My Philosophy
Attentively
Blaming Ourselves
Good Customer Service versus Bad Regulation
Learning from Gandhi:
addressing the current
dilemmas in microfinance
Hinduism and Microfinance
The Financial Crisis
of 2007-2009:
A Sketch of a Credible Explanation
Money Market Funds, Bank Runs and the First-Mover Advantage
The Morality of Money Lending
The Case for Central Bank Liquidity Facilities for Institutional Money Market Funds in the Offshore Market
Creating Sustainable Micro-lending in London
Darwin and Philosophy
Financial Inclusion
and Equality
David Hume's "Of Suicide"
Is God a democrat?
The Risk Premium
for Commodities
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Introduction
This paper describes the partnership between Fair Finance and Venturesome. Fair Finance is a London based micro-lender and Venturesome is the social investment arm of the Charities Aid Foundation. This year these two organizations, both leaders within their respective fields, embarked together on an ambitious programme to expand the size and scale of Fair Finance's personal lending activities. If successful, the partnership will offer the possibility of the first scalable business model for sustainable micro-lending in the United Kingdom.
Fair Finance - history and mission
Fair Finance is a micro-lender based in London. It was founded in 2005 by Faisel Rahman, who is Managing Director of the company. Faisel's insight was to see that the microfinance model developed successfully by Grameen Bank in Bangladesh (Faisel's parents' homeland) could be applied, with some modifications, to serve poor communities in London.
Although the client base for Fair Finance differs from that of Grameen in a number of respects, in other ways the two groups are similar: they are excluded from mainstream financial service provision; they are mostly willing and able to repay their debts; and access to high quality financial products can have a significantly beneficial impact on their well-being.
There is no agreed meaning for the term "financial exclusion" and, moreover, researchers and policy makers disagree on the extent to which financial exclusion is a problem in the United Kingdom. However, some indication of the scale of the problem is indicated by data that was published by New Philanthropy Capital in their report, Short Changed in July 2008:
- around 2 million adults in UK do not have access to a transactional bank account;
- around 3 million adults in UK excluded from mainstream credit; and
- around a further 3 million adults in UK make use of expensive sub-prime credit.
It is a reasonable assumption, then, that the number of financially excluded adults in the UK who would benefit from the services of a micro-lender is somewhere in the region of six million, which represents more than 10% of the adult population.
Fair Finance offers three products. First debt advice, for those who have run up significant personal debt and now face the threat of court action by their creditors and, in some cases, the risk of eviction. Over five years the Fair Money Advice team has given advice to over 2,000 people, with average debts in excess of £10,000. They have helped to reschedule debts worth more than £6mn and have helped over 1,000 people to avoid the threat of eviction. In addition the service has seen a net positive movement in the rent statements of referred clients and have demonstrated overall savings to residential social landlords many times more than the referral fee charged.
The second product is business loans. Since inception the business loan team have made around 160 loans, totalling around £600,000, to small business owners and the self-employed. These loans are made to individuals who are trying to move off state benefits and into full-time employment, either by starting a small business or by becoming self-employed. Although the loans are for business purposes they are lent to the individual rather than to a company, and they are unsecured.
The third product is personal loans. Over the past five years the personal loan team have made more than 2,000 loans with a total value of £1.6mn, with an average size of around £720. Around 80% of borrowers are out of work and in receipt of benefits; around 75% are women, many single-mothers; and around 60% are from one of the many minority ethnic communities found in London.
Fair Finance's vision is set out in a series of statements, which can be found on its website (http://www.fairfinance.org.uk):
Fair Finance is a social business based in London. We offer a range of financial products and services designed to meet the needs of people who are financially excluded. We aim to revolutionize personal finance, starting with the people whom the mainstream providers have left behind.
We are committed to providing high quality products and services that are affordable and accessible. Wherever possible we work in partnership with other companies and agencies that share our goals.
Most of our customers are ignored by the mainstream financial services industry and exploited by the sub-prime financial services industry. When we have helped to put the loan sharks and predatory lenders out of business, then we will know we have been successful.
