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Community Development Finance Association Research Report

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MIND THE ^^^ GAP EVIDENCING DEMAND FOR COMMUNITY FINANCE

Dr Nick Henry & Philip Craig, ICF GHK

FULL REPORT January 2013

Supported by

Community Development Finance Association Research Report

Mind the Finance Gap Evidencing demand for community finance

Dr Nick Henry & Philip Craig ICF GFH

FULL REPORT January 2013

This report and the summary report are available on our website at: www.cdfa.org.uk/mindthefinancegap

Any enquiries regarding this report, contact: Ian Best, Policy & Research Manager, CDFA [email protected]

Views expressed in this report are not necessarily those of the Community Development Finance Association or RBS Group.

Research and report by ICF GHK, conducted on behalf of the CDFA and made possible though the support of RBS Group.

The Community Development Finance Association represents non- profit social enterprises known as Community Development Finance Institutions (CDFIs). CDFIs provide loans to those unable to access finance from mainstream financial institutions such as banks. CDFA’s mission is to support the development of a thriving and sustainable CDFI sector that provides finance for disadvantaged and underserved communities and, as a consequence, contribute to the increasing prosperity of these communities. www.cdfa.org.uk

In 2012, GHK Consulting became ICF GHK, a wholly owned subsidiary of ICF International. A multi-disciplinary public policy research and evaluation consultancy of around two hundred staff, we are one of Europe’s leading providers of impact assessments and ex ante, mid- term, final and ex post evaluation services to central Government departments, the European Commission and national, local and civil society organisations. Research and analytical services are offered across the full range of economic, social and environmental policy fields. www.ghkint.com

The Royal Bank of Scotland Group supports businesses of all shapes and sizes, in every sector of the economy. We’re committed to promoting economic growth and to fostering the right conditions for people’s business ideas to flourish. In addition, we focus efforts on three groups that we believe, with further support, could play a stronger role in the entrepreneurial economy: young people, women and social entrepreneurs. We call this RBS Inspiring Enterprise. Through Inspiring Social Enterprise we will support 2,500 social enterprises, working in partnership with the sector to improve access to expertise, markets and finance by the end of 2015. www.rbs.com/inspiringenterprise

Acknowledgements

The CDFA wish to thank RBS Group, as part of RBS Inspiring Enterprise, for funding this research.

Mind the Finance Gap

Contents

Foreword ...... 7 Executive summary ...... 8 1 Introducing community finance ...... 9 1.1 What is community finance? ...... 9 1.2 The community finance ecosystem...... 9 1.3 The Evidence Review: aims, method and report structure ...... 12 2 Community finance for businesses ...... 13 2.1 The underserved market of business lending: start-ups, micros, SMEs and disadvantaged communities, and access to finance ...... 13 2.2 Market failures in SME access to finance ...... 15 2.3 CDFIS as intermediaries: bringing demand and supply together ...... 16 2.4 Other enterprise lenders and sources of external finance ...... 22 2.5 Investors ...... 28 2.6 Market developments ...... 30 2.7 Community Finance and Enterprise Lending: Demand, Supply, and Barriers ...... 33 3 Community finance for civil society ...... 34 3.1 The underserved market of civil society: social entrepreneurship, social ventures, the voluntary and community sector, and access to investment ...... 34 3.2 Market failures in Civil Society access to finance ...... 35 3.3 CDFIs as intermediaries: bringing demand and supply together ...... 37 3.4 Other civil society lenders and sources of external finance ...... 39 3.5 Investors ...... 44 3.6 Market developments ...... 45 3.7 Community Finance and Civil Society: Demand, Supply and Barriers ...... 47 4 Community finance for individuals ...... 48 4.1 The underserved market of personal lending: financial exclusion and lack of access to affordable credit ...... 48 4.2 Specific market failures ...... 48 4.3 Credit Unions and CDFIs as intermediaries: bringing demand and supply together ...... 49 4.4 Alternative funding paths: the high-cost credit market ...... 52 4.5 Investors ...... 54 4.6 Market developments ...... 55 4.7 Community Finance and Personal Lending: Demand, Supply and Barriers ...... 56 5 Community finance for homeowners ...... 57 5.1 The underserved market of homeowner finance: meeting the cost of maintaining, repairing and adapting homes to changing circumstances ...... 57 5.2 Specific market failures ...... 58 5.3 CDFIs as intermediaries: bringing demand and supply together ...... 58 5.4 Alternative funding paths driving market development ...... 59 5.5 Investors ...... 61 5.6 Market developments ...... 61 5.7 Community Finance and Homeowners: Demand, Supply and Barriers ...... 62 6 Key Findings ...... 64 6.1 The supply of community finance ...... 64 6.2 Demand for community finance ...... 64 6.3 Opportunities and challenges ...... 64 6.4 Summary conclusion ...... 65

Annex 1 Bibliography 67 Annex 2 CDFI funding (2010-2011) 69 Annex 3 Recent national access to finance schemes 72 Annex 4 Access to finance schemes and applicability to social enterprises 73

Table of Tables Table 2.1 Economic impact of CDFI enterprise lending ...... 20 Table 2.2 Cross section of crowdfunding platforms ...... 26 Table 2.3 Summary of the leading equity-based crowdfunding platforms ...... 28 Table 2.4 Sources of revenue access – CDFIs and business lending...... 30 Table 2.5 Type of product, market and capital available ...... 31 Table 3.1 Types of financing instruments ...... 38 Table 3.2 Impact of CDFIs – civil society ...... 39 Table 4.1 Cost comparison of a £300 loan ...... 50 Table 4.2 The consumer market for credit – current met demand ...... 51

Table of Figures Figure 1.1 The community finance ecosystem ...... 11 Figure 2.1 Share of enterprises and their associated employment and turnover, UK 2011 ...... 13 Figure 2.2 Stages of SME development and financing options ...... 14 Figure 2.3 CDFI numbers over time ...... 17 Figure 2.4 Total business loans disbursed by value (£m) and number, 2004-2011 ...... 18 Figure 2.5 Business loans disbursed by value to SMEs and Microenterprises (£m) ...... 18 Figure 2.6 Business loans disbursed by number to SMEs and Microenterprises ...... 19 Figure 2.7 Business customer socio demographics 2010-11 ...... 19 Figure 2.8 Security taken on business loans disbursed (2010-11) ...... 20 Figure 2.9 The funds paid out to equity based crowd-funds in 2011, based on 10 platforms ...... 28 Figure 3.1 Proportion of CDFIs serving civil society (2010-11) ...... 37 Figure 3.2 Civil society loans disbursed by number and value (2004-11) ...... 38 Figure 3.3 Social investment timeline ...... 40 Figure 3.4 Functions of intermediaries (* excludes CDFIs) ...... 40 Figure 3.5 Sources of finance (social enterprises) ...... 45 Figure 4.1 Personal lending disbursed by number and value (2004-11) ...... 52 Figure 4.2 Breakdown of the £7.5 billion the high-cost credit market ...... 53

Foreword The past decade has seen huge strides in building the UK’s community finance sector to better meet the needs of financially underserved households, businesses and social enterprises. That we are where we are is a tribute to the many that have shown vision, courage and commitment to establishing a new type of financial service – the community finance provider. Banks – and the RBS Group in particular – have played a vital role in this journey through offering the capital and development support necessary to kick start the whole venture.

Yet we’ve known for some time that, whilst the services our CDFI members offer is a lifeline to the 33,000 customers they serve annually, it remains the tip of the iceberg in meeting the full need of the UK’s financially underserved. We’ve known that there’s a gap – a gap in capacity, skills, understanding and of course availability of capital. But we’ve not known the extent of this gap, particularly in terms of the capital shortfall – until now.

With the welcome support offered by the RBS Group, Mind the Finance Gap pioneers a whole new approach to developing the sector, through providing precisely the evidence we need to engage key partners in the banking, public and independent sectors, in scaling the sector as a corner stone to the financial services industry. Then and only then can we begin to replicate the genuinely collaborative approach we’ve developed with the RBS Group, to better meet the needs of those eight million underserved clients and ensure a fully inclusive financial services industry.

Ben Hughes Chief Executive CDFA

Mind the Finance Gap

Executive summary Access to finance, credit and financial services by businesses and households remains a key requisite for full participation in today’s economy and society. In 2011, the big banks made £75 billion of loans to small and medium enterprises. Between September 2011 and August 2012 banks and building societies combined provided £7 billion of overdrafts and loans and £137 billion of credit card lending to individuals. For those businesses, organisations, individuals and homeowners that cannot access mainstream finance such as that described above, Community Finance is an alternative option. Community finance describes the provision of affordable financial services and other support to businesses, civil society organisations, individuals and homeowners unable to secure mainstream finance. The Community Development Finance Association (CDFA), with the support of the Royal Bank of Scotland Group, commissioned ICF GHK to undertake a review of the state-of-play in community finance. A rough estimate of current potential annual demand for community finance is in the order of £5.45 to 6.75 billion (excluding the Green Deal), comprised of four major underserved markets:

■ Businesses and entrepreneurs (especially in disadvantaged communities) unable to secure finance from mainstream commercial institutions;

■ Civil society organisations (CSOs) such as not for profit businesses (social enterprises), charities, community and voluntary organisations, and mutuals that place a strong emphasis on social, environmental and stakeholder as well as financial objectives;

■ Individuals unable to access short-term, low value credit and other financial services who must deal with sometimes abrupt fluctuations in income; and,

■ Homeowners who are unable to access a loan from a commercial lender to carry out essential repairs and improvements to their property. In contrast, in 2012, community finance organisations delivered an estimated £0.7 billion of community finance to UK businesses, civil society organisations, individuals and homeowners. Community finance investments generate a wide range of economic and social benefits (especially within the most disadvantaged and excluded communities of the UK) - and which meet a wide range of Government policy objectives. Community finance organisations, if capitalised to do so, have the potential to generate sustainable economic development and social well being at the heart of UK communities. Currently, the majority of potential economic and social benefits are being lost to UK economy and society. The current community finance infrastructure is, however: largely unknown by its target markets; patchy in geographical and community coverage; of limited capacity; and struggling to achieve sustainability. New developments, innovations and entrants are evident as the underserved markets of community finance expand – but as yet these offer a still limited set of solutions to the long run and deep seated market failures in finance markets which community finance seeks to overcome. Whilst the economic and social outcomes achieved through community finance remain central to the objectives of Government, Government alone cannot (and does not desire to meet) the demand for community finance. Such demands can only be met through a tripartite partnership between public, private and social investors. The challenge to this partnership remains to embed community finance as a sustainable part of the UK’s financial landscape – and the pipeline for tomorrow’s mainstream finance customers.

8 Evidencing demand for community finance

1. Introducing community finance In autumn 2012, the Community Development Finance Association (CDFA) commissioned ICF GHK to undertake a review of the state-of-play in community finance. This evidence review is the first output of the project, defining the scope of the community finance sector, its key themes and issues.

1.1. What is community finance? In 2011, the big banks made £75 billion of loans to small and medium enterprises. Between September 2011 and August 2012 banks and building societies combined provided £7 billion of overdrafts and loans and £137 billion of credit card lending to individuals1. For those businesses, organisations, individuals and homeowners that cannot access mainstream finance such as that described above, Community Finance is an alternative option. "Community finance describes how affordable financial services and other support are made available to businesses, civil society organisations and individuals and homeowners. In the publication Just Finance the CDFA defines community finance as2: Loans and credit charged at a non-exploitative rate accessible by underserved markets unable to secure mainstream finance, delivering both social and economic benefits. The CDFA has an organisational membership – Community Development Finance Institutions (CDFIs) - that sit at the heart of community finance and provide loans and credit to the following underserved markets:

■ Businesses and entrepreneurs (especially in disadvantaged communities) unable to secure finance from mainstream commercial institutions;

■ Individuals unable to access short-term, low value credit and other financial services who must deal with sometimes abrupt fluctuations in income; and,

■ Homeowners who are unable to access a loan from a commercial lender to carry out essential repairs and improvements to their property. Through provision of their services, CDFIs and other community finance intermediaries deliver both economic and social benefits in the form of new and growing businesses, employment, community and environmental services and financial services. These benefits would be foregone to society otherwise.

1.2. The community finance ecosystem 0 below provides an overview of the community finance sector and a simple illustration of how finance is deployed. In summary, the machinery of the sector includes:

■ (A) Investors: An expanding range of public and private investors exist who are seeking to meet economic, social and environmental objectives. The investor landscape is characterised by great variety in motivation, the target sector (business, community, individuals and homeowners), the desired ‘blend’ of return (social, economic and financial) and investment type. Key investors have been Government, institutions and foundations and individuals. A major development is the emergence and growth of ‘social investment’ – a financial transaction intended to both achieve social objectives and deliver financial returns - and whose core principle is the application of market mechanisms (not grant) to fund and incentivise the delivery of social value3.

1 See http://www.bankofengland.co.uk/statistics/Pages/bankstats/current/default.aspx accessed January 8, 2013 2 CDFA (2012), Just Finance: Capitalising Communities, Strengthening Local Economies, page 3 3 Cabinet Office (2011), Growing the Social Investment Market, p.21-29

9 Mind the Finance Gap

■ (B) Intermediaries: An increasing number and range of intermediaries have emerged to connect investors and investment with investees, target businesses and communities. Examples include CDFIs, credit unions, charities and social banks. Intermediaries bring together the resources (finance, skills, spaces, systems, market engagement, etc.) to ‘do deals and provide services’. A key challenge has been building the capability and capacity of intermediaries in the face of expanding demand and market complexity4.

■ (C1) Enterprises: Start-ups, micros and small and medium sized businesses (SMEs) that cover all sectors of the economy and are unable to access mainstream finance at certain points in their life stage. Alongside traditional profit-based businesses, this business demographic includes a growing number of ‘social ventures’ (for example, social enterprises, mutuals, charities, Community Interest Companies, etc). Such businesses are expected to be viable but can often lack investment readiness.

■ (C2) Civil Society Organisations: Civil society operates in a space not occupied by government or for‐profit business and includes two traditions – ‘one of mutual self interest, where people come together to meet their own needs, and another of charity where individuals and organisations are directly responding to social needs’5. Its organisational form includes formal and informal associations such as voluntary and community organisations, charities, social enterprises and social firms. Many of these organisations also fall within the definition of SME and face many of the same barriers accessing mainstream finance.

■ (C3) Individuals: A small but significant minority of the population cannot access even the simplest financial services, meaning that they pay more to manage their money, find it harder to plan for the future and cope with financial pressures, and are more vulnerable to financial distress and over-indebtedness. Unexpected financial pressures mean they have to borrow, are treated as high-risk borrowers, and pay a very high price for credit. Many also lack access to suitable financial products and tend to make expensive decisions to go with home credit or payday lending; or fall in with illegal lenders.

■ (C4) Homeowners: Homeowners on low incomes with limited savings who are unable to meet the cost of remedial action or maintaining, repairing and adapting their home to changing circumstances as they are unable to obtain a loan from a mortgage lender, bank, building society and do not qualify for a grant.

■ (D) Market Infrastructure: A well-functioning market relies on appropriate infrastructure (for example, specialist investment / risk management skills, industry organisations, associations and education, standard metrics / benchmarks / ratings, trading mechanisms, routes to market, etc). As social returns do not attract capital in the same way as financial returns, Government has deemed it necessary to create a system to support community investment6.

4 NESTA (2011), Understanding the demand for and supply of social finance, p.6-8 5 Buonfino, A and Mulgan, G. (2009) Civility Lost and Found, p.16 6 Sir Ronald Cohen (2012), Speech at the Bridges Ventures: Ten Years On event

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Figure 1.1 The community finance ecosystem

Debt & (D) Market Infrastructure (A) Investors return (C1) Debt / equity Businesses Returns Institutional Equity & assistance In-kind investors Support Debt / equity Returns Equity & assistance (C2) Civil

Individual Society investors Debt & Organisations Trading (banks, return Income investment houses, etc.) (B) Intermediaries

Government Counselling and Government / Big Society advice Contracts Capital (C3) Individuals Debt & Debt / equity return Returns Support Grant Grants & makers / Counselling and Donations donors advice Help with running costs (C4) Homeowners Debt, equity release & return

Source: ICF GHK

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1.3. The Evidence Review: aims, method and report structure The CDFA is seeking to develop a strong, robust understanding and evidence base of the current state and scale of the community finance sector, its impact and the sector’s potential over the medium term future – including estimation of potential demand. The following evidence review has sought to comprehensively document the ‘state of play’ in the community finance market. It includes reports and studies about the community finance sector from the United Kingdom and more widely. It has drawn on published literature in books and journals, grey literature from non-governmental organisations, national government, think tanks and projects.

1.3.1. Structure of the Report The Report is structured against the most common community finance interventions currently operating in the UK – lending to business, social ventures, wider civil society, individuals and homeowners. In the process we identify the different approaches and new business models being established to raise investment for community finance and the barriers to current provision and future growth. We conclude by drawing together indicative policy implications. This Report continues in the following sections:

■ Section 2 reviews the underserved market of enterprise lending;

■ Section 3 reviews the underserved market of civil society;

■ Section 4 reviews the underserved market of individuals;

■ Section 5 reviews the underserved market of homeowners; and,

■ Section 6 draws together conclusions on the state of play in community finance, including demand, supply and barriers to further market development. The main report is supplemented by Annexes which contain a bibliography and supporting information on CDFI funding, alternative finance schemes and their applicability to social enterprises.

12 Evidencing demand for community finance

2. Community finance for businesses

New entrants and new methods suggest greater market provision for viable but unbankable businesses. The question remains as to whether such provision extends beyond new SME entrants into the underserved market whilst ‘traditional’ micro finance providers continue to face issues of sustainability.

2.1. The underserved market of business lending: start-ups, micros, SMEs and disadvantaged communities, and access to finance The UK business stock is dominated by around 4.5 million SMEs, 99.9% of all businesses. Of these 95.4% are micro businesses employing fewer than ten employees7. These businesses cover all sectors, with their owners coming from a full diversity of background. SMEs also have a broad typology with vast differences between the smallest owner-managed firms to much larger and more complex medium sized firms that employ hundreds of people with turnover in the tens of millions. SMEs make a significant contribution to job creation and economic growth (see 0). In 2011 they employed almost 14 million people (58.8% of jobs in the private sector) and they accounted for almost half of turnover (48.8% or just under £1,500 billion) in the UK private sector8. Between 1998 and 2010 existing small firms of fewer than 50 employees contributed 34% of the total jobs created in an average year9. Figure 2.1 Share of enterprises and their associated employment and turnover, UK 2011

100% 90% 80% 70% 60% 50% Number of enterprises 40% Employment 30% 20% Turnover 10% 0% Small (0-49 Medium (50- Large (250 plus employees) 249 employees) employees)

It should be noted, also, that the SME definition also encompasses social enterprises and many voluntary and charitable sector and mutualised organisations. The most recent estimate suggests 84,000 social enterprises, and which account for 7% of the UK’s SME business population10. Although often treated as a specialist arena within SME policy, the long-term objective of Government has been (and remains) to mainstream social enterprise activity in enterprise policy. Nevertheless, at the current time, social enterprise remains a distinctive strand in Government policy and financing and is incorporated more fully in the following Section 3 on civil society and community finance. Concerning entrepreneurship, on average around 400,000 businesses are created per year in England and Wales. The Global Entrepreneurship Monitor provides just one indicator of the internationally high levels of entrepreneurship in the UK11. Yet entrepreneurship rates vary

7 BIS (2011) Business Population Estimates for the UK and the Regions 8 BIS (2011), Business Population Estimates for the UK and the Regions, p.8 9 NESTA (2009), Measuring Business Growth 10 BIS (2011), Business Population Estimates for the UK and Regions, October 11 GEM (2012) GEM 2011 Global Report

13 Mind the Finance Gap

significantly across UK regions and social groups, with women and black ethnic groups notably under-represented.

2.1.1. SMEs and the issue of access to finance The ability of SMEs to access finance is important for funding business investment, ensuring businesses reach their growth potential and for facilitating new business start-ups. External finance – at various stages of development and through a range of financial products - is a key input for businesses and social enterprises, enabling them to sustain themselves and/or expand sustain through an uneven income cycle (see 0). Figure 2.2 Stages of SME development and financing options

Source: Adapted from European Investment Fund presentation, 2012

For the most part, demand for finance is met by commercially motivated investments made by banks and investment funds:

■ In 2011, mainstream banks made £75 billion of loans to SMEs and between September 2011 and August 2012 banks and building societies combined provided £7 billion of overdrafts and loans and £137 billion of credit card lending to individuals.

