Developing a model for community bonds

In October 2016 Gordon Noble and Ingo Kumic presented to the National Economic Development Conference in Perth ideas on how to establish community bonds. The following is an edited extract of the paper developed for the conference.

To obtain the full paper email noble@gnbk.com.au

Can Local Government and Superannuation Funds Become Partners?

The subject of this paper is whether there are sufficient areas of common interest to make it economic for superannuation funds to develop partnerships with local government. If there is sufficient common interest, then the secondary question then is how best could a partnership be structured?

The importance of ‘partnerships’ and ‘partnership based’ approaches are now seen as fundamental to delivering city futures.

With globalisation driving the process of urbanisation, the pressure on cities to keep pace is increasing. While in the past many of the services and long term strengthening requirements for cities were largely met by local government, now cities are faced with an exponential increase in the quantum of services and long term development needs. As a result, this can no longer be delivered by one entity and as such requires a convergence or partnership across the public, private and civil sectors to meet the needs of cities and their communities.

The challenge with the word ‘partnership’ is that it means different things to different people and in an operational sense takes on very different complexions, with everything from Public Private Partnerships through to Community Partnerships characterising the landscape.

While the form of agreement that binds partnerships can look very different there are three things that all successful partnerships must have. They must have alignment on the mission they seek to complete, they must agree to the pace of delivery and, they must agree on what constitutes a reasonable return on investment or if you like, success .

This section will deal with the key challenges confronting a possible alliance between local government and superannuation funds, high level principles that might underpin this alliance, and the fundamental mechanics of a partnership arrangement and service ecosystem required for delivering ‘community futures’ at the local level. Finally we will consider potential investment opportunities and investment models.

Defining Areas of Common Interest

To determine whether there are opportunities for Australian superannuation funds to partner with local government, it is necessary to define areas of common interest.

Superannuation funds are likely to have an interest in partnering with local government because of its rich and diverse asset base. However this is conditional on these ‘investable opportunities’:

• Providing sufficient liquidity to enable sale in a timely manner to meet member needs
• Are structured in such a way to minimise due diligence and transaction costs
• Are scalable and repeatable, providing an opportunity to allocate new capital
• Offer the prospect of investment returns with a low probability of investor loss of capital
• Offer cost structures consistent with other investments in superannuation portfolios
• Diversify an investment portfolio
• Have different correlations to other assets, that is the value of the investment does not change in the same way as existing investments in a portfolio in response to particular events

Local government is likely to have an interest in partnering with superannuation funds because of its access to investment opportunities and its expertise in maximising the commercial function and impact of an asset. However this is conditional on these ‘investable opportunities’:

• Delivering for the local community
• Are developed in a manner which is inclusive of the community, ie reflect a ‘place-based’ approach.
• Are compliant with Local Government Act
• Provides a return on investment for the local authority in order to finance and or fund further investments
• Employ approaches/ mechanisms that assist in the mitigation of financial exposure
• Align with local government decision making and gateway processes

From ‘plan and wait’ to ‘plan and make it happen’

In order to move towards these more innovative financing and funding approaches local government must see these options as business as usual. The innovation required of local government can best be surmised as a shift from a ‘plan and wait’ approach to a ‘plan and make it happen’ model.

While there are exceptions, local government ‘business as usual’ is largely characterised by sound competencies in the comprehensive planning of community futures and the identification of specific opportunities which could make a difference. However, it is rarely in a position to deliver these in a substantial manner.

This is largely an historical consequence of the relative authority or power to be self-determining handed it by State and Federal Government.

In essence, local government has been empowered to be a local policy and planning authority which by its very nature means it creates performance frameworks with which to assess the merits of the investment proposals of ‘others’. Local government has little, as they say, ‘skin in the game’.

The nature of urbanisation challenges are such that it now requires local government to not only have ‘skin in the game’ but to drive the game.

Rather than wait for and manage the investment proposal of others it must develop its own investment partnership and facilitation competency in order to drive and manage the investment its communities require.

Sitting at the heart of this is a new ecosystem which is dedicated to the identification of suitable investable opportunities, the development of investment partnerships, and the establishment of sophisticated funding and financing vehicles which connect to the massive flows of private and institutional capital currently circulating within superannuation funds.

