In 2019, the Education Policy Institute shared its fears that the reduction in the attainment gap between disadvantaged pupils and their peers was close to flattening out, and that the gap might start to increase again.
The same report found that disadvantaged pupils were more than 18 months behind non-disadvantaged pupils by the time they left secondary school. The closing of schools, cancelling of exams due to Coronavirus, system used to award A-level grades, and subsequent confusion and changes to how grades in 2020 would be determined, is thought to have particularly impacted disadvantaged students.
A radical shake-up
It is abundantly clear, that in order to provide disadvantaged pupils with the opportunity to achieve the same grades as their peers, radical shake-up and innovation is needed in the sector. This requires change on many levels, but it certainly requires the absorption and scaling of proven ideas and practices into schools. Some of the most innovative, high impact ideas sit slightly outside the school system itself, created by passionate and visionary charities, mission-led businesses and social enterprises. But how does a social enterprise find the funding needed to develop a new idea? Historically, seed financing has not been so readily available for organisations focused on high impact growth but where financial returns grow more slowly.
The Young Foundation has a long history of working in social innovation and education and, in 2014, we identified a gap in the market for long term, patient investments to fund early growth and launched The Young Academy Investment Fund, with UBS and Cabinet Office as our fund investors.
Tackling education inequality
The Young Academy invests in ventures which tackle education inequality, through a two-year Convertible Loan Note, which accrues interest but does not demand any cash from the early stage ventures. After two years, investments convert into either a Revenue Participation Loan, which is repaid over five years through an agreed percentage of revenue, or equity – if there is share capital. This kind of instrument can support any kind of legal entity, and can flex well in response to the needs and growth strategy of the investee.
It is now almost universally accepted in the social investment market, that there continues to be a funding gap for patient, risk-bearing capital in social investment. This sector knowledge was brought together well through Shift’s research. And later this year, Access is planning to use grant funding to bring more patient capital into the social investment market
Young Academy investments do three things: they provide patient, risk-bearing capital, being held over a minimum of seven years; they are flexible, in that the terms of repayment aren’t agreed until two years in, and; they are risk-bearing as they flex with the organisation’s own revenues.
As the most recent of Young Academy investments reach conversion, what have we learned about making patient social investments through this type of financial instrument?
Risk vs return
We all know that investing in early stage innovative ventures is risky. Each organisation established to do something completely original is an experiment; some will succeed, some will fail. In a venture capital fund you aim for the right balance between failures, moderate successes and unicorns in order to achieve fund returns.
While The Young Academy fund also has a similar mix of failures, moderate successes and some huge successes, does a patient capital social investment model permit the levels of return you could see in a classic commercial equity investment?
Certainly, there are limits to the speed of growth of ventures in the education sector. – Schools have limited budgets and present a fragmented market in the UK. Social enterprises must invest some of their surplus in gathering data and measuring and reviewing social impact. Education focused social enterprises tend to grow more slowly than commercial organisations and therefore returns at the same point in time would be lower.
The structure of Young Academy investments also caps the financial returns we can receive. Revenue Participation Agreements usually work by taking a set percentage of revenue over a set time frame. They mirror equity like risk and returns – if the venture grows well the investor may receive a multiple of the initial investment. If the venture doesn’t grow so quickly, only part of the investment may be returned. Our Revenue Participation Loans were designed to be used with charities and we received legal advice that charity law would not permit open ended returns. The repayment had to be capped at capital and interest. However, the downside risk of payments being linked to the charity’s revenues continued to be borne by the fund.
By limiting returns but trying to recreate equity style risks, it may be difficult to bring returns focused money into the sector. It would be interesting to understand how other investment funds have introduced more equity like investments into organisations structured as charities. While we are sharing in the risks our investees face, we are perhaps not adequately sharing in the upsides of our most successful ventures.
Financial risk and return are of course not the only considerations in impact investing – the social impact of the investments is key. This is why the Young Academy invested in charities as well as businesses, which prevents us from achieving true equity like investments. Young Academy impact returns need to be amalgamated with our financial returns to get a complete picture of the returns on the initial upfront risk.
By sharing in the risk, and only extracting cash in the form of repayments when there is sufficient cash coming in for organisations to cope with the repayments, our social enterprise and charity investees can focus on delivering impact in the best form possible.
Moreover, as impact investors our thesis is that if an organisation is providing something that is of social value and meets a genuine need, then someone will pay for that value because it either reduces cost through prevention or aligns with a social goal of that customer (e.g. better educational attainment is something that schools are happy to pay for). Therefore, revenue can be an approximate proxy for impact, thus financial returns are only generated if a social enterprise is having a social impact.
Focus on revenue
Equity-like investments like ours tend to focus on the growth of early stage ventures. At the point of investment, many of the Young Academy investments were pre revenue, or only had a year or two of operating history.
One concern others have raised about Revenue Participation Loans is that they incentivise growth above long term sustainability. In our experience however, the investor must monitor the surplus and general financial sustainability of the organisation if they are making a patient capital investment. Repayment over five years means that we are as interested in the long-term survival of an organisation as a CEO or employee would be.
As investors, we also contribute to that long term sustainability through quarterly monitoring of the financial, governance and social impact ‘health’ of the organisation. When Young Academy investments convert to Revenue Participation Loans or equity, we require five year forecasts. While we don’t expect these to be wholly accurate, it encourages entrepreneurs who are focused on the day to day running of the enterprise to look at longer term strategies.
Fund management costs
The instruments we have used in our investments are more complex than others in the social investment market. There are two points where an “investment” decision is made – at the point of investment and two years later at the point of conversion. This means that early stage ventures are supported twice with pulling together the correct information and making fairly detailed forecasts and business plans. Once converted to a Revenue Participation Loan, there is quarterly monitoring to compare progress to forecasts and provide support as and when needed.
Feedback from our investees is that while this can be a lot of work on their side, the discipline enforced by this routine is helpful. For ventures run by one or two people, reporting can easily fall down the list when there is a multitude of other things to do. The reviews also ensures that repaying the loan does not undermine financial sustainability which is important to the longevity of the organisation and the impact it makes. Time and time again it appears to have supported the growth of the organisation by providing additional focus.
While valuable for both investee and investor, intensive fund management in the early years of the investment is time consuming. The Young Academy works less like a traditional social investment fund, and more like a 2-3 year scale up accelerator programme and the costs have to be funded accordingly.
Care is needed
The social investment sector needs, and is ready for more patient, risk bearing capital and we would agree that this is what is needed to support ventures, particularly where initial cashflows are uncertain and time is needed to allow growth. This is true of early stage enterprises such as the ones we work with, but certainly also true for more mature social enterprises right now – where the adverse economic climate requires sensitive and flexible investments.
The Young Academy investment structures offer one way of growing social enterprises and their impact, but care is needed to ensure that financial risk and return are balanced more appropriately in this, and future funds. We have already started adjusting some Young Academy agreements to allow us to better manage risk by annually adjusting the revenue participation percentage, depending on whether growth targets are achieved.
I hugely welcome Access’s decision to encourage more of this type of funding to allow more experimentation in this space and will continue to share more findings on our investments as they emerge.