“If the state has to rescue the financial system – the heart and soul of the capitalist economy – the game has to change”, pronounced Martin Wolf, chief economics commentator at the Financial Times, on the financial crisis of 2007-09. He means system change. The Third Sector – Big Society if you will – has an unprecedented chance to demonstrate that it can rise to the challenge. The new blended economy will necessitate the delivery of both social as well as financial returns, the JenLi Manifesto is a roadmap for how the Third Sector can lead the way.

The JenLi Manifesto – Part 1 described principles which will be evident in the new blended economy; they will seem anathema to the hardcore disciples of Thatcher-Reagan orthodoxies, but that does not make them wrong. Critics will say they are high-risk, bohemian and lacking in commercial acumen. However the opposite is true – in a complex, interconnected and often unpredictable world; we require a deeper understanding of systemic risk and the mechanisms with which to manage it.

Contents

1. Structured finance and the Third Sector
2. Why are UK organisations not already utilising these models for social investment?
3. The JenLi Model: Attracting philanthropic capital to work for the blended economy
4. The JenLi Model: Leveraging philanthropic capital
5. The JenLi Model: Commercial exit and long-lasting benefit for the community

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1. Structured finance and the Third Sector

‘Structured finance’ describes a range of financial products that were created to help transfer and package risk using legal and corporate entities which are often complex – unfortunately structured finance was given a bad name by reckless and nefarious purveyors of the ‘toxic’ Collateralised Debt Obligations (CDO’s) which triggered the sub-prime mortgage crisis. Abuse of the mechanism does not invalidate its constructive use; the underlying financial innovation is highly beneficial in structuring investments where capital is sourced from a number of different investors and bundled into a single pool of capital.

In brief, investors are assigned to investment tranches, each with separate risk and return profiles so that some tranches are indemnified from certain risks whilst others bear the full impact of these risks. Returns from the underlying assets, both capital growth and revenues, can be distributed to the various investor groups based on a set of rules which provide each investor with a prioritised or subordinated position within the investment stack, depending on their appetite for risk and consequently return.

There is currently a very lively debate about how the Third Sector can adopt structured finance models, and thereby make better use of its resources by allowing philanthropic capital to open the door to commercial capital seeking market-rate returns. This will substantially increase the sum of capital available for social investment.

We know that the markets are irrational at times and perceive some risk as unacceptably high and unpalatable. This is where philanthropic capital can take a more pragmatic view of systemic risk (and potential returns) by creating a layered fund, in which the philanthropic capital is allocated to a first-loss/high-risk investment tranche of sufficient proportion to be able to mop up any unacceptably high risks, and thereby prioritise the creation of social benefit. This approach will facilitate a rebalancing of social as well as financial returns by reducing the cost of capital through better risk management, and providing capital on softer terms and over longer durations where it is most needed.

It is important to remember that projects don’t fail to receive funding because everything about them is high risk, but because one or a small handful of risks are ‘show-stoppers’. By using philanthropic capital as a first-loss tranche (i.e. able to take the first hit if these risks materialise), risk can be ring-fenced and other, more commercial forms of capital can be attracted, on much more attractive terms.

There are very compelling reasons for the Third Sector to adopt and create its own structured finance products, and thereby to create for society a cheaper and much more socially focussed alternative to mainstream financial services. This is because the Third Sector by definition:

• places a much stronger focus on creating social benefit,
• can balance financial and social outcomes by treating financial returns as a cost of capital,
• functions best when it confederates activity without seeking to eliminate competition through conglomeration,
• it can take on the efficiencies of ‘big business’ without having to make a profit (no shareholders to satisfy), these savings can be passed on through much cheaper transaction costs, fees and charges, and,
• is able to take a much longer financial view about the preservation, growth and application of its own capital.

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2. Why are UK organisations not already utilising these models for social investment?

In short – charitable, social and philanthropic organisations are not explicitly permitted by the Charity Commission (which regulates them) to establish their own structured finance products. In fact, some of the principles of structured finance (however well-intentioned) are effectively prohibited by the Charity Commission.

