Debt, Equity and Sustainability – Part 3: The great social enterprise lie
I have recently written two blogs with the above title; always intending to write a third, which I have decided to publish in Third Sector Magazine. The series assesses sustainability from the perspective of debt and equity in the economy. The first piece questioned high debt levels and the importance, as we moved out of the crisis, of encouraging more equity investment. The second analysed the banks and chastised politicians for their criticism of them. To demand more bank lending while at the same time placing increasingly stringent requirements upon banks which raise their cost of lending, felt unfair and unwise. This third and final piece addresses an ongoing debate around whether social enterprises really need debt or equity.
Whenever the demand for capital in the social enterprise sector is discussed someone proclaims that “what the sector really needs is not equity investment but reasonably/fairly priced debt”. This statement is normally met with nods all around, but it is highly misleading.
It is true that many social enterprises cannot receive investment in the form of equity. Their legal structures preclude issuing shares. What many therefore seek is debt capital with either a low interest rate or no interest rate at all. Anything exceeding 5% is considered aggressive and beyond the pale. Institutions seeking such “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 are looking to secure a return that covers their own cost of capital and takes into account the risk of the underlying enterprise. It is in this latter aspect where the problem lies. Social enterprises (SEs) seem ignorant/unaware of or indifferent to their 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 (although research suggests the risk is lower than with conventional enterprises), especially early-stage social enterprises, 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 very high and the required rate of return to compensate makes the cost of the debt seem really high, if not downright “Wonga-like”. 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 only realised when the enterprise is exited – 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 have found that successful social enterprises can feel “ripped-off”, because their own growth makes the return to investors seem high, after the fact. They quickly forget that if things had not worked out the investor would have seen zero return, or even a loss of capital (up to 100%).
Thus what we believe SEs are really looking for is for capital which to an investor gives them “equity-like” risk, but at a cost that matches what the highest quality companies pay for debt in the financial markets. Perfectly reasonable to WANT this; quite different to EXPECT a cost which does not reflect underlying risks. Social investors agreeing to offer capital at this “wrong” price are playing a valuable role but they will not be sustainable. For them to become sustainable, their capital base or their returns need to be subsidised by some party valuing the social impact generated by the SEs (Government, foundations or wealthy angels being the most likely candidates), or the risk needs to be reduced (same candidates). Finding these pots and blending them into the mix to facilitate transactions is a key to social finance. Being clear and honest about what is really going on is vital.