We believe that:
- Customers deserve a fair deal
- Products and services should be simple and accessible
- Financial advice should be honest and trustworthy
- Credit should be affordable for all
- Profits should be reinvested for the benefit of customers
Fair Finance has grown rapidly. The company started with four full-time staff in a small office in Stepney, in Tower Hamlets. It now has over twenty full-time staff, located in three full-time offices (Tower Hamlets, Hackney and Waltham Forest) and one part-time office (Islington). Its customer base is drawn from eight boroughs in north, east and south-east London.
The problem Fair Finance faces, after several years of strong growth, is how to secure its vision in a sustainable manner; that is, how to develop into a company that covers its own costs rather than relying on gifts or donations for its survival. Understanding how to solve this problem has not been straightforward.
An unsustainable road
Fair Finance defines financial sustainability in terms of achieving a stable financial position in which self-generated income is sufficient to cover all the company's running costs; and to achieve a small annual surplus to be reinvested in the business. Self-generated income includes interest payments on loans and payments from contracts to deliver services; expenditure is mostly staff and office costs. The business model might best be described as "profit optimization" rather than "profit maximization".
In its first full year - 2005/06 - self-generated income covered only 20% of the costs; to balance the books Fair Finance relied on donations from a variety of sources. In its fifth year - 2009/10 - self-generated income accounted for around 85% of the costs, with the residual 15% covered by gifts and donations. However, because the company had grown so quickly, the amount of money needed to be raised each year, in the form of gifts or grants, has increased.
Shortly after inception Fair Finance received funding from the UK Government, as part of its Growth Fund initiative to tackle financial exclusion, which is administered by the Department of Work and Pensions (DWP). The money from the government included capital to be loaned and revenue to cover the costs of opening and staffing offices. This was exactly the sort of contract that should, in principle, have enabled the company to make quick progress along the road to sustainability; in practice it turned out to be a cul de sac.
For the business to be sustainable it is important that the largest product by value - the personal loan product - is sustainable. This is the product for which the DWP Growth Fund money was given. However, the revenue contribution was insufficient to match the costs of making loans to customers; consequently, Fair Finance did not meet all of the targets set by the DWP and, somewhat to its surprise, discovered that working with the DWP was leading to an unsustainable future.
The DWP set a target loan size, a target loan volume and a target cost per loan made. They also set targets for bad debt (or default) rates and for social impacts (although these are hard to measure). According to the DWP, compared with other companies they were funding to provide similar services, Fair Finance was expensive in making loans and consequently they did not want to continue their relationship after two years. (The DWP did acknowledge that Fair Finance's bad debt rate was lower than others and that its social impact was perceived as high).
In the view of Fair Finance, the funding the DWP provided was insufficient to make loans in a sustainable way, since the DWP gave priority to the number of loans made rather than quality of loans approved. In retrospect, this meant that the end of the relationship turned out to be a significant step forward for the company.
The cost of making loans is relatively expensive when it is done properly. Clients require face-to-face interviews and the loan repayment process needs to be flexible, given potential uncertainties around clients' income flows. It is because the costs of making micro-loans are high that the interest rates charged are relatively high. (Fair Finance's loans, priced at under 40%, are significantly cheaper that the cost of borrowing from door-step lenders, at over 200%, or from illegal loan sharks, at over 800%).
Also important are the productivity levels of the staff and the levels of bad debt. Fair Finance takes the view that it must employ well-trained, high quality staff to ensure: first, that the clients receive an excellent service; second, that the staff are highly productive; and, third, that the bad debt rate remains low. Good staff ensure not only that loan volumes are high so that interest income is high, and that default rates are low so the amount of capital lost is low, but also, and most importantly, that lending is done in a responsible way, giving priority to the interests of the client. However, it takes time to train staff to be highly productive while making responsible underwriting decisions.
The DWP targets would have required Fair Finance to make more loans at lower cost, in turn this would have necessitated a reduction in the amount of interview time allocated to each client and a reduction in the training period for each loan officers. Fair Finance considered that this would lead to higher default rates and, potentially, more people with unmanageable debts. In short, the financial model that the DWP were seeking to impose would have delivered a poorer service to Fair Finance's clients.
