Ronald Cohen: Helping the poor become rich

With the right incentives from government the private sector can help lift poor areas out of poverty , says Ronald Cohen

The liberalization of western economies over the past two decades has unleashed a wave of entrepreneurial activity and generated a huge amount of wealth. While welcome, this entrepreneurial success has brought with it a widening gap between rich and poor that is worrying governments.

Last November’s riots in France show the sort of violence that may occur if whole sections of society are excluded. There are now countries, regions and whole cultures that are being left far behind successful entrepreneurial economies. A wall of fire will come to separate rich and poor across the world if we do not act to make society fairer.

In April 2000, at the request of Britain’s finance ministry, I agreed to establish and chair the Social Investment Task Force. Our remit was to carry out an urgent but considered assessment of the ways in which Britain could achieve a radical improvement in its capacity to create wealth, economic growth, employment and an improved social fabric in its poorest communities.

During the 1990s, Britain had enjoyed a longer period of sustained growth than, perhaps, ever before. Yet poverty had become more concentrated and inequality more marked. Some of Britain’s poorest urban and rural neighbourhoods had become no-go areas for investment.

Paternalism to empowerment

In the past, such communities depended on philanthropy and public money, whether in the form of welfare payments or community regeneration grants. This money is vital to maintain basic living standards but will never be sufficient on its own. In some circumstances, public money can discourage or crowd out private-sector investment.

The long-term aim of the Social Investment Task Force was to achieve a move away from this culture of philanthropy, paternalism and dependence towards one of empowerment, entrepreneurship and initiative.

Enterprise and wealth creation are vital to building sustainable communities. But under-
invested communities are too often seen as areas with little economic or business potential, reinforcing the cycle of underinvestment.

Our research shows that such communities can offer profitable opportunities for companies, banks and other investors. Social investment can work alongside conventional commercial finance and business to the advantage of the whole community.
In venture capital and private equity, where I spent most of my working life, money follows Say’s law: supply creates its own demand. This is equally true in the case of social investment. Therefore, capital is the right starting point for reversing the spiral of underinvestment.

The task force made five recommendations, several of which were quickly implemented. First, we proposed a general tax incentive, which was implemented as Community Investment Tax Relief. If you lend money or provide equity for five years to an approved Community Development Finance Institution, you get a 5% investment tax credit. For higher-rate taxpayers, this is equivalent to a gross annual return of 8.5%. This tax relief has greatly increased the pool of capital available to the community finance institutions, and social entrepreneurs have created some powerful social investment models to take advantage of it. As a consequence of its introduction, for example, the Charity Bank was created in April 2002. It is the first organization to be both a bank – recognized by the Financial Services Authority – and a charity.
If you deposit money in the Charity Bank for five years, you receive a gross annual return, while benefiting from the government guarantee against loss of all bank deposits of up to £30,000 ($51,700). The Charity Bank makes loans to charities operating in disadvantaged communities. To date, it has attracted £40 million of deposits, has made loans to more than 400 charities in Britain and is now drawing up plans for an equity-raising to support a larger deposit base

Venture capital for deprived areas

The task force’s second recommendation was to establish Community Development Venture Funds that would provide venture capital to businesses in the 25% most deprived areas of the country. As an incentive to attract institutional and private-sector capital to these funds, the government agreed to match, on a subordinated basis, the amount invested. The capital structure was designed to achieve a better return for the government than the return on British government bonds.

Bridges Community Development Venture Fund, established in 2002 with £40 million, was the first such fund. It invests from £100,000 to £2 million in promising businesses in the poorest areas of England. To date, it has made 16 investments and one significant realization and seems well on its way to achieving its return objective of 12% to 15% net of fees and carry (the profit paid to the fund managers) for its investors. It is now raising its second fund.

The key to raising half the capital from the private sector was setting clear financial objectives while targeting the fund’s activity exclusively to Britain’s poorest areas. Investors are wary of the fuzzy “double bottom line” that mixes financial and social returns without setting clear targets for either. In the case of the Bridges venture fund, too, a new social investment model is in operation, in which the financial return is the locomotive and the social returns are the carriages. Bridges has developed metrics that the companies in which it invests must track to quantify their social impact. It presents both the financial performance of the fund and the social impact of its investments to its investors every six months. One of the key challenges facing social investment is how to measure social return accurately, which is crucial to attracting significant private-sector capital.

The Task Force’s third recommendation is that British banks should follow the American practice of publishing details of their lending in disadvantaged areas. The lending patterns of individual banks make it possible to compare practice and encourage a cumulative “improvement in performance”. After we came up with this recommendation, the New Economics Foundation published The Power of Information, which provides a framework for voluntary reporting by banks. However, this voluntary approach has achieved only a partial success.

Charitable activity in Britain should be more broadly defined than it is now. Under Victorian legislation, charities were effectively deemed to exist to help poor people if they stayed poor, but not to help them get rich.

Our fourth recommendation is that charities be given greater latitude to invest in community development. In the past, charitable and investment activities were kept separate within charities. Programme-related investment (that is, lending on a favourable basis in order to achieve a social purpose) was considered impossible. Such investment is now not only permitted but also encouraged. Magic Roundabout, a guide on programme-related investment, has been published, and the Charity Commission, the
body that regulates charities, is a wholehearted supporter.

Our final recommendation was to establish a trade body representing the community development segment of the social investment sector. The government gave money to help set up the Community Development Finance Association, which assists community financial institutions, provides training, publishes guidelines, advises on government policy and encourages entrants into the sector.

Together, these five recommendations are designed to create a system of social investment that can meet a wide spectrum of social needs in a sustainable, self-reinforcing way, harnessing the forces of entrepreneurs and markets in order to reverse the existing spiral of underinvestment.

Peace by economic means

Through the experience of the Social Investment Task Force, I have become increasingly involved in efforts to help peace by economic means in the Middle East. I established the Portland Trust at the beginning of 2003 to promote economic development, improve living standards and encourage moderation in the region. The trust has undertaken research on the Irish peace process that shows the importance of economic growth in increasing moderation and reaching a peaceful resolution of that conflict. It is working to secure loan guarantees for Palestinian banks in order to increase their lending to small and medium-sized businesses. We believe that the Palestinian private sector is capable of creating a million jobs over five years, with the addition of a relatively limited amount of capital, $500 million over the period. This would be a boon to peace.

While entrepreneurship is necessary for a thriving economy, it creates ever-greater discrepancies in income and wealth. In a system that enjoys low tax rates, free markets and privatization, the state is no longer such a significant redistributor of wealth and income. The private sector, therefore, has an obligation to step in if it wants entrepreneurial society to succeed. Since capitalism cannot create equality of outcome, the private sector should help to provide equality of opportunity in order to make the system fairer.

Government then becomes an enabler, providing incentives for an effective “social investment” system and for the development of mission-driven organizational and investment models that are capable of wide replication. This is a crucial task as models in community venture funds, microfinance and venture philanthropy, although improving, are not yet sufficiently well developed to attract substantial private and institutional third capital.

Successful entrepreneurs, venture capitalists and others of our generation who have accumulated capital feel a sense of social obligation and are looking for effective ways to put something back into society, more effective than traditional, passive philanthropy. The potential supply of capital from them, and from corporations and banks that are emphasizing social responsibility, is considerable. Momentum is building in social entrepreneurship and investment. The challenge is for governments to provide support and incentives to transform this momentum into an effective sector.

CV SIR Ronald Cohen

Sir Ronald is the chairman of The Portland Trust and the Social Investment Task Force and founder of Apax Partners.