Perpetual Bonds: An answer to equity-like social investment?
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September 2020
Perpetual Bonds: An answer to equity-like social investment?
Since the inception of social investment, social investors have been seeking the most appropriate ways to support social purpose organisations with capital which can both enable the creation of long-lasting social impact and provide a financial return. In more commercial investment settings, the supply of equity (and ‘equity-like’) finance is commonplace, whereas in a social investment context, it is not. This is due to a variety of constraints, often relating to the kind of legal structures which social purpose organisations adopt leading to an inability to take ‘genuine’ equity investment. Other limitations exist such as the structure and availability of wholesale finance, investors not having the expertise, risk appetite and resource to structurally innovate, concerns of private benefit arising in the context of future equity investors and fears of mission-drift when supporting companies limited by shares.
Problem
These challenges have undoubtedly restricted innovation and the creation of impact. Research, such as that conducted by Shift1 and Flip Finance2 has demonstrated the demand for, yet lack of supply of, equity-like (or ‘quasi-equity’) patient risk-bearing investment capital for social purpose organisations. There have been attempts to plug this gap: crowdfunding platforms, government-backed patient debt funds and Social Investment Tax Relief (SITR) are a few such examples. Yet efforts have tended to focus on solving the needs of investors rather than developing solutions for, and with, social purpose organisations. This is not only counterproductive to getting services to people who need help from resilient organisations, it also goes against the core mission of social investment. Connect Fund’s call for ideas to support the deployment of Access Foundations’ Flexible Finance for the Recovery3 offers another opportunity to tackle this issue.
The most popular example of an equity-like instrument is a Revenue Participation Agreement in which repayment is linked to revenue performance. Whilst this can be one solution to aligning the interests of investors and investees, it fails to tackle one of the significant, yet rarely referenced challenges: this is still a debt instrument. It will remain on the investee’s balance sheet as a liability, having an impact on how the organisation is perceived, their stability as a business and ability to leverage future finance.
Equity-like finance (aka quasi-equity finance) A form of investment which shares some of the characteristics of equity investment without the sale of shares.
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Perpetual Bonds: An answer to equity-like social investment?
Introducing… the Perpetual Bond What is a Perpetual Bond? In July 2020 we finalised an investment into Fair for You4 – the affordable credit provider – in the form of a Perpetual Bond. Whilst commonly used in commercial investment settings, Perpetual Bonds are extremely rarely used in social investment. Indeed, this was the first time such an investment structure was used in the UK affordable credit sector.
As well as falling firmly into the category of ‘equity-like’, crucially a Perpetual Bond can overcome the major barrier other equity-like investment instruments may suffer: treatment as a liability on the organisation’s balance sheet. A Perpetual Bond may be treated as equity, rather than debt, on the recipient’s balance sheet, depending on the rights attached to the instrument. Crucially, Perpetual Bonds can be raised by limited by guarantee and charitable organisations which are unable to raise traditional equity.
Solution
A Perpetual Bond is a fixed income security which has no maturity date; it is a form of permanent capital. The issuer of the Bond (the social purpose organisation) may or may not pay interest (or a ‘coupon’) depending on the nature of the deal. In theory, the principal (or ‘capital’) of the loan could be outstanding forever, or at least until the organisation ceases to exist. Significantly, a Perpertual Bond can be structured as debt, equity or as a compound instrument.
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Perpetual Bonds: An answer to equity-like social investment?
Perpetual Bonds in practice: Fair for You case study Fair for You is an affordable credit provider, providing small loans to lower income households for the purchase of essential items for the home. As a Community Interest Company limited by guarantee, Fair for You cannot access genuine equity investment. Fair for You approached Thinking Legal to help put together a suite of documentation that would enable their new investor (Fair4All Finance) to invest alongside existing investors (Esmée Fairbairn Foundation, Joseph Rowntree Foundation, Tudor Trust, Barrow Cadbury Trust, Robertson Trust and Ignite).
In 2020, the seven investors invested £4.35m upfront, rising to £7.5m, into a newly issued £10m Perpetual Bond. The Perpetual Bond is structured as a compound instrument. The principal is paid at the discretion of Fair for You with no repayment date and interest is paid quarterly, with the interest amount linked to impact targets (starting at base rate plus 3%). A significant portion of the Perpetual Bond is accounted for as equity on Fair for You’s balance sheet. This coupled with the low interest rate charged, means Fair for You have stability as a business which will enable further affordable lending and the opportunity to leverage commercial funding. Above: Fair for You
Since the start of Fair for You’s lending in 2015:
59,000
loans have been supplied to
27,000 customers.