■ The amount outstanding of all loans (excluding overdrafts) from all financial institutions to UK businesses was estimated to be around £450 billion at end-May 2012 and, of this total, around 35% represented lending to SMEs12. Yet access to finance remains a key barrier to growth and as a result of the global financial crisis this problem has intensified with small businesses, particularly micro-enterprises and start- ups, increasingly struggling to secure credit13. For example, from its peak of £657 billion in December 2008 gross lending to the non-financial private sector had shrunk by £151 billion14, reaching £506

12 Bank of England (2012), Trends in lending, p 6 13 See BIS (2012) SME Access to External Finance, BIS Economics Paper, No 16 14 Bank of England Statistical Database, Table C, lending by industry „lending to non-financial corporations‟ (Data extracted on 12/03/12, actual figures i.e. non-seasonally adjusted) - sourced in Breedon (2012) Boosting Finance Options for Business

14 Evidencing demand for community finance

billion in December 2011. Recent data shows that 33% of SMEs applying for a bank loan were rejected and had no credit facility by the end of the application process15. This reinforces the longstanding evidence base for ‘stubborn’ market failures in the SME business lending market and a continued debt funding gap16. The Breedon Report, for example, predicts that by the end of 2016 ‘the finance gap to meet the working capital and growth needs of the UK non- financial business sector could be in the range of £84bn to £191bn’. Moreover, it recognises that the market failure/funding gap is especially acute at the start-up/SME micro-finance level and among certain entrepreneurial groups, with an estimated gap of between £26bn and £59bn related to smaller businesses17.

2.2. Market failures in SME access to finance BIS, in SME Access to External Finance18, sets out a number of market failures, both supply and demand, that restrict viable SMEs from accessing finance. On the supply side, difficulties exist for lenders in distinguishing between high and low risk entrepreneurs and being able to mitigate this. This information deficit (‘asymmetry’) leads lenders to often require borrowers to provide evidence of a financial track record or collateral (or both), which some commercially viable businesses (especially young start-up businesses) do not have. Recently, of those SMEs having difficulties raising finance, 20% gave insufficient security as the reason why their financial provider rejected them for finance and 2% cited insufficient track record19. It is in these circumstances also that, for example, certain entrepreneurial groups (such as of black ethnicity and/or migrants) are less likely to be able to provide the required collateral or track record leading to outcomes of under-represented groups in start-up and SME activity. Access to finance is more difficult amongst certain groups – and accentuated in disadvantaged communities - because of issues such as the limited amount of personal equity in those localities, more precarious local economies, the proportionally high cost of making small loans, and ‘cultural distance’ making banks seem unapproachable and uninterested (if local branches actually exist)20. Moreover, multiple causes of market failure can, then, interact and magnify the scale of the problem spatially in disadvantaged areas21. Overall, the recognised outcome is that of the ‘discouraged entrepreneur’ or the existence of certain groups who do not see entrepreneurship as ‘for them’. Structural changes in the banking industry, including the replacement of ‘relationship banking’ with standardised credit scoring techniques and the closure of local branches, are argued to have accentuated these market failures22. The market failure of information asymmetry is accentuated further in the case of equity finance – most often applied to high growth potential SMEs – where the transaction costs related to assessing a proposal are relatively inelastic to the size of investment. Transaction costs, therefore, are a higher proportion of the deal size for smaller investments leading to investor preference for larger and later-stage investments. Furthermore, whilst spillover effects such as innovation and knowledge transfer might occur from such investments these accrue to the economy at large rather than the private investor – and therefore do not form part of the investment calculation.

15 See www.sme-finance-monitor.co.uk 16 BIS (2012) SME Access to External Finance, BIS Economics Paper, No 16 17 Industry-led working group on alternative debt markets (2012), Boosting Finance Options for Business, p.16 18 BIS (2012) SME Access to External Finance, BIS Economics Paper, No 16 19 BIS (2011), Small Business Survey 20 See, for example, Bank of England (2000), Finance for Small Businesses in Deprived Communities, p. 5-12; Smallbone, D. et al. (2003), Access to Finance by Ethnic Minority Businesses in the UK, p.291-314; Enterprise for All Coalition (2006), Enterprise for All: progressing the agenda, p.4-5; Roper, S. et al. (2006), Exploring Gender Differentials in Access to Business Finance: An Econometric Analysis of Survey Data; SBS (2007) The Impact of Perceived Access to Finance Difficulties on the Demand for External Finance, CEEDR for Small Business Service. 21 HM Treasury (1999), Enterprise and Social Exclusion - National Strategy for Neighbourhood Renewal: Policy Action Team 3 22 See, for example, John Kay (2010) in The Future of Finance: The LSE Report, ch.8

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On the demand side, business owners can also lack knowledge of funding sources available or lack the skills to present themselves as investable opportunities to investors (for example, poorly specified business plans or demonstrating inadequate management skills) and which combine with problems on the supply-side. This problem is also likely to be more acute in certain more complex finance markets, such as equity. Indeed, this reflects a longer run related market failure in business support whereby too few SMEs access the external advice and guidance they need to improve business outcomes. This is partly as many businesses do not know how to price such advice and guidance correctly, which in turn inhibits the operation of private sector providers in a fully functioning market. Overall, then, strong theoretical and empirical evidence exists for long run market failures which lead to ‘commercially viable but unbankable’ businesses unable to access the finance they require.

2.2.1. Market failure in conditions of economic uncertainty These market failures may become exacerbated in uncertain economic conditions when lenders become more risk-averse. Post credit crunch and recession, increasing difficulties for SMEs accessing finance are explained in the following terms:

■ Banks are now more risk averse, both due to the credit crunch and because they are required to be by new financial services regulations;

■ The recession has increased the underlying credit riskiness of SMEs due to the decline in sales and greater uncertainty; and,

■ Although overall costs are lower there has been an increase in margins, particularly for smaller SMEs with less than £1m turnover23. Current empirical evidence also highlights that in such conditions the demand for external finance has also reduced as businesses pay off existing bank debt (deleverage) and slow down or put off investment plans in the light of economic uncertainty24.

2.3. CDFIS as intermediaries: bringing demand and supply together Given long run market failures in enterprise lending, a number of types of specialist intermediary have developed to service this underserved market and bring demand and supply together. The most substantial group of intermediaries are CDFIs, although there have been recent developments of other intermediary solutions such as business angels, crowdfunding and the entry of ‘high cost lenders’ such as Wonga.

2.3.1. Community Development Finance Institutions (CDFIs) and enterprise lending 2.3.1.1. Scope and scale CDFIs are a type of community finance organisation that lends and invests in entrepreneurs and SMEs in deprived communities and underserved markets unable to access mainstream finance25. CDFIs contribute to SME finance through the supply of capital and advisory services to customers that have been rejected by banks as being too risky or unprofitable. CDFIs operate responsibly – using relationship banking models to lend only to those considered capable of repaying the debt, often termed ‘viable but unbankable’. CDFIs are independent and self-regulated, and most are affiliated to the CDFA as a trade body. Although some CDFIs were established in the 1980s (often intertwined with local enterprise support agencies), many of the over 60 CDFIs currently operating in the UK were set up in the late 1990s and later, partly through financial and technical support from the government under the Phoenix Fund26.

23 BIS (2012), SME Access to External Finance, p. 11-12 24 BDRC Continental (2012), SME Finance Monitor Survey (September) 25 As community finance organisations, CDFIs are active in enterprise lending, civil society and personal lending markets. This section focuses on their enterprise lending activities – other lending activities are dealt with in turn in the remainder of the review. 26 See GHK (2004), Evaluation of Phoenix Fund and Freiss (2005) Evaluation of Phoenix Development Fund

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CDFI numbers have stabilised at somewhere between 60 and 70 during the last few years after a period of substantial growth over the last two decades (see 0)27. At least one CDFI exists within each of the Devolved Administrations and each of the English regions. Figure 2.3 CDFI numbers over time

Source: CDFA (2012) Inside Community Finance, p.10

In 2004, the sector lent around £12m (in the form of loans) to 1,300 businesses (see 0). Gradual growth in loan value was accelerated in 2009 when the sector was used as a flexible and responsive system to deliver enterprise lending in the face of the global financial crisis and the associated credit crunch in SME lending28. Since that annual peak of £33m lent, total enterprise lending has declined to £23m in 2012, although total number of loans made has remained at a high level of 1,500 businesses assisted.

27 CDFA (2012), Inside Community Finance 28 See GHK (2010), National Evaluation of Community Development Finance Institutions

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Figure 2.4 Total business loans disbursed by value (£m) and number, 2004-2011

35 1800 1600 30 1400 25 1200 20 1000

15 800 600

Value of loans (£m) of loans Value 10 400 Number of loans disbursed of loans Number 5 200 0 0 2004 2005 2006 2007 2008 2009 2010 2011

Business loans disbursed by value (2004-11) Business loans disbursed by number (2004-11) Source CDFA (2012), p21

Within the sector, enterprise lending is further delineated between micro-enterprises (under 10 employees) and SMEs. The number and value of loans to microenterprises have remained stable over time, with only slight variance from the average of 1,200 loans worth £11 million disbursed annually (see 0 and 0). In contrast, SME lending surged during the credit crunch in terms of loan values and numbers of loans and remains historically high at almost £10 million lent to over 250 SMEs. Figure 2.5 Business loans disbursed by value to SMEs and Microenterprises (£m)

£m 15

0 2004 2005 2006 2007 2008 2009 2010 2011

SME Micro

Source CDFA (2012), p21

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Figure 2.6 Business loans disbursed by number to SMEs and Microenterprises

1800 1600 1400 1200 1000 800 600 Number of loans Number 400 200 0 2004 2005 2006 2007 2008 2009 2010 2011

SME Micro

Source CDFA (2012), p21

In total, in 2011 the loan portfolio for CDFI enterprise lenders stood at £76m and over 5,600 loans. The nature of businesses and entrepreneurs who receive loans from CDFIs is significant also through their focus on serving disadvantaged areas and communities. CDFIs serve customers from entrepreneurial groups traditionally recognised as experiencing greater barriers to accessing finance on account of ethnicity, gender, age, creed, and other defining characteristics (see 0). Figure 2.7 Business customer socio demographics 2010-11

Women 25%

Unemployed 23%

On state benefits 20%

BAME 13%

Older people (>55) 8%

Young people (<25) 7%

Ex-offenders 3%

Disabled 2%

0% 5% 10% 15% 20% 25% 30%

Source: CDFA (2012), p.19

2.3.1.2. The CDFI enterprise loan product In serving the underserved market of start-ups, micro and SME businesses, CDFIs tend to lend smaller amounts than banks, at higher rates and requiring lower levels of security. In 2011, CDFIs reported an average loan size of £11,300 to microenterprises and £37,000 for SMEs. Across the whole market, loans reported ranged from £500 up to £92,000.

19 Mind the Finance Gap

The average annual percentage rate (APR) charged by CDFIs last year for loans to microenterprises was 14%, ranging from 0% to 33%. The average APR charged to SMEs is similar at 13%, but with a much smaller range of 9% to 18%. Security was not taken for 29% of loans in 2011 (see 0). Figure 2.8 Security taken on business loans disbursed (2010-11)

Other, 2% Debentures, 5% Charge over property/assets , 5%

Personal guarantee, 23% EFG, 14%

Directors guarantee, 22% No security, 29%

Source: CDFA (2012), p.25

Alongside loan capital, CDFIs may provide pre-loan business support and advisory services to customers as well as post-loan management. Using relationship banking models, it is argued that the greater risk of loan default compared to mainstream lending is managed down. In 2010-11, default rates for microenterprise stood at 8% and for SME lending at 5%. A total of 28% of the value of micro loans were in arrears and 15% of the value of SME loans29. CDFIs are also increasingly adapting their financing products to meet community needs for equity- like capital (just five equity investments were made in 2011 but of a value of £9.4 million, 5% of the total value of funds disbursed). 2.3.1.3. The impact of CDFI enterprise lending In 2010, the National Evaluation of CDFIs30 undertook a ‘snapshot’ assessment of the gross impacts generated by the sector’s outstanding enterprise loan portfolio of some 6,500 loans. It was calculated that:

■ Around 2,200 business had been created, and a further 1,650 safeguarded;

■ Around 13,800 jobs had been created, and a further 12,800 safeguarded;

■ Around £667m of turnover had been created, and a further £834m safeguarded; and,

■ Around £135m of GVA had been created, and a further £169m safeguarded. Moreover, 29% of these loans had been made within the most 20% deprived areas. 0 provides an update for CDFI enterprise lending made between 1st April 2010 and 31st March 2011 and shows the continued economic impacts of enterprise lending by the CDFI sector. Table 2.1 Economic impact of CDFI enterprise lending

Customer Size Impact Businesses 1,500 loans made totalling £23m 712 businesses created

29 CDFA (2012), Inside Community Finance, p.23 30 GHK (2010), National Evaluation of Community Development Finance Institutions

20 Evidencing demand for community finance

Customer Size Impact 637 businesses safeguarded 2,168 jobs created 3,535 jobs safeguarded £171m turnover created Plus £47m bank leverage

Source: CDFA (2012), p.10

2.3.1.4. The sustainability of CDFI enterprise lending Given the economic and social impacts of CDFIs, over the last decade policy makers have aimed to boost the coverage and capacity of CDFIs as a primary provider of credit for a subset of small business owners in underserved markets who lack the experience, collateral, or credit history to obtain financing from conventional banks. Underlying this substantial public sector support (from European Funds, UK and devolved Government, Regional Development Agencies and Local Authorities) has been growing expectation that individual CDFIs should seek to move to self-sustainability or that they should at least not rely on public subsidies, raising instead private philanthropic and yield-based investments. In their evaluation of the sector in 2010, GHK undertook an assessment of sector sustainability utilising income data from sector performance statistics. The analysis for 2006-07 to 2008-09 suggested that the sector had become slightly more sustainable over time, with the median level of operational sustainability increasing from 30% in 2006-07 to 39% in 2008-09, and the level of financial sustainability increasing from 22% to 24%. Nevertheless, it concluded that the CDFI sector was clearly still a long way from achieving operational sustainability, and even further from achieving financial sustainability. A number of drivers of sustainability for the sector were identified, including:

■ Increased scale of lending pot: providing greater portfolio income and facilitating larger (and more efficient) loans;

■ Improved partnership working: in particular, the referral of viable businesses contributing to policy targets by partners and, relatedly, the provision of pre- and post-loan business support by partners;

■ Increased staff efficiency: focus of effort and expenditure on loan activity, reducing other administrative activity and broader formal and informal business support to applicants and clients alike;

■ Improving portfolio performance: maximising income through loan fees and interest rates and, more fundamentally, reducing bad debt; and,

■ Reduction in very small loans: The cost of delivering very small loans and collecting interest and principal often exceeds the amount earned - a move away from such loans will increase CDFI sustainability. Nevertheless, the national evaluation was clear in pointing out that inherent within the drivers of sustainability are clear trade-offs between pursuing sustainability and securing ‘depth of reach’ within underserved markets (and against policy targets); for example, larger loans, lower risk clients, higher rates of interest and minimal business support all improve CDFI sustainability but shrink the breadth of the underserved market covered (and are likely to reduce policy impacts sought by Government). Since the national evaluation the sector has seen substantial change in its landscape, including the continued effects of the global financial crisis, recession and austerity, and the abolition of some of its major funders (Regional Development Agencies). There is, however, ongoing evidence that the sector as a whole is slowly becoming more sustainable. In 2011, 20% of CDFIs covered their costs through earned income, and 40% were sustainable when

21 Mind the Finance Gap

grant funding was also considered. The remaining 40% were unable to cover their costs using income streams and had to rely on reserves and other assets31. In 2011, 35 enterprise lending CDFIs reported holding £58m in capital to on-lend (£1.7m average). The majority held less than £0.5m and three reported that capital for lending was completely depleted32. Almost £8m of this capital had been raised in the previous year, including £2m from private banks. In 2012, the CDFA Regional Growth Fund launched which will provide up to £60m of funding over 5 years to the sector, 50% of which will be commercial lending.

2.4. Other enterprise lenders and sources of external finance Alongside CDFIs, there exist a range of other potential sources of external finance for the underserved markets of enterprise lending. These include:

■ Equity based finance through Business Angels and Venture Capital: a small minority (around 1- 2%) of SMEs, notably early stage businesses with the highest potential for growth, also access equity finance through business angels, high net-worth individual investors that invest their own money in growing businesses and venture capitalists who mainly invest other peoples’ money through established funds33. This finance often acts as a catalyst in developing and commercialising emerging technology and shortening product development cycles. It has also stimulated research that supplements research in university, government or corporate R&D departments34.

■ Short term loan provision: Especially during a recession or credit crunch, the share of short-term loans could be expected to increase relative to long-term or investment loans, because short- term borrowing is needed to solve cash flow problems and the ready availability of cheap debt is curtailed. Small businesses are, then, more willing to use other external sources of finance such as: factoring, invoice discounting, supply chain finance and, most recently, new specialist short term loan providers (for example, one major payday lender, Wonga, recently launched a service providing credit for small businesses); and,

■ Crowdfunding (especially peer to peer lending): A new concept of crowdfunding, using online platforms to enable lots of people to invest small amounts, has also started making its way into the seed and early-stage markets. SMEs do not generally access capital or bond markets due to their size and the small amounts of money they are seeking. The following provides an overview of the further range of sources of external finance beyond mainstream bank loans.

2.4.1. Equity based financing The Breedon Report identified equity finance as a key area under-utilised by SMEs in UK. (i.e. only 3% of small businesses use equity finance, whereas 55 per cent use credit cards). It suggested that: Equity, along with alternative channels for debt capital, can potentially benefit these businesses in the early stages of their development...Whilst equity is not the subject of this review, it is important to create a framework to stimulate investor appetite for equity and lower the cost of raising such capital35. While entrepreneurs tend to start their ventures with informal financing they may need other external sources of seed capital such as angel investment or venture capital.

■ Angel investors tend to be experienced entrepreneurs or business people. They are increasingly recognised as an important source of equity capital at the seed and early stage of company

31 CDFA (2012), Inside Community Finance, p.24 32 In 2012, the CDFA Regional Growth Fund was launched and will provide up to £60m of funding over 5 years to the sector. 33 BDRC Continental (2011), SME Finance Monitor Survey 34 OECD (2006), The SME Financing Gap (Volume 1), p.71 35 BIS (2012), Report of industry-led working group on alternative debt markets (the Breedon Report), p.12

22 Evidencing demand for community finance

formation. They play a key role in providing strategic and operational expertise for new ventures as well as providing important contacts and introductions. It is for this combination of reasons, not just for the funding, that many entrepreneurs seek angel investment. The angel investment sector is growing and becoming more formalised and organised through the creation of angel groups and networks. The total deal size for companies seeking early-stage financing investment has increased through the involvement of these groups and syndicates36. It is estimated that in 2009-10 in UK a total of £98.3 million was provided through business angel networks37.

■ Venture capital (VC) is ‘professional’ equity, in the form of a fund run by general partners, to invest in early to expansion stages of high growth firms. Venture capital is an important source of funding for young, technology based firms and has played a key role in industries such as ICT and biotech and, more recently, in the clean tech industry. Venture capital is only appropriate for a small proportion of start-ups (high-growth firms with scalable, high-growth business models) and therefore is rarely viewed as the solution for new venture financing. The most successful and experienced venture capital firms also have considerable managerial expertise, and the transfer of this expertise can have a major influence on the success of their portfolio firms 38. Measures have been introduced to promote equity financing and fill gaps in the seed and early-stage investment market. Policy makers have sought to address market gaps through both demand and supply-side measures. For example:

■ Supply side: Government policy typically takes the form of capital participation in VC which the state invests as a special limited partner in a venture capital fund managed by a commercial venture capitalist. The state devolves the responsibility for commercial investment decisions to the private VC partner once the general focus, objective and distribution of incentives of the fund are negotiated and agreed.

■ ‘Demand side’: Problems are typically associated with the poorly developed quality of the firms that may be seeking investment or the lack of skills within the VC industry needed to find, build and sell a profitable portfolio of firms39. Improved support for Business Angel networks seeks to improve the flow of high-quality firms available to the VC sector. Some explanation of the limited role of equity in SME financing was provided by NESTA (2009) which examined a number of ‘hybrid’ venture capital schemes backed by both private and public sector funding and their role in the risk capital funding of early-stage firms. The report concluded that the UK suffers from a ‘thin market’ in the provision of specialised venture capital funding and managerial expertise whereby: ‘...small numbers of high potential firms and small numbers of investors with the skills to help them grow find it difficult to find one another without incurring unacceptable transaction and/or search costs. As a result, firms complain about difficulties in getting funding while investors bemoan the difficulties in finding attractive portfolio firms. In a thin market both entrepreneurs and investors are telling the truth. Because thin markets make it difficult for the supply and demand for finance to match they reduce overall levels of investment40’.

