Social Investment : Anything but Vanilla
Clare McCartney is currently in our October 2017 cohort and in her first placement. In this blog, she explores some of the challenges and opportunities of the social investment landscape in the UK.
Before starting the On Purpose Associate Programme, I did not fully appreciate how quickly the social investment landscape in the UK is changing. The UK was one of the first markets to pioneer and expand social impact investment initiatives over a decade ago and this landscape has been in rapid development ever since. One of the key talking points in the market today is the gap that exists between the motivations and end goals of social impact investors and the social enterprises they fund. This issue is well known to market participants, but overall I am encouraged by the collaborative learning I have seen so far. Between the longstanding pioneers and the more recent entrants (including market steward Big Society Capital), partnerships have been formed and an increasing amount of case-based research has been published around new approaches and forms of funding which try to align the interests of both investors and enterprises. I believe through the continued sharing of best (and worst) practice, as well as the use of new innovative models which I will go on to explore in this post, this gap can narrow further. The unique and variable nature of social enterprises and the institutions that fund them means that these new practices are diverse, progressive and anything but vanilla.
For social impact investors, the basis of most funding models is still rooted in traditional debt and equity; however, social impact investment is no cookie-cutter process. The nature of social enterprise business is vast and varied: looking to address specific needs, measure social impact and at the same time be financially sustainable. Achieving this is no small feat. What many social investors are quickly learning is that funding models need to be general enough that they are scalable and produce an appropriate risk-adjusted return, yet flexible enough that they can cater for the idiosyncrasies of these social enterprises.
Take loan finance for example. This is a popular financing route for many social enterprises in the UK, particularly those not wanting to relinquish any control via equity participation agreements. Despite its popularity, servicing loans can be difficult for social enterprises when working capital needs are high and they are striving to hit social and financial targets. Evidence from various groups suggests that repayable finance arrangements need to be flexible whilst businesses scale, restructure or transition away from grant-dependency. For the social impact investor this may mean sharing more risk with the social enterprise where possible.
Amongst the numerous financing models currently being tested in the market (quasi-equity, convertibles, performance-based grants etc.), the patient capital approach is one that has been gathering momentum in impact investment circles in the UK. Patient capital can be loosely described as longer-term financing arrangements which allow greater flexibility around repayment schedules and terms, thereby enabling social enterprises much needed slack during the early, ‘capex-heavy’ years . Common examples include allowing for some sort of capital and/or interest repayment holiday, but may also involve event-triggered repayments or stepped repayment models, where borrowers repayments start low but increase gradually over time. While these conditions may not represent perfect alignment between the needs of every investor and investee, they do offer a functional model for those investors who have longer term views and more patient investment horizons.
Social Impact Bonds (SIBs) are another alternative patient funding model that has been front and centre recently, especially since the world’s first SIB in Peterborough Prison successfully delivered on its targets (primarily to lower the incidence of reoffence by prisoners who have served their sentence). SIBs are ‘payment-by results’ contracts issued by commissioners to investors and donors in order to fund public services or tackle social issues, for example housing deficits or homelessness. Pioneered here in the UK, there are now a total of 70+ in circulation domestically, and many more abroad targeting a variety of social problems. Again, whilst this model is not necessarily appropriate for every societal need, experts in the field have commented that where there are a set of agreed metrics, measurable outcomes, sufficient economic value for the donor and an appropriate return for the investor, it can be a highly favourable approach to tackle social issues.
Critics of SIBs have commented on the high transaction costs of these instruments (and thus their unsuitability for smaller projects), as well as the difficulties in delivering and monitoring impact. New innovative models have already begun to address these issues directly; one such model incorporates the use of blockchain technology.
Blockchain is new and conspicuous, yet in its early years it presents an extremely interesting and promising technological application for the industry of impact. One of the fundamentals behind the creation of blockchain is that it can help to resolve trust issues in peer-to-peer transactions, thus removing costly intermediaries and processes, and adding more transparency throughout the value chain. In the case of social impact investment the use of this technology could lower costs around contract setting, due diligence and impact management, effectively helping to align interests of social investors and social enterprises.
So how would this process work exactly in the case of SIBs? It involves the issue of tokens, valued on measurable impact outcomes around a particular social or environmental issue. The use of smart (pre-programmed) contracts outline the specifics of the impact investment agreement and release payments every time impact outcomes are met, much like a normal SIB. In the case of blockchain however, these payments are made automatically, on the receipt of ‘proof of impact’ inputs from independent verification sources which may be human or machine generated (learn more @ Proof of Impact). This effectively overcomes hurdles in traditional investment around due diligence costs and impact measurement. Investors can also hold or trade the tokens associated with a particular project on a secondary market. This resolves any issues around mismatch in investor time horizons and creates liquidity for investors to exit investments easier, with lower transaction costs. When tokens are sold, future payment streams are then automatically re-routed to the new investor on the blockchain. Notwithstanding the challenges around resource consumption and scalability for blockchain, many new platforms such as Alice are already using this technology for social impact initiatives.
Had it not been for the On Purpose programme, I would not have had such direct exposure to these new models, nor been able to witness first-hand the social impact investment industry in transition. I am excited to be a part of this passage to the next frontier and will be following these dynamic and innovative practices closely. Watch this space.
