As exits are more or less non-existent in the social investment world, debt and equity merge. Do we need a new Corporate Finance theory for our sector? In the social investment market, what is the difference between the return expectations of debt and equity instruments?
In my Applied Corporate Finance course at INSEAD, the differential between the return expectations on debt and equity instruments was comparatively easy to calculate. The required return on a debt instrument would be a function of the investee company’s credit rating and the seniority of the specific instrument among other debt instruments (if any) on the balance sheet.
The required return on equity, on the other hand, would be the function of the Capital Asset Pricing Model (CAPM) and the Weighted Average Cost of Capital (WACC). Without going into technical detail on these concepts, equity returns generally (in the form of dividends and capital gains) are unknown up-front and therefore riskier than returns on debt instruments. Equity holders risk losing their capital if the business does not perform. Debt instruments can also be risky, but holders of debt instruments have a prior charge on the company’s assets in case of bankruptcy. Given that equity holders take on board more risk, the required return on equity is higher. This differential between required returns on equity and debt contracts and expands as the business and its market evolves, but it remains positive.
Social investments are different from commercial investments in (at least) two fundamental aspects: Firstly, the majority of socially-driven companies and social enterprises have no equity. I believe that I would capture 95% of all socially-driven companies and social enterprises if I included (a) charities and their operating subsidiaries; (b) Industrial and Provident Societies who exist for the benefit of their community (IPS ben comms); (c) Community Interest Companies (CICs) and (d) For-Profit Social Sector Organisations (SSOs). It is only in groups (c) and (d) where equity capital is at all present.
Secondly, even if CICs with share capital and SSOs have the ability to take on board equity investments, most of these organisations can generate only dividends for the equity holder. We are operating in an exciting and nascent market so we have limited precedent transactions to go by, but I would wager (fill in your choice of bubbly!) that that there are less than a dozen cases in the past decade where equity in a CIC or a SSO has been sold and a capital gain has been recorded for the vendor of the equity. There is a variety of perfectly reasonable explanations for this lack of precedents. Firstly, if the social enterprise is a CIC with share capital, equity can be sold from one equity holder to another third party owner – at whatever price is negotiated between the vendor and the buyer. However, the ultimate exit out of the equity position would only be through a sale at par to the CIC itself. CICs by definition are supposed to keep value creation with the company and not allow shareholders to benefit from it. A rationale buyer would therefore be prepared to only pay for the expected dividend stream and not for the ability to sell the equity at a premium. Otherwise, ultimately, the Last Mohican would be left with a capital loss.
Some practitioners in the social investment market pay less attention to the legal form and more to the substance of the business. As such, one could envisage a For-Profit Social Sector Organisation (SSOs) with articulated social objects. In this case, again, capital gains could be achieved on a theoretical level; however, practical circumstances will prohibit the realisation of gains. Why would social entrepreneurs, profoundly wedded to their social causes, risk a proportion of their equity to be sold off? In my experience, social entrepreneurs are incredibly protective of their social mission and will heavily scrutinize (rightly so) the motivations of an external provider of equity investment. Equally, on the other side, where are the purchasers of equity? There are no three-letter-acronym exits in the social investment market: no IPOs (Initial Public Offerings), no MBOs (Management Buy-outs) or LBOs (Leverage Buy-outs). Depending on the industry, there also appears to be a very limited number of trade buyers – buyers whose social objects are the same as the SSO’s. Given this dearth of purchasers, how could capital gains be realised?
Given the absence of capital gains in the vast majority of cases in the social investment market, the difference between debt and equity blurs. An equity investment generates only a dividend stream to the equity holder: this dividend stream is then akin to an interest payment variable with performance of the underlying business (e.g. a type of Social Loan). As such, the return differential between equity and debt should also shrink – possibly even disappear. In fact, as already pointed out earlier, in IPS ben comms, charities and CICs without share capital, junior debt already plays the role of risky equity.
To me, applying Corporate Finance theory to the social investment market is a must: we are analysing investments where there is an articulated intention, subject to the normal vagaries of running a venture, to repay capital and create a return for the investor. However, some aspects of our market are so fundamentally different that new thinking is needed. As cherished as it is by conventional Corporate Finance theory, in our nascent market it is time to desert the return differential between debt and equity in favour of a more appropriate, situation-specific theory of required return.
By Annika Tverin, Director at Social Finance