2.4.2. Shore-term loan based provision Whilst short-term loan based provision has been a longstanding element within SME finance markets, recent years have seen further developments. 2.4.2.1. Asset based finance /factoring/invoice discounting Asset Based Finance describes a range of financial products that involve funding against a range of corporate assets including invoices, stock, property, plant and machinery and sometimes even intellectual property. It describes a range of products including:

36 OECD (2011), Financing High Growth Firms: The role of Angel Investors, p.21 37 UK Business Angel Association (2011), Annual Report on the Business Angel Market, p.6 38 OECD (2011), Financing High Growth Firms: The role of Angel Investors, p. 22 39 OECD (2004), Venture Capital: Trends and Policy Recommendations 40 NESTA (2009), From funding gaps to thin markets, p.21

23 Mind the Finance Gap

■ Factoring: Used by start-ups, SMEs and small companies (including sole traders and partnerships) with flexible loans made against invoices;

■ Invoice Discounting: Used by SMEs and larger organisations with a more mature collections process in place, with loans made against invoices (and with or without bad debt protection) to improve cashflow; and,

■ Asset Based Lending: Used by financially mature, multi-national, and even global corporations with loans made against a range of corporate assets (including invoices, stock, plant and machinery, property, etc.) to provide a cashflow solution for strategic purposes (for example, a Management Buy Out, refinancing or rapid expansion). In terms of funding volume, large companies remain the major recipients of asset-based funds. For example, in 2011:

■ Companies with an annual turnover in excess of £100 million (less than 1% of the total number of clients) claimed £3.3 billion or just over 20 per cent of total advances;

■ Advances received by medium-size clients, with an annual turnover between £1 million and £100 million, grew by 19% in twelve months and reached £11.2 billion or 71% of total advances made; and,

■ Advances to companies with an annual turnover below £1 million also grew by 9% and reached £1.33 billion41. 2.4.2.2. Supply chain finance The Breedon Report recommended the development of stronger supply chain finance market in the UK. In essence, in this financing model a financial intermediary lends to a sub-contractor on the back of an agreed contract with the buyer – historically, this role has been undertaken by mainstream banks. Supply-chain finance operates on the principle of large companies using their credit strength to support smaller suppliers applying for finance through mainstream lenders. It works as follows:

■ A buyer issues a purchase order (PO) to a supplier and a bank;

■ The bank verifies the PO and seeks confirmation for the supplier;

■ If the buyer accepts the credit being issued to its name the supplier obtains early payment from the bank; and, 42 ■ The bank debits the buyer when the transaction is complete. This mode of finance presents advantages to the buyer, supplier and wider UK economy. The benefits to the buyer include assurance that they will have supply-chain security and more choice of suppliers. The benefits to suppliers are that they have access to low cost mainstream finance as opposed to relying on high-cost unsecured alternatives. This also addresses liquidity barriers that may prevent some small suppliers accessing large contracts. This model may also be beneficial to banks. While this means they are likely to earn less income by way of interest than they may otherwise have earned from SME’ overdrafts, it also means that they do not need to maintain such high capital reserves.43 In theory this model presents many advantages but the uptake in the UK has to date been small. In 2010, the Association of Corporate Treasury (ACT, 2010) reported that the supply chain finance market had grown from £100m in 2008 to £700m in 2009 and anticipated that this would increase above £1 billion by 2010. Barriers to entry include the requirements to set up complex financial arrangements that usually require senior management buy-in and coordination. However, recent developments illustrate how this complexity can be overcome. Companies such as JCB, Amazon and Google are increasingly using large balance sheets to support consumption of their products. Amazon has begun lending to independent sellers that offer products on their market place but

41 http://www.abfa.org.uk/members/newsletter/EconomicReportQ42011.pdf (accessed 9 October 2012) 42 BIS (2012), Report of industry-led working group on alternative debt markets (the Breedon Report), p.47-49 43 BIS (2012), Report of industry-led working group on alternative debt markets, p.27-30

24 Evidencing demand for community finance

cannot, for example, finance inventory expansions. Google has launched an SME credit card with initial interest rates considerably lower than prevailing market rates to support purchases of its online advertising by businesses.44 2.4.2.3. ‘High cost’ enterprise lenders In May 2012, Wonga launched a new service aimed at businesses experiencing immediate cash flow problems rather than those needing long-term credit. Wonga is one of a rapidly growing breed of payday lenders that offer credit to customers who cannot obtain it elsewhere. Its traditional business model is to make computer-generated decisions within 15 minutes on personal loans of up to £1,000, charging interest rates of 4,214%, when calculated on an APR. Wonga are offering loans of between £3,000 and £10,000 to businesses for up to a month at APR starting at 16.6% but rising to 180% for businesses with poorer credit ratings. Under the new service, business will have to provide information about their company and its directors, who personally guarantee the loan. It will initially offer loans to companies established for at least three years that have sales more than £20,000 a month. Wonga has a sophisticated automated risk-processing algorithm to quickly tell an applicant if they can have a loan or not. It turns down about two-thirds of applications. This simple application process it being extended to small businesses. Wonga says the application takes about 12 minutes, and money can be transferred to the business in around half an hour.45

2.4.3. Crowdfunding Crowdfunding describes the collective cooperation of people who network and pool their money and other resources together, usually via the Internet, to support efforts initiated by other people or organizations to raise funds. It enables an enterprise or individual to raise external finance from a large number of people who make a small contribution. In return investors or donors receive a financial return, social benefit, in-kind reward or a combination of these, depending on their motivation to participate46. This approach has the following advantages:

■ For investors: Crowdfunding may offer more attractive returns aligned with their wider financial and social investment objectives. Investors may also benefit from networking opportunities and the feeling of being part of a project from the start.

■ For investees: Access to a new source of finance; the potential of gaining knowledge and feedback of the ‘crowd’; and the ability to create market awareness and support their project or business venture.47 Crowdfunding platforms bring investors and investees with compatible needs and objectives together. They are responsible for vetting potential projects or business ventures, to ensure they are legitimate and their propositions and valuations are realistic and attractive to investors. Crowdfunding platforms are differentiated by the type of projects or venture they raise funding for and the motivations of the investors they are targeted at; for example, debt-based (peer to peer) focused at for profit enterprises, donation-based (social enterprises, charities, etc.) and rewards- based (non-financial returns)48. Platform operators are usually paid on a commission basis, related to the value of the funds raised (donation platforms, discussed later, are sometimes an exception to this). The number of platforms has more than doubled over the last three years. An industry website estimated that in 201149:

44 http://www.ft.com/cms/s/0/55be35f2-1093-11e2-a5f7-00144feabdc0.html (accessed 8 October 2012) 45 http://www.ft.com/cms/s/0/97000b58-983e-11e1-ad3e-00144feabdc0.html (accessed 7 May 2012) 46 NESTA (2012), The Venture Crowd: Crowdfunding equity investment into business 47 Spring (2012), Crowdfunding: the wisdom and wallets of crowds (http://www.spring- giving.org.uk/2012/07/crowdfunding-the-wisdom-and-wallets-of-crowds/) accessed 22.08.2012 48 Donations and reward-based platform lending are dealt with in Section 3 under civil society funding. 49 Crowdsourcing (2012), Crowdfunding industry report, market trends, composition and crowdfunding platforms

25 Mind the Finance Gap

■ There were 452 platforms operating globally, mostly based in North America and Western Europe (and often operating around the world), with 44 based in the UK;

■ Over €150 billion had been distributed to over one million campaigns globally to date; and,

■ The annual growth in the number of crowdfunding sources is estimated to have increased by 60% since 2008. Successful fund raising requires an intensive marketing campaign, usually taking the form of a viral advertisement, website or presentation, pitched to appeal to investors or donors. Social media has been instrumental in disseminating marketing material and attracting interest in effective and affordable ways. Most platforms operate as a timed competition. This gives project managers a specified time period in which they must raise the target amount of funding required. During this period investors can pledge donations or investments but the funds are only released once the target is reached. If the target is not reached the money is returned to investors. Some platforms, particularly where donations are made to charities or charitable projects, will allow investees to retain the funds raised for their project. Once a critical mass is reached this usually attracts the interest and confidence of wider crowd as investors attract other new investors they are connected with50. 2.4.3.1. Debt or lending crowdfunding – ‘peer-to-peer’ The debt model of crowdfunding operates similarly to a bank loan but here the lender is the crowd. There are some variations within this model depending on the financial motivations of the investors. Where the lending motivations are purely financial this is referred to as peer-to-peer lending. Peer- to-peer lending platforms bring savers and borrowers together and create investment packages offering both sides more attractive interest rates than offered by mainstream lenders. This model attracts the largest fund per project and lending based campaigns take about 50% less time to complete than equity or donation based projects. Under this model, loans are spread across borrowers to diversify risk and investors choose the risk level, interest rate and maturity of their lending. This model is most suited to entrepreneurs, inventors, start-ups and business owners. The crowd is usually made up of investors and entrepreneurs. Peer-to-peer lenders have operated in the UK since the mid-2000s. Zopa and Rate-Setter are the market leaders for personal loans and Funding Circle and Thincats are the largest operators of peer- to-peer SME loans. The value of the outstanding loans and average loan size provided by each platform are outlined in 0. Cumulatively this year, this market is expected to finance over £200 million in loans. Table 2.2 Cross section of crowdfunding platforms

Zopa Ratesetter Funding Circle Thincats Founded 2005 2010 2010 2011 Primary Market Personal loans Personal Loans SME loans SME loans Outstanding loans £96m £18m £29m £4.5m Avg borrower loan size £5,000 £4,000 £45,000 £130,000 Loan maturities Up to 5 years 0.5-5 years 1,3 or 5 years 0.5 years

Source: Bank of England (2012) While this model provides an alternative to mainstream finance to some small businesses and individuals seeking finance, this is not a viable option available to all. Capital Enterprise51 report individuals most likely to access this peer-to-peer lending are those with a good credit rating or those who are able to provide additional security or guarantee. Those meeting these criteria are,

50 NESTA (2012), The Venture Crowd 51 http://www.media.ft.com/cms/2b91e5ee-122d-11e2-868d-00144feabdc0.pdf (accessed 11 October 2012)

26 Evidencing demand for community finance

then, more likely already able to access mainstream finance, albeit potentially at a higher interest rate. While this model potentially offers investors a higher return, this is also associated with more risk. Under this model, platforms are responsible for vetting individuals and SMEs. This usually involves verifying their credit history, income and current debts. The recent collapse of loans company Quakle, a peer-to-peer lender targeted at small-scale savers, has tested early confidence in the industry. It has highlighted the risk to lenders that borrowers may be unable to repay the loan or that businesses may fail. Currently, peer-to-peer lending platforms are not regulated and critics such as Consumer Focus have warned that lenders entering the market are not fully informed of the risks. For example, at present, investors who use platforms do not have deposits covered by the Financial Services Compensation Scheme (FSCS) in the same way that a savings account would be. This covers loss arising from bad investment advice, poor investment management or misrepresentation, or alternatively when an authorised investment firm goes out of business and cannot return investments or money. Later this year, and following lobbying from the Peer-to-Peer Financial Association, they will be regulated by new financial body, the Financial Conduct Authority (FCA). It is not yet clear whether companies will be protected by the FSCS under any new regulation52. 2.4.3.2. Equity based crowdfunding Nesta (2012) defined equity crowdfunding as ‘the offering of securities by a privately held business to the general public, usually through the medium of an online platform’. This is similar to a debt-based model of crowdfunding - as investors tend to be motivated by more attractive financial returns than they can obtain from mainstream banks - but differs in terms of risk and ownership structure. The crowd becomes a shareholder in the business and each investor holds a stake. The rules of ownership and the financial motivations for investors are similar to investors buying shares in a company quoted on the stock exchange. The businesses seeking investment from crowdfunding platforms tend to be much smaller, new business start-ups and there is a lot less reporting and financial rules are required. For investors, this model allows those with small capital reserves, but willing to make risky and potentially high value return investments, to access the venture capital market and the opportunity to be part of a new enterprise from the very start. For new start-ups this provides access to venture capital finance as well as business advice and support. Compared to the growth in the number of new platforms entering this market, growth in this market is more modest, but the value of each fund raised tends to be much higher. 0 below illustrates, for example, that in the USA over 40% of equity-based funds paid out were over $100,000.

52 http://www.thisismoney.co.uk/money/saving/article-2246522/Lend-save-firms-official-regulation- 2014.html#ixzz2HIwM8acb (accessed 13 November 2012)

27 Mind the Finance Gap

Figure 2.9 The funds paid out to equity based crowd-funds in 2011, based on 10 platforms

Source: Crowdsourcing.org (2012)

A summary of the leading platforms operating internationally and how this model works is summarised in 0 below. Table 2.3 Summary of the leading equity-based crowdfunding platforms

Name Location Capital raised to date Fees Crowdcube UK £3.7 m For business: 5% of amount raised + £1,750 legal fees if successful Symbid Netherlands £<1 m For Business: €250 upfront for existing business and 5% of the amount raised For investors: 2.5% of investment amount + transaction costs My Micro Invest Belgium €500K from professional For business: 12% of amount raised if successful WiSeed France €2.5m For business: 10% of amount raised if successful For investors: 5% of amount invested if successful Innovestment Germany €0.5m For business: 10% of amount raised if successful Seedrs UK £120K, operating since For business: 7.5% of amount raised if July 2012 successful For investors: 7.5% of profit from investment Bank to the UK No data, operating since For business: 5% of amount raised + Future July 2012 £1,750 Company secretarial fees Crowd Mission UK Launching in September For business: 5% of amount raised 2012

Source: Nesta, The Venture Crowd (2012)

2.5. Investors In terms of enterprise lending, the starting point for this section on investors is to acknowledge that the definition of the underserved market is essentially the business demographic (entrepreneurs, start-ups, SMEs) whose variety of finance needs are deemed at any one point in time to be

28 Evidencing demand for community finance

‘unattractive’ to commercial investment by the mainstream banks. It is recognised that in certain niches, or on the margins of this shifting underserved segment of SMEs, a few specialist commercial lenders have developed specific service offers or products targeted at elements of the underserved market – most strongly in venture capital but similarly in the growing provision of factoring and invoice-based finance to start-ups, micros and smaller SMEs or the movement of Wonga into business lending. Angel investing and peer-to-peer crowdfunding draws investment, essentially, from individual investors and entrepreneurs seeking a more direct way to invest in a broader range of businesses than offered by mainstream investment routes (such as investment funds, stocks and shares). Overall, possibly the key point to note here is how new opportunities are opening up or new innovations being brought to market as structural changes in bank finance suggest a medium to long run expansion in the underserved market of ‘viable but unbankable’ businesses. These have been the traditional customer base for CDFI enterprise lending.

2.5.1. Investment in CDFI enterprise lending activity Given the blend of economic and social returns which accrue from enterprise lending in underserved markets, the major investor sources to date have been public funding against desired policy objectives (local authorities, central government and regional development agencies) and philanthropic (trusts, foundations and individuals). More recently, greater levels of commercial investment have been evident. Given their dominance in the supply infrastructure, CDFIs have been the major recipients of such investment. Investment funding can be split into two key elements: capital for on-lending and revenue to undertake lending and provide business support services. Historically, the CDFI sector is intimately linked to government policy to foster entrepreneurship and self-employment in deprived neighbourhoods and among low-income groups. The Phoenix Challenge Fund ran from 2000 to 2006 and injected £42 million of funds into around 60 CDFIs in the form of revenue grants to support operational costs, capital grants for on-lending to businesses, and a loan guarantee fund to stimulate banks and other organisations to lend money to CDFIs for on- lending to businesses. These resources were intended to enable CDFIs to develop and test new models of outreach and delivery, whilst also building the capacity of the sector with a view to scaling up its role within the enterprise finance market. The end of the Phoenix Fund in 2006 led to an increased role for the Regional Development Agencies (RDAs) in support of CDFI activity, with an additional £9.5 million of DTI funding being allocated towards transitional support for the sector for the period 2006 to 2008. The RDAs were generally very supportive of CDFIs, with significant amounts of investment being provided by RDAs for CDFIs, drawing on their own Single Pot resources, coupled in some cases with allocations from the 2000- 2006 EU Structural Fund programmes (Objectives 1 and 2 and the European Social Fund). Resources were provided for both capital and revenue purposes, in order to deliver finance to businesses and also to boost the capacity of regional CDFI sectors, until the announcement of the abolition of the RDAs in 2010. In particular, the sector was utilised as a rapid and flexible delivery mechanism for business finance during the immediate aftermath of the 2007 ‘credit crunch’53. Community Investment Tax Relief (CITR) was introduced in 2002 to encourage private investment in under-invested communities. It is currently available for both individuals and companies that invest in CDFIs, which invest in both not-for-profit and profit-seeking enterprises that operate within or for disadvantaged communities54. Take up of CITR has been disappointing, with only £84 million of investment made through CITR in its first ten years compared to an ambitious target of £1 billion ‘over the programme duration’. CITR remains the only available tax break for investing in disadvantaged communities. Whilst figures on investment in to the CDFI sector over time are limited, in 2010 it was reported that of £34m of capital funding received by the sector in the previous year for lending across all

53 GHK (2010), Evaluation of Community Development Finance Institutions, p.118-129 54 Cohen R et al (2000) Enterprising Communities Wealth Beyond Welfare, London: Social Investment Task Force

29 Mind the Finance Gap

community finance markets, almost half came from RDAs (£15m, almost entirely business lending), a further quarter from European funds, just under a fifth from central and local government and around a tenth from bank loans. Less than 1% came from trusts, grants, etc. Revenue funding of £9m was spread across a similar range of funders. A more detailed breakdown of funding sources, for all aspects of the community finance sector, can be found in Annex 2. In 2011, figures for CDFI business lending activities alone are available and reflect the substantial loss in funding from RDA and European sources – and the increased significance of earned income and bank loans (see 0). Table 2.4 Sources of revenue access – CDFIs and business lending

Capital Funding Revenue Costs £7.6m 61% public funds (30% ERDF, 13% £11.8m 73% earned income (loan interest, fees, RDAs, 13% Local authorities) etc) 27% bank loans 9% Local authorities 3% trusts and charities 8% RDA/ERDF 4% individuals

Source: Source: CDFA (2012), p.26

In 2011, the CDFA was awarded £30 million of funding for capital on-lending matched with £30 million of bank finance from The Co-Operative Bank and Unity Trust Bank, under the Government’s Regional Growth Fund (RGF) scheme. The funding will be used to support the financing and growth of CDFIs through the provision of capital to on-lend55.

2.6. Market developments Taking a historical viewpoint, it can be suggested that the supply infrastructure for SME finance, its market failures, funding gaps and any response by enterprise policy was (relatively speaking) both mature and well understood, Now, however, it can be suggested that the ‘credit crunch’ of 2007- 2009 and continued on-going developments in the post crisis financial world, imply a ‘changed world’ for enterprise finance. Bank finance has not dried up; it remains available but banks are applying new and more rigorous testing than at any time in the last 15 years. As a response to new capital adequacy requirements and other regulations imposed by the financial regulator, lenders have been consciously re-profiling their loan books while also enhancing the checks they do on customers’ business cases. In some cases lines of credit are also being withdrawn at short notice, leaving an environment characterized by significant uncertainty56. Compounded by the broader problem of a sluggish and uncertain macroeconomic environment involving both public expenditure constraints and wage constraints, the net result is that lending is simply a riskier prospect today than before, resulting in a higher bar across the piece. EU and UK regulations are also putting upward pressure on pricing. Where bank finance is being offered, terms and conditions can often pose too heavy a burden on applicant companies; this is heard particularly from smaller businesses, whose ability to shoulder heavier charges and greater repayment risk is lower than for larger businesses. The Breedon Review found that, between now and the end of 2016, there is a risk that companies in the UK will need more credit than the banks are able to supply, creating a ‘funding gap’, with a significant funding shortfall likely to be felt by the smallest companies. For example:

■ Gross lending to the non-financial private sector peaked at £657bn in December 2008 but had shrunk by £151bn, reaching £506bn in December 2011;

■ Applications for bank debt remain weak, with only 9% of SMEs seeking finance in the year to 2011;

55 http://www.CDFA.org.uk/2011/04/12/cdfi-sector-secures-60m-in-regional-growth-fund-announcement/ 56 Source: CBI presentation

30 Evidencing demand for community finance

■ Rejection rates in 2008-09 were higher than the historical norm (controlling for changes in risk and other factors) with 33% of SMEs applying for a loan rejected and having no credit facility by the end of the application process; and,

■ Modelling suggests that, between now and the end of 2016 the finance gap could be in the range £84bn to £191bn – the amount potentially required to meet comfortably the working capital and growth needs of the UK non-financial business sector 57. On this basis, Breedon outlined the need to increase the range of debt financing sources available to UK businesses58. As it stands, within the underserved market of enterprise lending, sources can currently be listed as: Table 2.5 Type of product, market and capital available

Product Market/Focus Loan and capital available CDFIs Lending to businesses in disadvantaged £23.1 million disbursed in 2010-11 from communities a peak of £32.8m in 2009 Asset Based Finance Funding against a range of corporate Advances to companies with an annual assets including invoices, stock, etc. turnover below £1m reached £1.33 billion in 2011 (9% of the total) Peer-to-Peer Platforms match up savers (who are Lending via the three largest websites willing to lend) with borrowers – either as reached £250m in July 201259 individuals or small businesses Equity Equity capital at the seed and early stage It is estimated that in 2009-10 in UK a (business angels) of company formation total of £98.3 million was provided through business angel networks Equity (crowdfunding) The pooling of money and other Over €150 billion had been distributed resources, usually via the internet to over one million campaigns globally to date (figures for just the UK are not available)

The Government’s Plan for Growth published alongside the Budget in March 2011 has recognised the key issue of access to finance in current economic conditions60 and a range of policies and schemes have been brought forward to address the market failures affecting SMEs raising finance (see Annex 2). These include:

■ To ensure that viable businesses can access the finance they need at an affordable rate: – Access to cheaper finance through a National Loan Guarantee Scheme (NLGS) to deliver cheaper bank loans to businesses. Eligible businesses receive a discount on their loan of 1% compared with the interest rate that they would otherwise have received from that bank outside the scheme61. – Access to finance for firms without sufficient track record or collateral, by increasing by 7% the level of guarantee on lenders’ Enterprise Finance Guarantee portfolios to enable banks to offer more loans to viable businesses lacking sufficient track record or collateral to secure bank finance. – Access to finance for exports via UK Export Finance with products such as a bond support scheme, an export working capital scheme; and a foreign exchange credit support scheme62.

