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Understanding and managing risk with social investment

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There are different types of risks and opportunities for voluntary organisations in relation to loan-based finance. Risk can never be entirely eliminated, but can and should be actively managed and reduced. Sustainable funding is not just about raising funds but also about good governance – monitoringrisk managementfinancial and strategic planning, and skilled operational management – which can all reduce risks associated with managing an organisation.

How is the funding mechanism matched to the charity’s needs?

The diagram shows two axes, with the vertical axis labelled ‘High chance of repayment’ at the top, and ‘Low chance of repayment’. Along the vertical axes, from top to bottom, are additional labels as follows: Secured loan (at the top), standby facility, overdraft, unsecured loan, patient capital, quasi-equity, equity, grant (at the bottom).The horizontal axis is labelled ‘Low risk’ on the left, and ‘High risk’ on the right. Additional labels run along the horizontal axis: ‘Property/asset purchase (mortgage)’ (on the extreme left); ‘Working capital’ (in the centre); ‘Growth capital’ (on the extreme right).A shaded ellipse runs from the top left hand corner of the diagram to the bottom right hand corner with its centre crossing the horizontal axis. A dotted diagonal line runs along the centre of the ellipse, from the top left to the bottom right. There are short lines with an arrow at each end, at three points in the ellipse: at the top left, at the centre, and at the bottom right.

Copyright CAF Venturesome.

The diagram above illustrates how different investment mechanisms can provide capital appropriate to its use and risk profile, with the shaded area representing the zone of appropriate funding. Therefore, if an organisation intends to buy a property, this is lower risk both for the organisation and the investor because the financial instrument used will be a loan secured against the property. There are mainstream banks willing to lend for this purpose.

On the other end of the spectrum, a voluntary organisation may want to execute a growth strategy to expand its services and reach more beneficiaries. Even though this will increase its social impact and potentially earn more income, there is more risk attached due to the strategy’s uncertainty. However, a good management team, backed by a comprehensive business plan will help reduce these risks.

The supply of this higher risk capital for development and early-stage capital remains relatively scarce, but there are now more suppliers of such capital. For example, CAF Venturesome will take a high financial risk on an organisation that has the potential for high social impact and retains a skilled management team.

Each type of finance will have its own associated risk. Therefore, organisations should choose the right financial instrument appropriate for the intended funding need. For example, property purchases should be financed by a mortgage, while high risk, high impact growth should be funded by grants or equity-like instruments rather than secured loans.

The most common types of risk to be aware of

Excessive risk-taking

Some organisations may take on more debt than they can manage due to over-optimistic financial assumptions and models. This could have serious consequences as financial milestones may not be achievable, so that servicing the debt is more difficult than initially thought. Therefore, the management team should take a prudent view of future income projections, as these will be affected by internal and external shocks. In addition, the fundamental assumptions that projections are based on should be reviewed regularly as it will affect the outputs of the model.

An investor will also check these assumptions through the due diligence process, and advise the organisation on the most realistic models. This will help a voluntary organisation evaluate its own business plan and recognise any shortcomings or errors. This process will also help a voluntary organisation match its financial need to the appropriate financial product to reduce further risk.

If loan-based finance is not a suitable option, the organisation should consider grants, but this is becoming more challenging in the current economic climate. However, an investor will usually be able to advise a voluntary organisation about other providers and options.

Risk aversion

Lack of financial understanding and a short-term focus can lead to organisations being excessively risk averse. To ensure that a voluntary organisation does not become so risk averse that it damages its social objectives, both management teams and trustees should ensure they are thinking beyond traditional funding sources such as grants. Consultants such as CAF,NCVO, CAN and UnLtd are able to provide training and advice on the best approach to this. Talking to investors can also help highlight the benefits of external financing and the opportunities it may enable.

Social impact risk

For social investors, social impact is a significant part of the due diligence process and continuous assessment. Therefore, there will be pressure from investors to ensure that social impact is clearly articulated and evidenced.

Social impact risk is defined as the probability of achieving, or not achieving, a specified social outcome. As social impact is integral to a voluntary organisation’s mission, reduction of social impact is a serious risk. Growth or transition may lead to ‘mission drift’ where a voluntary organisation deviates from its social mission to become more profitable. However, adherence to the social mission should be monitored by the trustees and a good governance structure will make this easier. This ‘drift’ can also occur if an organisation is unresponsive to a changing external environment. This can reduce an organisation’s ability to serve the community it works in, thereby reducing its social impact and efficacy.

Five key steps to managing risk

  • Good strategic planning . To take on investment finance responsibly, organisations must have a robust and achievable strategic plan, and a management team with strong planning and financial management skills.
  • An engaged board . The board is ultimately liable for any default, so their input into decisions about external finance is vital.
  • Good communication between borrower and lender at all stages of a lending arrangement will ensure that the lender is kept up-to-date on the direction of the organisation, and any difficulties are picked up and resolved early. It is in the interest all parties for the borrower to succeed and deliver the agreed social impact through the investment, so lenders would rather help than be kept in the dark.
  • Willingness to seek advice from organisations or consultants that are experts in investment readiness and strategic planning.
  • Diversification of funding sources . A diverse range of income sources will assist a voluntary organisation to remain financially sustainable as this prevents an over-reliance on just one source of finance.
Page last edited Oct 22, 2015

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