OPINION
2019 Jun/19
Impact Investment and Facility-Based Social Services
Jun. 19, 2019
PDF
Park, Chang Gyun
- Summary
- Concerns on the quality of social services by private providers have been continuously increased, especially in the areas of childcare, long-term care for the elderly, and public housing. The difficulty, however, is hard to avoid when profit-oriented private providers take part in the social services market under government price controls. Much of service quality concerns could be alleviated by inducing social enterprises seeking social as well as economic returns to enter the market. But it will be a daunting challenge for social enterprises with weak funding capacity to enter the market for social services such as childcare, long-term care, and public housing, because the market entry requires acquisition of large amount of fixed assets such as facilities. One possible solution is to establish impact investment funds that provide capital into impact areas including social enterprises by inviting investors with various kinds of appetite for risk and return combinations. Social enterprise would play a pivotal role in building a firm foundation for provision of high quality facilitybased social services. Tax benefits for individual investors would be very useful to facilitate impact investment. To further stimulate capital flows into impact areas, a donation to impact areas by a corporation should be allowed to be counted as expenses in calculating the tax base for corporate income tax.
1. Introduction
It is now not surprising to hear the news of child abuse, unhealthy meal program or accounting fraud at private childcare facilities. We also hear an unbelievable story that the competition to attract patients among private long-term care centers became so overheated that patient trading is not an exceptional practice. Construction companies build a large portion of public housing in Korea. A serious conflict sometimes occurs between them and their tenants when the mandatory rental period expires and public housing units are put up for sale at high prices unaffordable for current tenants. Two common characteristics can be pointed out from the aforementioned cases that caused controversies. First, they are social services that, in principle, should be provided by the government to achieve social goals. Second, the provision of such services requires acquisition by service providers of large scale facilities in which services are provided. A significant challenge in the field of so-called facility-based social services is to raise large amounts of capital to finance the construction or acquisition of necessary facilities as a precondition for service delivery. For that reason, the government entrusts much of service provision to the private sector to ensure timely and adequate provision of services without financing burden.
We cannot avoid the controversies surrounding private social service providers unless the government gives up controlling prices of the services. In other words, problems can be solved if the government either relinquishes price control or provides the services by itself without the help of private agents. But neither of them is an easy option the government can take. This article argues that we should pay more attention to social enterprises and impact investment funds as useful vehicles for minimizing the difficulties in provision of social services by private agents. In addition, we discuss policy measures that are thought to be necessary to build an ecosystem for the efficient delivery of high-quality social services.
2. Difficulties in provision of social services by private agents
Although the government is the ultimate provider of social services, it usually commissions the production and delivery of social services to the private sector for practical reasons. The government positions itself as a monopsonist in the market for social services provided by private agents that it is the only purchaser of the services in the market and the price setter. This power relationship is materialized in the market as the government sets and offers service prices, and private service providers determine whether they accept the price offer and participate in the market. In Korea, childcare for an infant or toddler provided by day nurseries is priced between KRW 220,000 and KRW 450,000 per month based on the type of childcare service. Long-term care for an older person provided by senior care facilities is priced between KRW 59,170 and KRW 69,150 facilities per day and is paid based on service grade under the national long-term care insurance scheme. Deposits and rents for public housing, although there are no uniform ceilings, must not exceed 90% of prevailing market rates in the areas surrounding the rental property. And the rent cannot be increased annually by more than 5%, indicating government price controls. In such a situation, a cost-cutting effort is the natural response of profit-oriented private service providers to the price controls. The effort to reduce costs without undermining quality would bring desirable results, i.e., contributing to improving social welfare. But social services are experienced goods, meaning that the quality cannot be evaluated before the actual use of the service. In many cases, therefore, the cost-cutting efforts of service providers result in a decrease in the quality of the service. Of course, the government demands the provision of social services at certain quality levels from private providers in order to avoid a decline in the quality.
The problem lies in a high degree of information asymmetry that exists with respect to the quality of social services. The information asymmetry around the quality of social services provided by private agents can be tackled in part by stronger monitoring or reputation among service users, but these are costly and time-consuming. Accordingly, a sharp deterioration in service quality occurs when private service providers’ cost-reduction efforts are not properly regulated.