■ Taking steps to encourage the development of more diverse sources of finance for SMEs:

57 BIS (2012), Report of industry-led working group on alternative debt markets 58 BIS (2012), Report of industry-led working group on alternative debt markets 59 http://www.bbc.co.uk/news/business-18370777 (accessed December 2012) 60 HMT & BIS (2011), The Plan For Growth 61 http://www.hm-treasury.gov.uk/nlgs.htm 62 http://www.bis.gov.uk/efg

31 Mind the Finance Gap

– An increase in the funds available to invest through the Business Finance Partnership (BFP) to £1.2 billion. The BFP will invest in smaller and mid-sized businesses in the UK through non-bank channels, with £100m allocated to investing in SMEs specifically63. – The Enterprise Capital Funds programme, which will provide for more than £300m of venture capital investment into the equity gap for early stage innovative SMEs with the highest growth potential64. – Encouraging a more enabling environment for Business Angel investments through the £50m Business Angel Co-Investment Fund, which supports angel investments into high growth potential early stage SMEs, particularly in areas worst affected by public spending cuts.

■ Support to equity finance through the provision of tax incentives to investors: – The Enterprise Investment Scheme (EIS) annual investment limit for individuals was increased to £1 million; – The introduction of the new Seed Enterprise Investment Scheme (SEIS), providing income tax relief of 50% for individuals who invest in shares in qualifying seed companies.

■ Business support measures for small businesses, including awareness raising and campaigns on information and advice available, advice on financing for growth, investment readiness support, and new coaching and mentoring schemes.

■ Finally, it should be noted that a substantial share of the successful bids for £2.4bn allocated under the Government’s Regional Growth Fund has gone to a range of access to finance schemes. RGF will operate for 3 years between 2011 and 2014 to stimulate enterprise by providing support for projects and programmes with significant potential for creating long term private sector-led economic growth and employment, especially to support communities that are currently overly reliant on the public sector for jobs and economic activity. Example projects include: – CDFA wholesale loan fund (nationwide): The £30 million Fund will provide funds to Community Development Finance Institutions to enable them to on-lend these funds to viable micro, small and medium-sized enterprises who have been declined by banks for normal mainstream lending. – CfEL - Business Angels (nationwide): A £50 million co-investment fund to deliver risk capital investment with the private investors providing business advice and support as part of the investment package. – Economic Solutions Ltd (North West): To engage with high-street banks to manage SME credit decline. It is a partnership between a Community Development Finance Initiative in Greater Manchester and a commercial bank. – Fredericks Foundation (nationwide): The programme aims to provide access to finance to the micro-enterprise market in disadvantaged communities via 10 community micro enterprise hubs located within 10 community foundations. – NEN / Barclays - Let's Talk Business (nationwide): A new business start up programme that will create 6,000 new businesses and up to 10,000 jobs across the country. The Ready for Business programme is being run by the National Enterprise Network (NEN) alongside six other enterprise support organisations and Barclays Bank, who have invested a further £1 million. – Santander UK (nationwide): Santander UK plc will deliver a £53.5 million SME mezzanine finance programme matched by a £100 million Santander scheme to finance debt products for high-growth SMEs in the English regions. The programme will provide professional business support to support private sector growth in communities.

63 HM Treasury (2012), Business Finance Partnership: Request for Proposals 64 http://www.bis.gov.uk/policies/enterprise-and-business-support/access-to-finance/enterprise-capital-funds

32 Evidencing demand for community finance

2.7. Community Finance and Enterprise Lending: Demand, Supply, and Barriers Bank finance remains available to the substantial majority of businesses but as a response to new capital adequacy requirements and other regulations imposed by the financial regulator, lenders have been consciously re-profiling their loan books while also enhancing the checks they do on customers’ business cases. Compounded by the broader problem of a sluggish and uncertain macroeconomic environment involving both public expenditure constraints and wage constraints, the net result is that lending is simply a riskier prospect today than before, resulting in a higher bar across the piece. Similarly, risk averse businesses are delaying investment and/or seeking to reduce rather than increase debt. Either way, the net result is that less money is being lent It is estimated that the current total investment inflows into the UK market are around £100 million per annum65 but potential demand (including latent) for access to finance by entrepreneurs and businesses unable to access mainstream finance is in the order of £1.3 billion per annum from around 103,000 clients66. The long-standing CDFI sector remains at the core of debt-based lending provision to ‘viable but unbankable’ SMEs - delivering £23m of loans in 2012, providing the stepping stone to mainstream finance for small businesses and delivering economic and social returns to UK government. Yet the sector remains patchy in coverage, under-capitalised and facing on-going issues of sustainability; it is also delivering less loan capital than two years ago. The sector is also facing ‘competition’ from new or expanding alternative providers. In 2012, for example, peer-to-peer lending is estimated to have delivered equivalent levels of SME loan funding to that of the CDFI sector – utilising the power of digital platforms to reduce the costs of reaching both investor and investee markets. The sector remains in its infancy (with consequent concerns such as about regulation and portfolio performance) but is demonstrating new ways to reduce the transactions costs of enterprise lending. Other providers, including ‘high cost’ lenders, are also seizing the opportunities offered by new SME entrants to the underserved market.

65 ICF GHK estimation, 2012, as aggregate of reported supply 66 ICF GHK estimation, 2012, utilising nationally published statistics (mostly for 2011). Key assumptions are that all UK nascent entrepreneurs and enterprises bar those funding themselves or funded by mainstream finance and seeking external finance would apply to CDFIs with current sector enquiries-to-loans conversion ratio applying (13% micro-enterprise and 31% SME) at current average loan rates (microenterprise, £11,300 and SME £37,000).

33 Mind the Finance Gap

3. Community finance for civil society

The social investment market is relatively immature and underdeveloped. Social Investment Finance Intermediaries are not able to respond adequately to the financing needs of Civil Society Organisations as they lack sufficient capital. A lack of market infrastructure and investment infrastructure is also holding back the market.

3.1. The underserved market of civil society: social entrepreneurship, social ventures, the voluntary and community sector, and access to investment Civil society organisations (CSOs) range in size from informal community organisations which are generally very small with very limited, if any, income and no paid staff, to the 453 major charities with income above £10 million and which account for 44% of all charitable income67. Successive governments have emphasised the key role that CSOs play in promoting social and environmental change, for example:

■ helping to design and deliver innovative and responsive public services, often reaching people and communities that the public sector struggles to reach;

■ contributing to building new markets by pioneering the provision of new ethical and socially or environmentally responsible products and setting new standards for socially responsible business practices and encouraging enterprise and entrepreneurship; and,

■ attracting those who may not be interested in conventional business into social enterprise, including women, young people, and people from ethnic minority communities. Furthermore, recent policy drivers are creating the conditions for the sector to expand:

■ The Open Public Services White Paper has set out a clear strategy for opening access to public service delivery contracts to diverse providers including the sector.

■ The Community Right to Challenge and Bid (in the Localism Act) gives voluntary and community groups the opportunity to bid to run public services (DCLG are providing funding and support to help eligible organisations to take advantage of the opportunities).

■ The Government is rolling out new ‘Rights to Provide’ across public services, so that employees can request or bid to take over the services they deliver. The Department of Health is at the forefront of ‘Rights to Provide’ in health and social care and there is support available from the Mutual Support Programme, a £10m programme that comprises a website, dedicated hotline and the funds. Social enterprises (sometimes also termed social ventures68 and businesses) are an important subset of the civil society sector. They are businesses with primarily social objectives. They principally reinvest their surpluses in the business or community for these purposes:

■ There are approximately 68,000 social enterprises in the UK contributing at least £24bn to the economy. Social enterprises are estimated to employ 800,000 people69;

■ Around 39% of social enterprises are concentrated in the most deprived communities, compared to 13% of standard SMEs;

■ In total, 58% of social enterprises reported growth last year (2011), compared to 28% of all SMEs; 70 ■ 57% of social enterprises predicted growth next year, compared to 41% of all SMEs ;

67 NCVO (2010) The UK Civil Society Almanac 68 This term is often used in Government and was taken from a Young Foundation report from February 2011, which explains that social ventures are organisations that tackle social problems, are financially sustainable and aim to scale what works i.e. from organisational growth, through franchising and federations, to licensing and looser diffusion 69 BIS (2010), Annual Survey of Small Businesses 70 Social Enterprise Uk (2011), Fightback Britain, - the State of Social Enterprise Survey

34 Evidencing demand for community finance

■ Between 2008-11, the cooperatives sector increased its turnover by 31%;

■ Social firms have experienced a numerical growth of 32% since 2006; and,

■ Since their introduction in 2005, Community Interest Companies now number almost 7,000. There is a growing trend for social enterprises to operate in markets and generate income from trading and contracts. Since 2003-04 earned income has been the sector’s most important type of funding and, in 2007-08, it accounted for 49% of the sector’s income, an increase of 76% since 200171. Contrary to common understandings, social enterprises raise most of their income from consumers, followed by the public and private sector72.

3.1.1. Civil society, social enterprises and the issue of access to finance Historically, the sector has been funded principally through grant funding and philanthropy. Given reductions in grant funding, recognition of traded income as a source of sustainability, the growth of commercial business models with social objectives and new commercial opportunities, the sector has seen substantial expansion in its demand for investment finance. To date, government that has often been the investor, offering finance to the value of £385m by 201073, through grants, unsecured loans, quasi-equity and equity products74. As with all SMEs, social enterprises and other social ventures need access to finance if they are to invest and grow. External finance provides capital that gives social enterprises the capacity to deliver returns (which may be social, financial or both). A similar proportion of social enterprises as SMEs actively seek external finance - 16% of frontline social enterprises access finance from public sources, the remaining 84% do not. Recently, 29% of the social enterprise employers that sought finance were rejected outright by the first source they approached (a similar proportion as for SME employers generally) and, overall, obtaining external finance has been noted as a more significant barrier to growth by social enterprises (48%) compared with other SMEs (33%)75.

3.2. Market failures in Civil Society access to finance There are two principal reasons why private financial markets supply insufficient capital to frontline social ventures – and hence the creation of an underserved market:

■ Positive externalities: Commercial institutions only take into account the expected financial return offered by considered projects. As the aim of a social enterprise is to achieve a blended financial and social return, commercial institutions will not award finance for some of the returns achieved and thus social enterprises are likely to obtain a socially inefficient level of funding.

■ Information asymmetries: Private retail investors lack the experience and understanding of social enterprises. The specific investment profile, needs and structures of frontline social ventures (which differs from ‘mainstream’ investments) make it harder (and potentially more expensive in transaction costs) for private investors to assess the risk of lending. The social investment market seeks to address these market failures by providing a blend of social and financial returns. Yet, despite recent progress, the social investment market is still far from maturity and does not respond adequately to the financing needs of frontline social enterprises. One symptom of market inefficiency and underdevelopment is small market size: total social investment in 2010-11 was estimated at £190 million compared with £3.6 billion philanthropic grant

71 Big Society Capital (2012), Vision and strategy, p.10 72 See http://www.socialenterprise.org.uk/about/about-social-enterprise; accessed19.04.2012 73 As cited in ClearlySo (2011) and including Futurebuilders, SEIF, Community Builders and other funds such as the ACF 74 Although grants have the clear advantage of being non-repayable, the conditions attached to them have been argued to limit the capacity of organisations to expand and leverage in commercial finance. It should be noted, also, that where loans have been provided they have been so only where bank financing cannot be secured. 75 BIS (2010) Social Enterprise Barometer, February

35 Mind the Finance Gap

funding, £13.1 billion individual giving and £55.3 billion of wider bank lending76. Individual deals tend to be very small, with recent research suggesting only 15% are over £15,00077. Other symptoms of market under-development include: 78 ■ High transaction costs : Social finance intermediaries estimate the typical transaction costs per deal are around £5,000. Given the small value of deals these costs are likely to be high as a proportion of investment size. Social investment deals are generally bespoke rather than standardised. This is reflected in much longer completion times than for comparable transactions for SMEs, estimated at 9-18 months79. 80 ■ Lack of market information : The market lacks transparency and there is only very limited data about the social investment market today (i.e. leading to higher legal, due diligence and risk assessment transactions costs related to lending to new and non-standardised forms of enterprise).

■ Lack of standardised metrics, benchmarks, and ratings. Metrics for measuring the sector’s outcomes are inaccessible, inconsistent or do not exist. There is a lack of understanding about why or when you would use one methodology over another to measure impact against these metrics81. Many of the symptoms of this embryonic market, then, reflect the underlying market failures of positive externalities and asymmetric information. As part of the State Aid case for Big Society Capital, the UK government provided the European Commission with an economic paper testing for difficulties in accessing finance encountered by frontline CSOs compared to their private sector equivalents. The evidence concluded that the market fails to supply CSOs with £0.9 - 1.7 billion per year. It concluded that the finance gap holds the sector back from operating as effectively as non-social peers as they are less likely to obtain working capital to smooth business cycles or growth capital to expand82. As discussed in Section 2, the government has made a number of interventions in financial markets to help entrepreneurs and businesses access the finance they need to enable greater levels of entrepreneurship, whether expressed through start-up or growth. The nature of social enterprises, such as their business models and the legal forms they adopt, mean that they often are not able to benefit from these interventions (see A3.1 for further details and examples):

■ Tax incentives: There are tax reliefs for investing in SMEs including Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS) and Venture Capital Trust scheme (VCT). These are share relief schemes and are not available for most existing CSOs because their legal form prevents them from issuing equity;

■ Guarantees: Existing SME guarantee schemes such as the National Loan Guarantee Scheme and the Enterprise Finance Guarantee (EFG) are only available to social enterprises via high street banks which do not provide sufficient finance for the reasons set out above;

■ Investment funds: Social enterprises do not tend to issue equity which means they are not able to benefit from initiatives that encourage equity investment such as the Business Growth Fund and the Enterprise Capital Fund. The Business Finance Partnership targets lending, rather than equity finance, but is designed to increase the supply of capital at commercial rates to larger firms which will rule out most social enterprises.

76 „Social venture intermediaries: who they are, what they do, and what they could become,‟ Young Foundation, February 2011. 77 Ibid 78 Monitor Institute (2009) Investing for Social & Environmental Impact. US: Monitor Institute, available at: www.monitorinstitute.com/impactinvesting/ documents/InvestingforSocialandEnvImpact_ FullReport_004.pdf 79 Source: UnLtd briefing. 80 Mitchell L et al (2008) Financing Civil Society: A practitioner’s view of the UK social investment fund. London: CAF, available at: www.cafonline.org/PDF/ Venturesome_FinancingCivilSociety_1806091.pdf 81 NPC (2011), Inspiring impact: Working together for a bigger impact in the UK social sector 82 European Commission (2011), Notification of State Aid Approval – Big Society Capital

36 Evidencing demand for community finance

3.3. CDFIs as intermediaries: bringing demand and supply together Recent years have seen the launch of a number of intermediaries that focus on providing finance to CSOs. These include, for example, CDFIs and similar organisations that attract money from social investors and use it to make direct investments in social enterprises - known as Social Investment Finance Intermediaries (SIFIs). This category includes organisations whose primary activity is social investment as well as organisations for which social investment forms part of a wider portfolio of activity.

3.3.1. Community Development Finance Institutions (CDFIs) and social investment A total of 22 CDFIs report the ability to serve CSOs, with 16 of these disbursing loans between 2010 and 2011. Of these, 10 served CSOs exclusively and a further six had provided loans alongside other community finance markets.83 Figure 3.1 Proportion of CDFIs serving civil society (2010-11)

Potential, 10%

Minor, 11%

Exclusively, 18% Not serving, 61%

CDFIs serving this market are extremely divergent, distinguished by:

■ The markets served: the majority of civil society loans made (81%) went to social enterprises with the remainder to non-enterprise ventures such as charities, voluntary associations, social clubs or religious establishments.

■ The loan products offered: most targeting small or local ventures, only a few specialising in large projects, with two being deposit-taking banks (unique in the CDFI sector). Last year CDFIs reported disbursing 390 loans to CSOs worth £145m84, compared with a suggested total figure for the social investment market of £190m85. The number of loans disbursed per annum has been relatively constant in recent years apart from a 25% increase reported in 2010 above the previous average, attributable to increased activity by one CDFI providing large sums to major projects. While the number of CDFIs serving this market has remained relatively stable over time, the value of loans disbursed has been on a general upward trend, averaging about 20% growth per year (despite a dip in value of loans reported in 2008 and 2009).

83 CDFA (2011), Inside Community Finance: Annual Survey of CDFIs in the UK; see Section 2.3 for an introduction to CDFIs 84 CDFA (2012), Inside Community Finance, p.36 85 „Social venture intermediaries: who they are, what they do, and what they could become,‟ Young Foundation, February 2011.

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Figure 3.2 Civil society loans disbursed by number and value (2004-11)

180 600 160 500 140 120 400 100 300 80 Number

Value (£m) Value 60 200 40 100 20 0 0 2004 2005 2006 2007 2008 2009 2010 2011

Value (£m) Number

Source: CDFA (2012), p.36-37 CDFIs reported the cost of credit provided to CSOs to be between 6% and 8% APR, with little difference between rates charged by small and large lenders. Recent years have seen a wider range of new financing instruments emerging – though some of these are relatively new, untested and small in proportion to traditional types of finance such as grants or donations86. More finance is available at the low-risk end (secured loans and bridging finance) where suppliers have larger balance sheets, although there are a small number of intermediaries across the spectrum (including growth capital). Table 3.1 Types of financing instruments

Type of Description investment Secured Creditor agrees to lend a sum of finance to a debtor in return for future repayment, loan/mortgage interest and security on the debtor’s assets (usually property). A contingent funding arrangement or pre-agreed line of credit. Underpins cash flow Overdraft or requirements and often used to allow organisations to commit to projects for which standby facilities they are fund raising before the fund raising is complete. Unsecured loans are those which do not take security on assets, and are therefore Unsecured loans or higher risk to the supplier. Patient capital refers to the terms on which the loans are patient capital made – often over an extended period and below market rates – e.g.. 10 year capital repayment holiday Fills the gap between debt/equity and grants. Hybrid finance which allows an investor Quasi-equity or to provide cash upfront and then benefit from the future revenues and financial mezzanine finance success of an organisation through royalty payment (a fixed % of income). Investor stands to gain nothing if the organisation does not achieve expected revenues. Ownership interests in a venture in the form of common stock, used to inject funds to Equity achieve significant growth. Investors aim to sell their share of ownership at a profit to recoup initial investment plus dividend. Currently not possible for social investors.

Source: ICF GHK analysis CDFIs had 1650 civil society loans outstanding worth just over £500m as at 31 March 2011, with the three largest CDFIs accounting for 94% of the value. The average outstanding loan in the portfolio has increased substantially from £140,000 for the period 2008 to 2010 to £300,000 in 2011, due to a few large specialist CDFIs which continued making ever larger deals87.

86 CAF Venturesome (2008), Financing Civil Society 87 CDFA (2012), Inside Community Finance, p.37

38 Evidencing demand for community finance

Alongside loan capital, CDFIs may provide pre-loan business support and advisory services to customers as well as post-loan management. Using relationship banking models, it is argued that the greater risk of loan default compared to mainstream lending is managed down. Smaller lenders reported write offs across their portfolios at 7% last year, ranging from 0% to 8% at the individual CDFI level, whilst larger lenders write offs have remained consistently below 1%. 3.3.1.1. The impact of CDFI social investment lending 0 outlines the impact of CDFI civil society lending made between 1st April 2010 and 31st March 2011. Table 3.2 Impact of CDFIs – civil society

Size Impact

392 loans made totalling £145m  65 social enterprises created  250 social enterprises safeguarded  75 charities supported  Plus £72m bank leverage

Source: CDFA (2012), p.32

The net economic impact generated by the CDFI lending includes88: approximately 3,300 jobs created and 4,000 jobs safeguarded; and around £52 million GVA created and £62 million GVA safeguarded. 3.3.1.2. The sustainability of CDFIs civil society lending Comparing CDFI operating costs with earned income provides insight into commercial self sufficiency in this market. Half of CDFIs covered all or over 95% of their costs through earned income. Those CDFIs unable to cover costs from earned and grant income are reliant upon revenue from other non- finance products and services or from reserves or other assets89. In 2011 CDFIs reported receiving £27m in capital, nearly two-thirds of which was raised by CDFI banks as customer deposits. Excluding CDFI bank deposits, eight lenders reported raising nearly £10m in capital to onlend to CSOs. Public sources of capital were relatively insignificant (about 40% of capital was raised as bank debt). Taking on investment in the form of bank loans has become increasingly important, in 2011 accounting for over one-quarter of total capital raised.