Over three quarters of Fair for You’s customers have children present in the household.
£1,500 is the median monthly net income of Fair for You customers, with 15% of customers having incomes of less than £1,000.
We wanted to retain our founding funding from the trusts and foundations who had supported our concept from the beginning. Being a Community Interest Company meant we needed to design a new investment instrument that sees our investors retain their investment at full value and earning a modest commercial return balanced with a strong impact investment return. The Perpetual Bond has been transformational in enabling us to consider funding options unavailable to us previously.” Angela Clements, Chief Executive, Fair for You Enterprise CIC
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Perpetual Bonds: An answer to equity-like social investment?
The accountancy behind a Perpetual Bond
Rights attached to financial instruments
Capital raised by ordinary corporate entities usually takes the form of financial instruments which are relatively simple from an accounting perspective – they are either accounted for as debt (recognised as a liability on the balance sheet) or equity (representing ownership and recognised as equity on the balance sheet).
In general, there are two key concepts driving the rights attached to financial instruments: economics (the financial implications for the investor and investee) and control (the control the investor can exert).
The Financial Reporting Standards (FRS) 102 define a liability as a “contractual obligation to deliver cash or another financial asset to another entity”.5 The presence of a contractual agreement to repay capital and/or pay interest at a specified point in time means that an instrument will constitute a liability. Equity does not share this same contractual obligation.
Complex (or ‘compound’) financial instruments contain a mixture of both debt and equity. The treatment as debt or equity depends, among other things, on the rights attached to the instrument.
As noted earlier, a Perpetual Bond can be structured as debt, equity or
as a compound financial instrument. The extent to which the investment is accounted for as debt or equity depends largely on the placing of the instrument upon these continua, as well as the difference in the present value of the projected future interest compared to a market rate.*
Economics:
Control:
• The date by which capital must be repaid.
• The degree to which the investee has discretion over the amount and timing of repayments.
• The amount and frequency of interest (or equivalent) to be repaid.
How does a Perpetual Bond work?
• The degree to which the investor has control over the investee (ranging from control over further capital raises to day-to-day decision making).
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Perpetual Bonds: An answer to equity-like social investment?
Many determining factors might go into an investor’s decision as to whether to use a Perpetual Bond structure for a social investment.
When considering the social purpose organisation: • Strength of social impact How strong is the current and potential social impact? • Financing needs How much finance is required to fund, enable and achieve the intended goal and over what period? • Investment purpose Is the investment designed to bridge a short-term gap, secure a position to enable long-term sustainability or leverage additional investment? • Affordability How affordable are the different forms of available investment when considering existing and projected income? Over what period is repayment realistic?
• Legal structure Does the organisation’s legal structure permit ‘genuine’ equity finance? • Need for future financing Are future funding rounds likely? If so, what are the intended sources of this potential investment? • Business model Is the organisation reliant on public sector contracts, the source of which may be impacted by the health of the social purpose organisation’s balance sheet?
For the investor: • Mission alignment How closely does the social impact of the social purpose organisation align with the social investor’s long-term mission? • Need for liquidity Does the investor require constant streams of investment income to recycle and enable future investments? • Available resources Does the investor have the experience, skill and ability to allocate resource to structuring?
Using a Perpetual Bond: key considerations
• Business model What are the investor’s margins and required balance between volume and value of investment deals to remain sustainable? • Control Does the investor want to control future fund raisings?
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Perpetual Bonds: An answer to equity-like social investment?
When might a Perpetual Bond be appropriate? Some investors may need to consider liquidity: The decision to look at a Perpetual Bond investment structure cannot be taken lightly by the investor or the social purpose organisation, nor will it be right for everyone. It is a long-term investment commitment and, at least as things stand, may be an expensive, resource-intensive process (over time, as instruments of this nature become more widely used, structuring costs should reduce through standardisation and knowledge sharing). For the investor, it is only appropriate when the strength of the impact, and mission alignment, justifies the patience of capital, and: • A long-term relationship between the social purpose organisation and investor will be beneficial to both parties; • The length of investment will mean that future interest payments should eventually cover a significant portion of
the capital outlay (note that if certainty is needed on this point, that would require a contractually committed ‘coupon’, which is likely to be viewed as a debt-like characteristic from an accountancy perspective); • There is an exit horizon: a prospect of a return of principal. This may be at a future fundraising round, as can be the case with genuine equity investments, or a refinancing event, likely from commercial capital. At its best, the Perpetual Bond should become catalytic in nature to prove commercial viability, permitting investors to recoup their capital once the organisation has achieved stability and can obtain its funding from more traditional sources (note that if certainty is needed on this point, that would require a contractually committed redemption date or trigger. This could also be viewed as a debt-like characteristic from an accounting perspective).