Other key considerations required to manage the relationship between local government and superannuation funds ultimately leading to a condition which:

• Aligns the mission of industries/ businesses which have no historical working relationship,
• Establishes an ecosystem of actors with the agency and flexibility to connect the fine grain of investment opportunity at the local government level with the meta-structures and flows of capital that characterise the super industry
• Embeds a way of working that reflects traditional decision making gateways and accountabilities consistent with both.

Place-based working

It is important to note that no other entity understands the complete material and immaterial requirements of a local community as well as local government. As such, local government also understands that it is not the technical quality of a solution which serves as the greatest threat to delivering an asset and realising its value but is instead the poor political resolution of the change that this solution or asset implies.

If the superannuation industry is to capitalise on the massive investment potential at the local level then local government and a ‘place-based’ approach to strategic analysis and solution identification for the project is critical.

Local government is moving into unknown territory largely brought on by an unprecedented level of urbanisation which shows no signs of slowing . This necessitates innovative approaches to, amongst other things, the way in which local government leads and manages its business.

While on the one hand local government must innovate the way in which it finances its local futures, it must also ensure that the process by which it does this reflects a sophisticated political approach.

To this end, research increasingly reveals that place-based approaches to ‘making cities’ are gaining momentum as the most effective way of achieving and sustaining an empowered, inclusive and ultimately resilient society and by which local government plans, delivers and monitors its business

According to Burkett (2012), ‘place-based working’ also holds the key to ‘catalysing new and innovative investment strategies that create real change’ in our communities. In a recent study on place-based impact investment, Burkett (2012) notes that ‘place-based approaches are gaining currency internationally as a mechanism for growth and human capital development’. Through an extensive undertaking, Burkett concludes that place-based impact investment further extends the idea of invest strategies such as ‘impact investment’ by focussing an alliance of public, private and NFP interests for the benefit of a specific community. As Burkett goes on to note, ‘it is an opportunity for investment leaders and visionaries looking to take the first step towards building new markets that generate (social and environmental) impacts in addition to (financial) returns’ (Burkett 2012)

Place-based approaches are predicated on the simple idea that change is inevitable and in order to make change work in a positive way it is important to engage those communities most likely to be impacted by that change. There are two components which therefore underpin all effective place-based approaches:

1. Relationships to develop and sustain with and for a community, and the
2. Design processes used to enable a community’s future.

Design comprises of two components, planning and strategy. Place-based design approaches invariably use human-centred design methods such as participatory design, co-design, and co-creation to name but a few.

At its most fundamental, ‘design’ reveals both a theory of change for a community and the likely social impact of that change and does so by, amongst other things, ensuring that:

• The community is integral to decisions about their place
• A culture of patronage and responsibility is built for place futures
• Political representation at the heart of the co-creation process with the community, and
• There is an investment, people and program alignment.

Investment Opportunities

It is important when discussing potential ‘investment opportunities’ for a local community, or in city futures, that a distinction is made between what we are investing in and how that investment is structured.

Typically investment is required when a need arises, that is when a community experiences either a decline in, or seeks to enhance its social, economic and environmental state. The former is referred to as responding to ‘deficit need’ the latter to ‘asset need’. When dealing in community futures we typically deal with a complex arrangement of both brought about by structural changes to local economies, labour markets and demographics, shifts in household or personal circumstance concerning income, education and employment or changes to commercial activity and investment in the local economy.

To this end we believe that there is a need for a new asset class known as ‘Community Futures Investments’ (CFI). This would typically focuses on both the hard and soft community infrastructure required for the long term change and impacts complex local communities seek.

CFI is an umbrella term for the three core investment strategies that characterise the investment landscape and which are highly applicable to a local government context.

The first is traditional philanthropic or grant base. Its return on investment is purely social or environmental. This type of investment strategy will suit those things which have no possibility of generating a financial return or where trying to exact a financial return would compromise the fundamental social or environmental reason for the asset. Examples are graffiti removal, business attraction and community art development.

