The Social Business Initiative: Promoting Social Investment Funds. Response to consultation

European Commission – Staff

paper on “The Social Business Initiative: Promoting Social

Investment Fund”

Response to consultation Milano, September 13th, 2011 Davide Dal Maso ([email protected]) and Davide Zanoni ([email protected]) +39 02 305160

Summary Who is Avanzi and why we are involved into the topic .....................................................................2

Support to social business...............................................................................................................2 Change the financial industry..........................................................................................................3

Comments on paper ............................................................................................................................4 Defining social business ..................................................................................................................4 The funding challenge .....................................................................................................................5 The role of investment fund.............................................................................................................6 The role of investors ........................................................................................................................7 Liquidity .............................................................................................................................................8 Risk diversification ...........................................................................................................................8 Types of asset and strategies .........................................................................................................8 Asset valuation .................................................................................................................................9

Financial assessment...................................................................................................................9 Social assessment and reporting ................................................................................................9

Investor participation..................................................................................................................... 10 Risk management ......................................................................................................................... 10 Depositary...................................................................................................................................... 10 Remuneration and cost structure................................................................................................. 10 Improving transparency and clarity .............................................................................................. 11 Improving transparency through common criteria ...................................................................... 11 A common EU label? .................................................................................................................... 12 Ensuring effective integration with social businesses and distributors ..................................... 12 Use of incentives, including tax.................................................................................................... 12

Avanzi. Sostenibilità Per Azioni 2

Who is Avanzi and why we are involved into the

topic

Avanzi. Sustainability In Action is a leading and independent Think-and-do tank for sustainable innovation. Since its founding in 1997, its mission has been to become an independent and credible player in the field of sustainable development.

Applied research and pilot projects carried out by Avanzi have shown an innovative approach in terms of both policy implications and actors involved. By collaborating with the most qualified universities and research centres in Europe, it has assured an independent and rigorous approach in both innovation drivers investigation and policies development.

Avanzi has played a pioneering role in promoting and disseminating sustainable development and has contributed to a radical perspective change in many public and private organisations in Italy. Avanzi has conducted research and provided innovative services and business activities, mainly in the field of Socially Responsible Investment (SRI) and Ethical finance, Corporate Social Responsibility (CSR) and Local Agenda 21.

Bridging academia, business and the public sector, Avanzi represents a quite unique context in Italy: the investigation on innovative approaches, policies and instruments is followed by their effective implementation and broad dissemination through pilot projects and start-ups incubation with high social and environmental impact potential. By closely working with the public, private and no profit sectors, it engages with stakeholders and challenges reputational risks and business opportunities.

Support to social business

Avanzi assists enterprises and other organisations in acknowledging their responsibilities towards stakeholders and in managing the change. The approach is modular and customised and aims to integrate social, environmental and ethical concerns into all business activities and levels, from strategy to operational management. Avanzi is also a social business incubator. We provide a full range of business support resources and services to selected start ups with high potential to impact social needs or challenge environmental issues. Avanzi welcomes innovative entrepreneurs with high potential for creating social and green value and provides comprehensive business support services, including back-office, governance expertise, access to knowledge and financing. Avanzi applies a “stage-gate” roadmap for incubation. First ideas and ventures based on their overall quality, degree of eco and social innovation and consistency with market and environment conditions are selected. Then the motivation of future entrepreneurs, their capabilities and relationship network are assessed. Building or revising the business plan to assess financial and operational viability is the next step in the process. Finally, the Avanzi team works closely with the entrepreneur on the key challenges to make the start up successful. Avanzi is based in Milan, into a place designed to inspire and realize new ideas. Located in a restored historical factory, it was once the home of the Italian-made cult design and technology brand Brionvega, It already hosts a community of qualified professionals and innovative start ups. The incubator is an activity carried out in cooperation with Make a Change, an association promoting a cultural change which puts capital and profit at the service of social good. MaC supports the development of new social business generating benefits for everyone within the traditional capitalist marketplace and does so using marketing levers in order to allow this new mentality to visibly spread and assert itself.