3. Social enterprises as social service providers and impact investment
Looking ahead, one cannot rule out the possible provision of social services that are bad enough to cause controversy if the current market structure continues. The government may weed low-quality private service providers out of the market by relinquishing its price controls. But it is hard to choose this option under the current social policy framework built upon the consensus that social services are merit goods which should be made available to everyone.
What is worth noting is that social enterprises can be used to provide facility-based social services, such as childcare and long-term care, in order to address problems in the private provision of social services. A social enterprise refers to a business that is created to achieve social goals, rather than maximizing profit gains. Social enterprises are different from for-profits in that their ultimate purpose is to deliver social value instead of maximizing profits, and they are also different from non-profits in that they aim to generate enough profits to achieve long-term sustainability. Social values sought by social enterprises are not confined to the provision of social services or the creation of job opportunities for the disadvantaged segments of society, but include a wide range of areas such as community development, environment, and human rights. As social enterprises are not designed to maximize profits, they have little incentive to cut costs at the expense of service quality, unlike private service providers. Given that, the use of social enterprises as social service providers could help addressing many problems in the delivery of such social services as childcare, long-term care, and public housing, which have hit headlines in recent years. Based on this idea, the government has been making various policy efforts to encourage the creation and growth of social enterprises as the key providers of social services in accordance with the Social Enterprises Promotion Act. For instance, the government provides financial support or tax benefits if social enterprises meet certain requirements.
However, it should be noted that there are critical barriers for social enterprises to enter the market for facility-based social services. Very rigorous requirements for physical and human resources are imposed on private providers to ensure that the quality of social services is sustained above certain levels. Service providers need to spend considerable costs on meeting those requirements. For example, a service provider must have its own building and land for a childcare facility to become a licensed private nursery, or prove the ownership of the land and building in which planned facility is set up to qualify as a long-term care facility for elderly people. It means that service providers need billions (at minimum) or tens of billions of Korean won (at maximum) in funding. It is not easy for social enterprises aiming at delivering social value to raise such large amounts of funds.
Social enterprises sometimes raise capital from the traditional mainstream financial market, but mostly rely on the impact investment market to finance their business operations. The impact investment market can be defined as a mechanism that connects impact investors with investees such as social enterprises, ventures or projects, which create social values. Companies, non-profit organizations, individuals, governments, and international organizations participate as investors in the impact investment market for different investment purposes. As with social enterprises, impact investors look to achieve social goals and economic or financial returns at the same time. Recently, impact investment funds are used as a crucial financing tool which mobilizes large pools of capital from a number of impact investors with different appetites for impact and return, and uses the pooled funds to make massive investment. According to the Global Impact Investing Network (GIIN)’s Annual Impact Investor Survey (2018) covering 299 respondents around the world,1) impact investments totaled USD 35.5 billion in 2017, covering a wide range of areas including microfinance, renewable energy, and housing. For Korea, the impact investment market is still in its infancy, but will be on the growth trajectory in the foreseeable future considering the government’s strong policy support2) and a gradual, albeit slow, increase in private sector engagement in impact investment.
4. Ways for impact investment funds to enter the facility-based social services market
When the information asymmetry around impact investment is taken into account, a prevailing approach would be the provision of capital to impact companies through intermediaries, especially impact investment funds, instead of the direct selection of investee firms by investors. Among other things, multi-layered impact investment funds employing public and private partnerships could be used as a vehicle to channel investments with various impact and return appetites into the impact investment market. Take an example of issuing both preferred stocks and common stocks to raise equity capital. Preferred stocks can be sold to impact investors pursuing social and economic returns, and common stocks that carry the greatest risk can be sold to public interest foundations or high net worth individuals that focus on social impacts. As for the public sector including public interest foundations and the government, equity acquisition may be legally prohibited or restricted, or burdensome in practice. Thus, it is worth considering that public-sector investors are granted the same rights as equity investors with regard to non-financial outcomes in exchange for making donations. If needed, impact investment funds can use debt financing. A proper mix of debt seniority and promised returns on debt would enable the funds to attract diverse investors. This cash flow structuring would help impact investment funds attract not only impact investors with different appetites for risk-return combinations but also commercial investors. Furthermore, in the case of a debt contract that presumes commercial investors as major clients, the public sector could provide credit guarantees at low costs. This approach would facilitate the voluntary participation of market-rate-seeking institutional investors, leading to the success of large finance deals.
