Today’s charities face a host of calls on their financial resources. With interest rates still hovering close to all-time lows, it’s harder than ever for organisations to generate the income they need to deliver on their charitable mission in a way that’s sustainable. A growing number of charities find themselves being forced to dip into reserves to cover shortfalls in their income. This might be necessary in exceptional, short-term circumstances, but is not a healthy long-term strategy.

With demand for charities’ services likely to increase still further over the coming years, organisations should now consider whether a different approach – blending investments and borrowing – could help them to meet this challenge.

Doing nothing carries its own risks

In today’s uncertain economic climate, opting to do nothing can be the biggest risk of all. Low interest rates mean that simply parking reserves in a bank account and leaving them there, or investing in government bonds – a traditional safe haven of investment portfolios – might seem like the least risky option for trustees concerned about funding their charity’s objectives. But if there’s a need to generate an increased amount of income, coupled with the prospect of low interest rates continuing, trustees could be forced into settling for an income that falls short of target. What’s more, the effect of inflation means that bank deposits have lost some of their real value in recent years. When setting the charity’s investment strategy, it’s important that trustees consider carefully all aspects of risk, including risk to capital and risk of generating the required rate of return.

Balancing risk and returns

An ongoing challenge for charities is to put their hard-earned reserves to work, to generate the returns they need to fund their objectives. Charity leaders and trustees can be so focused on delivering on their core goals that any significant financial commitment can trigger acute risk aversion – especially among smaller organisations. Trustees should seek to achieve the best returns they can to further their charity’s aims, within a framework of carefully assessed risk considered to be acceptable.

Investing and borrowing are both potential strategies to generate a greater return from a charity’s assets, whether as part of a charitable programme or as part of a financial strategy. While many charities recognise the role of investments in helping them to achieve their financial and charitable objectives, few have explored the potential benefits of combining investing and borrowing to do so.

Among this strategy’s potential benefits are developing a charity’s capital assets, to help diversify sources of income and grow capacity to support service users. For example, it could help fund the purchase of a property to expand an organisation’s office space, and open a café staffed by beneficiaries. This may enable a charity to expand its existing service provision, while also generating a new income stream which helps to service loan repayments.

Knowledge gap

So what are the barriers to more charities considering this recipe? Is it a lack of awareness and understanding of the potential advantages of such an approach? Or is it more a belief that charities should never borrow money?

Neil Wingerath, trust and tax principal at Payne Hicks Beach, has acted as a trustee of many charitable trusts for the past 45 years. He points to a relatively low level of awareness among trustees of the potential positive opportunities created by commercial lending, coupled with investing.

Wingerath attributes this knowledge gap to the fact that a number of trustees, despite having professional backgrounds, often in financial services, may have a narrow understanding of this specific area – and perceive it as an unnecessary risk. However, for trustees with the right combination of expertise and support, investment and commercial lending can work effectively in harmony to help them deliver on their goals as part of a solid, long-term investment strategy.

Preserve your reserves

Smaller charities, typically those with assets under £3m, might be discouraged from investing in asset classes such as property by high costs and illiquidity. But a charity with solid cash reserves that is looking to purchase a new property has more options at its fingertips than simply channelling all those funds directly into bricks and mortar.

Rather than liquidating an entire existing portfolio to fund the purchase of the new property, trustees could opt to hold onto their core holdings, and then borrow at margins that are preferential to the anticipated return on the remaining investments. Working through the calculations may show that blending investment with borrowing is more cost-effective than selling their whole portfolio. A combined approach will also have benefits in terms of maintaining a greater diversification of assets.

The benefits of a combined approach to investment and borrowing

• It allows a charity to successfully achieve its charitable goals
• It helps charities to avoid undermining the longevity of their cash
• It enables charities to achieve crucial diversification across a range of asset classes, and
• By maintaining core investments, a charity is positioning itself to generate high enough returns to service its debt.

Understand your investment horizons

Before making any commitments to investing, borrowing or a combined approach, trustees need to review their constitution to determine the extent of their powers to do so. Once they have established whether or not they have the necessary scope, they then need to take a close look at their investment horizons – and plan accordingly.

It’s always important to consider the environment in which your charity operates and the underlying economic and political climate. However, it can be all too easy to focus on reasons not to invest or borrow. As a result, charities with long-term investments should be wary of deferring investing or borrowing decisions based on what the economy is doing right now. Instead, a firm focus on longer planning horizons is vital. A charity established in perpetuity is more likely to be able to tolerate short-term volatility, as it should be managing returns over a much longer period.

Do your sums

Next, trustees will need to think carefully about the optimum share of their net assets to invest in a geared property investment. For example, they need to do their sums to establish the likely difference in the annual return from switching a proportion of their current asset portfolio into property. This needs to be weighed up against the potential cost of making that investment both with the help of borrowing, and without.

Loan-to-value (LTV) is an important consideration here, according to Wingerath. For example, in a bear market (one where asset prices are falling), trustees will want to feel sure that it won’t push them into negative equity, leading to a potential forced disposal at or near the bottom of a market cycle. It is perfectly possibly to ride out negative market shocks if the board’s strategy is underpinned by firm foundations such as steady, reliable income yields and a diverse range of tenants or beneficiaries.

Boost your board

The importance of strong governance – and a robust, effective board with the expertise to make the right decisions at the right times – cannot be underestimated when it comes to combining investing and borrowing. Charities should ask themselves some searching questions about the composition of their board of trustees:

1. Does it represent a diverse range of views and backgrounds? Diversity is not just an intuitively good thing to aim for. It can help an organisation better represent its beneficiaries, as well as boosting effective decision-making.
2. Does your board contain trustees with a range of expertise? Does it have the required level of specialist understanding? For example, does it include someone who understands investments?
3. Does the board have the ability to invest on its own? It might be well worth identifying an additional trustee with the requisite experience or seeking impartial, unbiased advice from an independent financial adviser (IFA).

Not all charity boards have the necessary expertise to enable them to make effective decisions. So trustees should consider seeking professional advice at the stage they are considering their investment and borrowing options, to ensure they fully understand the potential implications and to maximise the opportunities such an approach offers.

Monitor, measure, review

Finally, taking the decision to invest or borrow is just the start of the journey. Trustees need to carefully monitor and review their investments and borrowing, to ensure that they are successfully balancing the challenge of managing medium-term lending needs against their long-term strategy. With this in mind, it is important not to be locked into inflexible long-term borrowing, even if the asset is considered a long-term investment, states Wingerath. “Circumstances can, and often do, change over the long term, leading to inevitable changes in investment policy. This means retaining the flexibility to review the terms of borrowing at regular intervals is prudent, giving trustees the power either to negotiate alternative terms based on the economic environment at the time, or to repay, reduce or increase borrowing to suit changing circumstances.”

A successful approach to investing and borrowing

• Keep a firm focus on your charity’s mission and financial strategy for delivering on it
• Develop a board that considers both investments and borrowing and reviews its policy accordingly
• Take time to understand how investing and borrowing can help an organisation meet its mission and fulfil its objectives
• Appreciate how the optimum blend of both financial instruments can help maximise the delivery of positive outcomes and impact

With the financial pressures faced by charities unlikely to ease, trustees and senior managers need to be confident that their current financial strategy is fit to do their job. At your next board meeting, perhaps consider this simple question. How could we better develop our capital assets to achieve our objectives, whether directly or by generating the returns needed to achieve our charitable goals over the long term? If you’re considering how investments and borrowing could support your charity’s financial strategy, it is worth seeking help to explore the options available to you.

Neil Poynton is head of charities at CAF

Charity Finance wishes to thank CAF for its support with this article