www.makeachange.it

Change the financial industry

Avanzi was the promoter, in 2001, of Forum per la Finanza Sostenibile, the Italian social investment forum, member of Eurosif.

www.finanzasostenibile.it

Avanzi is developing a project in cooperation with a number of other organisations in Italy aiming at the launch of a Social Stock Exchange (in Italian, Borsa Sociale), that is a capital market dedicated to business with a social mission. With this definition, Avanzi refers to organisations that purposefully pursue a social value. Under Italian regulatory framework, there is a clear and rigid distinction between for profit and non for profit entities: on the one side, companies (limited or unlimited liability) can run commercial activities; on the other, associations or foundations (with members but without shareholders, i.e. without a capital that can be divided into share) can do any activity except commercial. The idea behind this scheme is that the State has the quasi-monopoly in the domain of social affairs, addressed through the redistribution of wealth collected via taxation. Private (non for profit) organisations can at most cooperate with the State, but act under its vigilance or on its mandate. At the level of Constitution, the recent modification of article 118 introduced the concept of “horizontal subsidiarity”, which encourages private entities (individuals and other organisations) to create public goods. In order to overwhelm this distinction, we launched the proposal of a hybrid subject, named Social Purposes Businesses (SPBs) (in Italian, Imprese a Finalità Sociale): legally speaking, they are companies, with capital and shareholders, but their mission is not profit maximisation but rather creation of social added value. SPBs offer a blended dividend, made up of a [limited] economic return, plus a social-environmental return. In Italy as well as in all industrialised countries, there is a large and growing demand of goods and services with a high social and environmental value. This broad area ranges from health to assistance, from education to cultural activities, from local public services to responsible financial services, from fair trade to eco-tourism, from organic food to eco-fashion, from green construction to renewables, with technologies linking all of them. What distinguishes these activities is the fact that, besides the environmental and social care, they imply some kind of relational goods – and when relationship plays a role, the nature and the credibility of the subjects are crucial. The traditional for profit companies, although “responsible”, suffer a lack of credibility, because people know or feel that their final goal is profit and other conditions are constraints that they have to consider. The conflict between the interests of shareholders and those of other stakeholders is immanent. Instead, for SPBs it’s the other way round: stakeholders’ value is the goal, profit is the constraint that has to be taken into account in order to assure long term continuity. A detailed methodology to measure social value creation has been developed and will be validated with pilot projects. Social assessment will be run at initial listing and repeated over


time. A social nominated advisor or sponsor will be in charge to provide the assurance vis-à-vis the market and the investors. SSE is therefore an instrument to enhance these enterprises, by matching their demand of capital with the supply of patient, responsible investors. It does not compete with existing exchanges, because it is addressed to companies that will never list into traditional markets. The capital supply side is represented by both institutional and retail investors. The appetite for responsible investment is growing across Europe: more and more people feel that they might invest part of their assets into a new asset class that, although likely to provide a smaller financial return, can generates social benefits for the communities and, indirectly, themselves. SSE will be established as a multilateral trading facility (MTF), regulated by the MIFID Directive and subject to the vigilance of the financial market Authority (Consob). The investment company that will manage it will be backed up by a promotion company (Pro-Borsa Sociale), whose mission is to attract both emitters and investors towards the market. The shareholding structure and composition of Pro-Borsa Sociale will guarantee the representation of all interested groups and a balanced governance system will be designed in order to preserve the social mission of the initiative. Rough estimations indicates some 60-80 companies eligible for listing by the first 3-4 years.

www.borsasociale.it

Comments on paper

Please find hereby our responses:

Defining social business

Do you agree that the main features of social businesses are as outlined above? We agree with the proposed definition, but we think that the prohibition to distribute profit can be a limit. As long as these entities are businesses, e.g. organisations that use capitals to produce products and services, they should play with the same fundamental rules that “traditional” companies are subject to. We believe that social business should grow into the market – not in a side playground. Therefore, risk capital should be rewarded. Otherwise, no investor will ever be willing to put its money into them. Social businesses typically don’t distribute dividends in the early stage of their development, in order to reinforce their assets by reinvesting the margins; but there is no reason why they should continue to do so over time, once that the financial stability is reached. The Italian law-decree 155/2006 has created the “social enterprise”. It’s a new category that can be added to the typical legal structure of both non-profit and for-profit companies. Without going into the detail of this measure, it’s clear that its failure (few hundreds entities asked to be registered as social enterprises) it’s also due to the fact that the prohibition of dividends distribution has been perceived as a barrier by investors. That’s the reason why we consider more appropriate a cap to ROI (return on investment) which includes dividends and capital gain limitation. This could prevent that assets


accumulation due to profit limitations translates into a capital gain when stocks are sold to the market. To what extent do you think this initiative should focus solely on those social businesses that do not distribute profits to their investors? Or shall it also focus on those which distribute profits to their investors (e.g. at least to a limited extent)? If so, how might social businesses be distinguished from other businesses? We think that the rationale of pure non-profit organisations is different from social business. Social businesses are less likely to generate massive capital gains because the logic behind their model prevents them to do so. Social business is low profit by definition, since the process of value creation implies equal treatment of all stakeholders: if workforce and suppliers are managed fairly, clients pay an honest price, environment and communities are respected, one can hardly produce huge margins. Typically, high profits appear when there are strong economies of scale (which is seldom the case for social businesses) or one or more of the stakeholders are exploited. But being low profitable does not necessarily mean that risk shouldn’t be rewarded. To a certain extent, dividend should be distributed. We are not, in principle, neither favourable nor contrary to a definite cap; we think that capping the distribution might be a good solution in some circumstances – but the decision should be left to the partners or the shareholders on a case by case approach. We think that a social business should be distinguished form other business on the ground of its outputs. No doubt that it has to clearly state into the Statute that the mission of the organisation is the creation of social and environmental value – but this can be not enough. The extent to which this goal is achieved has to be measured and communicated. We think that accountability is key in this respect and we encourage the highest possible level of transparency. In other words, the “sociality” has to be promised and, more importantly, to be proven.

The funding challenge

What are the main difficulties social businesses face, in your experience, in getting access to finance? Social businesses operate in a typical area of market failure: they are not enough profitable to attract venture capitalists and private equity investors – but they are not eligible for grants. Social business need a specific type of capital providers, e.g. responsible investors that are happy with a blended divided, made of a social as well as an economic return (the latter being inevitably lower than a “normal” one). Traditional capital suppliers are not comfortable with most social business because (i) they operate in the area of innovation – and therefore are more risky by definition; (ii) they are more often too small to cover the cost of assessment and due diligence; (iii) their governance is often driven by values rather than economic interests. Do different kinds of social businesses face different barriers? The features that make a social business more attractive to investors are:

• Size • Profitability • Maturity of the market • Credibility of the entrepreneurs


To what extent do you think barriers to access to finance are limiting the growth of social businesses across the EU? We feel that indeed finance is the most critical aspect for a social business. Do you agree that there is a need to tackle any such barriers at the EU level? Yes. In particular, we think that EU can intervene to regulate the fiscal system. The paradox that has to be handled is that social businesses are subject to the same tax regime of socially irresponsible industries. The taxation system is focused on the legal nature of a given entity rather than on its output. One can produce a huge amount of social benefit, but if it does so using a limited liability company as a vehicle, it pays as it were a tobacco maker. Even more important to promote social investment funds could be a specific tax regime for investors and financial operators that support social ventures. If we accept the idea of tax exemption for grants, we can imagine different levels of exemption for investments to non-profit and social business.