In Korea, impact investment funds can be set up in the form of a specialized privately placed fund (hedge fund) pursuant to the Financial Investment Services and Capital Markets Act (FSCMA) or a startup investment cooperative for small-and medium-sized enterprises (SMEs) pursuant to the Act on Support for Small and Medium Enterprise Establishment. The former is more suitable than the latter, given fund formation or investment flexibility. A general partner at a hedge fund must meet certain requirements and register as the fund manager with the Financial Services Commission (FSC). For impact investment fund managers, registered securities firms can be chosen as general partners, or a new type of hedge fund manager can be introduced for managing impact investment assets only. The former seems more realistic than the latter considering the registration burden. But, in the long run, it will be desirable to embrace a new type of business specialized in managing impact investment assets by amending the applicable laws. In this case, more relaxed entry regulations should be in place to reflect the spirit of impact investment.
Impact investment funds would play a role in identifying promising social enterprises that want to enter the market for facility-based social services, providing funding to them in various forms such as investment or loan, or providing startup capital if necessary. More specifically, impact investment funds could provide startup capital for social franchises that wish to enter the market. In doing so, they could play a part in securing cost-efficiency by achieving the economies of scale, and attaining a certain level of service quality by using standardized service delivery procedures.
5. Tax support for impact investment funds
As mentioned earlier, the Korean impact investment market is still in its nascent stage despite its potential for great social impact. The use of tax benefits is worth considering as one of policy support tools to invigorate the market. The Restriction of Special Taxation Act provides tax incentives to stimulate investment in venture businesses. If an individual invests in a business venture, either directly or indirectly, he or she is eligible for income deduction equal to 10% of investment, which shall not exceed 50% of aggregate or global income for the year (larger deduction is given depending on the amount of investment if a venture firm is an early-stage startup).3) Not only that, no corporate tax is levied on dividend income a small business startup investment company received from any investee venture firms or its gains from the sale of the shares in the venture firms.4) No capital gains tax is imposed on the sale of shares acquired by individual investors in return for an investment in a small business startup investment company or venture company.5) If a social enterprise is certified as a venture, investors in that social enterprise can receive tax benefits. But it may be difficult for a number of social enterprises or projects to obtain venture business certification. This situation calls for a revision of the Restriction of Special Taxation Act to establish legal grounds for providing impact investors with tax benefits similar to those granted to venture investors if certain conditions are met, taking into account the following: First, social services could be undersupplied because there is no proper reward for social value that is not traded in the market; Second, social ventures are flourishing with innovative solutions to social problems.
What is more, it is necessary to consider the recognition of donations to impact areas from legal entities, particularly corporations, as donations to non-profit, non-religious organizations, in order to facilitate the influx of funds into the impact investment market. Moreover, another way to channel large flows of funds into the market is to allow corporate tax deductions of donations (limited to 20% of donation) from corporations or legal entities to impact investment funds or projects, or uncertified social enterprises,6) which meet certain requirements, as is the case for certified social enterprises.7)
6. Conclusion
When profit-seeking private organizations or entities take part in the social services market under the government price controls, the risk of deterioration in service quality always exists. Much of service quality concerns could be alleviated by the market entry of social enterprises, which seek both social and economic returns, as new social service providers. However, it will be a daunting challenge for social enterprises with weak funding capacity to enter the market for social services such as childcare, long-term care, and public housing, because the market entry should be preceded by the acquisition of fixed assets such as large facilities. The key to addressing quality concerns over the private provision of social services would be to set up a large-scale impact investment fund, which pools funds from the public and private sectors with varying appetites for social impact and economic returns, and to build a financing ecosystem for social enterprises willing to enter the facility-based social services market. To make impact investment vibrant, tax benefits should be available for individual impact investors, like individual venture investors, to take advantage of global income deductions, and for legal entities to take advantage of the recognition of their donations to impact areas as expenses in calculating the tax base for corporate income tax, as is the case with donations to certified social enterprises. These policy measures will pave the way for fledgling impact investments in Korea to take a leap forward.