3.4. Other civil society lenders and sources of external finance Although CDFIs still provide the majority of external finance made available to CSOs, the specialist intermediary sector (Social Investment Finance Intermediaries or SIFIs) has grown and diversified in the last ten years.

88 Cabinet Office estimates based on GHK (2010) National Evaluation of Community Development Financial Institutions, on lending to Social Ventures. 89 CDFA (2012), Inside Community Finance, p.41

39 Mind the Finance Gap

Figure 3.3 Social investment timeline90

First DH Social Triodos Social Social Community Enterprise Opportunities Investment Enterprise Development Investment Fund finance fund Access Fund Fund launched launched Programme launched

CAF Venture- First 11 CDFIs some created registered

2001 2002 2003 2004 2005 2006 2007 2008 2010 2009

In 2010, the Young Foundation91 estimated that there were around 35 organisations (and 41 funds) providing finance to social enterprises. Just 10 intermediaries were responsible for over 96% (£180m) of the total finance going to social enterprises. Two main players dominate: Charity Bank (also a member of the CDFA) and Social Investment Business (which distributes government funds, including the former FutureBuilders, Adventure Capital Fund and the Department of Health Social Enterprise Innovation Fund92). Both tend to be interested in relatively low-risk, long-term investments. The majority of specialist intermediaries focus on providing finance and expertise, though many carry out more than one function (0)93. Most SIFIs are currently operating at a loss. As SIFIs continue to forecast positive financial returns, it could be argued that this poor operational performance is caused more by the immaturity of the social investment market than the flawed business models of SIFIs. Nevertheless, the impact of weak SIFIs is that product innovation suffers because they lack the necessary resources to take a new financial instrument to market. Until SIFIs are able to strengthen their balance sheets, soft capital is required in the social investment market to develop products that enable SIFIs to provide CSOs with appropriate capital. Figure 3.4 Functions of intermediaries (* excludes CDFIs)

60 50 40 30 20 10 0 No. of organisations of organisations No. with these functions functions these with Expertise, people, networks Finance** Marketing & distribution Innovation Monitoring Function

Alongside CDFIs and other SIFIs there are a number of other potential sources of external finance for the underserved markets of civil society including:

90 Social Investment Taskforce (2010), Ten Years On 91 Young Foundation, “Social Ventures Intermediaries: who they are, what they do, and what they could become”, (unpublished) 92 The research was based on Young Foundation survey data and published information (e.g. intermediaries‟ annual reports) 93 Young Foundation and BCG (2011) Lighting the Touchpaper: Growing the Market for Social Investment in England

40 Evidencing demand for community finance

■ Community investment: Opening up new sources of finance for local co-operative enterprises with finance raised from local people (for example, seeking to use the Industrial and Provident Society (IPS) Withdrawable Share Capital model to launch share offers to raise capital);

■ Community Land Trusts: A non-profit organisation that develops and maintains affordable housing, community gardens, civic buildings, commercial spaces and other community assets on behalf of a community.

■ Crowdfunding and Peer-to-Peer lending: Crowdfunding and peer-to-peer lending sites in the UK include Abundance, BuzzBnk, Crowdcube, Ethex, Funding Circle, LendwithCare, MarketInvoice, Seedrs and Zopa. There are many more and we are aware of a number of others in development. The market is growing rapidly94.

3.4.1. Community investment A major barrier to communities running community assets or running enterprises is how to finance the acquisition of the assets or service, which are predominantly owned by the public sector. Community investment is a way of raising money from communities through the sale of shares or bonds in order to finance enterprises serving a community purpose. Unlike charitable fundraising, community investors can get their money back, and many also receive interest or dividends on the money they invest. It is not a new idea. Community investment underpinned the birth, growth and development of consumer co-operatives in the nineteenth and twentieth centuries. In the last ten years there has been a resurgence of interest in using community investment to finance a range of community initiatives. Up to 2002, there were on average four community share offers per year in the UK. There are now known to be at least 177 enterprises that have, or plan to seek, community investment. Of these enterprises, 144 are co-operative or community benefit societies. The total also includes 23 share companies, 8 community interest companies and 2 charities95. Since the start of 2009, and the launch of the Community Shares programme (funded by the Office for Civil Society and DCLG, and delivered by the Development Trusts Association [now Locality] and Co-operatives UK):

■ the number of enterprises registering interest in launching community shares has grown rapidly, with 29 new enterprises in 2009, and 43 new enterprises in 2010;

■ there have been 43 share offer launches, of which 32 had been completed (June 2012);

■ most of these offers have been made by start-up enterprises, 34 in total, with only three cases of societies seeking capital to finance later-stage growth. The most popular trade activity among new initiatives over the last decade is renewable energy, followed by community-owned retail stores (e.g. the Plunkett Foundation has helped to establish over 250 of these stores). Community investment has also been used to finance fair trade initiatives, community farms, land and buildings, and even telecommunication services96. The amounts raised by individual societies range from just under £8,000 to over £1m, with an average of £179,281 and a median of £85,000. The numbers of investors in each society range from under 40 to over 1,000, with an average of 192 and a median of 151. The role of intermediaries in advising community investment is often crucial in advancing the progress of schemes. Schemes can leverage intermediaries’ expertise to catalyse their own development, through the provision of investment readiness support (overall strategy and financial shaping/planning). Community investment potentially provides a mechanism to support the Government programmes of Right to Buy and Right to Challenge. New provisions in the Localism Act 2011 aim to help local communities to save important community assets, tackle social need and build up resources and employment in their neighbourhood in more innovative, enterprising and cost-effective ways. There is some, but limited, evidence on the types of assets and services that will be brought forward under

94 BWB (2012), Ten Reforms to Grow the Social Investment Market, p.11 95 Presentation by Co-operatives UK and Locality to the Cabinet Office (2012) and the Locality convention (2012) 96 Community Shares Unit (2009), Factsheet 1: What is community investment?, p.2

41 Mind the Finance Gap

the rights. The sectors which generated most enquiries through the CLG funded Asset Transfer Unit were, for example: libraries; community buildings; land / housing; schools; sport / leisure centres; retail / shops; and natural spaces.

3.4.2. Community Land Trusts A Community Land Trust (CLT) is a local community-controlled organisation set up to own and manage land and other assets in perpetuity for the benefit of the community. The assets other than land may be, for example, affordable housing, workspaces, agricultural facilities, commercial outlets, or community facilities97. Typically newly formed CLTs are constituted as a company limited by guarantee, an Industrial and Provident Society (IPS) or as a community interest company. The concept of CLTs is not new but has been the subject of increasing interest over the last five years due to:

■ the numbers of homes built not keeping pace with increases in new households formed;

■ the almost doubling between 2000 and 2010 of house prices; 98 ■ young people renting for longer, buying their home later and often relying on family support . In addition, deficit reduction plans mean there is an increasing need for government and local authorities to do ‘more for less’ and seek more innovative ways of financing housing development and other community facilities. New and innovative funding models are increasingly being explored by local communities, including99:

■ new forms of co-operative/mutual housing tenure, where the mutual owns the housing built on land that is a community owned asset; and,

■ homes are then financed by a corporate mortgage loan, with members owning equity shares in the mutual’s property portfolio. The National Community Land Trust Demonstration and Empowerment programmes have been led by Community Finance Solutions (based at the University of Salford) and have been funded by the former Housing Corporation, Carnegie UK Trust, the Higher Education Funding Council for England and the Department of Communities and Local Government (CLG). This programme has provided support and advice to CLT projects in England on their formation, business planning and general technical assistance. The work was primarily focused on the provision of affordable housing but in some projects other community asset classes were included. A recent report from the University of Salford highlighted the following benefits of a CLT100:

■ CLTs work by enabling occupiers to pay for the use of buildings and services at prices they can afford;

■ The value of the land, housing subsidies, planning gain and any equity benefits are locked in to the benefit of the local community being provided for;

■ As a result, a CLT can ensure access to housing for those on low and moderate incomes and owner occupancy that is affordable though part purchase models; and,

■ Providing a local vehicle for charitable giving, financial investing, local community control and participation (addressing the social action priority of Government). Coalition Government policy has increasingly focused on the possibility of making use of CLTs to move control of building projects and planning to communities. The Coalition agreement contains a commitment to ‘create new trusts that will make it simpler for communities to provide homes for local people’.

97 CLG (2008), Community Land Trusts: A Consultation, p 8 98 CLG presentation to the Community Land Trusts Conference and Exhibition 2012 99 The Co-operative Party (2009), Unlocking the potential for affordable homes 100 University of Salford (2011), Proof Of Concept: Community Land Trusts

42 Evidencing demand for community finance

3.4.3. Crowdfunding The development and role of debt and equity based funding is outlined in Section 2.4.3 above. As the economic climate has made raising finance an increasingly harder challenge for all types of businesses, including CSOs, crowdfunding is playing an increasingly important role. 3.4.3.1. The donation model of crowdfunding The donation model of crowdfunding operates similarly to most charity fundraising. Crowds, usually small scale philanthropists in the general public, donate with the expectation that the money will be used to achieve the aims of a charitable project. In most cases donation crowdfunding is facilitated by a third party via a crowdfunding platform and each fund is targeted at funding a specific, time- limited project. Most donation crowdfunding platforms do not charge upfront fees. This makes this model of finance very attractive to charities or social enterprises. This provides a safe and efficient platform to take advantage of technology-enabled giving and reach potential philanthropists on a mass scale, via social media. Variations within donor platforms include:

■ When and how funds are transferred to a charity;

■ If there is an all or nothing or keep what you get model;

■ If there are upfront fees; and,

■ If they need to provide additional rewards or proof of social impact. Compared to other models of crowdfunding, donation platforms tend to attract a large number of projects but the fund raised by each project is relatively small. Based on its survey of over 25 reward and donation based platforms, crowdsourcing.org (2012) estimated that two-thirds of donation and reward based funds raised less than $5,000. The leading crowdfunding platforms in this category in the UK are ‘Just Giving’, ‘Seethedifference.org’ and ‘Spacehive’. They all charge nominal fees to cover the administration of their sites and as most donations are tax-deductable these fees are usually covered by additional tax revenue they can claim. Spacehive is targeted at a niche area but the other two platforms raise funds for a spectrum of charitable causes: 101 ■ JustGiving operates globally and claims to be the first platform of this kind to make donations simpler and safer via crowdfunding. To date they have raised over 1 billion for charities. The categories of project they fund include international aid, social welfare, elderly health and care, religion, medical and health and animal welfare; 102 ■ Seethedifference is a UK based platform that helps individuals raise funds for specific charity projects or give a gift to friends and family. Each project has to demonstrate the difference that the project makes through specific and achievable objectives. They have helped raise funds for over 56 charity projects, all of which are registered with the UK charities commission. The categories of projects it supports include animal welfare, children and sport, disability, education and health; 103 ■ Spacehive is a UK based charity that provides a platform for funds for anything in a public space; examples include building a park or rejuvenating a rundown area. It allows groups or community leaders to suggest and seek funding for projects in public spaces. 3.4.3.2. The reward-based model of crowdfunding The reward-based model is best known for raising funds to support creative products, services or experiences targeted at new and existing fans. This model is similar to the donation model in that investors donate to projects rather than invest for just financial return. As the funded projects are not charitable, donors expect a non-financial reward. This is usually by way of access to products or services later developed by the project. Investees are encouraged by project owners to be creative in

101 http://www.justgiving.com 102 http://www.seethedifference.org/ 103 http://spacehive.com/

43 Mind the Finance Gap

their propositions. Pre-purchase based crowdfunding is a variation of this whereby the fund is raised by pre-selling ticket or products, such as CDs or concert tickets. This model is suited to individuals or organisations that are looking for start-up finance for a consumer related product or services or a creative enterprise (i.e. artists, investors, filmmakers, musicians, writers) and tends to attract crowds consisting of philanthropists, avid fans and gadget lovers. Similarly to donation platforms, the funds raised are usually small. The leading platforms that support projects that meet these criteria include: 104 ■ Kickstarter was one of the first platforms dedicated to this model of crowdfunding. This is a US based platform and is still considered the market leader for crowdfunding creative products. To date, Kickstarter has raised funding for over 20,000 projects in the areas of music, film, art, technology, design, food and publishing. Approximately half of all projects pitched on Kickstarter are funded. The average project is raising under $10,000. The average pledge is $71 but donations are positively skewed. The most common pledge is $25; 105 ■ PleaseFund.Us is a UK based platform which follows a similar business model to Kickstarter. They support crowdfunding for creative projects. It markets itself on providing a risk free platform to raise finance for creative projects. Funders are not offered investments as the project owner retains full ownership and control of the idea. Instead they are offered an experience, products, acknowledgments or accreditation in return for their contribution; 106 ■ Indiegogo is a global crowdfunding platform that funds a mix of creative projects as well as causes and entrepreneurial ventures. Most of the funds are not charities and thus contributions are not tax-deductable. Projects attract investors either by appeal on social grounds or by offering non-monetary perks, such as limited addition merchandise, preview or tickets to an event and credit.

3.5. Investors In February 2011, the Government published a vision for growing the social investment market. Social investment is defined as the provision of finance to achieve social outcomes and gain a financial return107. The Government highlighted the need to make it easier for CSOs to access external finance and advice. At the heart of this vision is the development of a new ‘asset class’ of social investment to connect CSOs that have financially self-sustaining business models, including social enterprises and mainstream capital. The most explicit statement of this intent has been the launch of Big Society Capital – an independent financial institution established to develop and shape a sustainable social investment market in the UK108. Social investors have three basic types of financial instruments at their disposal: debt, equity or grant (see 0):

■ Debt: Debt has historically been the instrument of choice in the social investment market because it is well understood and it tends to be asset-backed. The low levels of risk that debt investors are comfortable with has not, however, favoured greater social innovation – and levels of unsecured lending remain low.

■ Equity: Equity has tended to be neglected by social investors; the risks are considered too high compared with the potential financial return. Only 2% of social investments in 2010 were equity instruments (with a further 3% in quasi-equity instruments)109.

■ Grants: Foundations awarded grants of £3bn in 2008/09 (representing 20% of all UK private charitable giving of £15.4bn). As well as the Big Lottery Fund110, the top 5 family foundations by

104 http://www.kickstarter.com/ 105 http://www.pleasefund.us/ 106 http://www.indiegogo.com/ 107 Cabinet Office (2011), Growing the Social Investment Market: A vision and strategy. 108 See http://www.bigsocietycapital.com/ 109 This reluctance to deploy equity instruments is largely due, amongst other things, to: organisational structure, only 12% of organisations that received social investments in 2010 had profit distribution mechanisms; inability of business models to generate returns that reflect the investment risk; lack of exit opportunities - no route to IPO, few potential trade buyers, and no secondary investment market.

44 Evidencing demand for community finance

charitable expenditure were the Wellcome Trust (£681m), the Gatsby Charitable Foundation (£50m), the Leverhulme Trust (£45m), the Wolfson Foundation (£39 m) and the Monument Trust (£35m). These sit alongside government investment finance to the value of £385m by 2010111, through grants, unsecured loans, quasi-equity and equity products112. Figure 3.5 Sources of finance (social enterprises)

3% 2% 0

11%

84%

Sources of finance Secured lending Unsecured lending Quasi-equit Equity

Source: BCG - by quantity of social investment CSOs source external finance from multiple sources and in a range of forms. A bank loan is the type of finance most likely to be sought (around a third of all finance sought), followed by a grant (20%) and a bank overdraft (17%). The purposes for which external finance are sought are broadly similar for CSOs and SMEs. The predominant need for, and use of, money is for working capital to cover the short-term costs of delivering their service and core operating costs. A higher proportion of CSOs plan to acquire property or increase their asset base and are looking to undertake this capital investment generally through a portfolio which includes loan finance and grants where available113.

3.6. Market developments The last decade has seen a number of cultural shifts in which people have begun to think more carefully about the ethical and environmental impact of the choices they make as investors. Moves towards ethical consumerism, ethical finance and community enterprise all present important opportunities for social enterprises. Equally, recent trends and changes in government policy in the UK such as the focus on localism, the opening up of public services to a wider range of providers (discussed in Section 3.1.1) and the move to a regime of payment by results in the delivery of public services also create opportunities.

3.6.1. Increasing the supply of social investment Big Society Capital (BSC) became fully operational on 4 April 2012. It is the first social investment institution of its kind anywhere in the world. BSC is capitalised with the English portion of the estimated £400 million in unclaimed assets left in dormant bank accounts for more than 15 years, as provisioned under the Dormant Bank and Building Society Accounts Act 2008. It will also receive up

110 BLF are a major player in the grant making community; BLF‟s strategy for social investment provides an opportunity to shape how grants are awarded in the social investment market 111 As cited in ClearlySo (2011) and including Futurebuilders, SEIF, Community Builders and other funds such as the ACF 112 Although grants have the clear advantage of being non-repayable, the conditions attached to them have been argued to limit the capacity of organisations to expand and leverage in commercial finance. It should be noted, also, that where loans have been provided they have been so only where bank financing cannot be secured. 113 SQW (2007), Research on Third Sector Access to Finance, Report to the Office of the Third Sector

45 Mind the Finance Gap

to £200 million equity investment from HSBC, Barclays, Lloyds TSB and RBS as set out in the Merlin Agreement114. The ultimate goal of BSC is to accelerate the emergent (and underserved) market of social investment to a robust and sustainable market that can provide social enterprises, mutuals and other social sector organisations with an appropriate, reliable and sustainable supply of finance over the long term. As a wholesaler BSC will not invest in front line social sector organisations directly; rather it will seek to invest in CDFIs and other SIFIs and, in doing so, enable them to become more financially robust, able to attract investment, and able to provide effective financial and business support services to frontline social sector organisations. BSC will focus, initially, on making investments and providing support to the social investment market in response to demands for capital from SIFIs, who in turn will be driven by the needs and demands of front-line social sector organisations. Through its capacity to invest debt and equity and to co-invest with other investors, BSC will have the ability to accelerate the establishment of diversified social purpose funds, such as venture funds, property funds, community asset funds, microfinance funds and funds that invest in social impact bonds. Such funds will provide social and management expertise as well as investment capital to social sector organisations capable of expanding to deliver significant social impact as well as a financial return. As the market develops and as BSC, through its initial investment activity and through its research, builds up a more and more detailed picture of both the social investment market and of the finance needs of the frontline social sector, BSC will take a more proactive approach to its investments, potentially identifying a need for capital or greater intermediation activity where there is neither articulated demand nor supply and facilitating flows of capital and support to those areas.

3.6.2. Increasing the demand for social investment Other recent Government initiatives to increase the demand for social investment include:

■ Encouragement for Social Impact Bonds: The Cabinet Office has supported four local authorities115 to develop payment by results contracts that could be financed by social impact bonds to fund intensive intervention for families with problems such as crime, addiction and poor education. A Social Outcomes Fund has been announced by the Cabinet Office (November 2012) to provide a ‘top-up’ contribution to payments by results or social impact bonds contracts that are designed to deal with complex and expensive social issues.

■ Investment and Contract Readiness: The Investment and Contract Readiness Fund is a three year £10 million fund to help CSOs secure social investment and bid for public service contracts116. It will support organisations that have the potential to deliver their services and positive social impact at scale, but are not yet in a position to take on repayable finance. The ICR Fund will give out grants of between £50,000 and £150,000 and expects to support about 130 CSOs over the three years.

■ Increasing support for public sector spin outs, with Government indicating a long term potential for up to 1 million public sector workers to spinout and form mutuals: Support is being made available from the Mutual Support Programme, a £10m programme that comprises a website, dedicated hotline and funds. 21 Pathfinders, fledgling mutuals being set up by entrepreneurial public sector staff who want to take control of their services, have been launched.

■ Impact measurement: The Cabinet Office have been working with the social sector to drive a new programme, Inspiring Impact, designed to accelerate the uptake of impact measurement across the UK social sector over the next decade117.

114 Big Society Capital (2012), Vision, mission and activities 115 The four local authorities that the Cabinet Office supported are: Westminster, Hammersmith and Fulham, Leicestershire and Birmingham. 116 http://www.beinvestmentready.org.uk/ 117 Inspiring impact (2011), Working together for a bigger impact in the UK social sector

46 Evidencing demand for community finance

3.6.3. European support and debate The European Commission published a Communication on a Single Market Act that included ‘twelve levers’ to boost growth and strengthen economic confidence. One of the twelve levers was social entrepreneurship and the Commission’s proposals in this area included a Social Business Initiative. The Commission identifies social enterprise as means of addressing social problems using business methods. It suggests that more needs to be done to provide an environment in which social enterprise can thrive and maximise their impact118. The Communication on a Social Business Initiative sets out the Commission’s approach to supporting the development of social enterprises. It aims to develop a short-term action plan to support the sector and prompt debate on actions required in the medium to long term. Key actions include a proposal to improve access to finance through:

■ a European regulatory framework for social investment funds before the end of 2011 to facilitate access to the financial markets for social enterprises;

■ easing access to micro-credits through the Progress Microfinance Facility and improvements to the legal and institutional environment for micro-credits;

■ a €90 million (c£78.4 million) European financial instrument to facilitate access to funding; and,

■ the prioritisation of investment in social enterprises in the ERDF and ESF regulations.

