New Impact Investment opportunity for ancillary funds a ‘game changer’

An innovative financial product coming soon to market will give PAFs and PuAFs the opportunity to provide vital operating costs for not-for-profits, freeing up their resources to maximise impact. The long-term growth prospects should return capital to funders and leave NFPs with a sustainable asset. Craig Connelly, partner at Perpetual Limited, explains.

A new Impact Investment Opportunity for Australian PAFs/PuAFs

Australian Private Ancillary Funds and Public Ancillary Funds will soon have an opportunity to consider deploying funds as impact investments into a new type of philanthropic loan heading to market – a Capital Impact Loan.

The problem faced by many not-for-profits (NFPs) achieving outstanding impact in areas in which the work is complex, evolving, and long-term is that critical operating expenditure is almost never available for a duration and quantum commensurate with the complexity of the issue they are seeking to address. 

Equally, many funding decisions do not necessarily reflect an informed perspective of an organisation’s impact. Continuing to seek smaller dollar and modest-duration grants will not support many outstanding NFPs to sustain and amplify their impact.

The Idea

The answer is a multi-million-dollar limited recourse, zero interest rate 25-year Capital Impact Loan, intended to generate:

1. Material, recurring annual funds available for the eligible NFP to fund [critical] operating expenditure.

2. A substantial balance sheet asset at the end of the loan term that assists the NFP’s sustainability.

How will a Capital Impact Loan work?

For example, let us assume the value of a Capital Impact Loan is $20 million. The product secures loan funds for the eligible NFP, which the NFP invests into a suitably constructed investment portfolio, with the aim of generating total returns of approximately 7.5% per annum. The investment portfolio should be able to distribute approximately 5.0% per annum as cash distributions to the NFP.

Those annual distributions are then available for the NFP to deploy to fund [core] operating costs, with a proportion available in the early years to accumulate a working capital buffer equivalent to 12-months operating expenditure.

This capital is anticipated to grow in value until after 25 years the $20 million loan can be re-paid and the NFP retains any residual capital, which on conservative 7.5% annual total return assumptions should amount to approximately $13 million.

• Are the loan funds secure?

The loan will be secured by security over the investment portfolio. Recourse to the NFP in relation to the loan is limited to the proceeds of enforcement of this security. The loan structure will include an appointed security trustee whose role is to hold the benefit of this security on behalf of each PAF/PuAF lending to the NFP. The NFP will not be able to dispose of the investment portfolio during the loan term, only benefiting during the loan term from the regular cash distributions.

• Will the investments consider suitable Responsible Investing considerations?

Yes. A professional investment manager will articulate suitable ESG and Responsible Investing fundamentals of the investment portfolio constructed.

• Will the funds available to the NFP consider “pay what it takes”?

Yes. The funds distributed to the NFP will be available for the NFP to distribute in a manner determined by the NFP (with some limited exceptions), and so consider all relevant overheads and related operating costs. The intention of the loan is to allow the NFP’s sole focus to be to amplify its impact.

• Did you say 25 years?

Yes, but the Capital Impact Loan will be accompanied by a comprehensive learning and evaluation framework that will inform lenders of the impact of their funding. Every 5 years, formal evaluations will enable the lenders, from year 10, to either extend funding for a further 5 years or trigger a loan repayment 5 years after a negative evaluation. So, the loan term is really a minimum of 10 years and a maximum of 25 years.

The Impact

Such a loan could generate approximately $35 million of income over the 25 years and leave a tranche of residual capital of $13 million+ at the end of 25 years and repay the lenders their $20 million. That residual asset will assist the NFP’s long-term sustainability.

The structure of the loan is a little complicated but is beneficial for the borrower and should be economically neutral for the lender. The current high interest rate environment provides an opportunity to issue such a loan that is financially effective for the lenders. The lenders will principally be PAFs (Private Ancillary Funds) and PuAFs (Public Ancillary Fund), which by law must make grants each year equivalent to 5% and 4% respectively of their asset base at the beginning of each year.

The guidelines of the Australian Taxation Office (ATO) allow PAFs and PuAFs to loan funds to Deductible Gift Recipient (DGR) NFP organisations and in doing so can credit, as a non-cash grant distribution against their 5% or 4% commitment, the difference between the arm’s length market rate for such a loan and the actual interest charged. 

In the current high-interest rate environment, the commercial rate for an 100% LVR equity margin loan will be at least as high as 9.5% per annum, so if the lenders, (the PAFs and PuAFs) charge 0% interest on their loan funds they should be able to then credit the 9.5% of the face value of their loan against their 5% or 4% annual grants commitment. The arms-length commercial interest rate will be structured for the duration of the loan-term, priced relative to a base rate, with a margin appropriate for the loan risk assessed by a suitably qualified commercial lender.

Why does this matter?

NFPs who successfully raise Capital Impact Loan funds will receive substantial, secure, long-term annual cash flows to fund their core operations. Rather than our leading changemakers having to fundraise for these funds, they are empowered to “lift their eyes’” and focus solely on impact and outcomes.

A Capital Impact Loan represents an opportunity to mobilise substantial balance sheet investment in direct support of our most outstanding charitable organisations, focused solely on impact as prioritised by the NFP. It will also leave a substantial and enduring balance sheet asset to assist long-term sustainability. This will be a game changer for those organisations.

This article is intended as an explainer and should not be considered financial advice or endorsement. Any funder or NFP who considers this kind of product when available should consult with specialist investment agents. The value of investments can go down as well as up.