1) Global Impact investment Network (GIIN), Annual Impact Investor Survey 2018.
2) Competent authorities, February 8, 2018, Facilitating social finance.
3) Article 16 of the Restriction of Special Taxation Act
4) Articles 13 and 13.3 of the Restriction of Special Taxation Act
5) Article 14.1 of the Restriction of Special Taxation Act
6) Certified social enterprises are subject to certain restrictions on corporate governance, decision making, financing, asset management, and profit allocation. There are a number of social enterprises that are doing business for social value without obtaining the certification to avoid those restrictions.
7) Article 24.2 of the Corporate Tax Act
It is now not surprising to hear the news of child abuse, unhealthy meal program or accounting fraud at private childcare facilities. We also hear an unbelievable story that the competition to attract patients among private long-term care centers became so overheated that patient trading is not an exceptional practice. Construction companies build a large portion of public housing in Korea. A serious conflict sometimes occurs between them and their tenants when the mandatory rental period expires and public housing units are put up for sale at high prices unaffordable for current tenants. Two common characteristics can be pointed out from the aforementioned cases that caused controversies. First, they are social services that, in principle, should be provided by the government to achieve social goals. Second, the provision of such services requires acquisition by service providers of large scale facilities in which services are provided. A significant challenge in the field of so-called facility-based social services is to raise large amounts of capital to finance the construction or acquisition of necessary facilities as a precondition for service delivery. For that reason, the government entrusts much of service provision to the private sector to ensure timely and adequate provision of services without financing burden.
We cannot avoid the controversies surrounding private social service providers unless the government gives up controlling prices of the services. In other words, problems can be solved if the government either relinquishes price control or provides the services by itself without the help of private agents. But neither of them is an easy option the government can take. This article argues that we should pay more attention to social enterprises and impact investment funds as useful vehicles for minimizing the difficulties in provision of social services by private agents. In addition, we discuss policy measures that are thought to be necessary to build an ecosystem for the efficient delivery of high-quality social services.
2. Difficulties in provision of social services by private agents
Although the government is the ultimate provider of social services, it usually commissions the production and delivery of social services to the private sector for practical reasons. The government positions itself as a monopsonist in the market for social services provided by private agents that it is the only purchaser of the services in the market and the price setter. This power relationship is materialized in the market as the government sets and offers service prices, and private service providers determine whether they accept the price offer and participate in the market. In Korea, childcare for an infant or toddler provided by day nurseries is priced between KRW 220,000 and KRW 450,000 per month based on the type of childcare service. Long-term care for an older person provided by senior care facilities is priced between KRW 59,170 and KRW 69,150 facilities per day and is paid based on service grade under the national long-term care insurance scheme. Deposits and rents for public housing, although there are no uniform ceilings, must not exceed 90% of prevailing market rates in the areas surrounding the rental property. And the rent cannot be increased annually by more than 5%, indicating government price controls. In such a situation, a cost-cutting effort is the natural response of profit-oriented private service providers to the price controls. The effort to reduce costs without undermining quality would bring desirable results, i.e., contributing to improving social welfare. But social services are experienced goods, meaning that the quality cannot be evaluated before the actual use of the service. In many cases, therefore, the cost-cutting efforts of service providers result in a decrease in the quality of the service. Of course, the government demands the provision of social services at certain quality levels from private providers in order to avoid a decline in the quality.
The problem lies in a high degree of information asymmetry that exists with respect to the quality of social services. The information asymmetry around the quality of social services provided by private agents can be tackled in part by stronger monitoring or reputation among service users, but these are costly and time-consuming. Accordingly, a sharp deterioration in service quality occurs when private service providers’ cost-reduction efforts are not properly regulated.
3. Social enterprises as social service providers and impact investment
Looking ahead, one cannot rule out the possible provision of social services that are bad enough to cause controversy if the current market structure continues. The government may weed low-quality private service providers out of the market by relinquishing its price controls. But it is hard to choose this option under the current social policy framework built upon the consensus that social services are merit goods which should be made available to everyone.