In addition, by increasing the capital base (the loan book) without sufficient revenue (running costs) to fund fully trained loan officers, the growth in lending that Fair Finance achieved was wholly unsustainable. Fair Finance realised that once the Growth Fund initiative came to an end, it risked being in the position of having a large but unsustainable personal lending business that would require a high degree of subsidy from another source. Or the business would collapse.
Fair Finance's plans to become sustainable were not being advanced by the relationship with DWP; in fact, had the relationship continued, sustainability would have been deferred indefinitely.
A business model for sustainability
Following the cessation of the relationship with the DWP, the senior management team and the Board members of Fair Finance developed a new business strategy. They knew they needed to find a business model for the personal loans product that would allow Fair Finance to continue to grow, but in a manner that moved the company closer to sustainability not further away from it. Specifically, that meant addressing the question of staff training and productivity, bad debt rates and the price charged to borrowers for loans.
Fixed elements of the model included a measure for the time taken for each personal loan to be made, which included the face-to-face interview between the loan officer and the borrower, plus administrative time for the loan to be processed and monitored. Personal loan officers were then categorised as trainee, junior or senior loan officers according to how many loans they would be able to process in a year. Based on Fair Finance's own experiences it was able to include assumptions about the amount of time it takes for a newly hired personal loan officer to be trained, and the impact of this training regime on the productivity of senior loan officers.
Having established a baseline of staff productivity in the financial model, further assumptions were then added, notably assumptions about the cost of raising capital to lend to clients, the cost of hiring new staff and opening new offices to expand the business, the expected average size of loans made, and the cost, in terms of lost capital, from bad debts. The model allowed for some variation in costs of capital, expansion rates and bad debt rates, which then suggested which of these elements were most important in determining the speed at which Fair Finance could become sustainable.
Next, the shared (or indirect) costs of the business - business management, risk and regulatory management, technology, marketing - were calculated, and apportioned to the three products according the where these resources were used. The personal lending product would need to cover not just its own staff costs, but also its fair share of the wider business cost at Fair Finance.
Finally, the model included a pricing component for new loans, for repeat loans and for an administrative charge for each loan made. The administrative charge is beneficial to the company because it represents an upfront payment that immediately covers some of the staff costs involved in setting up each new loan. Repeat loans can be charged at a lower rate because the time taken to process a repeat loan for an existing client is shorter than the time taken to process a first loan for a new client; in addition, the risk profile of repeat borrowers is lower because they have already established a repayment record and credit history.
Using the information produced by the financial model Fair Finance's Board and senior managers concluded, first, that to become sustainable the company must grow to reach critical mass with economies of scale, so that indirect costs could be spread more thinly cross the business; and it must do so quickly. Second, the price of personal loans would need to be increased (from 21% to 35% for new loans, and from 21% to 28% for repeat loans) to ensure that the cost of making the loans could be fully covered by the interest income (adjusted for bad debt). Third, in order to cover the fixed costs of the making the loan an upfront admin fee of 5% was added to the price.
Fair Finance's rate of organic growth in its first five years (that is, growth based upon recycling of its own capital with no significant external capital injection) was strong at 40%. However, if the company continued to grow at this rate it would take a further seven years to achieve sustainability (even assuming that Fair Finance could cover its outstanding costs in the meantime).
Therefore, Fair Finance decided to borrow capital at commercial rates to accelerate the growth of the company, and to seek to achieve sustainability in four years rather than seven. Based on its financial model, Fair Finance was able to calculate how much capital it needed to expand its lending book and how much revenue it needed to expand its staff and offices.
Fair Finance also realised that these two different funding streams would appeal to two very different types of investor. The capital requirement could be borrowed from a bank in the form of a secured loan. Banks are used to lending capital - as part of a drawdown facility - against some form of security. Although Fair Finance's business model is innovative and therefore was unlikely to fit a pre-determined bank loan template, it is sufficiently similar to other forms of collateralised borrowing for mainstream banks to be able to consider the risks and to price the cost of capital accordingly.