This presents a deeper conundrum: for many charitable organisations, the prospect of engaging directly in the complexity of these financial instruments is simply not of interest, too daunting or too far removed from their core competencies. For those that would consider it, there is the very real fear of loosing their charitable status (and with it their concomitant privileges) if they fall foul of the rules; the Charity Commission would probably consider these activities as either trading (engaging in “such commercially-oriented trades where a significant risk to their assets would be involved”) or a speculative investment (one which may result in early loss of capital for the organisation). This is simply not a risk worth taking and Trustees understandably err on the side of caution.

Nick Hurd MP, the Minister for Civil Society, challenged the status quo on 9 Nov 2010 by urging the Charity Commission to permit social investment and to give “charities more leeway to invest in products that offer social as well as financial returns”. He went further to point out that “existing guidance emphasises the legal requirements of investor charities to maximise returns, so if charities want to invest in new products that balance financial returns with social impacts, the message from the Commission is generally ‘discouraging'”. However, he cannot do any more than ‘urge’ the Commission due to it being independent of Ministerial influence. In fairness to the Commission, it is underway with a consultation on future strategy and it is widely anticipated that there will be substantive changes to the Charities Act in 2011.

Do we need to wait for legislative change? No.

The JenLi Foundation, as a European domiciled charitable and non-profit organisation with a global remit, has pioneered a social investment model which works within the current legal framework. JenLi invites all active and would-be Social Investors, PhilanthroCapitalists and Venture Philanthropists in the UK to become part of this ground-breaking initiative (email us at info@jenli.org). Having recently secured all approvals from the respective Authorities, JenLi is currently preparing compliance documentation and an investor prospectus for the launch of a pilot social investment fund in the UK. JenLi is planning to raise an initial £100 million, ring-fenced for the UK, as the forerunner for its Pan-European Social Investment Fund (See the JenLi Foundation: Case for Support blog).

JenLi can rise to Nick Hurd’s challenge of implementing social investment within the UK – moreover, JenLi can do it now!

How? Read on…

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3. The JenLi Model: Attracting philanthropic capital to work for the blended economy

By philanthropic capital, we mean capital which prioritises social returns over financial returns; it includes charitable gifts and donations, grants (recoverable or irrecoverable), development and/or relief aid, programme related investments, impact-first investments, venture philanthropy, patient capital etc. Providers of this capital are prepared to accept an inversion of the normal risk-return ratio and deploy their capital for either no financial return or below market-rate return in exchange for securing social outcomes, and the capital is often deployed over much longer periods than would normally be expected from commercial sources. The JenLi Model pools this capital within a first-loss/high-risk tranche at the base of the structured finance stack and it is deployed solely at the discretion of the JenLi Foundation.

Sources of philanthropic capital include individuals and corporations (charitable gifts as well as Corporate Social Responsibility funds), charities and foundations, Government, Regional or Local Authorities, development agencies, family offices (as part of long-term wealth management strategy) and international funding institutions such as the EU, DfID etc.

The capital is available and it can be attracted, provided it is offered a befitting balance of risk and return which aligns with its investment objectives.

As with most innovations, the greatest initial enthusiasm will be from a handful of early adopters matching, ideally, the boldness demonstrated by the supporters of the Giving Pledge in the USA (promoted by Buffet and Gates). Over time, as UK legislation becomes more accommodating (sources close to Government say this is highly likely), there will be an influx from more mainstream Third Sector players. Until then, JenLi has the opportunity to exploit a first-mover advantage, to prove itself as market leader and to demonstrate that its model is sufficiently robust to instil the requisite market confidence to be scaled up and replicated.

As with all charitable donations, UK registered tax payers may be entitled to tax relief on gifts made to the JenLi Foundation. Where this is the case, capital is irrevocably committed to the Foundation and the benefit a donor is entitled to receive is prescribed by HMRC. However, not all providers of philanthropic capital will be seeking tax relief. For example, some UK organisations are exempt from tax, some individuals already have efficient tax planning strategies in place and some may hold assets via off-shore entities which do not pay tax. In these cases, it would be possible for JenLi to return some or all of their capital, with or without a return. This is because the JenLi Model is able to treat financial returns as a cost of capital – provided that the returns are capped to pre-agreed levels and that JenLi retains full discretion over how funds are deployed whilst they are under its management.