What is worth noting is that social enterprises can be used to provide facility-based social services, such as childcare and long-term care, in order to address problems in the private provision of social services. A social enterprise refers to a business that is created to achieve social goals, rather than maximizing profit gains. Social enterprises are different from for-profits in that their ultimate purpose is to deliver social value instead of maximizing profits, and they are also different from non-profits in that they aim to generate enough profits to achieve long-term sustainability. Social values sought by social enterprises are not confined to the provision of social services or the creation of job opportunities for the disadvantaged segments of society, but include a wide range of areas such as community development, environment, and human rights. As social enterprises are not designed to maximize profits, they have little incentive to cut costs at the expense of service quality, unlike private service providers. Given that, the use of social enterprises as social service providers could help addressing many problems in the delivery of such social services as childcare, long-term care, and public housing, which have hit headlines in recent years. Based on this idea, the government has been making various policy efforts to encourage the creation and growth of social enterprises as the key providers of social services in accordance with the Social Enterprises Promotion Act. For instance, the government provides financial support or tax benefits if social enterprises meet certain requirements.
However, it should be noted that there are critical barriers for social enterprises to enter the market for facility-based social services. Very rigorous requirements for physical and human resources are imposed on private providers to ensure that the quality of social services is sustained above certain levels. Service providers need to spend considerable costs on meeting those requirements. For example, a service provider must have its own building and land for a childcare facility to become a licensed private nursery, or prove the ownership of the land and building in which planned facility is set up to qualify as a long-term care facility for elderly people. It means that service providers need billions (at minimum) or tens of billions of Korean won (at maximum) in funding. It is not easy for social enterprises aiming at delivering social value to raise such large amounts of funds.
Social enterprises sometimes raise capital from the traditional mainstream financial market, but mostly rely on the impact investment market to finance their business operations. The impact investment market can be defined as a mechanism that connects impact investors with investees such as social enterprises, ventures or projects, which create social values. Companies, non-profit organizations, individuals, governments, and international organizations participate as investors in the impact investment market for different investment purposes. As with social enterprises, impact investors look to achieve social goals and economic or financial returns at the same time. Recently, impact investment funds are used as a crucial financing tool which mobilizes large pools of capital from a number of impact investors with different appetites for impact and return, and uses the pooled funds to make massive investment. According to the Global Impact Investing Network (GIIN)’s Annual Impact Investor Survey (2018) covering 299 respondents around the world,1) impact investments totaled USD 35.5 billion in 2017, covering a wide range of areas including microfinance, renewable energy, and housing. For Korea, the impact investment market is still in its infancy, but will be on the growth trajectory in the foreseeable future considering the government’s strong policy support2) and a gradual, albeit slow, increase in private sector engagement in impact investment.
4. Ways for impact investment funds to enter the facility-based social services market
When the information asymmetry around impact investment is taken into account, a prevailing approach would be the provision of capital to impact companies through intermediaries, especially impact investment funds, instead of the direct selection of investee firms by investors. Among other things, multi-layered impact investment funds employing public and private partnerships could be used as a vehicle to channel investments with various impact and return appetites into the impact investment market. Take an example of issuing both preferred stocks and common stocks to raise equity capital. Preferred stocks can be sold to impact investors pursuing social and economic returns, and common stocks that carry the greatest risk can be sold to public interest foundations or high net worth individuals that focus on social impacts. As for the public sector including public interest foundations and the government, equity acquisition may be legally prohibited or restricted, or burdensome in practice. Thus, it is worth considering that public-sector investors are granted the same rights as equity investors with regard to non-financial outcomes in exchange for making donations. If needed, impact investment funds can use debt financing. A proper mix of debt seniority and promised returns on debt would enable the funds to attract diverse investors. This cash flow structuring would help impact investment funds attract not only impact investors with different appetites for risk-return combinations but also commercial investors. Furthermore, in the case of a debt contract that presumes commercial investors as major clients, the public sector could provide credit guarantees at low costs. This approach would facilitate the voluntary participation of market-rate-seeking institutional investors, leading to the success of large finance deals.
