The financial crisis of 2008 seriously tarnished the public's confidence in financial innovation overall. The idea that instruments like collateralized debt obligations and credit default swaps are accelerators of growth suddenly looked improbable, if not false, as the fall of markets dried down credit across the system. Indeed, many people now define those devices as weapons of mass devastation.
It's easy to overlook that society has benefited from the same instruments both practically and fundamentally. Millions of individuals would not be able to afford homeownership even while the dust from the real estate crash hangs about if banks could not pool mortgages and sell collateralized bonds against those pools. Debt pooling has not just helped middle class citizens of industrialized countries. Serving more than 90 million borrowers in some of the poorest nations worldwide, microfinance now boasts a $65 billion business. The capacity of investment banks to pool the microloans of multiple lenders and issue collateralized debt obligations against them in the international financial markets, therefore releasing the capital of those lenders and enabling them to make new microloans, hastened its expansion.
The next pages will show how financial engineering might enable the channeling of money from the financial markets to companies committed to social goals—organizations known as social entrepreneurs, which have historically looked to charity for much of their funding. By means of appropriate financial innovations, these businesses may access a far larger pool of finance than was formerly possible, therefore enabling them to significantly increase their social impact.
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Blended Returns' Businesses
Social entrepreneurs are innovative, entrepreneurial businesses meant to tackle issues. They comprise for-profit and nonprofit businesses whose returns combine financial profits with social impact. Though they exist in numerous flavors, their basic concern is whether they can attract enough investment and create enough income to pay for their expenses and increase their operations.
Some social entrepreneurs can make a profit strong enough to attract investor funding for their firm. They may provide goods and services to consumers ready to pay more for a socially conscious product—green energy, organic food, instance. While still offering that service more reasonably than other providers, they may sell a basic good to underprivileged consumers at a reasonable profit. But many, if not most, social entrepreneurs cannot finance themselves totally from sales or investment. Their profitability is insufficient to reach conventional financial markets, so there is a financial-social return gap. Although giving underprivileged individuals reasonably priced health care, basic meals, or safe cleaning supplies has great social benefit, the expense of private support usually exceeds the financial return. Many social entrepreneurs live only by the generosity of government subsidies, charity foundations, and a small number of high-net-worth people who would donate money or accept reduced financial returns on their investments in social initiatives. The capacity of such businesses to offer their goods and services depends on the availability of funds from these sources; hence, their fundraising activities occupy time and energy that could be used for their social objectives.
The New Balance Sheading of Social Enterprise
Imagine that a social business running in Africa needs an investment of $100,000 to establish new health clinics and expects the clinics to generate $5,000 a year—a return of 5%. This helps one to understand how the process works.
Sadly, 5% is too low to draw private investment. Usually, the company would get the $100,000 from a philanthropic foundation rather. Imagine, though, if the company requested the contributor just $50,000. It may then provide a 10% return on the remaining $50,000 to a financial investor. The donor would have $50,000 to donate to another socially deserving business, but she would not be repaid.
A charity gift is like an investment, much as debt and equity are. The return on the contribution is not financial, though. The donor expects their money to provide a social benefit; it does not want to have it returned. It regards a failure in investment only if that social benefit is not generated. And the social company gains value and lowers risk for traditional investors when a donor-investor ready to cover half the cost is involved. The conventional paradigm of social entrepreneurship leaves this value off the table. Investors hardly engage at all and donors lose out as they totally fund a project that may have drawn investment money.
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Debt with quasi-equity.?
Some companies have created financial vehicles combining debt and equity characteristics. Businesses legally registered as charities and hence unable to get equity finance will find a quasi-equity debt security very helpful. Although it is officially a type of debt, this kind of security has a significant quality of an equity investment: Its returns follow the financial situation of the company. Although the security holder does not have a direct claim on the governance and ownership of the company, the loan terms and conditions are meticulously crafted to provide management incentives to run the company effectively. Purchasing these securities, which serve as equity, social investors enable social entrepreneurs to present banks and other profit-seeking lenders with a competitive investment possibility.
Aggregation.
Because the pooling institution may customize its obligations to the demands of various types of investors, techniques involving pooling money have also opened new financial opportunities to social entrepreneurs. For example, BlueOrchard, a social capital investor with headquarters in Switzerland, compiles portfolios from many microlenders and arranges three tranches. BlueOrchard's equity makes up the bottom tranche; it takes first loss but promises great profits. Though less expected, the following tranche carries less danger. Like a convertible bond, it suffers the second loss following the wipe-out of equity. Purchased by traditional debt investors, the top tranche provides a low but somewhat secure return. Globally, the pooling approach has been adopted by innovators like IFMR Trust, in Chennai, who securitize microfinance loan portfolios in which they maintain an investment portion under structured finance guidelines.
Bonds having social significance.
Given public budgets are being reduced and municipal bond markets are under pressure, another innovation—the social impact bond—deserves particular attention for its capacity to help governments fund infrastructure and services. Introduced in the UK in 2010, this kind of bond is sold to private investors paid a return only should the public initiative be successful—that instance, should a rehabilitation program reduce the recidivism rate among recently released inmates? It lets private investors pursue profits by carefully weighing risks, therefore performing what they do best. For its part, the government retains any extra savings and pays a set return to investors for confirmed outcomes. This mechanism has the power to change political debates over extending social services as it moves the risk of program failure from taxpayers to investors. National and local governments are creating pilot bonds from the United States to Australia to finance programs aimed at homelessness, early childhood education, and other concerns. This strategy may even be used by the United States to assist its finance-starved space program—for example, creating "space bonds" that would pay a return only should a manned mission reach Mars on time and within budget.