3.7. Community Finance and Civil Society: Demand, Supply and Barriers There are almost 900,000 CSOs in the UK, which vary enormously from informal community organisations to large charities. The 68,000 social enterprises are an important subset of the sector and, like other SMEs, they need access to finance if they are to invest and grow. A variety of market and policy drivers (e.g. including the Government’s Open Public Services and Community Rights agendas) are encouraging an expanding array of CSOs to begin the journey towards sustainable business models. Historically demand for finance has been met through a variety of provision, with Government playing a long term and key role alongside commercial lenders. Market failure exists, however, because mainstream banks can only fund based on financial return – not the social returns to society also generated. The nascent social investment market seeks to address these market failures by providing finance to CSOs based upon their blend of social and financial return. It is estimated that the total social investment in 2010-11 was £190 million (compared with £3.6 billion philanthropic grant funding and £13.1 billion individual giving). As the market has emerged CDFIs have become the dominant providers of finance to the sector, last year disbursing 390 loans to CSOs worth £145 million. A small number but wide variety of other SIFIs than just CDFIs also exist who lend, develop and structure funds and financial instruments. However the State Aid case prepared by Government on difficulties accessing finance encountered by CSOs concluded that the market fails to supply the sector with between £0.9 and £1.7 billion per year. The social investment market remains immature, although in development through a range of activities funded through Government (including the launch of Big Society capital), so it is unlikely that CDFIs and other SIFIs will be able to meet the future demand and do so sustainably. Most intermediaries still carry an operational gap in their model where the cost of investing and supporting frontline organisations is not covered by the income earned on the investment. This is partly due to the lack of scale and the associated efficiencies as well as the length of time required for a social investment to begin delivering financially.

118 European Commission (2011), Communication – Social Business Initiative

47 Mind the Finance Gap

4. Community finance for individuals

Credit unions (and CDFIs) help to address the gap in the credit market but their costs are high and they are not financially sustainable. They rely on grant income, but with these sources of funding likely to be under greater pressure in the future they need help to change. There is a need to reduce costs, increase capacity and improve products and services to attract more customers.

4.1. The underserved market of personal lending: financial exclusion and lack of access to affordable credit The vast majority of people rely on a bank account to pay their bills, receive their salaries and access other financial products such as mortgages and pensions. A significant minority lack access to even the most basic financial services and products, incurring significant financial costs as a result. The previous Labour Government established the Financial Inclusion Task Force in 2003 and its subsequent strategy, Promoting Financial Inclusion119, set out a range of measures in the following priority areas:

■ access to banking and affordable credit: improving access to products and services that are suitable and meet the needs of the financially excluded; and,

■ money advice: improving understanding of financial concepts and the skills and motivation to plan ahead120. The number of UK adults without a bank account subsequently dropped from 3.75 million in 2003 to 1.4 million in 2011121. This fall coincided with the introduction of two new types of account – basic bank accounts (banks and building societies opened nearly 4 million basic bank accounts in the UK between 2004 and 2008122) and post office card accounts123. The current Government believes that the continuation of these positive trends is ‘considered unlikely’124. In addition to the unbanked, 4 million low income households are ‘under-banked’, having poor access to mainstream financial services offered by retail banks. Nearly one million households also need money management advice to avoid high levels of regular bank charges. Many of those with bank accounts are on the margins of banking and barely use their account – about half of basic bank account holders prefer to withdraw all their money each week and manage it as cash, because it gives them more control over their finances than using a bank account that does not suit their needs, or because they have a basic bank account that comes only with a cash card125. At the same time household finances are under severe pressure from a combination of high rates of inflation and weak earnings growth. Real household disposable income has fallen and households have deleveraged only slightly. The ratio of debt to disposable income has fallen from 156% in the fourth quarter of 2008 to 146% in second quarter of 2011. Some 23% of UK households report that they are already ‘somewhat’ or ‘heavily’ burdened in paying off unsecured debt126. Indeed, the debt payments of UK households are 10% higher than they were in 2000. This statistic is particularly problematic because at least two-thirds of UK mortgages have variable interest rates, which expose borrowers to the potential for rising debt payments should interest rates rise.

4.2. Specific market failures As outlined above, a small but significant minority of individuals and households cannot access even the simplest financial services. Lending small sums to low income (sub-prime) consumers is

119 HM Treasury (2004), Promoting Financial Inclusion 120 Collard, S. (2006), Affordable credit for low-income households, p.6-10 121 DWP Credit Union Expansion Project (2011), Feasibility Study Report 122 JRF (2008), Financial inclusion in the UK: Review of policy and practice 123 National Consumer Council (2005), Basic Banking: Getting the First Step Right 124 DWP (2011), Feasibility Study Report, p.4 125 ibid 126 McKinsey Quarterly (2012), Working out of debt, p.5-6

48 Evidencing demand for community finance

expensive, and carries a higher risk of default and eventual write off. The banks do not tend to serve this sector of the market, seeing reputational risk from the high interest rates required to make adequate returns on capital127. For example, the Financial Inclusion Taskforce Report for the 2009 Budget reported that: Many consumers require small cash loans that mainstream credit providers do not offer. These loans are typically under £500 and are repayable over short periods by weekly payments. Mainstream banks have little appetite or capability to serve this market effectively, in part because the cost of delivery would necessitate charging APRs of a level that could bring reputational risk. Low income, high-risk consumers have typically been served by high cost credit providers such as home credit lenders or hire purchase retailers. There are also a complex set of wider contributory factors that also contribute to financial inclusion, including128:

■ geographical exclusion: for example, resulting from branch closures;

■ condition exclusion: the failure to qualify because of minimum deposit required, poor credit history or identity requirements;

■ price exclusion: the relative cost of financial products and services such as unauthorised overdrafts;

■ marketing exclusion: some less profitable groups of customers are not targeted by providers and so they are unaware of the financial services available; and,

■ self-exclusion: cultural and psychological barriers – financial services as ‘not for people like us’. The literature shows that those who do not make use of financial services fall into five main groups:

■ householders who have never had a secure job are the largest group;

■ elderly people (aged over 70) who are part of a cash-only generation;

■ young householders who have not yet made use of financial services, but may do so in the future;

■ women who became single mothers at an early age; and,

■ some minority ethnic groups - particularly Pakistani and Bangladeshi households – who make limited use of financial products due to language barriers or religious beliefs. Moreover, financial exclusion is a dynamic process with many more households moving in and out of exclusion than are without products at any one time. Whatever the explanation, people on benefits and low incomes are then forced to pay a high price for credit when they need to borrow (i.e. often termed ‘paying a poverty premium’). This means that they pay more to manage their money, find it harder to plan for the future and cope with financial pressures, and are more vulnerable to financial distress and over-indebtedness.

4.3. Credit Unions and CDFIs as intermediaries: bringing demand and supply together People without access to financial products have an unmet need for: day-to-day money management, including savings or consumer credit products; medium-term security (i.e. insurance against loss of income or loss or damage to possessions); and long-term financial security (including pensions). Community-based organisations such as credit unions and CDFIs are active in providing affordable credit and money advice to those on the lowest incomes. Originating in the communities they serve, they deliver affordable credit provision in financial exclusion hotspots, increasing the supply of affordable credit and developing more suitable methods of loan delivery.

127 Opinion Leader Research for the Financial Inclusion Taskforce (2005), Financial inclusion deliberative workshops 128 JRF (2008), Financial inclusion in the UK: Review of policy and practice

49 Mind the Finance Gap

4.3.1. Credit unions Credit unions are member-owned, not-for-profit financial institutions providing bill payment facilities, financial advice and education, life insurance and other financial products. They are legally obliged to define a group of people who share a ‘common bond’ from whom they can recruit their membership and to whom they can provide services. This is often the workplace and/or the local community. In being prepared to lend to people who are (or are likely to be) rejected by commercial banks they address financial and social exclusion. In summary, the latest available evidence suggests that in the UK:

■ there are 433 registered credit unions providing financial services to 826,557 adult members and an additional 114,000 young people (as savers); 129 ■ they hold £689 million in deposits with more than £561 million out on loan to members ; and,

■ in the past two years total loans from credit unions have increased by around £100m and membership has grown by around 120,000130. Credit unions have struggled to make the transition from small borrower-oriented organisations to more business-like and commercially-oriented financial institutions, having a capacity to offer the range of products and services required by people on low incomes. Participation typically demands a higher level of personal commitment from members than the relationship between a bank and its customer and the activities of credit unions have been tightly constrained by legislation. Credit Unions currently have just 4% market penetration, which compares to 44% in USA, 47% in Canada and 75% in Ireland. There are some areas in which credit unions are more prominent, including Northern Ireland (26% of the population belong to a credit union) and Central West Scotland (35% of the total UK membership)131. The majority (75%) of credit unions in the UK are small (with assets of less than £0.5 million). The bulk of assets (75%) and members (55%) are to be found in the larger credit unions (with assets greater than £2 million), which, in numerical terms, account for only 11% of the sector. Despite low levels of capitalisation and market penetration, credit unions save people on lower incomes an average of £401 per year compared to the interest charged by other high cost lenders132. A more detailed cost comparison of a typical loan is outlined in 0.

Table 4.1 Cost comparison of a £300 loan

Credit provider Repayment APR Amount period repaid Typical Credit Union (at least 8 weeks saving required 52 weeks 12.7% £318.64 beforehand) Credit Unions (offering instant loans) 52 weeks 26.6% £337.99 26.6% APR, paid over 52 weeks Community Development Financial Institution (offering 50 weeks 47.5% £357.50 instant loans) Typical home credit company (home collection, APR 52 weeks 272.2% £546 272.2%) Difference between the cheapest and most expensive £227.36

Source: DWP (2011), Credit Union Feasibility Study

129 FSA (2011), Annual Returns 130 Financial Services Authority - Note: These statistics are based on unaudited figures and can therefore not be relied upon as giving an accurate snapshot of the sector at any given time. 131 Ward, A. and McKillop, D. (2005) An investigation into the link between UK credit union characteristics, location and their success. 132 HMT PfRC (2010), Growth Fund Evaluation

50 Evidencing demand for community finance

The feasibility study underpinning the DWP’s expansion project for credit unions reported that they offer the most competitive interest rates on personal loans of up to about £2,000 in the UK market. The position extends to loans up to £3,000 where credit unions can afford to reduce the interest rate charged to 1% per month on the receding balance133. The challenge to expansion of the sector is not one of demand. The study segmented the market for credit unions into two categories, excluding people on middle or average earnings but including two ‘tiers’ for those on a mix of benefit and wages as well as those on lower wages. 0 illustrates that the scale of met demand for credit union services: Table 4.2 The consumer market for credit – current met demand

Consumer Income Description Outstanding Total bracket borrowing savings Tier II 11% to 40% Likely to be in employment but household 18bn £23bn income below £30,000 Tier III Lowest 10% The majority of which are benefit claimants £7.3bn £7.6bn

Source: DWP (2011), Credit Union Feasibility Study

In total, 60% of low income consumers not currently served by credit unions said they were looking for low interest rates on loans provided by local, trusted service providers but only 13% had heard of credit unions and only 8% thought they could help134. Potential customers, when asked what financial services they wanted, demanded a range of bill payments service, including direct debits and standing orders, and access to a savings accounts and other facilities such as jam jar accounts priced at affordable levels. The report concludes that135: This demonstrates how far from mainstream financial services sector many credit unions are still considered to be by consumers. However, if this image and awareness gap can be addressed low income consumers are likely to see credit unions as trusted providers, especially if they are able to offer the specific products and services required at an affordable price.

4.3.2. CDFIs As discussed in the previous two sections, CDFIs are not-for-profit organisations that provide lending and investment facilities at competitive rates in disadvantaged communities. The majority of CDFI activity is focused on lending to small businesses, including civil society. However, in recent years there has been a rise in the levels of lending to individuals and households, including personal loans for a variety of purposes (e.g. decorating, furniture, school uniforms, etc) or to pay off or consolidate a loan with doorstep lenders136. Eleven CDFIs serve individuals and homeowners as their primary market and three as a major secondary market. Five provide both personal and home improvement loans and five provide personal loans only. The products and services provided vary greatly but personal lending tends to be high volume and low value. Last year CDFIs reported making 20,650 personal loans worth £8.3m. Two CDFIs accounted for 42% and 18% of the total value, respectively. The number of loans disbursed per annum has increased significantly over the past four years, with nearly six times as many loans made last year than in 2007. The value of loans disbursed has increased, albeit at a lower rate, with about three-and-a-half more in value disbursed last year than in 2007. The relative greater increase in number versus value of loans made means that more customers were being served with relatively smaller sum loan amounts.

133 DWP (2011), Credit Union Expansion Project (2011), Feasibility Study Report, p.9 134 DWP (2011), Credit Union Expansion Project (2011), Feasibility Study Report, p.11 135 DWP (2011), Credit Union Expansion Project (2011), Feasibility Study Report, p.10 136 Home improvement loans where an individual is unable to obtain a loan from their mortgage lender, bank or building society or grant funding is described separately in Section 5.

51 Mind the Finance Gap

Figure 4.1 Personal lending disbursed by number and value (2004-11)

9 25000 8 7 20000 6 15000 5 4

10000 Number Value (£m) Value 3 2 5000 1 0 0 2004 2005 2006 2007 2008 2009 2010 2011

Value (£m) Number

Source: CDFA (2012), p.52

There has also been an unprecedented growth in portfolio value since 2007, with £2.7 million outstanding in 2007 and £7.7 million in 2011 (an increase of over 300%, largely due to funding made available through the Government’s Growth Fund). In total, 70% of CDFIs made average loans of between £400 and £600 with only two lending less than that amount on average and one much more, with average loans of nearly £1500. CDFIs charged an average APR of 31%, not dissimilar to the 26.8% credit unions can charge, with a range from 14% to 44%. Around 12% of loans across the portfolio value were written off, with individual CDFI write off rates ranging from 2% to 33%137.

4.4. Alternative funding paths: the high-cost credit market These products are typically small loans borrowed over short periods, where high interest rates or premium prices are charged (sometimes including product insurance). This consumer market is intended to provide quick and easily obtained short-term finance to individuals, offering an alternative to overdrafts or credit cards provided by mainstream lenders. Providers operate lawfully within the terms of credit licenses from the Office of Fair Trading (OFT) and other financial regulation, but can place a heavy burden on the low-income consumers they serve138. The Office of Fair Trading defined the high-cost credit market as including pawn brokering, payday and other short term small sum loans, home credit and rent-to-buy credit. In 2008, the OFT estimated that this market was worth over £7.5 billion139. The breakdown of this is illustrated in 0 below. The OFT concludes that: ‘although the precise current market size is disputed, it is clear that it is continuing to expand at pace, both online and on the high street’140.

137 CDFA (2012), Inside Community Finance, p52-53 138 ibid 139 The Office of Fair Trading (2010), Review of high-cost credit final report, p.2 140 http://www.oft.gov.uk/OFTwork/credit/payday-lenders-compliance-review/qandas

52 Evidencing demand for community finance

Figure 4.2 Breakdown of the £7.5 billion the high-cost credit market

Source: Burton, 2010

One high profile example of a payday loan provider is the venture capital backed Wonga, which is building up a strong share of the market (4 million loans worth £1 billion already made since its launch in 2007), with its lending platform offering loans of up to £400 for a maximum period of 30 days. A quick trip to Wonga's website shows how quick and (apparently) easy it is to secure a loan. Wonga claims to make an 'instant decision' and send out the payment within 15 minutes. The OFT investigation into the high cost credit market suggested that suppliers of high cost credit are meeting consumers’ demand for easier to access and fast financial products and filling a gap not filled by mainstream suppliers. The report made some recommendations to improve competition and regulate some aspects of price and debt collection. However it also recognised that without access to high-cost credit some groups of people would be denied access to any form of licensed credit. In its study – Keeping the Plates Spinning – Consumer Focus estimated that charges in the high cost credit market typically range from £13 - £18 interest for every £100 borrowed, but can be as high as £30 per £100 for some online providers. This can generate APRs in the region of 1,000% to 2,000% given the short-term nature of these loans141. By its very nature, this type of credit is very expensive because the values of the loans offered are low and therefore the transaction costs are proportionally high. Furthermore, as those accessing this type of finance have a higher risk of defaulting, this risk must be compensated with a higher return for investors. This model of finance has been criticised by consumer interest groups for exploiting the most financially vulnerable individuals. The danger for consumers comes when they take out a loan and cannot repay it the next month. If they defer payments or take out repeat loans, charges can quickly balloon. People can find themselves dependent on loans and facing a downward spiral of increasing debt. This can then sometimes create an inescapable cycles of debt and poverty142. The Government’s response to this has been to initiate negotiations with industry to introduce enhanced consumer protection conditions in their codes of practice143. However Consumer Focus’s further in-depth qualitative research144 with payday loan users suggests that some borrowers like payday loans, despite the high interest rates, because they are quick,

141 Consumer Focus (2010), Keeping the Plates Spinning 142 OFT (2010) , Review of high-cost credit final report, p.3

143 BIS and HM Treasury (2011), Response to the consumer credit elements of the Government‟s Review of Consumer Credit and Personal Insolvency 144 Qualitative research and analysis was conducted by Synovate in early 2010. Synovate conducted in-depth face-to-face interviews with 20 borrowers in London, Leeds and Glasgow. They had all taken out a payday loan at least once in the previous 12 months.

53 Mind the Finance Gap

convenient and it is easy to understand how much it will cost them to repay the loan. Some consumers in the study choose them over mainstream borrowing from banks because they fear being hit by unexpected overdraft and credit card charges or that these credit options will tempt them into long-term debt. Indeed payday loans can, for example, be cheaper than running up an unauthorised overdraft.

4.4.1. Alternatives to high cost credit The majority of people who enter arrangements for high cost loans are not aware of other alternatives145. Households with a need to make an essential purchase are faced with more than one option with different costs. Alternatives include:

■ Loans from the Social Fund: Net expenditure through the Social Fund in 2010-11 was £138.9 million through community care grants, £104.7 million for crisis loans for general living expenses including rent in advance and £26 million for budgeting loans to help pay for things like furniture, clothes and travel146.

■ Money advice through the Citizens Advice Bureau (CAB): In the form of an identified project or office, or a person who specialises in giving this sort of advice.

■ Local government, with this service usually directed at take-up of benefits and payment of rent, as well as at giving money and debt advice.

■ Advice given by an independent financial adviser (IFA), although they tend to offer limited capacity in advice services because they are profit driven, and advice given by a private sector financial services provider in connection with its own services. Advice to consumers about debt problems has for many years been provided free by Citizens Advice Bureau, independent money advisers, the Consumer Credit Counselling Service, National Debtline and others. Since the mid 1990s, fee-charging debt management companies (DMCs) have also entered the market. They advise on how to restructure debts, how to alter debt repayments or how to achieve early resettlement of debts. This often extends to contacting or negotiating creditors in order to make new arrangements. The social housing sector has also begun to play a role in the affordable credit market. A small number of larger housing associations have now established financial services divisions or are working in partnership with credit unions or CDFIs to deliver loans products and insurance products to their tenants. Typical services include:

■ support and promotion of credit unions operating in areas with housing stock (e.g. providing office accommodation, displaying literature, including information about the credit union at sign-up, etc);

■ the provision of information and advice with claiming benefits and maximising income including, for example, energy efficiency measures and local furniture reclaim schemes);

■ advice and help to residents in debt and/or arrears with rent. These services were previously supported by the DWP Growth Fund and the Financial Inclusion Champions initiative. However the scale of delivery is small and reached 20,000 customers in 2011147.

4.5. Investors In March 2007, the then Government set out its strategy to tackle financial exclusion, which until 2010 set the direction for public support for the sector. The Government re-emphasised the important role played by credit unions and CDFIs, providing additional funding through its Financial Inclusion Fund, which provided £25 million a year to support the work of debt counselling agencies, including Citizens Advice, to allow them to keep working and providing free help.