There are other sources.

Although the Public Sector is fiscally constrained, there is still money available – just less than before. It is entirely appropriate that Government uses its limited resources to maximise the social bang for the taxpayer’s buck. It is entirely appropriate that it uses its capital to pump-prime initiatives which will be able to leverage these limited sources many times over to increase its efficacy. It is entirely appropriate that it doesn’t just spend but wisely invests so that it can recoup and recycle its capital. Is entirely appropriate that it underwrites the commercially unpalatable risks to attract private capital where it would otherwise not go.

To be clear, this is not advocacy for Government to directly enrich the private sector – tax payers £’s going straight into the pockets of shareholders is simply unacceptable. It is defunct logic to suggest that the lure of personal enrichment will percolate into social benefit. However, incentivising the private sector to create social benefit and economic prosperity as a means of making profit is very different.

Entrusting the Third Sector with Public Sector capital makes sense because the Third Sector does not need to make a profit – it is governed by Trustees and not led by interests of shareholders. Even better then to direct Public Sector capital towards Third Sector organisations which, after the social benefit has been entrenched, use a commercial exit via private sector sale or refinance to recoup the capital allowing it to be recycled.

The JenLi Model can do this because JenLi can offer a financial as well as social return. For example, Local Authorities have investment portfolios, often invested for maximum financial return without any direct social benefit accruing to their stakeholders, as revealed by the exposure many authorities had to the Icelandic Banks when they went under. Would it not make sense rather to direct some of this capital towards JenLi’s philanthropic tranche to pump prime socio-economic revitalisation of our towns and cities? Or to use their land and property portfolios as either security to borrow against (say using Prudential Lending available from Central Government) if they know that they have a better than good chance of recouping that capital and that it is going towards prioritising social benefit and creating the foundations for economic prosperity and not simply subsidising private sector deals to prop up profit? This is not about crowding out or being disparaging about the Private Sector; it has a vitally important place. This is about making public money work much harder for social benefit before it manifests as private profit, and it is about being able to recoup Public Sector capital once it has done its job – we can’t just keep on raising taxes or printing money like Zimbabwe and the Weimar Republic!

The Public Sector also has a wide range of non-cash devices that it can use to attract private capital, and to channel this capital so that it prioritises social benefit. This includes offering guarantees, underwriting of risk and providing tax incentives; as well as utilising recent innovations such as Social Impact Bonds (which pay investors a dividend depending on the degree of social benefit achieved), or providing the lure of access to future tax revenues via Tax Increment Finance (TIF) initiatives (which use the income stream from future tax revenues to repay capital borrowed in the markets today). Importantly, these new initiatives incentivise private capital to create social benefit or an increase in real economic prosperity as opposed to profiteering or rent-seeking behaviour. It makes sense for a suitably qualified and resourced Third Sector to oversee the deployment of private capital in this way, as highlighted above.

The JenLi model is compliant with Sharia Law and principles of Islamic finance. This is important not only to attract capital from abroad which must subscribe to Sharia Law, but also to attract UK capital from UK providers who require their investments to be compliant.

It is worth noting that there is a global increase in demand for Islamic investment products. Many traditionally ‘Western’ institutions are now offering these products and much of the demand is from non-Islamic investors. This is because Islamic investment products are perceived to be inherently less risky and/or that the risk is better managed because of the principles they must adhere to:

• the prohibition of usury i.e. the taking or receiving interest,
• capital must have a social and ethical purpose beyond unfettered financial return,
• investments in businesses dealing with alcohol, gambling, drugs or anything else that the Sharia considers unlawful are deemed undesirable and prohibited,
• prohibition on transactions involving masir (speculation or gambling), and,
• a prohibition on gharar, or uncertainty about the subject-matter and terms of contracts – this includes a prohibition on selling something that one does not own.