The second is a relatively new category known as impact investing that can be considered part of the broader responsible investing approach. Impact investment seeks to generate ‘blended value’, in which social and environmental return is the dominant expectation albeit not at the exclusion of financial returns. This investment strategy will suit those things which may be required to defy market dynamics in order to yield the social or environmental impacts being sought. Examples include affordable housing, refugee entrepreneurship, social or environmental start-up/ SME. According to industry estimates the market size for Impact Investment in Australia is up to $10 billion. Currently Impact Investment in Australia is focussed on the social services sector, housing and on sustainability agendas, however there is potential for this to extend to include community economic development and small business”. (Burkett. I 2012 Place-based Impact Investment in Australia: A Literature Review Exploring Opportunities for Place-based Impact Investment in Australia)

The third is what we understand as traditional investment where financial returns are the dominant expectation albeit, not at the exclusion of the social, environmental or economic outcomes associated with the asset itself. This investment strategy will suit those things that can reflect market value and still sustain its community benefit. Examples of potential investments include renewable energy infrastructure, multi-purpose hubs, co-working spaces and community sporting facilities.

Because this paper is concerned with exploring the possible relationship between local government and superannuation funds, the remainder of this section will focus on how this relationship might be conceived in the context of the impact investment and traditional investment space.

To this end, designing appropriate investment structures and vehicles suitable for the task of investing in communities is crucial. At the core of this challenge is “developing a pipeline of investment proposals that link the need and opportunity in under-invested communities with appropriate investment structures and vehicles through which investors can participate”. (Burkett. I 2012)

The Potential – Community Assets

Local government is a significant owner of community infrastructure assets. According to the National State of the Assets 2015 produced by the Australian Local Government Association, 230 councils (represents 41% of Councils across Australia) are managing a total of $180 billion in infrastructure with a gross replacement value estimated in excess of $438 billion.

• Roads representing $73.7 billion, with $8.2 billion (11%) in a poor to very poor state.
• Buildings & Facilities representing $30.3 billion, with $3.1 billion (10%) are in a poor to very poor state.
• Parks & Recreation representing $7.9 billion,
• Stormwater representing $33.3 billion, with $3.1 billion (9%) are in a poor to very poor state.
• Water & Wastewater representing $33.5 billion with $4.1 billion (12%) are in a poor to very poor state.
• Airports & Aerodromes representing $0.8 billion with $0.1 billion (12%) in a poor to very poor state.

Areas of potential focus for possible future partnership between local government and super funds might include:
• Development of regional airports
• Development of buildings and facilities such as community-hubs, leisure and recreation facilities, co-working space etc
• Development of ICT and ‘smart’ infrastructure
• Development of ‘green’ infrastructure

In contrast to the investment potential in ‘hard’ infrastructure, there are also many opportunities to invest in the ‘soft infrastructure’ of local communities and create a more resilient community.

This can primarily take the form of investment in businesses which are capable of delivering on local government objectives concerning key social, environmental and economic outcomes.

Investment Structures

Investors have a wide range of investment structures that are used depending on the investment. Broadly speaking, investments can be categorised as either equity or debt investments. Whilst over simplistic, equity investments are characterised by large potential upside and large potential downside whereas debt investments are characterised by a small potential upside, but still have the potential for a large downside.

The remaining focus of this paper is the potential to develop community bond instruments. This is not to suggest that there are not opportunities for equity investments in local government. Many assets, including swimming pools and regional airports have the potential to be sold in an open market. However equity investments, with their larger returns to investors are perhaps not the best first step in establishing a long term and sustainable partnership.

Community Bonds

It is proposed to develop a Community Futures Investment Initiative that would establish a framework for institutional investors to invest in community bonds.

The objective of a Community Futures Investment Initiative would be to package up debt investments, or debentures, to support investment in small scale community assets that would otherwise not be investable from an institutional investment perspective.

Debentures are a traditional structure that has been used by community groups to raise funds to develop community assets. There are many examples of the use of debentures to finance community assets. Perhaps the best known debenture is Wimbledon which has historically used the vehicle to fund capital investment, with debenture holders entitled to seats at Centre Court over the period of the investment. Wimbledon Debentures are traded on the London Stock Exchange.

In Australia many community assets have been built by communities pooling resources and issuing debentures. The reasons that communities came together depended on their individual interests and needs. The desire to have a place in the local community to be able to socialise was a common factor behind the development of club rooms for a range of sports including sailing, football, golf and bowling.

