The Harvard Business Review has an interesting piece in its upcoming magazine on the value of financial engineering for social enterprises. I have a couple of responses to some of the points made in the article.
1. The social-finance gap is another way of describing positive externalities.
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
What the authors are describing here economists call externalities. Social enterprises engage in activities that have positive externalities – that is, the social value of those activities to society is greater than the private value of those activities to the individuals that pay for them. Consider for example the provision of food. The provision of food by Kroger or Whole Foods to a person with average income in the US can be described as a transaction that has no externalities. This is a generalization, of course, that assumes that all the costs and benefits of producing and consuming this good are captured in the price of the good.) Therefore the private value of providing this good, or its price, equals the value to society of having this good provided.
Now consider the provision of food to an impoverished person who lives in government or other types of shelter. The provision of food to that person carries both a private and a social return, with the latter being that society has an interest in feeding people that would otherwise go hungry. That social benefit is not reflected in the price of the food that the poor person would purchase in at a place like Kroger or Whole Foods because those prices reflect just the intersection of the private marginal cost of producing the food and the private marginal benefit to the consumer of the food.
Positive externalities like the one that results from feeding the hungry lead to an underproduction of the relevant service or good. Society has an interest in seeing more of these transactions than currently occur. In the case of food, the price point may be above that which many poor people can afford and therefore many transactions that society may prefer to happen do not take place. (Conversely, negative externalities result in overproduction of relevant goods and services.) This is one of the basic justifications for government intervention in the marketplace: if the government can subsidize this type transaction, then more will take place.
The financial-social gap that the authors mention, therefore, is a gap between the value that the customer is willing to pay for the good or service that the social enterprise is offering and the value that society gets from having that good or service be provided.
Government subsidy is one way to “internalize the externality” – that is, to make the private value (the price) reflect the social value. In this case, government subsidy would reduce the price of the good and thereby increase the quantity demanded of the good. More of the good will be sold, reflecting, in perfect scenarios, the social benefit of the good.
2. There is financially-better way to accomplish the financing that the authors describe.
To see how the process works, imagine that a social enterprise operating in Africa requires an investment of $100,000 to build new health clinics and expects the clinics to earn $5,000 a year—a return of 5% on the investment.
Unfortunately, 5% is too low to attract private sources of capital. Traditionally the enterprise would obtain the $100,000 from a charitable foundation instead. But suppose the enterprise asked the donor for only $50,000. It could then offer a financial investor a 10% return on the remaining $50,000. The donor would receive no repayment—but it would have $50,000 to give to another socially worthy enterprise.
The private investor in this example gets a 5% return on $100,000 (or $5000) in the first scenario and a 10% return on $50,000 (or $5000) in the second scenario. The investor prefers the latter scenario because, although the amount of the money he gets is the same, he now has to invest less to obtain that amount and therefore has a higher ROI. The investor is able to access the higher, 10%, ROI in the second scenario because a philanthropic funder fronts $50,000, or half of the total needed investment, to the social enterprise. Because one of the goals in the article is to explain how social enterprises can access for-profit funding, this scenario accomplishes that by showing how two investors with different return expectations accomplish that.
However, the social enterprise can access the same capital if the philanthropic funder were to simply GIVE the private investor $5000. Consider this scenario: A private investor wants a 10% ROI, but sees an investment of $100,000 that yields only 5%, or $5000. If a funder were to offer the investor an additional $5000 contingent on the investment taking place, the investor now sees an ROI of ( [$5000 + $5000] / $100,000 = ) 10%. In the scenario the authors describe, the philanthropic funder spends $50,000 to obtain a for-profit investment. In my scenario, the funder spends on one-tenth of that, $5000. The social enterprise sees the same investment amount of $100,000. And the for-profit investor is now arguably on the hook for the entire clinic.
My scenario has several problems. First, the philanthropic funders have legal, political and personal considerations when making their investments. The country’s legal regime may not allow them to give money directly to for-profit investors. (For example, I do not think that Citi Foundation can simply give money to Citigroup to increase their return in microfinance investments.) The political regime may also look down on this transfer of money. Finally, philanthropies may have trouble raising money from donors if their money goes into the pockets of “other donors” – that is, rich investors.
Despite all that, the funder accomplishes more with less in my example, and has money left over to fund additional clinics.
3. Social impact bonds resemble infrastructure projects.
Social impact bonds. Another innovation, the social impact bond, deserves special notice for its ability to help governments fund infrastructure and services, especially as public budgets are cut and municipal bond markets are stressed. Launched in the UK in 2010, this type of bond is sold to private investors who are paid a return only if the public project succeeds—if, say, a rehabilitation program lowers the rate of recidivism among newly released prisoners
I love that the authors mention infrastructure here. Social impact bonds act very similar to governments’ current infrastructure projects, where the government temporarily leases assets to private companies in return for a performance-based return on the infrastructure that those companies create. I will write more on this similarly – and on what infrastructure contracts can teach us about social impact bonds – in a later post.
Source:
Harvard Business Review
A New Approach to Funding Social Enterprises
by Antony Bugg-Levine, Bruce Kogut, and Nalin Kulatilaka
Michael Belinsky 