Seb Elsworth: Making sense of risk finance

'Quasi-equity' is a growing trend in social investment, but there are some important issues charities need to know about it, says our columnist

Seb Elsworth (Photograph: Claudia Leisinger)
Seb Elsworth (Photograph: Claudia Leisinger)

The reason charities and social enterprises take on loans is that they have a need for a chunk of money that, once received, will allow them to increase their income and pay the loan back over a fixed period of time.

But what if the period between needing the money in the first place and being able to repay it is many, many years, or if repayment is not certain?

For example, a charity might be at an early stage of thinking about a trading activity. It can see how it can use its expertise to develop an offer for new "customers", but it will need money up front to employ more staff, improve marketing and develop a sales operation.

It has done the sums and it knows it will take several years before it is turning a profit, and that’s if everything goes according to plan. During those first few years, all the income from the new activity will need to be ploughed back in to make sure targets are met.

In this case, a simple loan might not be suitable because the income from the new service is neither sufficient nor reliable enough to meet the repayments, even if there was an interest or capital repayment holiday at the start of the loan term.

In the private sector an organisation in this position might wish to take on an equity investment – essentially, cash for a share of the ownership. The investor will hope that the value of the company increases as its trading grows and it can therefore expect some sort of return on investment.

Charities and social enterprises cannot be owned and therefore cannot give away equity. So some social investors have developed "quasi-equity" products as a type of risk finance, where the terms of the repayment of a loan are linked in some way to the success or otherwise of the organisation.

David Floyd from Social Spider has been looking at this trend in more detail. Last year with colleagues at Flip Finance he published a review of the use of these products. The findings were that few QE deals had actually been done, probably between 30 and 50 out of 3,500 social investment deals at the time.

Another finding was that investors found the deals complicated and expensive to set up compared with conventional loans, and feared attracting investees who would see the investments as ones that did not need to be repaid. 

The final conclusion was that for many charities and social enterprises, QE had been an unknown, obscure part of a social investment market that already seemed confusing enough in itself.

In spite of these challenges, it does seem that QE can play an important role in the financing of charities and social enterprises. If its use is to increase, a number of questions need answering.

What sort of "trigger" suits what sort of enterprise?

Rather than regular loan repayments, QE investments are usually repaid once a "trigger" event takes place. This might be when a certain income target is reached, and might then be based on a percentage of sales. It might be when a clear milestone is hit, or an investor might simply have a veto over raising any further investment until they are repaid.

Each of these models will have their own pros and cons and will be suitable for different sorts of enterprising activity and at different stages of an organisation’s life. More work is needed to understand the most appropriate form of finance for common models in the sector.

How to keep it simple and fair?

Because a QE investment cannot be based on ownership, unless trust between the investor and investee is very high the arrangements usually need to be spelt out in a contract.

The principles of a given arrangement might sound simple enough. For example, we will start to repay the loan once our turnover exceeds £250,000, at a rate of 9 per cent of our sales.

But what if the organisation’s turnover increases as a result of receiving a grant, which is not connected to the enterprising activity the investment is there to support? Should that be included? Did we mean net or gross sales? And what if things go spectacularly well and we are stuck repaying our investor 9 per cent of sales, giving them a return of many multiples of their original investment? Drafting a contract that is both simple and captures all these eventualities takes a very competent lawyer.

How do we fund QE?

In most cases investors will need to wait a long time to be repaid, if at all. For social investors to make QE deals, they themselves need to be financed in a patient way, potentially via grants. Support for more QE might come through venture philanthropy or new approaches to blending finance.

A better knowledge base of the risk involved in the different forms of QE and how much subsidy they might need will help to grow this important part of the social investment market.

Seb Elsworth is the chief executive of Access, a foundation that helps to widen access to social investment for charities and social enterprises

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