An example is the Mounties Club which was originally established by a group of locals from the Mt Pritchard community in the 1920’s who simply wanted to have a place to have a beer, and didn’t to have to travel to the nearest pubs in Cabramatta. In an era before sophisticated financial services laws it was a relatively simple thing to issue debentures with Mounties raising £300 to fund its initial activities. Another example is the Mulgrave Country Club. In 1960, 18 people in the outskirts of Melbourne’s growing suburbs got together and committed to a debenture to purchase 5 acres of land.

Some community initiatives, such as the case of the Mounties Club in NSW have gone on to be significant businesses. The Club now has 104,956 members with assets of $256,973,099 and gross revenues in 2014-15 of $584,672,586. In its latest annual report the Mulgrave Country Club delivered a net profit of $1,979,748. With total net assets in excess of $21 million the Club has been able to reduce its bank loan for building redevelopment from $9.4 million to $4.75 million. Other community assets, such as Neerim District Show, which was established in 1925 when the local community purchased a parcel of land, whilst they have not grown significantly, have continued to serve their original purpose.

The past development of community assets may provide lessons that can be applied to developing a framework for future community asset development. The features of successful community assets are:

1. Development of a funding base
Community Assets that were able to develop a sustainable funding base have been able to survive and grow over time. The desire to drink and socialise provided a sustainable funding base for many communities. But other activities have also been able to provide a stream of income to finance activities.

2. Diversity of needs
Communities have come together to build community assets for many different reasons. One particularly interesting story is the development of the Kiama Alpine Club which was established due to the efforts of a Ukrainian migrant couple who migrated to Australia after World War 2 and who simply wanted to ski as they had in Europe. The couple were able to convince the local Thredbo community to purchase land and construct a 12 bed lodge, with debentures providing the source of funds.

3. Governance
Communities that have been able to establish community groups that serve their interests have had strong local governance. The first act of newly established community organisations is to establish a governance structure that creates an accountability mechanism for decisions.

Needs Have Changed

Over the decades community interests and needs have changed. The role of community organisations and community assets have subsequently changed. Examples include the development of automobile clubs in Australia. The role of clubs in the early years included negotiating with country hoteliers to stock fuel, making them Australia’s first petrol stations. Following complaints regarding the interactions between vehicles and horse drawn vehicles, clubs were given responsibility to issue Competency Certificates, the forerunners of today’s driving licences. The development of the Men’s Shed movement is an example of community assets being repurposed. According to the Australian Men’s Shed Association there are now 930 Men’s Sheds across the country that are commonly in buildings that were previously established for other purposes.

Local Government Capital Market Experience

Local Governments recently developed expertise to tap global capital markets. A case study is the Local Government Funding Vehicle which was originally established to finance local government defined benefit superannuation obligations. In June 2016, the Local Government Funding Vehicle raised A$100 million in its second domestic deal at an issue yield of 3.64%. The bond was arranged by Commonwealth Bank of Australia and National Australia Bank. The bond was rated Aa2, defined as investment grade. LGFV have now raised a total of A$340 million. The Local Government Funding Vehicle has the following features:

• Local Councils in Victoria established the LGFV Program Trust as the structure through which an aggregated portfolio of Council Loans bonds were issued to institutional investor.
• Bonds were issued by National Australia Trustees Limited in its capacity as trustee for the LGFV Program Trust.
• In accordance with the LGFV Program Trust Deed National Australia Managers Limited was appointed as Trust Manager
• Proceeds from bonds are used to provide loans to Councils under Council Loans Agreements.
• Security for the bonds consists of Issuer’s rights under all Council Loans provided to the Councils. Council Loans are, in turn, secured by a security interest granted in favour of the Issuer over the general rates of the Council.
• The Issuer is a pass-through conduit without any credit tranching of the Notes. It is therefore the credit strength of the Councils that participate in the LGFV Program which underpins the credit strength of the Issuer and the Notes.
• The Issuer is a special purpose trust, and its only assets, and the only assets available to meet the obligations of the Issuer, are its rights under the Council Loan Agreements and related Council Security,
• A governance board (known as the LGFV Governance Board) was established under the terms of the LGFV Program Trust Deed. The LGFV Governance Board conducts a range of functions including due diligence with respect to the participation of a Council in the LGFV Program.

By acting collectively the bond issuance enabled 33 Victorian Councils to access debt at interest rates that are far more attractive than would have been provided by banks under normal commercial terms. The collective bond structure was first utilised when local governments were faced with defined benefit pension liabilities resulting from the collapse of capital markets during the Global Financial Crisis. The bonds are offered to institutional investors around the world including Australian superannuation funds who, through their investment managers have access to the bonds as part of a diversified fixed interest portfolio.