145 DWP Credit Union Expansion Project (2011), Feasibility Report, p.4 146 DWP data (2011) available at http://www.dwp.gov.uk/local-authority-staff/social-fund-reform/localisation-data/ 147 DWP (2010), Social Fund Reform: debt, credit and low income households, p.11

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To increase the scale of these ‘third sector’ lenders, government funding has been made available for enhancing organisational capacity by providing training and development of credit unions and CDFI lenders. The main driver of growth in the sector since 2000 has been the influence of Growth Fund capital support. This money was provided on the basis of developing and implementing business strategies for further growth and sustainability, thus requiring credit unions and CDFIs to adopt a new model of development focussed on financial sustainability. Since 2006, participating credit unions have increased: their membership from an average of about 3,000 to 7,000; and the number of loans they make each year to low income consumers (from 50,000 in 2006/07 to 150,000 - worth £70 million - in 2010-11). An independent evaluation reported that 80% of beneficiaries said their organisation had improved its working practices as a result of the Growth Fund and now operated in a more business-like way. Research seems to demonstrate that credit unions were keen to grow but had been cautious about losing their local identity, with a majority saying they felt the image of the movement as a ‘poor man’s bank’ was holding them back148. The evaluation also highlighted how funding had dramatically increased the scale of those credit unions which used the funds and thus has polarised the sector significantly between the traditional small, and relatively expensive and inefficient lenders and a few bigger credit unions with substantial loan books. DWP research indicates that funding has not generated increased deposits or membership by anything like the amount expected. The biggest unions are heavily dependent on public grants for their continued lending – as a result questions have been raised about whether the current funding model is financially sustainable (see Section 4.6 below). At present the effectiveness of credit unions is limited by their number and scale of activities, which prevents them from enjoying economies of scale and improving their services. Cost structures tend to be high, interest on loans is significantly lower than charged by other sub-prime lenders, and the gap between cost and income needs to be bridged if they are to become financially sustainable.

4.6. Market developments DWP recently carried out a feasibility study of how the sector can modernise and expand to serve many more customers. The feasibility study looked at options for expanding credit unions to serve a million more people with the financial products they need, including budgeting, or jam jar accounts as they are often known, and how credit unions could expand in a way that could become financially sustainable over time. In response, and based on evidence of latent demand for basic banking and credit services from those on low incomes, DWP proposes to invest up to £51 million in the credit union sector during Spending Review 2010 (£13 million of this was spent in 2011-12) but DWP does not expect to continue funding credit unions after March 2015. To modernise credit unions (and potentially CDFIs) funding will be directed towards:

■ taking immediate steps towards sustainability, aiming to achieve 40% cost reductions;

■ automation of loan decision making to reduce operating costs and the cost of bad debt;

■ the introduction of IT support systems/platforms to provide the online banking, jam jar accounts, and automated savings and credit products;

■ delivery of a national image building campaign to maximise customer awareness; and,

■ work with landlords etc. to increase membership and generate additional income. By combining the impacts of all of these strands the overall impact is expected to be a 50% reduction in process costs/process time and significant increases in members, loan values and savings. The Government also suggest that the introduction of Universal Credit provides an opportunity to offer benefit claimants access to suitable banking products so that they can budget their benefits and earnings from work effectively. In August 2012 DWP published a notice alerting suppliers of their intention to engage with the market to explore this proposition, including a potential investment of up to £145 million in financial products and services with extra budgeting functions to support

148 PFRC and ECORYS (2010), Evaluation of the DWP Growth Fund, p.39-41

55 Mind the Finance Gap

claimants as they move to Universal Credit. These products will include features to help people on low incomes to budget, including:

■ support for claimants to budget and manage their money;

■ regular payments for housing and other main bills;

■ facility for Direct Debits;

■ options for multiple income streams from work and benefits;

■ access to all claimants, irrespective of credit history;

■ options to build up a credit rating;

■ availability to people once they have moved off Universal Credit

4.7. Community Finance and Personal Lending: Demand, Supply and Barriers The vast majority of people rely on a bank account to pay their bills, receive their salaries and access other financial products such as pensions. However in 2011 there still remained a significant finance gap for financial services, consisting of: 1.4 million adults without even a basic bank account; up to 4 million low income households that are ‘under banked’ and have poor access to mainstream financial services; up to 7 million people who use sources of high cost credit; and up to 1 million people in need of money management advice to avoid high levels of regular bank charges. Mainstream banks have little capability to serve this market effectively as the cost of delivery would necessitate charging interest of a level that could bring reputational risk. Credit Unions and CDFIs are currently serving about 4% of the lower income population. A consumer survey commissioned by DWP showed that 60% of low income consumers wanted the type of local trusted service that credit unions and CDFIs can provide but only 13% were aware of the services provided. Meanwhile usage of high cost and payday lenders continues to grow. The community finance movement views theses costs to be exploitative and therefore these consumers are seen to comprise the finance gap. It is estimated that the current total investment inflows into the UK based on value of loans made is around £3-3.5 billion. Given that loans are typically short term this suggests the total money needed to service loans of around £1 billion per annum. DWP wishes to see the expansion of local trusted financial services to a million more people and will invest up to £38 million between 2012 and 2015 to achieve this objective. Its analysis suggested that the current credit union and CDFI model was not financially sustainable – cost structures were too high and the gap between cost and income needs to be bridged. However the growth expected through the DWP modernisation agenda would still see the community finance sector serving no more than 8% of the lower income population (2 million members).

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5. Community finance for homeowners

Existing provision by CDFIs to support homeowners unable to maintain minimum standards of housing or adapt their homes to changing needs is under intense budgetary pressure. The imminent Green Deal to support energy efficiency adaptation may provide very substantial opportunities for service provision.

5.1. The underserved market of homeowner finance: meeting the cost of maintaining, repairing and adapting homes to changing circumstances Unless a homeowner qualifies for a grant to help with the cost of home improvements (such as for energy efficiency or housing renovation), they will have to pay for the improvement themselves. Savings, if available, may pay for minor improvements but for bigger improvements - such as installing central heating or building an extension – this may require the homeowner to borrow money. The cheapest way to borrow for home improvements is usually to take out a ‘further advance’ on a mortgage. This simply means that the homeowner increases their mortgage by the extra amount. The new total amount of the mortgage (including the further advance) will need to be less than the value of the house. The further advance is usually repaid over the remaining mortgage term or arrangements may be made to pay the loan back more quickly if preferred. Arguably, mortgage lenders have a strong interest in encouraging repair and maintenance to the dwelling stock, both to protect their own investments and more generally to ensure that market values are sustained and that owners reinvest in their properties. However circumstances arise where the high set-up costs of relatively small loans, difficulties in servicing mortgage payments or a lack of equity to secure further borrowing additional debt rule out traditional financial products. For example circumstances arise where:

■ a household, especially an older household, remains in residence for a long period, there is potential for the development of serious disrepair problems;

■ a young household is unable to afford necessary repair work, because they have insufficient income or savings;

■ a household is in insecure employment which prevents further borrowing or saving to carry out repair, or reduces the household’s confidence in their ability to remain in homeownership; and,

■ relationship instability or breakdown, and an increasing propensity for people to live alone, undermines the capacity to meet mortgage payments regularly, accumulate savings, or take on further borrowing to finance repairs. The national housing condition survey provides information on the households most likely to experience poor conditions or require home improvements149. In 2009, of the 22.3 million dwellings in England, 6.7 million dwellings failed to meet the decent homes standard. Of these, 4.4 million dwellings were owner occupied. The profile of vulnerable homeowners is biased towards:

■ single women who comprise the largest group among vulnerable homeowners living in non decent homes;

■ a disabled person or households including someone who has a long-term illness; and,

■ lone parents and older age groups (a very high number of vulnerable homeowners living in non- decent homes are retired). The common characteristic linking most of these groups is poverty. There is a strong association between poverty and poor housing conditions in private sector housing. People on low incomes can only afford to buy low value dwellings which are often in poor condition. Frequently they cannot afford to repair and maintain their homes, so conditions deteriorate further. Home improvement services agencies, often funded through a local authority, are available to assist vulnerable homeowners who are older, disabled or on a low income to repair, improve, maintain or adapt their homes.

149 CLG (2009), English Housing Survey

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5.2. Specific market failures There are a number of specific market failures that prompt the state to intervene to deal with poor housing conditions:

■ Successive governments have accepted that households should have the right to housing which reaches a minimum standard in terms of condition, amenities and energy efficiency. For example, in 2000 the then Government introduced its flagship Decent Homes Programme to refurbish homes in England up to a minimum standard150. A target was introduced in 2002 to improve private sector homes in which vulnerable people lived.

■ There is a statutory obligation on the state to deal with very poor conditions and it will often be more cost-effective to intervene in a preventative way at an earlier stage151. However the perceived difficulties – both practical and financial – in carrying out home maintenance and improvement can lead homeowners to put off action until the property is in a state of disrepair. This means that they may needlessly spend several years living in deteriorating conditions and then have to pay for far more expensive works than if action had been taken earlier. Alternatively, by helping people to remain at home for longer, the costs of investment in adapting homes for disability or old age may be economical.

■ There is a growing awareness of the impact of poor housing conditions on health, which provides an increasingly important justification for intervention. For example, poor housing conditions have been linked to increased levels of limiting long-term illness, respiratory and infectious diseases, accidents and even to increased mortality.

■ Finally, housing conditions are an important element of broader policies aimed at regeneration, tackling social exclusion, the provision of care in the community, and environmental sustainability. For example, almost 50% of households in the lowest income quintile are also living in properties in the three lowest residential energy-efficiency bands and households in this income group also accounted for 78% of all households experiencing fuel poverty152. Despite the general increase in the capacity and willingness of homeowners to invest in their homes before 2007 and the credit crunch, a minority of homeowners have continued to struggle to keep up with the work that needs doing. ‘Right to buy’ has created a new cohort of owners, many of whom lack the income or savings to tackle repairs and maintenance in the longer term. The overall ageing of the homeowner population and increasing longevity are creating another large group who may lack the resources for dwelling upkeep. Often older owner occupiers have paid off their mortgages and may be very asset rich, but cash poor. And lastly, the flexible labour market and increasing instability in personal relationships are making it harder for younger people – once the main ‘engine’ for upgrading the older stock – to devote their energies and resources to renovation153.

5.3. CDFIs as intermediaries: bringing demand and supply together A small number of intermediaries have played a catalytic role in developing financial products that meet the needs of the underserved market. As funding was directed to local authorities, through the Decent Homes Programme or through funding made available through the regional housing pot, CDFIs were able to address legal, technical and accounting issues and effectively distribute funding to local communities and households most in need. Fourteen CDFIs currently serve households and work with local authorities and debt support agencies and others to inform and attract customers and deliver subsidised home improvement loans. In the last year almost £13 million was made available to around 1400 homeowners, with the average loan made being £13,000, within a range from £3000 to £58000.

150 The Decent Homes standard is based on four criteria and 15 hazards in order to maintain consistency with estimates. 151 A number of statutory responsibilities require government (or more commonly local authorities) to intervene to tackle poor housing conditions, notably the requirement to take action to deal with unfitness whenever this is identified. 152 CLG (2011), English Homes Survey 153 Leather (2000), Crumbling Castles? p.8

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CDFIs have developed a range of financial products in support of the private sector renewal agenda of local authorities. They work with partners to source referrals and provide technical or specialist service. Specialist home improvement CDFIs require expertise in mortgage lending, matching the most appropriate loan to the needs of the client and working under the regulatory supervision of the Financial Services Authority to protect the consumer. Issuing a home improvement loan can be an onerous process, involving in-depth interviews totalling many hours at the applicants home, extensive travelling and considerable paper work. Examples of CDFIs active in providing home improvement loans include:

■ Parity Trust: Home Trust Loans: In addition to supporting local enterprises through the provision of loan funds and other sources of finance, Parity Trust makes loans to homeowners through mortgage finance, to enable individuals to improve, repair and adapt their properties. A Home Trust Loan is delivered in partnership with 16 local authorities across Hampshire, Surrey and Sussex and provides subsidised, low interest loans and specialist services and support. The average secured loan is £7000 and is used for various purposes including home improvements, renewable energy and empty property projects (a £600,000 loan capital fund). They also invest in community buildings and development projects, working with partners and professionals (e.g. architects, surveyors, designers) to contribute to the regeneration of local areas. A Community Land Trust has been established and is now run by volunteers (also see Section 3.4.2). It develops housing and other assets at permanently affordable levels for long term community benefit

■ Wessex Reinvestment Trust: Wessex Home Improvement Loans (WHIL): The Trust was established in partnership with several local authorities in the south-west region in 2004–05. It now offers a range of financial services to the community through Wessex Community Assets, small business loans and support via the Fredericks Foundation, as well as a range of loans for home improvement and repair through the Wessex Home Improvement Loan Partnership (WHIL). The Partnership was initiated to assist low-income and vulnerable homeowners with repairs and improvements to their homes. It was established as a CDFI and whilst it does not offer equity release loans to homeowners, the interest rates on its loans, (as well as the set-up costs), are subsidised by local authority partners. WHIL is also regulated by the FSA. In recent years it has not only expanded the number of local authorities with whom it works, but also the range of loan products available and the type of clientele it addresses. It currently receives financial support from 19 authorities in the West Country and has a loan book of about £3.9 million with a further £2.5 million of work in progress (as of 2011).

■ The London Rebuilding Society (LRS): Home Improvement Services: London Rebuilding Society is a social enterprise specialising in innovative forms of finance. It currently operates in three different areas of activity; it provides loan finance for small scale social enterprises in London; a Mutual Aid fund for migrant communities providing credit and training; and a Home Improvement Scheme helping vulnerable low-income homeowners to renovate their homes through equity release loans. Its home improvement activities have focussed very much on elderly and disabled people and it often funds the difference between the grant available and the ultimate costs of works. LRS also works in partnership with other agencies such as AGE UK and the Royal British Legion to provide support to clients after the work has been carried out. It has completed 29 schemes in six London Boroughs amounting to almost £2 million (as of 2011).

5.4. Alternative funding paths driving market development Some alternatives to mortgage lending and community finance are also available, such as home equity release schemes for older and asset rich homeowners who want to continue to live in their home or fund improvements. Equity release schemes tend to be expensive, with annual percentage rates of 7% or more (twice as much as conventional mortgages). Proponents argue that is not unreasonable because lenders do not know when their capital will be repaid and borrowers pay no interest during their lifetime154. However, it is notable that none of the high street banks or building societies, which dominate the conventional mortgage market, offers equity release under their own

154 Aviva, Just Retirement, Key Retirement Solutions, LV= (formerly Liverpool Victoria) and Partnership are among the biggest lenders in this sector.

59 Mind the Finance Gap

brand. Critics claim this demonstrates ongoing worries about this form of lending to potentially vulnerable borrowers. Assessment of the current and future market (including its size and potential demand) remains extremely difficult due to current market developments. In the following sections two key sources of finance, focussed on differing social benefits, are outlined - decent housing standards/well-being and energy efficiency / carbon reduction.

5.4.1. Decent Homes The National Housing Condition Survey provides information on the number of households experiencing poor conditions or requiring home improvements (‘non-decent’). In 2010-11, there were 5.1 million homes that were owner occupied and failed to meet the decent homes standard (i.e. one that meets statutory minimum standards for housing, is in a reasonable state of repair and has reasonably modern facilities and services)155. It is estimated that the current total investment inflows into the UK decent homes finance gap is around £15m per annum156. It is estimated that current UK potential demand for home improvement finance is in the order of £250m and 21,000 households per annum157.

5.4.2. Energy Efficiency, The Green Deal and Fuel Poverty The Government has a number of programmes to improve the energy efficiency of the existing housing stock and reduce carbon emissions so as to meet domestic and international carbon targets. The primary one has been the Carbon Emissions Reduction Target (CERT), introduced in 2008, which included a statutory obligation on energy suppliers with a customer base in excess of 250,000 customers to make savings in the amount of CO2 emitted by householders. Under CERT energy suppliers were required to spend £2.8 billion on carbon reduction measures between 2008 and 2011 and CERT has subsequently been extended to December 2012 with a new higher target158. CERT also requires 40% of its target to be delivered from Priority Group (PG) households. In 2010, CERT targets and duration were extended and a Super Priority Group (SPG), a subset of PG, created. The amended CERT obligation requires 15% of the ‘extended target’ (or 5.5% of overall target) to be fulfilled through SPG. The Community Energy Saving Programme (CESP), which started in September 2010 until December 2012, is a CERT associate programme with a particular focus on hard-to treat dwellings in low-income areas. Energy suppliers and contractors have been using a range of delivery channels for CERT including: direct negotiation and partnership with local authorities, social housing groups, social landlords; direct partnership with insulation contractors and lead generation agents; area based initiatives such as Local Community Energy Partnership and Warm Zones; direct marketing such as emails, direct mail, flyers, telemarketing, door-to-door, local magazine/newspapers, etc. and charity organizations such as Age UK and Citizens Advice. Overall, however, many are failing to meet their target obligations, especially amongst SPG households. The ‘replacement’ for CERT is the Green Deal and the Energy Company Obligation (ECO). The Green Deal is an innovative financing mechanism that lets people pay for energy-efficiency improvements through savings on their energy bills. A loan is taken out for a series of energy efficiency improvements to the house and is repaid through the reduction in energy costs and, literally, through the electricity bill (the loan is essentially ‘attached’ to the meter in the house, not the person). Interest will be charged on the loan but the rate will be fixed. Funding will be through Providers who can access wholesale funds through the Green Deal Finance Company (comprising the energy suppliers, banks and investment houses and housing infrastructure companies). Government has committed also to financially incentivise early take-up by householders although this is yet to be finalised.

155 CLG (2011), English Housing Survey headline Findings 156 ICF GHK estimate, 2012 based on CDFI activity 157 ICF GHK estimate, assuming 500,000 homes per year brought up to decent standard, the average enquiry to loan conversion ratio for CDFIs (27%) and the average CDFI loan of £12,000. 158 See http://www.decc.gov.uk/en/content/cms/news/pn10_075/pn10_075.aspx

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The ECO for the big six energy suppliers comprises an:

■ Affordable Warmth Obligation: to provide energy efficiency measures to low-income and vulnerable households (except social housing tenants);

■ Carbon Saving Obligation: funding for insulation of insulate solid-walled and ‘hard-to-treat’ properties;

■ Carbon Saving Communities Obligation: free insulation and glazing measures to people living in the bottom 15% of the UK's most deprived areas (including the social housing sector). Investment by suppliers is expected to be £1.3 billion per year with target support to 230,000 low- income households. Energy efficiency is linked also to fuel poverty. Households are considered by the Government to be in 'fuel poverty' if they would have to spend more than 10% of their household income on fuel to keep their home in a 'satisfactory' condition – and the energy efficiency of the home is a key driving factor alongside income and energy costs159. Given CDFIs role in providing finance to disadvantaged and financially excluded householders and communities, including through loan activity, they are expected to offer a key ‘route to market’ for the Green Deal and delivery of the ECO.

5.5. Investors Revenue to cover home improvement CDFI operating costs between 2010 and 2011 was raised through two main sources:

■ Earned income , including charges on products and services totalling £3.1, of which 48% came from loan interest: ;and

■ External sources, comprised of grants or investments totalling £4.97m, of which 48% came from local governments and 30% from the DWP Growth Fund: 160. Last year CDFIs reported receiving nearly £12m in capital to onlend to households for both consumer and home improvement loans. Public sources of support amounted for virtually all of the capital raised to on-lend, with local authorities contributing two thirds. Prior to their closure, Regional Development Agencies provided upwards of £10m per year. The total amount of capital available to on-lend as of 31 March 2011 was £9.4m, with two CDFIs holding 70% of total funds. The CDFI with the most funds, £4m, provides home improvement loans only. Seven of the eleven CDFIs reported having less than £150,000 in capital available to on-lend to customers.

5.6. Market developments In the owner-occupied sector, and partly due to the availability of mainstream finance, there has been ‘a total social revolution in 30 years away from social rented housing and into low-income owner-occupation... and we have got more low income people in home ownership than we have low-income tenants’161. Since 2007 ongoing difficulties in obtaining mortgage finance and growing labour market insecurity have made it more difficult to obtain finance for home improvements. House prices fell by more than 10% from the cyclical peak in prices, but while many parts of the UK have now stabilised or resumed real growth, the picture remains patchy. There has been a reduction in the ongoing provision of resources to support home improvement schemes in the context of a very difficult public expenditure round. In addition, all types of lenders have severely curtailed lending as house prices fell and regulators are taking a more robust approach to regulating lending. As a result the option of a financial product or plan that helped homeowners turn some of the value of their homes into cash became less likely. In addition:

159 See http://poverty.org.uk/80/index.shtml 160 CDFA (2012), p.57 161 Evidence citied in CLG (2010), Beyond Decent Homes

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■ plans can involve significant setting-up costs, particularly if the amount to be raised is relatively small;

■ there is mistrust of equity release products and providers, and belief that they are not good value for money (despite regulation of the sales process by the Financial Services Authority); and,

■ the biggest high street banks and building societies have been slow to enter the market, partly due to concern that reputations could be damaged by adverse publicity about deals done by others162. This has consequences for households unable to access credit for home improvements. Banks are restricting lending to consumers particularity those they consider are not a low risk. Marginalised consumers are finding it more difficult to get access to fair, affordable credit from mainstream lenders and may be forced to turn to high cost sub-prime lenders if they need to borrow. At the same time, the Coalition Government is proposing very significant changes to planning, housing and welfare policy which may influence households. These changes are complex but potentially have significant implications for housing and those on limited incomes. For example, cuts to Housing Benefit and the bringing forward of proposals for significant benefits restructuring, eventually subsuming housing and other working-age benefits, and cuts to publicly financed services of guidance and support relating to repairs and improvements for vulnerable households.