The revenue requirement is rather different. The costs would be front-loaded as Fair Finance opens new offices and hires new staff and would therefore require long-term investors who were willing to be patient. Fair Finance put together a proposal to individuals and institutions interested in social investment, for a fixed-rate seven-year loan, with no cover (or collateralisation), and with interest and capital repayments back-loaded to when Fair Finance achieved sustainability.
The legal contract for these social investors was developed specifically for Fair Finance by lawyers at Clifford Chance, working on a pro bono basis. This contract enables organizations that are unable to raise equity finance (for reasons of legal structure) to offer an "equity-like" investment opportunity to social investors in the form of a long-term unsecured loan.
So in mid-2009 Fair Finance started conversations with a number of mainstream banks to try to secure loan-capital for lending; and with a range of social investors to try to secure revenue-capital for staff costs. One of the key social investors who supported the deal was Venturesome.
Venturesome - its goals and history
Unlocking access to capital for charities by pioneering a social investment market has been the key driver for Venturesome since it was established by the Charities Aid Foundation (CAF) in 2002. That market is now in existence, albeit at an early and fragmented stage, and Venturesome's focus has subsequently shifted to influencing its growth and development. Venturesome's ambition is to support a responsible market that is focused on the needs of charities, with a range of diverse suppliers, knowledgeable demand from charities, and a number of intermediaries that efficiently link charities and suppliers.
Social investment is now supported by all major political parties in the UK; there has been a marked increase in the supply of, and demand for, senior debt, and two major grant-making foundations (both of whom have worked closely with Venturesome) have allocated around £20m each to the area. Additionally, there is rapidly growing interest in 'impact investing', particularly 'financial first/impact second' models, where foundations and also mainstream investors accept a potential small reduction in financial return but look for some social impact as part of the deal.
By contrast, Venturesome focuses on social impact, with a recycling model that anticipates using donors' money repeatedly until exhausted. So Venturesome is an 'impact first' investor, recognising that much of the demand from charities and social enterprises cannot be met by 'financial first' investment at all, particularly for working capital and development finance. This area is neither well-understood nor well-funded. Venturesome will continue to work with grant-makers and other donors (i.e. those motivated primarily by social impact) to bring capital into this crucial but overlooked part of the market.
Interest in strategic intervention
As a social investor, Venturesome seeks to create the greatest social impact possible given a finite level of capital resources. Therefore it seeks not only to make a large number of investments but also to invest in those organisations where the impact of that investment has the potential to cascade far beyond one organisation to impact the wider market. In short, Venturesome seeks to be a strategic investor.
Fair Finance offers Venturesome - and its other social investors - a strategic investment opportunity because of the innovative capital structure it has developed - i.e. the clear separation of funding for (i) the loan book; and (ii) the operational costs of Fair Finance itself. Venturesome's hypothesis is that this structure will eventually help similar Community Development Finance Institutions (CDFIs) to attract external financing and expand at a rate beyond incremental growth. In other words, if Fair Finance is successful in reaching financial sustainability, it will create a new business model for the whole CDFI sector in the UK.
Getting the capital structure right
As part of the Venturesome investment, FF entered into a corporate restructuring in which it created separate ring-fenced business units for each of its subsidiaries. Fair Money Advice (the debt advice service previously known as Money Matters) has been separately incorporated as a charitable subsidiary of Fair Finance in order to secure the tax benefits of charitable status.
Restructuring the business in this way was a key innovation and makes it significantly easier for Fair Finance to raise capital more efficiently going forward. By separating out the personal loans business from the business loans business, Fair Finance is now able to attract separate investors for each business unit and avoid commingling the two sets of risks, which have different risk profiles and different sustainability dynamics.
The restructuring also enabled Fair Finance to separate out the financing of the capital for the personal loans portfolio (which is most suitable for a mainstream bank lender) from the financing of operating costs and working capital at the holding company level (for which Fair Finance approached social investors with a higher risk appetite, including Venturesome).
Separating out investors in this way enables a larger amount of finance to be raised, and on the most cost-effective and efficient basis, with each investor participating at the appropriate point in the capital structure consistent with their risk profile. Moreover, as Fair Finance implements its growth plan and the bank's comfort with the business increases, the size of the lending facility to support future personal loan portfolio growth can be increased without Fair Finance having to seek new funding partners. Fair Finance will, therefore, be able to concentrate on finding funding for working capital, and not worry about loan book growth. Going forward, this should make life considerably easier.
