The Law Commission recently proposed a statutory power to make it easier for charities to carry out social investment. Luke Fletcher examines some of the things it will allow charities to do.

The Law Commission is proposing a new statutory power for charities to make social investments, which could open up a world of possibilities for foundations when financing other charities and social enterprises.

I put the idea of a statutory power to Lord Hodgson in a submission to his Charity Law Review, in April 2012. I argued that charities are different to private trusts and pension funds and that the ability of charities to accept high social impact in exchange for lower risk-adjusted returns, something other fiduciary investors cannot do, should be put on a firmer footing than Charity Commission guidance.

Lord Hodgson agreed and recommended to Government that a statutory power be created. The Government in turn asked the Law Commission to look at the idea and, to my delight, the Law Commission has provisionally proposed that a new power be created.

The provisional proposals appear to have been widely welcomed and so it looks as if the Law Commission will probably confirm its recommendation that a new power be created in due course.

A world of possibilities

Importantly, the Law Commission suggests that the new power should apply to situations where a charity expects only all or part of the capital element of an investment to be returned and not just to situations where a charity expects to make a positive net financial return on an investment. An example would be a charity which provides a loan to a social enterprise and only expects 50 per cent of the capital to be repaid.

A new statutory power of this kind will give confidence to trustees to innovate with new financing techniques and approaches. The following are some examples of types of funding we’ve worked on at BWB.

Quasi-equity

Almost all charities and most social enterprises are unable to issue shares or distribute profits by way of dividend. Historically, this has meant that most charities and social enterprises have had to borrow to invest in new products and services. The problem with debt is that it tends to be impatient and to require the repayment of capital and interest even when the underlying business is not generating profit.

As a result, enlightened funders and social incubators have been pioneering new ways of providing 'patient' capital to charities and social enterprises. An example of this kind of 'quasi-equity' financing instrument - so-called because the investment is performance related and behaves a little like equity - is a revenue participation agreement, in which the borrower repays a percentage of revenue, often when revenues pass a certain threshold. This kind of instrument can allow a charity or social enterprise the space to grow and develop before needing to repay capital and interest, as repayments only begin when revenues exceed the agreed threshold.

It is much harder to connect repayment obligations to profitability – as is the case with share capital - as this can rub up against charity law restrictions on the distribution of profits and is more likely to raise complex withholding tax issues.

Another example of a quasi-equity instrument is a royalty agreement, under which the lender receives a right to a percentage of revenues generated through the sale of a particular good or service. This might be more appropriate where the finance is being used to fund a particular business line and not the business as a whole.

Repayable Grants

We are also seeing an increase in the use of 'repayable grants'. These are grants under which all or part of the grant is repaid but only if certain conditions are met. An example might be a grant to a social start-up which requires repayment if the start-up commercialises intellectual property it develops or raises more than a certain level of investment in a limited period of time.

In the case of a repayable grant, there is usually no expectation of repayment, which is usually only seen as an outside possibility. There is also no expectation of any upside or net return for the funder.

Conditional loans

A conditional loan in this sense is a loan which is only repaid if certain targets are not met, which might be linked to financial and/or social performance.

For example, a foundation might provide a loan to a social enterprise on the basis that the loan will be progressively written down as cumulative social impact targets are met, which might be anything from so many unemployed people back into work or so many at risk young people engaging in a mentoring programme. In some cases, if all the social impact targets are met, the loan is completely written off.

A sterling job

The Law Commission has done a sterling job. If its provisional proposals are confirmed and implemented, the law will finally be catching-up with social investment in practice. The variety of instruments and techniques which charities can use to finance good things are practically infinite. A statutory power, if framed sensibly, should lead to more innovation for the good of everyone.