Richard Litchfield from Eastside Primetimers has kicked off a welcome and timely debate in Pioneers Post about the cost of capital in social investment and the extent to which BSC’s requirements for a c. 5% return on the investments they make is a problem for the market.

There a number of important questions raised about BSC’s role both now and in the future, however I won’t go into my views on these broader strategic choices here. Rather in both Richard’s piece and Cliff Prior’s response, the Access Growth Fund is referenced as a tool intended to mitigate some of the challenges around the cost of finance in the sector. So in that context I think it is worth explaining a bit more about the role of subsidy alongside BSC’s capital in the Growth Fund.  

Through the hard work of a range of partners, the Growth Fund is increasing the availability of smaller scale, unsecured loans to charities and social enterprises in England by blending grant from the National Lottery Community Fund with mostly BSC’s money in 16 social investment funds. That grant is there to enable that sort of lending activity to happen in the first place, and does relatively little to support BSC’s return. Without the grant the loans wouldn’t be more expensive. They simply wouldn’t be being made at all.

The grant in the Growth Fund structure does three things: A) supports the operating costs of the lender to manage a large number of low value loans; B) provides coverage for expected losses on loans made; and C) provides some grant alongside the loan to charities and social enterprises.  (The structure is explained in more detail here.)

The three uses are interlinked but B is the most significant. 60% of the grant is used for this purpose. Grant B is literally blended with the loan capital in the fund and lent out to charities and social enterprises. Making small unsecured loans to small charities and social enterprises is a risky business. The median turnover of the borrowers on the Growth Fund is less than £250k. Many of them have not been trading for long. The lender won’t have much in the way of recourse if things go wrong.

Across the Growth Fund the 16 funds estimate likely default rates from the portfolios of loans they make. This ranges from 10% to 32%. So without subsidy an investor can expect to lose up to a third of their money when making these sorts of investments. The rate that BSC charge on the loans they make into the funds is 5%. Therefore the grant mitigates the loss of capital from the investor (in this case BSC) to a significantly larger extent than it funds BSC’s positive returns.

David Floyd argued in a series of tweets last week that the interest rates charged by BSC “fundamentally distort the application of subsidy in the market”. In terms of the economics of the funds themselves the figures above suggest that this is not the case. Those rates have an influence the level of subsidy, of course, but as you can see that influence is not fundamental when compared to the need to simply protect capital. (BSC’s return does also influence the operating model for the fund managers. In the Growth Fund the direct subsidy to support operating costs is capped at 10%.)

There are two more things worth saying about BSC’s return in the Growth Fund structure.

Firstly, although they are charging 5% to the individual funds it does not mean that they will receive this return across the whole Growth Fund; just as a fund’s overall performance differs from each individual investment. If a fund struggles to deploy or has higher than expected defaults it may not be able to return all of the capital it has borrowed from BSC. The 5% figure is partly to manage risk across the portfolio of funds. BSC probably won’t make 5% from their investment in the Growth Fund as a whole, although they should more than break even. We won’t know for several years.

Secondly, in the individual funds all of the payment of interest is rolled up to the end of the repayment period, helping to make repayments over time more affordable for the individual funds, and helping to make a clear distinction between the repayment of capital and the realisation of returns. It also means that their return can’t exceed 5%.

So in the case of the Growth the role of subsidy is principally to cover losses and not enhancing return.

On the boarder points about cost of capital I’ve written a number of times in my Third Sector column about the difference between the perception of headline interest rates and the actual affordability of borrowing (if you don’t have a Third Sector subscription I’ve copied the key argument below).

Whether repayable finance is really affordable has more to do with the business model of the enterprise activity, and the marginal nature of much of the trading within the sector, than the wholesale cost of capital. That’s why the ability for the lenders to be able to tolerate losses through blended structures is vital for the capital needs of the sector to be met. Richard’s argument is less about the difference between 5% and 2% but rather the difference between 5% and minus 20%.

Richard is certainly right about the perception of price being a real barrier. It stops some organisations from engaging from social investment when they otherwise should. It is important that we talk about this more and explain that unsecured lending to a small business is a different sort of risk from giving someone a mortgage. A more suitable benchmark would be SME lending which is commonly upwards of 15%.

It is also important that charities and social enterprises understand that in most cases there is little or no private benefit arising from a social investment being made. Higher interest rates lead people to think that someone is profiting from their work. That is rare in this sector. Explaining who the social investment fund managers are, that they are mostly non-profits themselves, and that many investors are either charitable or funded by public money, would help.

And finally, to Richard’s starting point: why social investment hasn’t made greater inroads, especially when compared to grants. It is a good question, however I prefer a slightly different one. Do organisations have access to the finance they want when then want it? New data from SEUK suggests that more often than not they do. Surely that’s how we should be measuring ourselves.

From Third Sector in June 2017:

“The interest rate is only one factor in affordability. Your monthly payments will be a mixture of repayment of the loan itself and the interest added on. The interest will usually be a small part of this. Therefore more important than the interest rate to the size of your monthly payments is the period over which the loan is repaid.

For example, if you borrow £50,000 over three years at 8% you will pay £1,567 each month. If the loan is over five years the monthly payments are £1,014.

For relatively short loans, a difference in the headline interest rate will have a fairly marginal impact on the monthly payments. For £50,000 over three years, the difference between repayments at 6% and at 8% is £46 per month.”