Is your charity thinking about debt financing for large expenditures? Elizabeth Jones from Farrer & Co discusses the pros and cons of borrowing.
Many charities will, at some stage, utilise debt financing, particularly for large expenditures such as the purchase or development of property, investment in new technology or to expand their offer to beneficiaries. This article is intended as a broad look at borrowing by charities from banks and other commercial lenders and what charities need to think about when considering debt financing.
What does a typical charity borrower look like?
Not all charities are the same size or operate in the same way, but many will need to borrow money at some point; the key question is whether the charity can demonstrate to potential lenders that it is sufficiently creditworthy.
This means that charities with regular, reliable income (and who are therefore more able to absorb potential increases to floating interest rates) will find lenders more amenable.
For example, a charity that provides paid-for services with a stable client basis, with their regular, predictable income, tend to be attractive borrowers for commercial lenders. Further, charities that spend regularly on infrastructure and maintenance of property or a charity’s site are more likely than most charities to make use of debt finance.
Securing borrowing against assets owned by the charity will also benefit a lender’s assessment of the charity’s creditworthiness (and allow borrowers to access better terms).
Any charity which has a large property or investment portfolio may be able to grant security over their assets in favour of their lenders and thereby reduce the cost or increase the size of their loans.
At the end of the spectrum, small charities wishing to purchase their first premises often turn to secured borrowing (i.e. a mortgage) to finance that purchase.
What should charities think about when looking at this as an option?
The first thing to think about is whether a charity has the power to borrow. Most charities have an express power to borrow and grant security in their governing document.
If they don’t, one can usually be added without having to involve the Charity Commission. Alternatively, a sweep-up power may be considered sufficient to authorise the borrowing in some circumstances.
Charity trustees will also need to ensure that a decision to borrow is an effective means of furthering the charity’s objects.
Charities should also recognise that if their assets are used as security, they may be limited as to what they can use those assets for.
The lender will want some level of control over them to preserve their value and accessibility as collateral for the loan. Those assets will also be at risk of being taken and sold by the lender if the loan repayments are not maintained.
What are the pros and cons for my charity?
The pros and cons of borrowing will be different for every charity. In broad terms, while debt finance will facilitate expenditure which might otherwise be impossible (e.g. the purchase of a property or capital development), it may increase regular outgoings in the form of interest and capital repayments.
This means trustees need to consider the charity’s financial forecasts and business plans when assessing a loan’s affordability. If other forms of funding are available (e.g. grant funding), this may prove to be a cheaper and easier option, particularly where no assets are available to provide security.
Charities should also consider the fees and expenses associated with commercial borrowing. Commercial lenders often charge upfront fees for providing the loan and are likely to require the charity to cover the lender’s legal costs in addition to its own.
What other considerations are there for trustees?
Any decision to borrow needs to be consistent with charity trustees’ legal duties. An exposition of these duties is beyond the scope of this article, but in summary such a decision needs to be made with the charity’s best interests in mind. It must also be one which is within the range of decisions that a reasonable trustee body could have made.
Trustees should also consider the Charity Commission’s guidance on decision-making, and ensure all decisions are properly recorded.
Where a loan is secured against property, particular formalities apply under Part 7 of the Charities Act 2011 which must be complied with.
Additional complexities arise where assets being secured are held by the charity as permanent endowment – this is a complex area on which specialist legal advice is likely to be necessary.
Case Studies
The below are case studies based on real-life examples of commercial loans to charities or social enterprises:
- A £5.9 million loan made available by a UK-based bank to an educational training charity for those working with children with special educational needs and disabilities which had revenue of approximately £10 million, mostly derived from contracts with the state education sector. The loan was used to buy and redevelop a property and was secured against that property. The loan was repayable in instalments over 25 years.
- A £7.5 million loan made available by a high street bank to a school with revenue above £22 million to fund the redevelopment of part of the school campus. The loan had a variable rate element and a fixed rate element and was for a term of 20 years. The loan was secured against the school’s land and buildings.
- A £1.38 million loan from a UK-based bank to a community interest company to fund the purchase of a managed workspace for letting out in connection with its charitable work and to assist with fit out costs for the property. The loan was secured against the property. The loan was for a term of 25 years. The borrower also managed to secure an additional £500,000 of further funding from a social investment lender at an interest rate significantly below that of the senior lender.