The role of investment fund

If you operate a social investment fund, or are aware of the (national) legislative requirements that apply currently in practice, could you please provide broad detail on these requirements. No comment. How do you think funding through investment funds might effectively compliment other sources of funding, e.g. philanthropic funding? Are there any challenges here? We think that investment funds can play an important role because they can minimise the information asymmetry. The problem of social businesses is that they don’t speak the same language of [traditional] investors; and these are not eager to invest time to know more and eventually understand a model that is miles away from their standard. The market would need specialised players, who know their counterparts, the context in which they operate, their logic and their approach. In order to became a specialist, one need to reach the critical mass that allows the investment needed for knowledge – which is in fact the case of a fund. On the other hand, we think that funds shouldn’t be the only or preferred instrument to supply capital to social businesses. In fact, different instruments can solve specific financial needs along with the development stage of the company. The problem is therefore broader: a complete chain has to be designed and supported. In other words, the market needs a sort of “parallel” system, where specialised players do the same job of traditional investors, but with a specific sensitivity and knowledge of a different object.

Business idea Start up Early stage Development Scale up Seed capital Venture capital Private equity Public listing

Do you think that the UCITS framework is sufficient for funding social business without change? Yes, we think that UCITS framework does guarantee the basic rules to regulate also this segment of the investment market. Do you think a bespoke fund framework tailored to the needs of social business might be better suited to channel funds toward social businesses? We think that, as long as it’s proven that social businesses do produce a measurable benefit for the community, they should be favoured through a dedicated system, for instance on tax level. Nevertheless, specific measures might be introduced within the existing UCITS


framework, especially if accompanied with a dedicated discipline for other instruments that can complete the range of financial services needed by social businesses – without the need to create a bespoke one. Of course, the definition must be stated very clearly in order to prevent any abuse.

The role of investors

Do you believe that social investment funds should be open to retail investors? We think that the role of retail investors is of the utmost importance. Social businesses are not a different way to get the same result; they represent an innovation of the economic pattern; they are, in fact, a cultural rather than an organisational change in the way capital can be used. In that respect, the participation of private investors means much more that a marketing opportunity; it’s a political act. Besides, institutional investors are often limited in their strategic allocation by limits in terms of weight of each asset class and are very risk adverse. Moreover, in some European countries (for instance, Italy), where the institutional segment is underdeveloped, the access of retail investors is in fact the only way to address significant flows of money towards social businesses. To limit the costs for retail protections, we can imagine different stages in the social business development and accordingly define appropriate investment vehicles (or specific segments): at the preliminary stages, the risk is too high for private investors, but as the business grow up, retailers may go into the market. This principle is related to the concepts of primary and secondary market. In our Borsa Sociale project indeed, the primary market is reserved to institutional investors, but the secondary one is open also to private investors. What features of a social investment fund do you think are most important for retail/professional investors? As stated before, the most important feature of a social investment fund, not only for private but also for professional investors, is the accountability and transparency related to social and environmental impacts. As the social business has to prove and measure its social output, the fund should measure its performance not only in terms of financial return and communicates its overall social impact. For instance, the return on investment should be transformed in social return on investment, and the price of shares of the fund defined according to different metrics. What specific pre-contractual information do you think would need to be provided to retail investors? Since the definition of social business is very broad – or it can be interpreted in many different ways, it is extremely important that the fund clearly states its value proposition, i.e. the type of social value it is going to pursue. In order to avoid any ambiguity and risk of misunderstanding, social businesses (and in consequence the funds willing to invest into them) should clearly state which social benefit they are going to deliver and how. Pre-contractual information should therefore be focused on indicators of social performance that are set as objectives of the business. Should the framework encompass funds that explicitly forego greater financial returns for the benefit of the social risks, or both? No comment


Liquidity

What do you think would be the appropriate time frame for redemption of units in a social investment fund, e.g. monthly? Liquidity is a critical issue. It is difficult to balance the conflicting interests of investors and companies. The appropriate time frame largely depends on the nature of the business and the stage of maturity. For investment in early stage, the period should be longer and the company should be sheltered with lock in obligations. For more consolidated business, a monthly redemption could be acceptable. Do you think there are other options for balancing the liquidity that small retail clients might be seeking with a focus on a long-term time horizon? No comment

Risk diversification

Do you think that social investment funds should be subject to diversification rules? We think that a social investment fund should invest exclusively or predominantly in social businesses. A mixture of different asset classes would eventually jeopardise the credibility of the value proposition. Diversification could be achieved by investing in different types of social businesses. At most, a portion of the asset could be invested in risk-free securities (monetary or AAA government bonds), just to cover the liquidity risk. To what extent do you think investors might expect a fund focused on social businesses to only invest in social businesses? See above. Should social investment funds be required to invest into different types or numbers of social business? (How many separate businesses might be required?). No, as long as the risk profile of the product is clear to the investor. Should there also be diversification across asset classes different from social business? See above.

