dividend cap and investments in industrial and provident societies currently have a £20,000 maximum holding per shareholder. But when balanced against the ‘social return’ on the investment, such limitations may be deemed by the trustees to be acceptable.
Social impact bond or partnership
2010 saw the first investment of this kind. A coalition of charities agreed to provide a programme of support to Peterborough prison.4 Under an agreement with the Ministry of Justice the payment received for providing the service differs depending on the extent to which the charities are able to reduce levels of reoffending amongst the programme participants. Seed finance is provided by a network of social investors who inject capital, on the basis that the return they receive on their investment is linked to the Ministry of Justice payments: the more reoffending is reduced, the more the investors receive. In essence, it is a variation of the revenue participation arrangement. If the charities working on the ground are successful, the investment achieves both social returns, in terms of reducing reoffending, and financial returns.
Measuring social return
If charities and others are going to invest more on the basis that they seek social returns, then the measurement of those returns becomes a vital matter for both investors and investees. There are existing models for measuring social return on investment, such as the New Economics Foundation and the Social Return on Investment Network, and these will no doubt develop and adapt to the expanding market place.
Trustee duties
In specific cases, charity trustees considering making or proposing social investment will still need to think through and be clear about the basis of any proposed investment in the light of charity and social enterprise law, tax law and, if applicable, the Financial Services and Markets Act 2000.
A brighter future?
On the basis of the Charity Commission guidance and the innovative finance models being thought up within and outside the sector, charities can start to consider a more flexible, more creative and hopefully more rewarding approach to make and receive investment from 2011 onwards. The rewards from this approach may be financial, they may directly advance a charity’s purposes or they may combine both of these elements.
We are now perhaps at a point where finance of the sector, by the sector, for the sector will become a reality on a much larger scale.
1. See also the Caritas supplement ‘To SRI or not to SRI’, September 2010. www.charitiesdirect.com/caritas-magazine/to-sri-or-not-to-sri-794.html
2. www.charity-commission.gov.uk/ About_us/ About_the_Commission/ Consultation_char_invest.aspx Note the consultation closed 28 February 2011
3. Tom Hall’s funding model at Scope makes interesting reading: www.charitiesdirect.com/caritas-magazine/leveraged-fundraising-792.html4. See www.parliament.uk/briefingpapers/commons/lib/research/briefings/SNHA-05758.pdf
Author: Philip Kirkpatrick
Philip Kirkpatrick is a partner and joint head of the charity and social enterprise department at Bates Wells and Braithwaite.
Philip advises charities and social enterprises, other voluntary organisations and commercial bodies on charity, corporate and commercial law.
He is general editor of Jordan Publishing’s Charities Administration Service and and serves on the Institute of Fundraising Standards Committee.
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