Mark Hannam
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Numbers 4 Good

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Proposals for a price cap on high cost short term credit

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Syria: the Economic Implications of the Civil War

In Praise of Non-Bank Finance

The Price of Money

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Life, Liberty and Access to Credit

Osborne's Banking Reforms: A Hedge Too Far

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A Truly Ethical Foreign Policy

Southern Africa: 2020 Vision

Mervyn Turns a Tidy Profit

Private Banking for the Poor

Teaching Jurisprudence in Namibia

George - Don't do that!

Do the Math

Two Cheers for the Walking Wounded

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What Crisis?

How to Stop the Next Bubble

Muhammad Yunus

Rethinking Risk

Today it is widely believed that financial innovations - and the bankers who promoted them - were the primary cause of our present economic problems; and that they are not to be trusted. As the social business sector faces growing demands for its services while, at the same time, the level of public funds available to support its work is falling, it is not surprising that few managers in the social business sector think that innovative financial engineering should be a priority. There are some who take a different view: I am one and Bertrand Beghin is another.

Like me, Bertrand spent more than a dozen years working in the City as an active participant in the global financial markets. His main focus was the development of innovative structural transactions for the clients of the investment bank where he was employed. Although the clients were mostly large-scale, for-profit institutions the principles upon which his transactions were based were, he thought, equally applicable to smaller, not-for-profit institutions. Bertrand believed that his skill-set and market experience could be of value to the social business sector; and that there was an urgent need for mainstream finance to become more supportive of the principle of sustainability. So he left his job in the City and set up a consultancy firm whose name captures his ambition: Numbers 4 Good.

When I spoke with Bertrand in April of this year, in the Members Room at Tate Modern, he described a number of problems that are characteristic of social businesses in the UK, and suggested how the solutions to these problems might involve some form of financial innovation. First, the resources available to the social business sector are limited in size, with gift and donation predominant, which makes the sector much more like the charitable sector than many of its advocates would like to admit. Given limited resources there should be some obligation to use them as efficiently as possible "financial optimisation" to use City jargon but often social business founders are, understandably, more interested in the social impact of their work than the financial structure that underpins that work. This leads to operational inefficiencies in the sector; and suggests the need for more sophisticated financial advisory work.

This, in turn, leads to a second problem, namely resource loss. Often new organisations in the social business sector simply repeat the mistakes of predecessor organisations, without learning from their failures. In addition, successful financial innovations are not widely shared or understood. Although there is now considerable effort being made to quantify the social impact of social business, there is less focus on comparing the different financial models and strategies that social businesses adopt, consequently the lessons learned for better or for worse are not widely disseminated within the social business community. Greater financial sophistication would also help to increase the capacity of the sector, which is apposite at a time when there is growing interest in social investment, not least the imminent launch of the Big Society Bank.

Third, the social business sector has an unusual structure, which discourages the easy transfer of financial innovation from company to company. A mature business sector develops a pyramidal shape, with numerous small start-up companies at the bottom, a smaller number of medium sized businesses above them, and finally a small number of large companies at the apex. Successful innovation at the bottom of the pyramid is disseminated in two ways: first, the large and medium sized companies learn from the small companies below them, sometimes by taking them over; second, successful small companies themselves grow into mid-sized and eventually large companies, allowing innovative practices to be applied across much larger organisations.

The social business sector is still immature and has yet to develop this pyramidal structure: there are very many small social businesses and a few mid-sized, but no large social businesses at all. Most social businesses are still at the start-up stage. The funding issues they face are difficult not just because they are social businesses, but also because they are start-ups. The scope for successful innovation is limited and, where it does exist, it is hard to pass this knowledge on to larger organizations which can use it to greater effect.