Types of asset and strategies

What types of assets should a social investment fund be able to invest in? Please give examples. We think that the primary need for social businesses is long term risk capital, e.g. equity. Subordinately, debt (bonds) or quasi-equity securities. Should the funds be limited to certain kinds of strategies (for instance, aimed at maximising their attractiveness for retail investors)? If so, which? No. We think that in an ideal situation, there should be as many social investment funds as possible, competing with each other on the ground of the attractiveness of their offer – e.g. risk profile, value proposition, cost …


What rules or limits might be necessary to prevent firms using a new framework to circumvent restrictions in other frameworks (e.g. UCITS)? We think that the only way to prevent abuses is the robustness of the definition of social business and, even more important, the disclosure standard for continual reporting of the social results – along with the financial result.

Asset valuation

Financial assessment

Do you agree that it would be impractical for social investment funds to have frequent valuations of assets? Please give reasons for your answer. The delivery of economic value is not the primary objective of social businesses; in consequence, social investment funds (and their clients) shouldn’t be obsessed by financial return. In other words, financial performance and other financial indicators shouldn’t be considered the most important pieces of information addressed to the clients. At the same time, social investors have a long-term perspective and they are probably not so interested in a daily or weekly valuation of their assets. If so, for the purposes of investor protection what frequency might be appropriate? We believe that a monthly or quarterly evaluation of asset could be acceptable to a socially responsible investor. Do you think that any non-social business assets that might be permitted should be subject to different valuation requirements? Might different kinds of assets require different approaches? As stated above, we dislike the mixture of different assets in a social investment fund portfolio – with the exception of “socially neutral” securities, whose evaluation should follow traditional requirements.

Social assessment and reporting

How do you think 'social returns' might be best addressed and measured? Avanzi, within the Borsa Social feasibility project, has developed its own methodology for the measurement of social return. This is a very complex issue, that can hardly be simplified. However, key points are:

• Outputs are more important than statement of principles • The crucial aspect is the consistency between mission and results • [social and environmental] indicators are sector-related

How might this build on other existing work, for instance on non-financial company reporting, social accounting, socially responsible investing, etc.? There might be some similarities and ESG accounting systems do contain elements of value but social businesses are different in essence from for profit, although “responsible” businesses. Therefore, the assessment methodologies should be tailored on their own characteristics. What information do you think needs to be disclosed to investors, and how might this best be presented?


There might be different sets of indicators to be disclosed and the frequency of their publication might differ according to their relevance. We think that some key figures should be disclosed almost on real time; other could be communicated on a half-yearly or yearly basis.

Investor participation

Do you agree that investor participation will contribute to the success of these funds? The evaluation of a social business, from both a social and economic point of view, is an extremely difficult job. We think that the added value of a vehicle such as a fund is the professional contribute that a competent fund manager can provide. Direct participation of the investors might be justified only in case it is a specialised one (for instance, a foundation). Otherwise, we see the risk that a non professional investor might be influenced by external factors and creates expectancies doomed to be frustrated. A specific exception should be regarded for investment in “local” social business, where the link between the activity of the business and the community in which it operates represent a value for the investor who live in that territory. If so, please outline how this might work in practice, and whether this can or should be required as part of the social investment fund framework itself.

Risk management

Which particular features of social investments might require specific risk management requirements? Whereas social business might run additional risk of failure due to the type of activity, on the other hand the non-speculative approach should limit the exposure to default risk. We don’t know to what extent these two features compensate each other, but we feel that social investment fund should adopt a risk mitigation strategy based on the specific nature of the business they invest in.

