High-risk investment is not available at the lower rates

Social investors that offer capital at the 'wrong' price are playing a valuable role, but they will not be sustainable, writes our columnist

Rodney Schwartz
Rodney Schwartz

I have recently written two blogs called Debt, Equity and Sustainability: The Great Social Enterprise Lie. I always intended to write a third - and this is it.

The first piece questioned high debt levels and the importance of encouraging more equity investment. The second criticised politicians for demanding more bank lending while at the same time placing increasingly stringent requirements upon banks that raise their cost of lending. This piece asks whether social enterprises really need debt or equity.

Whenever the demand for capital in the social enterprise sector is discussed, someone proclaims "what the sector needs is not equity investment but reasonably/fairly priced debt". This statement is normally met with nods all around, but it is misleading.

It is true many social enterprises cannot receive investment in the form of equity. Their legal structures preclude issuing shares. What many seek is debt capital with a low interest rate or no interest rate at all. Anything exceeding 5 per cent is considered aggressive and beyond the pale.

Institutions seeking what are called "obscene rates of return" are cited as evidence that the evils of the commercial sector are creeping into our beloved social sector.

This is unfair. Most mainstream investors seek to secure a return that covers their cost of capital and takes into account the risk of the underlying enterprise. It is in this latter aspect that the problem lies. Social enterprises seem ignorant, unaware of or indifferent to risk of failure or refuse to recognise that this is a necessary part of the calculation of a fair rate of return. Social enterprises do fail, especially early-stage ones, and social investors need to adjust for this if they are to become sustainable.

The fact is that for small, early-stage social enterprises, the likelihood of failure is high and the required rate of return to compensate for that makes the cost of the debt seem high. In conventional markets this high risk is offset by the hope for high returns, but typically such investments are structured as equity and not debt, and the return is realised when the equity is sold - not possible for many social enterprises. Quasi-equity, where the return on a debt instrument varies with the success of the social enterprise, is one answer, but we find successful social enterprises can feel ripped off because their growth makes the return to investors seem high. They forget that, if things had not worked out, the investor could have lost their money.

So social enterprises are looking for capital, which leaves the investor with an 'equity-like' risk, but costs what the highest quality companies pay for debt in the financial markets. It is perfectly reasonable to want this; but it is quite different to expect it.

Social investors agreeing to offer capital at this 'wrong' price are playing a valuable role, but they will not be sustainable. For this, they need to be subsidised by some party that values the social impact they generate, such as a government or a foundation. Finding these pots and blending them into the mix to facilitate transactions is key to social finance. Being honest about what is going on is vital.

Rodney Schwartz is chief executive of ClearlySo, which helps social entrepreneurs to raise capital

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