When we talk of risk we should look at two factors that increase, or decrease, that risk:
- The nature of the investment i.e. the different characteristics of an investment into equity as opposed to a loan and
- The nature of the investee businesses i.e. the way in which private limited companies behave as opposed to social enterprises
The nature of the investment
The key differences between an equity investment under EIS and a debt investment under SITR (from our experience in reviewing each of the SITR Funds launched to date) are:
- Income: Debt provides a regular and quantified income stream (i.e. interest). The amount and timing of the payments are fixed at the outset by agreement between investor and borrower. But equity investments in EIS companies do not provide this as the company is never bound to distribute reserves and, if it does, the amount and the timing of the dividend payment is within the control of the board of directors, not the shareholders
- Exit: Debt investors under SITR have three advantages over equity investors under EIS:
- Certainty: Debt will have a fixed maturity date, set at the outset by agreement between investor and borrower. Equity investors do not, partly because the EIS rules prohibit any pre-arranged exit and partly because the nature of equity is that there can never be a guarantee of a trade sale at all, nor any comfort as to the timing of that exit
- Amount: Debt will have a fixed return, set at the outset by agreement between investor and borrower. Equity investors do not, partly because the EIS rules prohibit any protection against risk and partly because the nature of equity is that there can never be a guarantee of the price at which a buyer might eventually be willing to buy the company
- Default rights: If a company in which individuals have subscribed for equity cannot achieve a trade sale at a satisfactory return, the investors can do nothing about it. They are dependent entirely on the ability to find a willing buyer and persuade that buyer to pay a good price. But they, as shareholders, can do little or nothing about it. However, under a loan agreement, if the company defaults in repayment, even where the debt is unsecured, the lender has contractual rights to demand repayment which can be enforced in the courts. In practice it’s unlikely they’d do that given the nature of the borrower, but nevertheless it gives them a lever with which they can compel the borrower to take action to procure repayment
So SITR investors have greater certainty as to the amount and timing of income distributions whilst they hold their investment and when they come to cash in their investment they have greater certainty that a realisation will occur, greater certainty as to the date on which that realisation will occur and greater certainty as to the amount they’ll receive when the realisation completes.
And if no realisation occurs as envisaged in the investment documents, they have contractual rights to sue.
So a SITR lender’s sole risk is insolvency of the investee social enterprise – whereas EIS investors depend on the company achieving growth and then finding a willing buyer offering a good price.
The nature of the investee businesses
Private trading companies tend to take a lot more risks than a charity or social enterprise ever would because the risk may well be met with a greater financial reward. If your sole aim is financial gain, you take greater risks as the potential rewards are that much greater. That’s how capitalism works (or doesn’t work, depending on your viewpoint – just watch the film “Big Short”)!
But this is not how charities or many social enterprises operate. They are not striving to make equity values grow to the exclusion of all else. The desire for growth is matched by the importance of achieving the social aims. So social enterprises (particularly charities) tend to take a more cautious, prudent approach to taking risk. Their owners accept that social enterprises will take less risk to preserve the social mission, albeit that this will mean less likelihood of big financial returns for members.
Meaning that SITR investee enterprises are unlikely to become the next Facebook. But they are equally unlikely to become the next Enron.
Conclusion on categorisation of risks under SITR
All of which leads us to the conclusion that the risk profile of an SITR investment in debt is different to an EIS investment in equity, but not necessarily greater.
We therefore believe that, when considering SITR Fund investments, the focus needs to be more on a client’s capacity for loss than their tolerance for risk or appetite for financial reward.