Because of the restriction on interest-earning investments, earnings must be obtained through fixed fee-based remuneration or partnership structures such as equity investments where the provider of capital shares in the risk; this makes the JenLi Model highly attractive to Islamic investors, particularly at the level of providing philanthropic capital in the first-loss/high-risk tranche but also as part of the investment capital as described in the next section. In case of investment capital, Islamic investment will be treated as quasi-equity.

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4. The JenLi Model: Leveraging philanthropic capital

Leveraging philanthropic capital is easier than raising it, and deploying a non-profit organisation to do it and keep the costs down is logical. JenLi has the approvals and legal mechanisms ready to go. It has also identified sources of investment capital and debt, and received expressions of interest from some providers.

Pension funds and insurance companies have investment capital available for much of which they cannot find suitable investment product. Banks are not meeting their lending targets. There are understandable reasons for this, Government can continue to tell them to invest and lend but unless the deals are attractive, the money isn’t going to flow. In the rebound following the financial crisis, providers of capital have retreated and are more risk averse. Who can blame them? The result has been a polarisation towards super-prime and sub-prime without anything in the middle. A handful of super-prime deals are being funded and medium-risk deals are bundled in with the junk and treated the same; they are being offered capital with such a high price premium or frightful terms that there is no point in taking it.

If deals can be sufficiently de-risked by philanthropic capital within a structured finance model, then we have the magic ingredient which will attract investment capital and debt. If deals are asset backed, create economic prosperity and a robust commercial exit strategy in place, then there will be confidence in a return of capital and a return on capital.

Not only can the JenLi model can do this, but it can also function very effectively as a scaling device to bridge between institutional funding (seeking out social investment products of hundreds of millions) and local initiatives (of paramount importance but requiring relatively small-scale funding).

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5. The JenLi Model: Commercial exit and long-lasting benefit for the community

There is no silver bullet for achieving success. Nevertheless, the JenLi Model is a comprehensive and precious mechanism for tackling the root causes of multiple-deprivation. A robust strategy for commercial exit is essential for any sustainable investment model. The major principles of the JenLi Model are as follows:

1. Discounted asset acquisition – asset prices in deprived areas are typically low, if not considerably depressed as a result of attendant socio-economic problems. Asset prices have a chance of rebalancing when the factors causing the deprivation are eased.
2. Flexibility and adaptability – to be able to access as much as possible of the commercial value created as a result of the initial investment, JenLi provides a robust model for hedging risk through exposure to multiple asset classes and the ability to hold, refinance, roll forward or sell investments at its discretion.
3. Secure an equity stake – both in strategic assets and enterprises which will directly or indirectly benefit from enhanced value as a result of JenLi providing funding for the capital projects, social programmes and organisations/ enterprises which would not normally be able to receive funding.
4. Cheaper cost of capital – essential in facilitating a shift towards creating blended returns (social as well as financial). It will take time for severly-impacted social problems to be properly dealt with and social solutions as well as economic prosperity to be entrenched: the lower the repayment cost, the lower the financial hurdle and the more capital can be directed towards creating social impact.
5. Longer time horizons – and the ability choose timing of exit to take advantage of maximum increase in value and improved economic activity i.e. no need for a quick or forced sale within the trough of a market cycle. Reliance on rapid capital growth brings with it the hazard of creating an asset bubble or pricing locals out of the market if the overall levels of economic prosperity do not also rise at the same pace.
6. Mutualisation and community asset ownership – it is important that local communities are able to share in the economic uplift and benefit from the latent value in their assets, whether it is their natural resource, land, infrastructure or skill-base. This economic empowerment, financial independence and reduced inequality is vital if communities are to become self-sufficient.

Although the model is dependent on acquiring assets at a discount, it does not merely speculate or hold and sell assets for commercial gain. Rather it focuses on redressing the underlying issues which are depressing or undervaluing asset prices and taking advantage of the rebalancing of asset prices. As such, the commercial exit for the JenLi Model is dependent on a vibrant and prosperous Private Sector to acquire or refinance assets and investments. This means that if a broader environment of economic prosperity does not already exist, part of the agenda throughout the process must focus on creating it . The commercial exit depends on genuine value enhancement and the creation of new economic prosperity within a community. Rather than crowd out the private sector, the JenLi Model proactively encourages and promotes it, which is advantageous in itself and essential in creating self-sufficient communities.