If there are plenty of tricky problems for social businesses to address, what skills might an ex-investment banker have to offer to help find solutions to these problems? First of all, says Bertrand, a focus on the importance of financial structure to achieve greater scale. If the social business sector is to develop the normal, pyramidal shape for a mature sector, then it needs more of the small start-up businesses to reach sustainable mid-sized businesses; and for some of these mid-sized companies to grow bigger to become large social businesses. This process "scaling up" in financial parlance in turn requires clear-sighted attention to the financial structure of the business.

Unless the financial model of the business is built with rigour and precision then, however good the products and services are, these benefits are likely to be lost through chronic inefficiency leading eventually to business failure. The social business goal of a "double bottom-line" (profit plus impact) is only possible if the business is financially sustainable, to allow continual investment in the staff and the products. Consequently, the development of credible performance metrics, both for financial and social impact, remains an important priority for the sector. Social business leaders and social investors need to agree how to measure what success really means for the sector.

Bertrand also emphasises the need to take into account the aims and interests of the social investors who provide the capital for social business to start-up and then to grow. He observes that many social investors are risk-averse and not necessarily innovative in their investment practices. This is clearly true when the investor is part of local or national government; but even private individuals who make social investments often do so in quite conservative ways. In part this is because gift-giving and grant-making are so thoroughly embedded in our culture. The idea of social venture capital type funding is still relatively new and the amount of capital that has been mobilised by such funds is still relatively small.

One idea that Bertrand is exploring is the development risk-tranching within a financial instrument such as a Collateralised Debt Obligation (CDO) market for the social business sector. Despite the association with the recent problems in the financial markets, the original insight behind the development of CDOs was that the investor community is highly diverse, particularly with regard to risk appetite. By creating an investment vehicle comprised of different tranches, each with its own risk and return characteristics, the investment bank manufactured an investment instrument that satisfied a wide range of investor demand thereby mobilizing capital for a range of different activities. This capital could then be apportioned to groups of borrowers according to their risk profile.

In the social business sector there are likewise a range of investor appetites, with only a few investors seeking to take long-term equity-type risk, but many others willing to take bond-type risk over a range of shorter maturity profiles. In addition there are philanthropic trusts and funds that might be willing to provide funds for a small subordinated tranche, with the highest risk profile, to provide the buffer capital that completes the structure. Thus an intermediary could create a Social CDO that would raise funds for a variety of social business uses: most of the capital would be available for relatively low-risk funding for "business as usual" activities in established companies, but there would also be some capital available for the more risky elements of social business, including start-up and scale-up opportunities.

For the SCDO idea to be successful it is important that both the social investors and the social businesses have a clear appreciation of their own risk profile. The recent problems in mainstream finance can in part be blamed on investors and borrowers taking on risks that they did not fully understand; and then being surprised when confronted with outcomes that they did not expect. Bertrand thinks that the lesson for financing social businesses is clear: it is not to avoid financial innovation per se, but to understand it and use it appropriately. The goal is to help the sector to think in more sophisticated ways about funding and to offer a more comprehensive range of investment opportunities.

So much for the theory, what about the practical application? Bertrand has a number of projects in progress, including work on a variation of the Social Impact Bond structure, to fund a project that would reduce litigation costs in the NHS. He is also working with OpenCinema to develop a sustainable financial model for their work, to provide access to film-viewing and film-making for people who are homeless or who suffer from social exclusion. In addition he is in discussion with a number of social businesses about how he can assist them in raising funds, or in using their funds wisely in pursuit of their goals. Much of this work is detailed on his website: www.numbers4good.com.

At the end of our discussion we both looked out across the River Thames to the City, where we had once plied our trade. It takes a leap of imagination to believe that one day the size of the social finance sector, acting as intermediary between social investors and social business, might be as large as the mainstream financial sector; to believe that one day the social finance sector might itself become mainstream. Nevertheless, Tate Modern is the perfect place to stimulate such leaps of imagination. Just as a small stream grows slowly and steadily into a wide river that reaches the sea, so too the modest trickle of social investment that we see today might one day become a veritable flood of socially responsible finance.

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© Mark Hannam 2011

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