5.7. Community Finance and Homeowners: Demand, Supply and Barriers Since 2007, post financial crises, reduced opportunities to obtain mortgage finance and growing labour market insecurity have made it more difficult to obtain finance for home improvements. Regulatory tightening and affordability criteria have seen a severe curtailing of mortgage lending. Similarly there has been a reduction in the provision of resources to support home improvements schemes in the context of a very difficult public expenditure round. The underserved market has grown as mainstream banks find it difficult to lend relatively small amounts of money, with high transaction costs, to low income homeowners. Marginalised consumers are finding it difficult to access fair, affordable credit and may be forced to turn to high cost sub-prime lenders if they need to borrow. Assessment of the current market size and potential demand remains extremely difficult due to current transformational market developments. For ease, two finance gaps focused principally on differing social benefits are explored:

■ Decent housing standards: In 2010-11, there were 5.1 million homes that were owner occupied and failed to meet the decent homes standard (i.e. one that meets statutory minimum standards for housing, is in a reasonable state of repair and has reasonably modern facilities and services)163. It is estimated that the current total investment inflows into the UK decent homes finance gap is around £15m per annum164. It is estimated that current UK potential demand for home improvement finance is in the order of £250m and 21,000 homeowners per annum165.

■ Energy Efficiency, The Green Deal and Fuel Poverty: The Government has a number of programmes to improve the energy efficiency of the existing housing stock and reduce carbon emissions so as to meet domestic and international carbon targets. The primary one has been the Carbon Emissions Reduction Target (CERT). Under CERT energy suppliers were required to spend £2.8 billion on carbon reduction measures between 2008 and 2011 and CERT has subsequently been extended to December 2012 with a new higher target166. The ‘replacement’ for CERT is the Green Deal and the Energy Company Obligation (ECO), an innovative financing mechanism that lets people pay for energy-efficiency improvements through savings on their

162 CDFA (2010), p.1-10 163 CLG (2011), English Housing Survey headline Findings 164 ICF GHK estimate, 2012 based on CDFI activity 165 ICF GHK estimate, assuming 500,000 homes per year brought up to decent standard, the average enquiry to loan conversion ratio for CDFIs (27%) and the average CDFI loan of £12,000. 166 See http://www.decc.gov.uk/en/content/cms/news/pn10_075/pn10_075.aspx

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energy bills. Investment by suppliers is expected to be £1.3 billion per year with target support to 230,000 low-income households.

Given CDFIs role in providing finance to disadvantaged and financially excluded householders and communities, including through loan activity, they are expected to offer a key ‘route to market’ for the Green Deal and delivery of the ECO. However CDFIs, as in other aspects of community finance, sustainability remains an issue and there is a current heavy dependence on local authority funding (i.e. public sources of funds comprised 83% of resources available to onlend, with local authorities currently contributing nearly half).

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6. Key Findings

6.1. The supply of community finance Community finance describes the provision of affordable financial services and other support to businesses, civil society organisations, homeowners and individuals unable to secure mainstream finance. Community Development Finance Institutions (CDFIs) sit at the heart of community finance and provide loans and credit to:

■ Businesses and entrepreneurs (especially in disadvantaged communities) unable to secure finance from mainstream commercial institutions such as banks;

■ Civil society organisations (CSOs) such as social enterprises, charities, and voluntary organisations that place a strong emphasis on social, environmental and stakeholder as well as financial objectives;

■ Individuals unable to access short-term, low value credit and other financial services who must deal with sometimes abrupt fluctuations in income; and,

■ Homeowners who are unable to access a loan from a commercial lender (or a grant) to carry out essential repairs, adaptations and improvements to their property. In 2012, community finance organisations delivered an estimated £0.7 billion of community finance to UK businesses, communities, homeowners and individuals. This investment generated a wide range of economic and social benefits (especially within the most disadvantaged and excluded communities of the UK) - and which meet a wide range of Government policy objectives. Community finance organisations, if capitalised to do so, have the potential to generate sustainable economic development and social well being at the heart of UK communities. Currently, the majority of potential economic and social benefits are being lost to UK economy and society.

6.2. Demand for community finance This report suggests current potential annual demand for community finance in the UK of some £5.45 to £6.75 billion (excluding the Green Deal). Table 6.1 Annual demand for community finance

Community Finance Total potential value of annual Total potential annual number of Market demand clients SME lending £1.3b 103,000 Civil society £0.9b – £1.7b 57,000 Personal lending £3b - £3.5b 8,000,000 Homeowners £0.25b 21,000 (excluding Green Deal) TOTAL £5.45b – £6.75b 8, 181,000

Meeting potential existing demand implies developing better-capitalised, more productive, more scalable providers and stimulating growth of new innovative, lower cost models - ultimately, providing appropriate and integrated financial services that deliver to clients a ‘no wrong door’ and ‘one stop shop’ approach.

6.3. Opportunities and challenges The last decade has seen a number of cultural shifts in which people have begun to think more carefully about the social, ethical and environmental impact of the choices they make as consumers and investors. These moves towards ethical consumerism, ethical finance and community enterprise present important opportunities for the community finance sector. Equally, recent trends and

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changes in government policy in the UK such as the focus on localism, the opening up of public services to a wider range of providers and the move to a regime of payment by results in the delivery of public services also create opportunities for increasing demand for community finance and the support provided by CDFIs and other intermediaries. Review of the current state-of-play in the provision of community finance highlights that, in seeking to take advantage of these opportunities, the sector will need to overcome some key and common challenges, including:

■ The community finance sector is relatively immature and underdeveloped and is consequently not able to respond even close to fully to the financing needs of enterprises, CSOs, individuals and homeowners unable to access finance from mainstream sources.

■ CDFIs and other intermediaries lack sufficient capital to onlend to the frontline (i.e. enterprises, individuals and homeowners) resulting in a finance gap at the frontline. This is partly because the sector itself is undercapitalised and lacks scale.

■ CDFIs and other intermediaries tend to operate ‘riskier’ business models due to their complex structures, low security and the bespoke, lengthy and expensive transaction process necessary to adequately meet the needs of businesses, organisations and individuals. Investments are generally small in number and in size and often only offer longer term returns. This means that the sector has a significant need for risk and working capital to sustain it through funding and payment cycles which are often long and lacking security.

■ While many CDFIs and intermediaries provide affordable, specialist lending to the frontline, they often do so with an operating deficit which is invariably financed by grants. The challenge to move to operational/financial sustainability whilst retaining impact remains substantial

■ The sector will only function effectively if it has an infrastructure which encourages investment readiness, facilitates access to comparative data, pricing and information through investment and market data platforms; provides transparency on measurement of impact and assists industry participants to network and share learning. The limits of this infrastructure in the sector is a key manifestation of the immature nature of the market.

6.4. Summary conclusion Given the contribution of community finance to numerous Government policy objectives, the level and range of economic and social benefits generated, and the substantial funding gap which remains, Government should seek to implement at least some of the range of potential mechanisms available to generate substantially increased investment in to community finance. Potential mechanisms might range, for example, from fiscal stimulus through better harmonised tax regimes (such as Community Investment Tax Relief), to loan guarantee mechanisms, targeted programmes and funding streams, and trialling of new funding instruments (bonds, wholesale funds, etc.). However, Government alone cannot (and does not desire to) meet the demand for community finance. Rather, given current times, the scale of the finance gap, and the range of economic and social outcomes generated by community finance that are of interest to investors, substantial opportunities exist for a tri-partite partnership for community finance. The challenge for such a partnership is to develop a viable community finance system as an established and embedded feature of the UK’s financial landscape: with the capacity and products to meet the range of client demands not met by mainstream financial services - and to generate the pipeline of tomorrow’s mainstream customers.

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ANNEXES

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Annex 1 Bibliography

Association of Corporate Treasury (2010), Supply Chain Finance, Report of the supply chain finance working group Bank of England (2000), Finance for Small Businesses in Deprived Communities Bank of England (2012), Financial Stability Report Bank of England (2012), Trends in Lending BDRC Continental (2011), SME Finance Monitor Survey Big Society Capital (2012), Vision and Strategy Big Society Capital (2012), Vision, mission and activities BIS (2010), Social Enterprise Barometer BIS (2010), Annual Survey of Small Businesses BIS (2011), Business Population Estimates for the UK and the Regions BIS (2011), Consumer Credit and Personal Insolvency Review BIS (2011), Small Business Survey BIS (2012), SME Access to External Finance, BIS Economics Paper BIS (2012), Report of industry-led working group on alternative debt markets (the Breedon Report) BIS (2012), SME Access to External Finance BIS and HM Treasury (2011), Response to the consumer credit elements of the Government’s Review of Consumer Credit and Personal Insolvency Buonfino, A and Mulgan, G. (2009), Civility Lost and Found Burton, M., (2010), Keeping the plates spinning - perceptions of payday loans in Great Britain BWB (2012), Ten Reforms to Grow the Social Investment Market Cabinet Office (2011), Growing the Social Investment Market Cabinet Office (2011), Growing the Social Investment Market: A vision and strategy. CAF Venturesome (2008), Financing Civil Society CDFA (2012), Inside Community Finance CDFA (2012), Just Finance: Capitalising Communities, Strengthening Local Economies ClearlySo (2011), Investor Perspectives on Social Enterprise Financing CLG (2008), Community Land Trusts: A Consultation CLG (2009), English Housing Survey CLG (2010), Beyond Decent Homes CLG (2011), English Homes Survey CLG (2011), English Housing Survey headline Findings Co-operative Party (2009), Unlocking the potential for affordable homes Cohen R et al (2000) Enterprising Communities Wealth Beyond Welfare, London: Social Investment Task Force Collard, S. (2006), Affordable credit for low-income households Community Shares Unit (2009), Factsheet 1: What is community investment? Consumer Focus (2010), Keeping the Plates Spinning Crowdsourcing (2012), Crowdfunding industry report, market trends, composition and crowdfunding platforms DWP (2010), Social Fund Reform: debt, credit and low income households DWP Credit Union Expansion Project (2011), Feasibility Study Report Enterprise for All Coalition (2006), Enterprise for All: progressing the agenda European Commission (2011), Communication – Social Business Initiative European Commission (2011), Notification of State Aid Approval – Big Society Capital Financial Times (2012), Peer-to-peer lending: Model takes off worldwide FSA (2011), Annual Returns GEM (2012), GEM 2011 Global Report GHK (2004) Evaluation of Phoenix Fund GHK (2010), National Evaluation of Community Development Finance Intermediaries HM Treasury (1999) Enterprise and Social Exclusion. National Strategy for Neighbourhood Renewal: Policy Action Team 3 HM Treasury (2004), Promoting Financial Inclusion HM Treasury (2012), Business Finance Partnership: Request for Proposals HMT & BIS (2011), The Plan For Growth HMT (2010), Growth Fund Evaluation Industry-led working group on alternative debt markets (2012), Boosting Finance Options for Business Inspiring impact (2011), Working together for a bigger impact in the UK social sector

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John Kay (2010) in The Future of Finance: The LSE Report JRF (2008), Financial inclusion in the UK: Review of policy and practice JRF (2008), Financial inclusion in the UK: Review of policy and practice Leather (2000), Crumbling Castles? McKinsey Quarterly (2012), Working out of debt Mitchell L et al (2008), Financing Civil Society: A practitioner’s view of the UK social investment fund Monitor Institute (2009), Investing for Social & Environmental Impact. US: Monitor Institute National Consumer Council (2005), Basic Banking: Getting the First Step Right. NCVO (2010) The UK Civil Society Almanac NESTA (2009), From funding gaps to thin markets NESTA (2009), Measuring Business Growth NESTA (2011), Understanding the demand for and supply of social finance Nesta (2012), The Venture Crowd, Crowdfunding equity investment into business NESTA (2012), The Venture Crowd: Crowdfunding equity investment into business NPC (2011), Inspiring impact: Working together for a bigger impact in the UK social sector OECD (2004) Venture Capital: Trends and Policy Recommendations OECD (2006), The SME Financing Gap OECD (2011), Financing High Growth Firms: The role of Angel Investors Opinion Leader Research for the Financial Inclusion Taskforce (2005), Financial inclusion deliberative workshops PFRC and ECORYS (2010), Evaluation of the DWP Growth Fund Pierrakis & Collins (2012), The year of the Crowdfunder Roper, S. et al. (2006), Exploring Gender Differentials in Access to Business Finance: An Econometric Analysis of Survey Data SBS (2007) The Impact of Perceived Access to Finance Difficulties on the Demand for External Finance Sir Ronald Cohen (2012), Speech at the Bridges Ventures: Ten Years On event Smallbone, D. et al. (2003), Access to Finance by Ethnic Minority Businesses in the UK Social Enterprise UK (2011), Fightback Britain, - the State of Social Enterprise Survey Social Investment Taskforce (2010), Ten Years On Spring (2012), Crowdfunding: the wisdom and wallets of crowds Spring, (2012), Crowdfunding: the wisdom and wallets of crowds SQW (2007) Research on Third Sector Access to Finance, Report to the Office of the Third Sector The Office of Fair Trading (2010) “Review of high-cost credit final report” UK Business Angel Association (2011), Annual Report on the Business Angel Market University of Salford (2011), Proof Of Concept: Community Land Trusts Ward, A. and McKillop, D. (2005) An investigation into the link between UK credit union characteristics, location and their success. Young Foundation (2010), Social Ventures Intermediaries: who they are, what they do, and what they could become Young Foundation and BCG (2011), Lighting the Touchpaper: Growing the Market for Social Investment in England

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Annex 2 CDFI funding (2010-2011)

A2.1 Business lenders

REVENUE CAPITAL Bank loan £ - Bank loan £ 2,010,978 Bank grant £ - Other loans £ 700,000 ERDF £ 561,253 Bank grant £ - Other European £ - ERDF £ 2,238,292 Regional / RDA £ 602,190 Regional / RDA £ 1,018,493 DWP Growth Fund £ 17,062 DWP Growth Fund £ - National Government £ 71,000 National Government £ 400,000 Local Government £ 1,058,340 Local Government £ 995,500 Trusts / Charities £ 106,000 Trusts / Charities £ 250,000 Corporations £ 192,408 Corporations £ - Housing Association £ 5,097 Housing Association £ - Individual Donations £ 433,312 Other £ - Other £ 152,483 Customer deposits £ - IPS shares £ 51,900 TOTAL £ 3,199,145 TOTAL £7,665,163

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A2.2 Civil society lenders

REVENUE CAPITAL Bank loan £ - Bank loan £ 4,100,000 Bank grant £ 30,000 Other loans £ 1,030,000 ERDF £ 50,552 Bank grant £ 553,026 Other European £ - ERDF £ 125,770 Regional / RDA £ 265,000 Regional / RDA £ - DWP Growth Fund £ - DWP Growth Fund £ - National Government £ - National Government £ - Local Government £ - Local Government £ - Trusts / Charities £ 197,060 Trusts / Charities £ 2,400,000 Corporations £ - Corporations £ 430,000 Housing Association £ - Housing Association £ - Individual Donations £ 5,592 Other £ 593,000 Other £ 4,822 Customer deposits £ 649,375 IPS shares £ 94,521 TOTAL £553,026 TOTAL £9,975,692

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A2.3 Personal and Household lenders

REVENUE CAPITAL Bank loan £ - Bank loan £ - Bank grant £ 27,500 Other loans £ - ERDF £ - Bank grant £ - Other European £ 5,000 ERDF £ - Regional / RDA £ 304,599 Regional / RDA £ 2,639,175 DWP Growth Fund £ 1,481,664 DWP Growth Fund £ 1,023,629 National Government £ - National Government £ - Local Government £ 2,382,807 Local Government £ 8,212,987 Trusts / Charities £ 133,767 Trusts / Charities £ 70,000 Corporations £ - Corporations £ - Housing Association £ 143,167 Housing Association £ 60,000 Individual Donations £ 2,000 Other £ - Other £ 486,042 Customer deposits £ - IPS shares £ 20,360 TOTAL £ 4,966,546 TOTAL £ 12,026,151

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Annex 3 Recent national access to finance schemes

Scheme Summary Big Society Capital Big Society Capital is a ‘social investment wholesaler’ which provides finance to social investment finance (BSC) intermediaries (SIFIs). These are organisations that provide appropriate and affordable finance and support to frontline charities, social enterprises and voluntary organisations. Business Angel Co- The £50m Business Angel Co-Investment Fund aims to support angel investments into high growth potential Investment Fund early stage SMEs, particularly in areas worst affected by public spending cuts. (CoFund) Business Finance The BFP will invest an initial £1bn in loan funds, alongside private sector co-investors. These funds will then lend Partnership (BFP) to mid-sized businesses, helping to diversify the channels of finance available to them. Business Finance This new tranche of BFP will focus on co-investing through non-traditional channels, such as peer-to-peer Partnership (small platforms, for businesses with a turnover below £75 million.BIS will invest up to a maximum of 50 per cent in any business tranche) fund or channel, on fully commercial terms. Business Growth The Business Growth Fund is expected to make available £2.5 billion (including bank match funding) to support Fund (BGF) established companies with strong growth potential and offers between £2m and £10m in return for an equity stake in the business. Where appropriate, the fund could offer innovative equity-like products such as redeemable preference shares. Enterprise Capital For many young innovative firms equity finance is the best option to reach their high growth potential but many Funds (ECF) struggle to obtain this form of finance. This disconnect is called the 'equity gap'. Enterprise Capital Funds (ECFs) address this market weakness. Enterprise Finance EFG is a loan guarantee scheme designed to facilitate additional lending to viable SMEs lacking the security or Guarantee (EFG) proven track record for a commercial loan. Export EFG ExEFG facilitates the provision of short term export finance to viable SMEs which lack the security necessary to obtain such facilities commercially Green Investment The Green Investment Bank will provide financial solutions to accelerate private sector investment in the green Bank (GIB) economy. Capitalised with £3 billion, the GIB will address market failures affecting green infrastructure projects to stimulate private investment. National Loan The scheme will allow banks to raise up to £20bn of funding guaranteed by the Government, to lend directly to Guarantee Scheme smaller businesses at a lower cost. (NLGS) Regional Growth The Government has announced a £1.4 billion Regional Growth Fund to help areas and communities at risk of Fund (RGF) being particularly affected by public spending cuts. The fund, which will operate in from 2011/2012 to 2013/14 will help areas most dependent on public sector employment. StartUp Loan scheme The £10m start-up loans for young people pilot scheme has been announced by Business and Enterprise Minister Mark Prisk. The initiative aims to provide budding entrepreneurs with support and a small amount of capital to help them get started as well as access to training and business mentors. Seed Enterprise The Seed Enterprise Investment Scheme (SEIS) is designed to help small, early-stage companies to raise equity Investment Scheme finance by offering a range of tax reliefs to individual investors who purchase new shares in those companies. It (SEIS) complements the existing Enterprise Investment Scheme (EIS) which will continue to offer tax reliefs to investors in higher-risk small companies. SEIS is intended to recognise the particular difficulties which very early stage companies face in attracting investment, by offering tax relief at a higher rate (50% income tax relief) than that offered by the existing EIS. Enterprise The Enterprise Investment Scheme (EIS) is designed to help smaller higher-risk trading companies to raise Investment Scheme finance by offering a range of tax reliefs to investors who purchase new shares in those companies. From 6 April (EIS) 2011 relief is at 30 per cent of the cost of the shares. Relief can be claimed up to a maximum of £500,000 invested in such shares, giving a maximum tax reduction in any one year of £150,000 providing you have sufficient Income Tax liability to cover it. Venture Capital The VCT scheme started on 6 April 1995. It is designed to encourage individuals to invest indirectly in a range of Trusts small higher-risk trading companies whose shares and securities are not listed on a recognised stock exchange, by investing through Venture Capital Trusts. Tax reliefs available for investors include income tax relief at the rate of 30 per cent Capital Gains Tax on any gain made when the shares are sold (called disposal relief). Community The CITR scheme encourages investment in disadvantaged communities by giving tax relief to investors who back Investment Tax businesses and other enterprises in less advantaged areas by investing in accredited Community Development Relief (CITR) Finance Institutions (CDFIs). The tax relief is available to individuals and companies and is worth up to 25% of the value of the investment in the CDFI. The relief is spread over five years, starting with the year in which the investment is made.

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A3.1 Access to finance schemes and applicability to social enterprises

Target Type of Investment Applicability to social business finance Channel enterprise Enterprise Investment Scheme (EIS) small equity bank low Export EFG small debt bank medium Green Investment Bank (GIB) small debt bank high National Loan Guarantee Scheme (NLGS) small debt bank medium Regional Growth Fund (RGF) small debt non-bank high StartUp Loan scheme small debt bank medium UK Export Finance Products medium debt bank low Venture Capital Trusts (VCT) small equity non-bank medium Big Society Capital (BSC) small debt non-bank high Business Angel Co-Investment Fund (CoFund) small equity non-bank low Business Finance Partnership (BFP) medium debt non-bank low Business Finance Partnership (small business tranche) small debt bank medium Business Growth Fund (BGF) medium equity non-bank low Community Investment Tax Relief (CITR) small debt bank high Enterprise Capital Funds (ECF) small equity bank low Enterprise Finance Guarantee (EFG) small debt bank medium

Mind the Finance Gap: Evidencing demand for community finance

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