A new source of Wonga

In July, asset management research firm Cerulli Associates produced a report suggesting that big European charities were increasingly looking to alternative assets as part of their investment strategy. Based on a survey of large European charities with combined assets of about $64 billion, it found that around 20 percent of them have restructured their portfolios since 2008 specifically in order to ramp up their exposure to alternatives.

It’s easy to see why. Cerulli argues (convincingly) that charities have faced a “perfect storm of devastating circumstances” since the onset of the financial crisis, as government funding has been cut and donations have dropped off – even as demand for their services has increased. So in light of this urgent need to do more with less, it makes sense that (particularly the bigger charities) would look to try and square the circle by boosting returns from their investment portfolio.
Sure enough, alternatives now account for almost a quarter of these charities’ assets under administration, Cerulli says – and the number is growing.

“The conclusion must be that for asset managers with a proven track record in alternatives – be it hedge funds, infrastructure fund managers, private equity groups, or an institution that can act as a broker for direct investments – there are some terrific opportunities within the sector,” says Barbara Wall, Europe research director at Cerulli. “Because alternatives often have lower correlations with traditional equity and fixed income, a growing number of charities are beginning to rely on them.”

So what kind of LPs would these organisations be? Judging from the survey answers about how they run their process, most operate in a way that will be very familiar to private equity GPs. 63 percent select their asset managers via an investment committee (with the finance director being involved in the decision in nearly half of the cases). A similar proportion use more than ten asset managers at any one time, suggesting that they’re open to new ideas.

And interestingly, these charities seem to care less about fees than pensions and insurers, according to Cerulli: 56 percent agreed with the statement: “Fees are considered, but only to check we do not overpay for a strategy we have decided to invest in”. Given the current SEC-induced row over fees and expenses, that could be a boon to GPs too.

ETHICAL DILEMMAS

On the other hand, there are some areas where these organisations would be a more complicated proposition.

For instance, Cerulli notes, some charities have a permanent endowment fund that must remain fully invested and has to fund all the charity’s projects. This need for income will limit any efforts to invest in a long-term and illiquid asset class like private equity.

More significantly, there’s also the ongoing debate around ethical investing, and the extent to which a charity’s investment strategy should mesh with its mission. Cerulli cites the example of Comic Relief, a high-profile annual charity fundraising event in the UK, which was found to have invested some of its millions in alcohol, tobacco and even weapons.

Another notable case recently involved the Church of England’s pension fund. Archbishop of Canterbury Justin Welby (the CoE’s spiritual leader) had been a high-profile critic of online payday lenders – to the extent that he announced plans to “compete them out of existence” by backing the establishment of a credit union. But a couple of days later, it emerged that the Church’s pension fund was actually invested in Wonga, the prime exponent of this dark art – because it was an LP in a fund managed by venture group Accel Partners, one of Wonga’s key backers.

This caused huge embarrassment to the Church, and the Archbishop promptly vowed to cut all ties. This summer, almost a year after the story broke, Welby told the BBC that the pension fund no longer had any exposure to Wonga – although he didn’t really explain how it had done this, or why it had taken so long (Welby previously told the BBC that the Church was reviewing how it could get out of the stake without making a loss for its pensioners; it’s also worth pointing out that for obvious reasons, he has no earthly dominion over the fund’s professional investment team).

However, that creates a new problem for the Church, of course. Accel is one of the best (and most sought-after) VCs in the business. If it’s now screened out because of a particular deal, the pension fund’s returns might end up suffering as a result.

The fact is that there’s always an inherent tension in trying to maximise investment income while also pursuing a social mission. That’s abundantly clear from the latest Charity Commission guidelines, which state that trustees should “have the tools to make their assets work harder in a tough fundraising environment”, but also that maximising returns should “reflect the charity’s ethos and values”. And it’s obvious where the balance lies at the moment: 77 percent of respondents to the Cerulli survey had less than 10 percent of their portfolio in ethical investments.

In the current environment, charities need the kind of returns that private equity can offer. But there’s always a danger of ethical conflicts arising; and given the nature of private equity, it’s not easy to disentangle those conflicts when they do. Of course, if the social investment market continues to develop and institutionalise, that could be a very different story…