This is a new structure and one that Venturesome believes could be applicable to many others in the CDFI sector. It will set a template for large-scale CDFI financing where others have previously stumbled. Venturesome, therefore, views its investment in Fair Finance as of one of considerable strategic importance.
Keys to sustainability
From an investor's point of view there are three keys to profitability, and therefore the achievement of self-sustainability, for the Fair Finance business model:
1) Loan book size
There is a certain minimum size that the loan book must reach in order to be self-sustaining (i.e. where interest and fee income are sufficient to cover all operating and debt service costs). At present, Fair Finance has not reached this level and has therefore been reliant upon subsidy. But financial projections suggest that it could achieve the break-even point within four years, if growth plans are successfully realised.
As Fair Finance seeks to expand to attain this breakeven level, it will necessarily incur more costs before it can achieve self-sustainability (i.e. opening new offices, hiring and training new staff etc). The purpose of the capital raising is to provide Fair Finance with the funds needed to support it through the period of expansion until such time as it is fully profitable.
Venturesome regards Fair Finance's growth plans as strategically important since, if successful, it would be a rare example of a social sector organisation that has expanded its core business to the point at which it became fully self-sustaining, and ceased reliance on subsidy going forward.
2) Productivity of loan officers
As loan officers become more experienced, they are able to underwrite more personal loans. Fair Finance estimates that, taking the first full year of employment as the base year, a personal loans officer's productivity will increase by 45% at the end of the second year, and by 60% at the end of their third year of employment. Fair Finance has recently completed a number of productivity enhancements (essentially freeing up officers from administrative duties so that they can spend more time making loans) and it now expects experienced loan officers to be able to underwrite around 15% more loans per year than was previously possible.
This means that after 3-4 years, Fair Finance should experience significantly greater profitability as staff hired at the beginning of the expansion process (in 2010/11) start to approach their peak productivity. This is a very significant driver for the growth of cash-flows.
3) Proportion of repeat customers
As loan officers underwrite more deals, a higher proportion of their clients will be repeat customers who have previously taken out and repaid a loan from Fair Finance. For an experienced loan officer, as many as 80% of her clients might be repeat customers.
Repeat customers are important for several reasons:
- They are already known to Fair Finance and have a good track record;
- They have lower default rates than new customers;
- They can be approved faster than new customers;
- They can be lent larger amounts and for longer periods. This means they are more profitable on a per head basis than new customers.
As Fair Finance expands and develops its customer base, these repeat customers become significant contributors to future profitability.
Exit strategy for Venturesome
An important part of Venturesome's disciplined investment process is to establish the planned exit strategy from each investment, together with a likely timescale for this withdrawal of fund.
Venturesome has two potential means of exiting from its investment with Fair Finance, both of which were discussed with the management of Fair Finance during the pre-contract phase.
1) Repayment from surplus cash-flow
If, for whatever reason, Fair Finance is unable to refinance as planned in Year 5, then 75% of all future surplus cash-flows (i.e. cash-flows available after paying operating costs and interest) will be directed towards paying down the Unsecured Loan Facility. Fair Finance's financial model suggests that there should be sufficient surplus cash-flow to pay out Venturesome's loan in full within two years of Year 5. This suggests that Venturesome should be out of the deal by Year 7.
Weaker than forecast cash-flows will obviously result in a longer pay-back time, but as a final back-stop Venturesome has a provision in its investment agreement that if it is not fully paid out by 31st December 2022 it will have the ability to call an Event of Default and bring enforcement proceedings against the company. Clearly, Fair Finance has a strong incentive to pay out Venturesome and all other creditors long before this point is reached.
2) Refinancing the investors
As soon as cash-flows become positive, around 2014, Fair Finance will seek to refinance its existing facilities. By that stage, it should be able to do this as it will have expanded its loan book sufficiently to reach the break-even point; and therefore it will have substantially de-risked its funding position. At this point Fair Finance should expect to attract better terms than are currently available and from a wider range of commercial sources. Venturesome therefore expects to be refinanced in around five years' time.
