ANTONY BUGG, BRUCE KOGUT, NALIN KULATILAKA | HARVARD BUSINESS REVIEW

SOCIAL ENTERPRISE’S NEW BALANCE SHEET: 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 percent on the investment.

Unfortunately, 5 percent 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 percent 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.

You can think of a charitable donation as an investment, just as debt and equity are investments. The difference is that the return on the donation is not financial. The donor does not expect to get its money back; it expects its money to generate a social benefit.

It considers the investment a failure only if that social benefit is not created. And with a donor-investor willing to subsidize half the cost, the social enterprise becomes valuable and less risky to conventional investors. The traditional model of social enterprise leaves this value on the table. Donors lose out because they fully subsidize a project that could have attracted investment capital, and investors do not participate at all.

What we’ve just described is, of course, analogous to the way conventional companies are financed. By raising a portion of the capital it needs from equity investors, a risky business can then borrow money from debt investors who seek predictable returns.

In the emerging model of social enterprise capital markets, donors play the role of equity holders, providing capital that supports an enterprise and that makes the debt taken on by financial investors safer, with better expected returns. Let’s look at the tools that are taking social enterprises in this direction.

INNOVATION IN PRACTICE: Some of the more forward-thinking foundations and social investors have realized that the current methods of financing social enterprises are inefficient, for the enterprises and themselves, and have started working to broaden the access to capital. Here are some of the mechanisms they’re employing.

LOAN GUARANTEES: The Bill & Melinda Gates Foundation now issues loan guarantees, rather than direct funds, to some of the enterprises it supports, recognizing that this is an efficient way to leverage its donations and provide organizations with more-certain funding. Its first guarantee allowed a charter school in Houston to raise $67 million in commercial debt at a low rate, saving the school (and its donors) almost $10 million in interest payments.

QUASI-EQUITY DEBT: Some organizations have developed financial vehicles that combine the properties of equity and debt. A quasi-equity debt security is particularly useful for enterprises that are legally structured as nonprofits and therefore cannot obtain equity capital. Such a security is technically a form of debt, but it has an important characteristic of an equity investment: Its returns are indexed to the organization’s financial performance. The security holder does not have a direct claim on the governance and ownership of the enterprise, but the terms and conditions of the loan are carefully designed to give management incentives to operate the organization efficiently. Social investors purchase these securities, which perform the function of equity and make it possible for social enterprises to offer banks and other profit-seeking lenders a competitive investment opportunity.

Consider the Bridges Social Entrepreneurs Fund, one of several social funds of the UK investment company Bridges Ventures. The fund has some 12 million pounds to invest in social enterprises. Recently it committed 1 million pounds to a social loan to HCT, a company that uses surpluses from its commercial London buses, school buses, and Park & Ride services to provide community transportation for people unable to use conventional public transportation. This social loan has a quasi-equity feature: The fund takes a percentage of revenues, thereby sharing some of the business risk and gains.

Because the loan is tied to the top revenue line, it provides HCT with strong incentives to manage the business efficiently.

Covenants on such loans are often added to avoid mission drift from the social goals.

To be continued