A New Approach to Funding Social Enterprises

The financial crisis of 2008 deeply damaged the credibility of financial innovation in the general public’s mind. As the collapse of markets dried up credit across the system, the notion that securities such as collateralized debt obligations and credit default swaps are enablers of growth suddenly seemed implausible, if not deluded. Indeed, those instruments are often described today as weapons of mass destruction.

It’s easy to forget that the same instruments have had a positive and transformative effect on society. Even as the dust from the real estate implosion lingers, we can see that homeownership would be impossible for millions of people if banks could not pool mortgages and sell collateralized bonds against those pools. It isn’t only the middle classes in developed nations that have benefited from debt pooling. Microfinance is now a $65 billion market, serving more than 90 million borrowers in some of the world’s poorest countries. Its growth was accelerated by the ability of investment banks to pool the microloans of many lenders and issue collateralized debt obligations against them in the international financial markets, freeing up the capital of those lenders and allowing them to make additional microloans.

Financial engineering, then, can be a powerful force for change. It can permit the mobilization of more capital for investment than would otherwise be available. It can generate rich opportunities to fund projects that fuel economic growth and improve people’s lives.

In the following pages we’ll explain how financial engineering can make it possible to channel investment from the financial markets to organizations devoted to social ends—organizations known as social enterprises, which have traditionally looked to charity for much of their funding. With the right financial innovations, these enterprises can access a much deeper pool of capital than was previously available to them, allowing them to greatly extend their social reach.

The Businesses of Blended Returns

Social enterprises are entrepreneurial organizations that innovate to solve problems. They include nonprofit and for-profit ventures, and their returns blend social benefit and financial revenues. They come in many flavors, but they all face the same fundamental question: Can they generate enough revenue and attract enough investment to cover their costs and grow their activities?

Some social enterprises can earn a profit that is sufficient to get the business funded by investors. They might provide goods and services to customers willing to pay a premium for a socially beneficial product—green energy, say, or organic food. They might sell an essential service to poor customers at a decent profit while still providing that service more affordably than other suppliers do. But many, if not most, social enterprises cannot fund themselves entirely through sales or investment.

They are not profitable enough to access traditional financial markets, resulting in a financial-social return gap. The social value of providing poor people with affordable health care, basic foodstuffs, or safe cleaning products is enormous, but the cost of private funding often outweighs the monetary return. Many social enterprises survive only through the largesse of government subsidies, charitable foundations, and a handful of high-net-worth individuals who will make donations or accept lower financial returns on their investments in social projects. The ability of those enterprises to provide their products and services rises or falls with the availability of capital from these sources, and their fundraising efforts consume time and energy that could be spent on their social missions.

The lack of funding opportunities is one of the major disadvantages social enterprises face. A conventional business can use its balance sheet and business plan to offer different combinations of risk and return to many different types of investors: equity investors, banks, bond funds, venture capitalists, and so on. Not so for many social enterprises—but that is changing. An increasing number of social entrepreneurs and investors are coming to realize that social enterprises of all sorts can also generate financial returns that will make them attractive to the right investors. This realization will dramatically increase the amount of capital available to these organizations.

Essentially, the insight is that you can treat the funding of a social enterprise as a problem of financial structuring: The enterprise can offer different risks and returns to different kinds of investors instead of delivering a blended return that holds for all investors but is acceptable to very few. This new approach to structuring can close the financial-social return gap.

References Sources: Harvard Business Review: https://hbr.org/2012/01/a-new-approach-to-funding-social-enterprises

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