In Korea, impact investment funds can be set up in the form of a specialized privately placed fund (hedge fund) pursuant to the Financial Investment Services and Capital Markets Act (FSCMA) or a startup investment cooperative for small-and medium-sized enterprises (SMEs) pursuant to the Act on Support for Small and Medium Enterprise Establishment. The former is more suitable than the latter, given fund formation or investment flexibility. A general partner at a hedge fund must meet certain requirements and register as the fund manager with the Financial Services Commission (FSC). For impact investment fund managers, registered securities firms can be chosen as general partners, or a new type of hedge fund manager can be introduced for managing impact investment assets only. The former seems more realistic than the latter considering the registration burden. But, in the long run, it will be desirable to embrace a new type of business specialized in managing impact investment assets by amending the applicable laws. In this case, more relaxed entry regulations should be in place to reflect the spirit of impact investment.
Impact investment funds would play a role in identifying promising social enterprises that want to enter the market for facility-based social services, providing funding to them in various forms such as investment or loan, or providing startup capital if necessary. More specifically, impact investment funds could provide startup capital for social franchises that wish to enter the market. In doing so, they could play a part in securing cost-efficiency by achieving the economies of scale, and attaining a certain level of service quality by using standardized service delivery procedures.
5. Tax support for impact investment funds
As mentioned earlier, the Korean impact investment market is still in its nascent stage despite its potential for great social impact. The use of tax benefits is worth considering as one of policy support tools to invigorate the market. The Restriction of Special Taxation Act provides tax incentives to stimulate investment in venture businesses. If an individual invests in a business venture, either directly or indirectly, he or she is eligible for income deduction equal to 10% of investment, which shall not exceed 50% of aggregate or global income for the year (larger deduction is given depending on the amount of investment if a venture firm is an early-stage startup).3) Not only that, no corporate tax is levied on dividend income a small business startup investment company received from any investee venture firms or its gains from the sale of the shares in the venture firms.4) No capital gains tax is imposed on the sale of shares acquired by individual investors in return for an investment in a small business startup investment company or venture company.5) If a social enterprise is certified as a venture, investors in that social enterprise can receive tax benefits. But it may be difficult for a number of social enterprises or projects to obtain venture business certification. This situation calls for a revision of the Restriction of Special Taxation Act to establish legal grounds for providing impact investors with tax benefits similar to those granted to venture investors if certain conditions are met, taking into account the following: First, social services could be undersupplied because there is no proper reward for social value that is not traded in the market; Second, social ventures are flourishing with innovative solutions to social problems.
What is more, it is necessary to consider the recognition of donations to impact areas from legal entities, particularly corporations, as donations to non-profit, non-religious organizations, in order to facilitate the influx of funds into the impact investment market. Moreover, another way to channel large flows of funds into the market is to allow corporate tax deductions of donations (limited to 20% of donation) from corporations or legal entities to impact investment funds or projects, or uncertified social enterprises,6) which meet certain requirements, as is the case for certified social enterprises.7)
6. Conclusion
When profit-seeking private organizations or entities take part in the social services market under the government price controls, the risk of deterioration in service quality always exists. Much of service quality concerns could be alleviated by the market entry of social enterprises, which seek both social and economic returns, as new social service providers. However, it will be a daunting challenge for social enterprises with weak funding capacity to enter the market for social services such as childcare, long-term care, and public housing, because the market entry should be preceded by the acquisition of fixed assets such as large facilities. The key to addressing quality concerns over the private provision of social services would be to set up a large-scale impact investment fund, which pools funds from the public and private sectors with varying appetites for social impact and economic returns, and to build a financing ecosystem for social enterprises willing to enter the facility-based social services market. To make impact investment vibrant, tax benefits should be available for individual impact investors, like individual venture investors, to take advantage of global income deductions, and for legal entities to take advantage of the recognition of their donations to impact areas as expenses in calculating the tax base for corporate income tax, as is the case with donations to certified social enterprises. These policy measures will pave the way for fledgling impact investments in Korea to take a leap forward.
1) Global Impact investment Network (GIIN), Annual Impact Investor Survey 2018.
2) Competent authorities, February 8, 2018, Facilitating social finance.
3) Article 16 of the Restriction of Special Taxation Act
4) Articles 13 and 13.3 of the Restriction of Special Taxation Act
5) Article 14.1 of the Restriction of Special Taxation Act
6) Certified social enterprises are subject to certain restrictions on corporate governance, decision making, financing, asset management, and profit allocation. There are a number of social enterprises that are doing business for social value without obtaining the certification to avoid those restrictions.
7) Article 24.2 of the Corporate Tax Act