A blended future: Addressing the funding needs of the small charity sector

We all want impact investing to go mainstream. After all, who would be against generating a positive financial return while also creating positive social and environmental change?

The term “impact investing” was coined at the beginning of the 21st century by the Rockefeller Foundation. In the UK, the likes of Social Investment Business, Esmee Fairbairn and Big Society Capital have undertaken market-building strategies, such as setting up their own funds or mobilising capital from external investors and channelling investments to charities and social enterprises. In 2016, the total amount impact investments (both loans and equity) reached £2 billion, an impressive tenfold increase from 2012 levels. However, when comparing this to the equivalent amount in the mainstream investing markets, at less than 0.1% this figure pales into insignificance (source: Bank of England). To help it go mainstream there is a need to attract more investors into the market, particularly for the support of smaller charities. In what follows, I will identify the issues faced by these organisations, the roots causes and recommend some potential solutions. These recommendations are based on my recent personal experience working with a small charity and discussions with numerous organisations, including investors and grant-makers.

The problem
I have recently been volunteering at The Avenues, a small charity in my local area which offers young people a safe space to interact with each other and connect with their community. This helps to improve their sense of belonging and contribution to society. I have been immensely impressed by the quality of the staff, the work they do and the benefit the charity provides to its users. However, Westminster Council funding cuts on youth spending have had a devastating impact. Despite huge efforts made to create alternative revenue streams from renting the building out during school hours, the resulting income has not been sufficient and The Avenues has been forced to halt many of its services, and even turn people away. It is clear these events have had a negative impact on not only the young members but also the wider community.

The Avenues has identified ways in which it could benefit from a loan and should be able to repay it through the rental income it generates. However, there has been little interest from investors. I therefore made it my aim to gain a better understanding of why this is the case, with the hope of finding ways to address it.

The investment environment
Charities seeking investment are typically looking to acquire assets, plug working capital gaps or fund long-term projects. Some examples of charities that have recently received investments include Golden Lane Housing, Fair for You and Hackney Community Transport. They have raised funds through:

1. Loans from investment intermediaries such as Big Issue Invest, Social and Sustainable Capital or Bridges Ventures;
2. Loans from social banks such as Charity Bank, Triodos or Unity Trust Bank; and
3. Bonds

Common features of charities that have successfully raised funding include:

1. Significant scale, with national or regional presence;
2. Recognisable brand and high profile, influential trustees;
3. Sustainable revenue model and long-term cash flow visibility;
4. Ownership of valuable fixed asset(s), such as real estate or a renewable project, that can be offered as security; and
5. Large funding requests (usually in excess of £100,000)

However, the reality is that most UK charities do not own meaningful assets, only have a local presence and are typically seeking small-scale funding. Hence, most charities, like The Avenues, are locked out of the investment market.

From a mainstream investor perspective, when deciding whether to extend a loan they tend to look at the expected financial risk-return of their investment. Impact investors also analyse the level of positive impact their loan will have on the investee, its beneficiaries and the wider society. Few investors, even impact investors are willing to assume a negative return in exchange for a profound and long-lasting impact as their primary goal is preservation of capital. The profile of small charities discourages investment:

1. Charities tend to be less ‘investment ready’ and unable to meet the expectations of investors in terms of compliance and control;
2. Charities are often dependent on one or two key people, increasing the level of operational risk;
3. Charities are unable to meet the short repayment periods required by investors;
4. Loans to these organisations tend to be risky, as they are vulnerable to internal and external shocks. To mitigate the risk, investors would need to charge substantial interest rates, which charities cannot afford; and
5. The transaction costs around due diligence for small investments renders them financially undesirable for investors

Given this profile, investors favor lower risk investments with lower social or environmental impact prospects.

In the absence of investors, grants and donations have played a central role in the UK charity sector. Without these, many charities would not be able to cover even their basic costs. Grant-makers and donors typically seek out charities that are aligned with their own mission, providing them with one-off or recurring funds.

There are a significant number of UK grant-makers looking to address the demand-supply imbalance, listed below. These range from high net worth individuals to charities, foundations or public bodies.

Source: 2016/17 annual accounts

It is clear from this data that there are numerous grant-makers with the necessary clout to influence and grow the impact investment market. However, grant applications are complex and time-consuming, and hence more suitable for larger charities. Moreover, there is the risk that charities grow increasing dependent on grant funding. These circumstances prompt a fresh approach to funding.

A New Approach — blended loans
There is a need to rethink funding of the small charity sector if we are to avoid the experience of The Avenues and reimagine the role that grants play in the sector. One approach would be that rather than grants going to charities directly, they are combined with investors’ capital, effectively creating blended loan structures:

The grant and loan would be blended “behind the scenes” and packaged as one repayable loan. With existing blended financing, the charities are fully aware of the breakdown between repayable loan and grant. In this scenario, charities receiving the funds would not be aware of the underlying agreement between grant-maker and investor.

Below is a depiction of three scenarios which demonstrate how these blended loans could work (all scenarios assume 50% loan / 50% grant):

Scenario 1: full repayment of the blended loan (capital + interest) at maturity

If the charity is able to repay the full amount of the loan plus interest, the investor receives the capital it contributed (plus interest) and the grant-maker recovers its grant portion. The grant-maker subsequently decides what to do with the amount it receives.

Scenario 2: 50% blended loan repayment at maturity

Scenario 3: 10% blended loan repayment at maturity

The grant acting as first-loss buffer would have several consequences. Firstly, investors would be incentivised to lend to “riskier” charities as long as they demonstrate capacity to repay the investor portion of the loan. Secondly, new investors would be attracted to this segment, increasing competition and causing interest rates to fall. Thirdly, the lower interest rate payments would free up cash for charities to deliver vital services.

For the above to be successful, grant-makers and investors would need to ensure they are aligned in their mission, vision and strategy before partnering up. Grant-makers would also need to gain comfort with investors making “appropriate” investment decisions by initially carrying out their own due diligence on the investments or reviewing the work undertaken by investors. Grant-makers might also want to be part of the decision-making process by having representation on the investor’s Investment Committee or Board. Importantly, the two should seek to build up a trusting, long-term relationship.

The case for change
One of the main resistances to this approach from grant-makers is that their grants should not go towards helping investors achieve a positive financial return. This is especially the case in large foundations where the Board of Trustees are concerned with protecting their legacy and would prefer to fund charities directly rather than channelling funds through investors. However, rather than dismissing it outright, I would encourage them to consider the positives:

1. If charities were able to access investment, they would no longer be as dependent on grants. Fewer grant applications would also free up vital resources at charities;
2. Their grants would be drawing in additional investors and funding which would support the continuation or growth of charities and the achievement of their social and environmental goals;
3. Repayable loans can support smaller charities to become more self-sustainable in the long run by improving their financial discipline; and
4. No matter how the grants are channelled, whether via investors or directly to charities, the funds end up in the same hands and achieve the same purpose

Taking a longer term view, the hope is that the grants will help investors gain the necessary experience of lending and working with small charities. Investors will be able to build a diversified portfolio of loans and greater competence in analysing the key risks affecting individual charities and impact areas. Over time their willingness to extend loans without the need for a grant should increase, and grant-makers would be able to put funds towards achieving other objectives. But most importantly, if grant-makers and investors are able to collaborate constructively, many charities such as The Avenues will have successfully secured their long-term future.