The “Mind the Finance Gap” reported the estimated unmet demand for finance amongst individuals and organisations that do not qualify for traditional bank funding to be approximately £6.75bn. The report - produced by consultants Dr Nick Henry and Philip Craig on behalf of the Community Development Finance Association also estimates the unmet demand for finance on the part of social sector organisations to be about £1.7bn.
A roundtable debate which we hosted recently on the role guarantees in the social investment market suggests that guarantees could play a significant role in helping to bridge this finance gap. To date, there has been very little exploration of the way in which guarantees could boost social enterprise.
Guarantees and moral hazard
A guarantee is essentially an agreement under which one party agrees to bear risk for another party. Guarantees come in all shapes and sizes and may be given different names in different contexts. For present purposes, a guarantee is a risk-sharing device, usually in the form of a contract and in return for an up-front payment of some kind, which involves a well capitalised party (which could be government or one or more charitable foundations, for example) bearing risk for a less well capitalised party or parties (in this case, most likely an intermediary, charity or a social enterprise).
Any guarantee structure must seek to minimise “moral hazard” by aligning the interests and incentives of the recipient of the guarantee and the guarantor. This will usually involve the recipient sharing a percentage of the downside risk, with the appropriate level of downside risk depending on the context, including the relative capacity of the recipient to bear risk.
Perception and reality
One of the key insights coming out of our roundtable debate was that there is often a gap between the real level of risk of an activity and the perceived level of risk. This means that a guarantee can enable a guarantor with a capacity for good risk analysis to generate a profitable income stream in contexts where this “perception gap” is significant, as the actual level of claims under the guarantee may be less than the projected level. In such situations, the price charged for the guarantee may be attractive to charities and social enterprises seeking to minimise risk whilst also seeking to expand activities. The better the level of risk analysis, the greater the opportunity for profit.
In new markets, the perception gap can be significant. Projected returns may be at or above market levels but often there is no history of performance and so risk analysis is difficult. The uncertain risk environment may delay the involvement of operators or investors in the market. However, even where there is little historic data, there is always space for risk analysis and the exercise of informed judgment. Where risk is uncertain but not necessarily high, guarantees can therefore be an effective tool for stimulating new activity. This is true of many parts of the social investment market. There are already examples of guarantee like products being used with impressively low default rates.
Cash flow and dysfunctional public service markets
Even in areas where historic data is available and levels of future claims can be calculated to a reasonable degree of accuracy - such as the loss rates attributable to the loans made by CDFIs to SMEs in deprived communities - there may be advantages in using guarantee structures instead of grant mechanisms to grow and support the market, due to the cash flow advantages guarantees can bring. There are also areas of CDFI activity where loss rates are lower or less clearly established.
At the moment, instead of a public service contracting environment in which government, which is best placed to absorb risk, shields charities and social enterprises, which are least able to absorb risk, government is often pushing contracting risk onto the much weaker balance sheets of charities and social enterprises. This can happen in very crude ways, such as where public authorities request “performance bonds”, which require charities and social enterprises to put large cash sums on deposit so that if anything goes wrong with the contract the authority can access the cash. It can also take place more subtly through unreasonable contract terms unfairly distributing risk.
Guarantees can be used to reduce the risk of crowdfunding loans to charities and social enterprises. This can reduce the risk for individual lenders and at the same time reduce the cost of funding for social enterprises by enabling loans to be made at reduced interest rates. An example of this approach is that of Banca Prossima in Italy, which runs a successful crowdfunding platform backed by a guarantee fund, to help social enterprises raise loan finance from members of the public.
Public Service Contracts
Another potential role for guarantees is to reduce the risk for charities and social enterprises to take on larger and more significant public service contracts. At the moment, many charities and social enterprises shrink back from taking on contracts when those contracts present risks to the wider viability of the organisation or endanger activity in other areas.
It is possible to imagine guarantees being used, for example, to encourage charities and social enterprises to bid for prime contracts and large subcontracts in the forthcoming Ministry of Justice probation service supply chains. A risk-sharing guarantee mechanism, where the guarantor takes on a percentage of the financial risk associated with contracts, could be a more efficient way of growing the social investment market than using grant finance to increase “contract readiness”.
A government scheme
The UK government through the auspices of the Treasury has rolled out a number of guarantee and equivalent risk-sharing schemes to try and increase lending to the real economy, including the National Loan Guarantee Scheme, Business Finance Partnership, Enterprise Finance Guarantee and the Funding for Lending Scheme. Guarantee mechanisms are also used routinely by the Export Credit Guarantee Department to increase the share of British manufacturers in international trade.
Government could use its existing knowledge about the design and implementation of national guarantee schemes to create a guarantee scheme targeted specifically to increase the flow of finance to the social sector in the UK, including through the existing national network of Community Development Finance Institutions. In particular, the government should consider the way that the proposed £1bn “business bank” might use its proposed guarantee powers to improve access to finance to the social sector. European structural funds could also potentially be used to take the bulk of the risk and leverage in private finance.
A pilot guarantee fund
A pilot guarantee fund could be established to test the demand for guarantees and the benefits they could bring to the social sector in the UK. To increase its impact, a pilot could be used to combine capital from different sources, including public, charitable and private grants and investments in a structured fund with layers of different forms of capital.
There are examples of guarantees and similar forms of underwriting playing a significant role in the development of new markets, including, notably, the development of the insurance market at Lloyds’ of London. The “names” of Lloyds effectively guaranteed risks and created a market which enabled productive economic activity to take place with the assurance that risks were coered.
There are also a number of ways in which guarantees could be used to enable charities and social enterprises to take on bigger contracts, generate greater revenues and achieve more impact. With a little creativity and commitment, guarantees could play a vital role in bridging the “finance gap”.