Depositary

What should be the duties of a depositary (e.g. tracking the funds' assets, reconciling units or shares issued with subscription proceeds received)? Please give reasons for your answer. We don’t think that the depositary should be charged of any additional duty.

Remuneration and cost structure

How might the sustainability and profitability of a social investment fund regime be ensured? The profitability of a fund is based on a vast range of factors and it’s the ability of the fund manager to find the right balance between the different interests. In principle, we think that the size of the fund is important in order to dilute the fixed costs, that might be higher than those of a traditional fund. Are there any particular factors in your experience that might determine the commercial success of the fund?


We don’t have a practical experience, but we think that the clarity of the value proposition statement is key to intercept investors’ objectives and assure the alignment between their expectancies and results. In your view, what kinds of incentive structures might be appropriate or inappropriate for the managers of the funds (e.g. performance fees versus flat management fees)? Price is a competitive factor. We would leave this to the market competition and we would recommend not to intervene with any regulation.

Improving transparency and clarity

What steps do you think should be taken to improve transparency for investors in relation to funds targeting social businesses? We suggest the issue of guidelines setting standards for disclosure. They might be proposed on voluntary basis in a first phase and become mandatory once “digested” by the marked and amended by the practice. What steps do you think should be taken to improve transparency for fund managers about the social businesses which they target? We don’t see the need to oblige social business to disclose a given set of information. It’s in their interest to guarantee the highest possible level of transparency towards investors. The most transparent will be considered more attractive (other things being equal). Having said that, we believe that in the mid term businesses will naturally converge to a common standard.

Improving transparency through common criteria

How do you think common criteria for defining, labelling and rating social funds and social businesses might be most effectively established? We believe that a bottom-up, multi-stakeholder approach might guarantee the highest level of involvement, variety of sensitiveness and ideas. We recommend to consider the specificity of each national market and not to exclude the possibility of different systems in different countries – within a common framework. Who should establish them and develop them over time? We see room for a regulatory intervention only to set the basic, fundamental norms of the game. Other, more detailed, rules can be decided by the professionals and the practitioners on a self-regulatory basis. The decision making process of formal legal norms can be too rigid and complicated for a sector that evolves very rapidly. How might they be verified, to ensure they are appropriately used in practice? We think that, as long as transparency is real, market forces will naturally be able to reward the honest players and punish the free riders. Traditional system of verification (third party assurance) can work properly for this purpose.


A common EU label?

Do you think a strong new EU label (e.g. supported by a common logo) would help social investment funds succeed? We believe that a complicated EU regulated system would eventually weight down the industry, that is small and fragile. We think that the best contribution EU can provide is a strong investment in a communication campaign to make the concept of social business better known. How might the appropriate use of such a brand be ensured in practice, and potential for confusion with other brands or labels diminished? There are too many labels in the market and the risk of confusion is virtually inevitable. We strongly doubt of their effectiveness.

Ensuring effective integration with social businesses

and distributors

What steps do you think might be taken at the European level to facilitate better intermediation between funds and social businesses? Are there particular responsibilities that you think fund managers should take on? We think that social investment should be encouraged and supported with framework measures, but market forces should be left free to find the best possible integration. Do you think there are any possible actions at the European level that might ensure effective distribution of social investment funds? Nothing besides transparency.

Use of incentives, including tax

How might tax incentives be made useful? Please provide data on any existing such incentives you are aware of. We think that tax [dis]incentives can be powerful measure to encourage [or discourage] some activities. Although widely used, they are in fact mechanism that can distort the free market competition. As we believe that social businesses should compete fairly with other models in the market and not in a separate ground. Therefore, tax incentives should be granted only for a limited period of time, say 3 up to 5 years, with the objective to allow the growth of a new practice. After that, a phasing out period should lead to a complete alignment. Are there any other measures you think might be possible to maximise investor's access to social investment funds, or the attractiveness of these for investors?

The Social Business Initiative: Promoting Social Investment Funds. Response to consultation

Economy & Finance

Transcript of The Social Business Initiative: Promoting Social Investment Funds. Response to consultation