As a Perpetual Bond is a form of bond, it should be transferrable meaning that an original investor can transfer the bond to an equivalent social investor if the investment no longer aligns to the original investor’s thesis or strategy, or if the investor needs to recycle capital to new projects. These considerations mirror those of genuine equity investments. When the discretion of repayment lies with the investee, a likely exit and repayment from the investment is significantly harder to predict. Without a widely established secondary market, lack of liquidity and the prospect of no return of principal within a predictable time horizon are significant considerations. It is also worth
noting that although with equity investments the hope is that the investor experiences capital growth, the same is not true for Perpetual Bonds where the best-case scenario is a return of the principal amount invested plus the expected interest income stream. The investment decision must be impact, not financially, driven.
It is important never to lose sight of the purpose of a Perpetual Bond investment: To more appropriately capitalise an organisation resulting in greater financial resilience and increased likelihood of creating transformative social impact.
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Perpetual Bonds: An answer to equity-like social investment?
Could a Perpetual Bond structured fund work? The utility of a Perpetual Bond structure does not have to be limited to direct investments. A similar structure could be adopted further up the capital structure: a fund set up with no fixed end date and interest payments linked to returns, perhaps accounting for a minimum amount of income to be recycled for further investments: a form of ‘social hurdle’. This could form the basis for a genuinely impact-first fund which is appropriately capitalised to offer the flexible and patient investments social purpose organisations need.
Recommendation More patient, equitable risksharing approaches to investing will be key to organisations as they recover from Covid-19 and beyond. Repayable funding will be required, but for many with uncertain income for the foreseeable future, standard debt products will not be appropriate.
The true purpose of social investment cannot be forgotten: placing the social purpose organisation and the creation of impact for those they support at the heart of investment decisions. For social investment to truly thrive, a culture of listening and co-design has to become routine, flexible wholesale finance must become commonplace and investor expertise and resourcing gaps need to be addressed.
While the momentum around offering equity-like investments is gathering, the nature of repayment is only half of the battle. Depending on how they are structured, Perpetual Bonds may offer a solution to the liability and accounting dilemma many social purpose organisations face.
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Perpetual Bonds: An answer to equity-like social investment?
Amortizing loan Principal and interest of the loan are paid in periodic, fixed payments. Bond A fixed income security that represents a debt owed by a borrower (the “issuer”) to an investor. Capital growth The potential increase in value of an investment. Compound instrument A financial instrument that has the characteristics of both equity and liability. Coupon The interest rate paid on a bond expressed as a percentage of the bond’s value. Equity finance Raising investment through the sale of shares.
Equity-like finance (aka quasi-equity finance) A form of investment which shares some of the characteristics of equity investment without the sale of shares. Financial hurdle Minimum financial return required on an investment by an investor. Financial Reporting Standards (FRS) Common rules set by the Financial Reporting Council so that financial statements are consistent, transparent and comparable. Fixed income security A debt instrument which pays a fixed amount of interest to investors.
Glossary
Liquidity The availability of, and ease with which assets can be converted into, cash. Market rate The estimated price that a buyer would pay, and a seller would accept, in an open and competitive market. Maturity date Agreed upon date on which the investment ends, triggering the final repayment to an investor. Permanent capital An investment which is never required to be repaid. Present value The current value of a future sum of money.
Principal The amount borrowed. Revenue Participation Agreement A loan in which the repayments are determined by the revenue performance of the investee.
Author
Secondary market A market in which previously issued financial instruments are bought and sold.
References
Social purpose organisations Non-profits, charities, co-operatives, social enterprises, and for-profit organisations with a social mission. Wholesale finance (aka indirect investment) Funds invested into investment funds, for investors to in turn invest directly into social purpose organisations.
Ben Smith Head of Social Investment, Esmée Fairbairn Foundation
1 Shift (2020) Beyond Demand: the social sector’s need for patient, risk-bearing capital 2 Flip Finance (2017) Social Shares: Risk finance for social enterprises and charities 3 Access (2020) Covid-19 related emergency support 4 Pioneers Post (2020) Affordable credit CIC Fair for You secures £7.5m in first-time quasi equity deal 5 Financial Reporting Council (2018) FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland
*Disclaimer The contents of this paper is not legal advice, investment advice, accountancy advice or any other professional advice. Please seek independent advice when making investment decisions and structuring investments.
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Perpetual Bonds: An answer to equity-like social investment?
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