The structure described above provides Venturesome with an acceptable compromise between its requirements to exit from the investment within 5-7 years, while at the same time mitigating the refinancing risk, and, finally, sharing with Fair Finance the risk of lower than expected cash-flows.
Analysis of risks
As with any investment of this kind there are a number of risks that must be assessed. Venturesome has identified the following key risks for its investment with Fair Finance, together with the factors that mitigate these risks.
Risk: Bad debts may increase in the personal loan book.
The key risk for the business is an increase in the default rate. As Fair Finance expands into new boroughs this default rate may increase due to the higher proportion of new customers and inexperienced new staff.
Mitigant:
Fair Finance has developed a successful proprietary credit assessment methodology to which all loan officers are trained, and there is an now an experienced core of loan officers who will be responsible for training new hires and bringing them up to speed. Loan applicants must interview in person at one of Fair Finance's offices and are required to pay a small upfront fee before they can take out a loan, to demonstrate good faith. The bad debt rate can be monitored carefully and Fair Finance can take actions to manage the rate if it is perceived to be increasing (including ceasing new lending, closing poorly performing offices and identifying and sacking staff with poor performance records).
Risk: Fair Finance may be unable to deliver on its growth plans.
Fair Finance may be unable to expand offices and bring on board staff as quickly as expected. The loan book may therefore not grow and reach breakeven profitability as quickly as projected.
Mitigant:
Fair Finance has not experienced difficulties to date in finding quality staff. It has already begun scouting for new premises in the boroughs in which it intends to expand. If growth is slower than expected, this will delay the time it takes to reach breakeven, but it should ultimately reach profitability and the debt has been structured to be able to accommodate a slower time-frame if necessary. Longer seasoning will ensure stronger cash-flows from existing offices due to increased officer productivity and a larger repeat customer base.
Risk: Adverse performance in the business loans book or the Fair Money Advice subsidiary may adversely impact the cash-flows of the consolidated group.
Mitigant:
The business loans book and Fair Money Advice have been ring-fenced from the personal loans book into separate subsidiaries. Although Venturesome's investment is ultimately secured against the cash-flows from all three business units, the expected net contribution from the business loans book is limited. Fair Finance is not under obligation to grow the business loans book or Fair Money Advice unless funding (in the form small business loan guarantees and service contracts with Housing Associations, respectively) have been secured. These other business units should not therefore constitute a cash drain on the company.
Risk: Fair Finance might be unable to control costs as it expands
Mitigant:
Venturesome will be in a position to monitor costs and profit margins carefully as the business grows. If profitability becomes an issue, Fair Finance has a number of levers to use in order to increase profitability, including increasing the interest rates or the upfront fees that it charges. Clearly an increase in the prices charged for loans would need to be managed in accordance with Fair Finance's social mission. However, its current interest rates compare well with the 240% to +1000% charged by many of its competitors. Fair Finance is a long way off from being seen as indulging in predatory or usurious lending practices.
Risk: Fair Finance might not be able to achieve the productivity increases forecast in the model
Mitigant:
Fair Finance has already implementing changes that have had a demonstrable impact on productivity. It remains to be seen how quickly new officers can be brought up to similar levels of productivity, but Fair Finance has established a solid level of in-house expertise which will be disseminated to staff in its new offices.
If productivity improvements do not materialise as expected, Fair Finance could still reach profitability by implementing changes to its pricing structure as discussed above, although this would obviously be less than ideal.
Risk: New competitors may enter the market to compete with Fair Finance
Mitigant:
At present Fair Finance has few if any competitors within its pricing range in the localities where it operates. Venturesome believes the market-place is big enough to support multiple players such as Fair Finance and would welcome more such entrants to grow this market segment.
Fair Finance's principal competitors at present are door-step and pay-day lenders such as Provident Financial and Oakham. These companies charge interest rates at many multiples of the rates charged by Fair Finance so Venturesome sees little threat of them seeking to compete on Fair Finance's terms.