The JenLi Model may seem complex, but as structured finance products go, it is not. During the good times or in ‘safe’ segments of the market, it may work perfectly well for some investors to base their commercial strategies on simple economic models. But when a game-changing event occurs, like the Financial Crisis of 2007-09, irresponsibility and negligence are soon revealed – the calamitous collapse of Lehman Brothers is a painfully good example.

The JenLi model provides a strong competitive advantage as is able to facilitating confident investment into areas suffering multiple-deprivation, where conventional investors would simply not dare to go. It does this by utilising philanthropic capital as a first-loss tranche and by increasing the number of routes available for commercial exit.

System risk and its associated complexity brings with it uncertainty, which is difficult to predict. The majority of risk-management strategies seek to quantify the probability of risks materialising and therefore they can be predicted reasonably well, or more importantly their consequences can be accurately priced. Uncertainty is not one of these risks, and quantitative models are simply not able to accurately predict detailed financial outcomes at the margins. The most useful weapons against uncertainty are flexibility and adaptability, combined with the agility with which to respond to events and good information upon which to base decisions – this is a key risk management principle of the JenLi Model.

JenLi builds flexibility and adaptability into the model by maximising the potential exit routes and it is able to recoup capital across multiple asset classes, whether they form part of the initial investment or not. At the outset, JenLi secures equity interests in downstream assets and or enterprises which will experience a direct or indirect value enhancement as a result of the initial investment. It is also able to roll forwards these equity interests if that is the most effective way of achieving socio-economic benefit.

This does not mean that every ounce of economic value will be ruthlessly squeezed from the project or extracted from the community. JenLi does not need to make a profit and therefore it does not need to maximise its financial returns, rather it ensures that JenLi is able to recoup its capital after it has been harnessed to work in prioritising social outcomes.

For example, an initial investment into enabling infrastructure (such as the construction of roads or the provision of utilities) and pubic realm enhancements could be matched with securing an equity stake in adjacent or nearby land which will have its value enhanced by the initial investment. That land may as a result be suitably ‘enabled’ to accommodate a factory or office building which will create new jobs. Unless the end-user is secured upfront (preferably one with an excellent covenant), the development may not be able to receive funding if the land is acquired at market rates. JenLi does not need to sell the land (or ‘flip’ the asset) like many ‘trader type’ real estate developers; rather it (like other long-term developers) is able to overcome this difficulty by being able to exchange the land for an equity stake in the development and for the financial returns to be realised at a future date. Furthermore, it may be that the social business or enterprise occupying the site will not be able to afford to buy the building or rent it at a market rate. It may be that as a start up business it requires a substantial rent-free period in order to establish itself. In this case JenLi is able to roll forward its interest yet again into an equity stake in the organisation which it can sell once the organisation has demonstrated its viability and commercial value.

To summarise: an infrastructure and public realm investment can be rolled forward into a land asset > then into a development project > then into real estate asset > and then again into a stake in a business or enterprise.

It should also be made clear that JenLi has a vested interested in making sure that social problems which may be adversely affecting inward investment to the area, or the employability of local people are not only dealt with as part of the broader plan, but become a primary focus of action. It makes financial sense therefore for JenLi to fund social programmes which are able to redress underlying social problems.

Notwithstanding the challenges and complexity of its projects, the JenLi Model is able to proactively reduce and manage financial risk. It is also, as a result, able realise financial surpluses where appropriate. An important choice is then presented about how surpluses are dealt with because the model does not require profits to be made (financial returns are capped and treated as a cost of capital). Once a project has run its course, surplus capital or assets can be either recycled back to the JenLi Foundation for future projects or used to empower the local community through asset transfer or mutualisation. There are numerous options and legal vehicles for doing this including a Community Land Trust, Community Development Trust, Cooperative, Foundation, Charity, etc – their respective merits are the subject of a separate discussion.

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To be continued… in Part 3 of the JenLi Manifesto