Risk: Fair Finance might be unable to refinance its debt after Year Five
Mitigant:
If Fair Finance's performance turns out as projected, and it can demonstrate positive net cash-flow by year 2015 following its major expansion phase, then Venturesome sees only a low risk that it will not be able to refinance its debt from either commercial and social sources. However if refinancing does not occur, Venturesome will be paid out in full, from 75% of the residual cash-flows (after payment of operating costs and interest). This should ensure pay out within two to five years after 2014, depending on the strength of the cash-flows.
Risk: Cash-flows may not materialise as strongly, or as quickly, as projected, due to unforeseen circumstances
Mitigant:
Venturesome will monitor cash-flows carefully over the next five years and will encourage Fair Finance's management to take necessary steps to improve profitability if needed, through cost reduction or changes to the pricing structure. If cash-flows are weaker than expected, Venturesome will be paid back over a longer time frame, but nevertheless expects to be refinanced or paid out in full over the agreed term of the debt.
Risk summary
Financial strength is reasonably strong: Fair Finance has its own reserves, which act as a first loss before any third-party capital is written down, either from the bank loan or from the social investors. Given that Venturesome's investment is structured on a flexible payment basis - i.e. paid down from 75% of net residual cash-flow, once they are positive - Venturesome expects to have exited the transaction within seven years and, at worst case after twelve years, depending on the performance of the cash-flows.
The principal mitigating factors for this transaction are that Fair Finance has a wide number of discretionary levers that it can execute to improve profitability, including ceasing lending to higher-risk new customers, slowing the expansion of offices, closing down unprofitable offices, and changing its pricing structure, should it need to.
Based on its close monitoring of the performance of the personal loan book, Venturesome believes that it should be able to keep good track of progress on the expansion phase towards sustainability, and it will be in a position to take corrective action if needed long before defaults have increased to levels sufficient to threaten pay back of its debt.
Conclusion
From Fair Finance's perspective the two main lessons were as follows:
1) Beware of offers of "free capital"
While the DWP's Growth Fund appeared at first to be an excellent opportunity to grow a young business quickly, it turned out to be a dangerous path to follow. Expanding the capital base without sufficient revenue support would have undermined Fair Finances client-centred business model, leading to a deterioration in the quality of the service offered to its borrowers. It would have created a loan book that would have always been unsustainable without significant subsidy.
2) Scale is essential for sustainability
Fair Finance realised that it must get bigger if it was to become sustainable. That meant spending more money more quickly on new offices and new staff, to facilitate the expansion of its loan book. The move from a donation-based business-model to a loan-based business model was not easy, but the company realised that to wean itself off of subsidy it would need to borrow at commercial rates.
From Venturesome's perspective the two main lessons were as follows:
1) Be sure which risks are worth taking
To maximise the impact of its investment Venturesome seeks not only to recycle capital several times over (which requires investments to be repaid) but also to invest in businesses where there is the prospect of a new business model emerging that can be copied by others in the social sector.
2) Get the capital structure right
Venturesome was able to invest in the Fair Finance at the most appropriate level of risk for both partners. By splitting out its main product lines into separate businesses and by separating capital and revenue requirements, Fair Finance provided a range of opportunities for different types of investors and lenders, including mainstream banks, philanthropists and social investment funds such as Venturesome.
This is a new partnership attempting to prove the success of a new business model: this has not been done before, many risks and uncertainties remain. But this is a very familiar story too. Fair Finance provides "old-fashioned" banking services, based on the needs of borrowers as established at face-to-face meetings with their lender. The partnership between Fair Finance and Venturesome, where risks are jointly shared and jointly managed, in pursuit of an agreed set of business goals, is similar to the traditional relationship between privately-run companies and their largest investors.
Perhaps the features of the partnership that are most interesting from the point of view of innovation are the products - debt advice and loan products, designed for those who experience financial exclusion - and the business mission of the company, namely to seek to be financially sustainable in order to develop more, better and cheaper products for clients, rather than to distribute profits to the shareholders.
In light of the current global financial crisis, increasing numbers of citizens like ourselves are reflecting on what alternative types of capitalist structures might be more inclusive of all stakeholders while offering greater long-term resilience
Paul Cheng is an Investment Manager at Venturesome
Mark Hannam is Chair of the Board of Fair Finance
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