It is proposed that a collective vehicle, similar to the structure established by the Local Government Funding Vehicle could be developed that would provide the opportunity to support the development of community assets that have a funding base.

There are a number of areas that community bonds could be utilised.

Case Study: Climate Bonds Initiative

The concept of a Community Futures Investment Initiative is based on the success of Climate Bonds Initiative.

The idea around community bonds is to enable institutional investors, through capital markets, to invest in communities in a similar to the way that community assets were historically developed through local communities investing in debentures.

The Climate Bonds Initiative started as a project of the Network for Sustainable Financial Markets (NSFM), an international network of finance sector professionals, academics and others dedicated to improving financial market integrity and efficiency. See: http://www.sustainablefinancialmarkets.net
An international process of collaboration developed an architecture for definitions of Climate Bonds. This aimed to provide greater certainty for investors about the climate benefit of their investments. Certification is available for assets and projects that meet the requirements of the Climate Bond Standards. In order to receive the “Climate Bond Certified” stamp of approval, a prospective issuer of a Green or Climate Bond must appoint an approved 3rd party verifier, who will provide a verification statement that the bond meets the Climate Bond Standard. The Climate Bond Standard allows Certification of a bond prior to its issuance, enabling the issuer to use the Climate Bond Certification Mark in marketing efforts and investor roadshows. The Climate Bonds Standards Board (comprised of members representing $34 trillion of assets under management) confirms Climate Bond Certification once the bond has issued and the proceeds have been allocated to projects and assets.

A key component of the Initiative is the Climate Bonds Standard & Certification Scheme (“Certification Scheme”). The Certification Scheme allows investors, governments and other stakeholders to prioritise ‘low carbon and climate resilient’ investments with confidence that the funds are being used to deliver a low carbon and climate resilient economy. A Scientific Framework underpins the definitions of which projects and assets are consistent with a low carbon and climate resilient economy and therefore eligible for inclusion in a Certified Climate Bond.

The Certification Scheme includes robust frameworks for monitoring, reporting and assurance of conformance with the Climate Bonds Standard. An international Climate Bonds Standard Board comprised of large institutional investors and leading environmental NGOs provides ongoing oversight of the Certification Scheme as well as decisions on Certifications. Day-to-day operations and decision making is delegated to the Climate Bonds Standard Secretariat.

Pre-issuance requirements focus on selection of eligible projects and assets, as well as the issuer’s stated internal processes to track and report on use of proceeds. Pre-issuance certification enables the issuer to use the Climate Bond Certification in marketing efforts and investor road shows. On the investor side, it allows bonds with robust environmental performance to be prioritised.

Post-issuance requirements focus on the actual use of proceeds, ongoing eligibility of the projects and assets, use of funds not yet allocated and the adequacy of and output from the issuer’s internal systems. To maintain the Climate Bond Certification, post-issuance certification must be confirmed within one year after issuance of the bond.

Post-issuance certification allows the issuer to demonstrate to investors that their bond meets the requirements of the Climate Bond Standard following its issuance. Post-issuance certification is valid for the term of the Climate Bond, as long as mandatory annual reporting requirements are met.

Features of a Community Futures Investment Initiative

It is proposed that a Community Futures Investment Initiative would provide a mechanism for superannuation funds to invest in a group of community assets. A CFII would establish a framework based on the Climate Bonds Initiative that would have the objective of providing assurance to investors that community bonds meet the following principles:

• The community is integral to decisions about their place
• A culture of patronage and responsibility is built for place futures
• Political representation at the heart of the co-creation process with the community, and
• There is an investment in people and program alignment.

A Community Investment Funding Vehicle (CIFV) would be established that would be based on the successful model of the Local Government Funding Vehicle. Specifically a CIFV would have the following features:

• Community Investment Program Trust would be established as the structure through which an aggregated portfolio of community loans were issued to institutional investor.
• Security for community bonds would consist credit enhancement that could be provided by Councils and other stakeholders. In the event that a community group defaulted on a bond, then credit enhancement would ensure that super funds did not bare first losses.
• A governance board (known as the Community Investment Governance Board) would be established under the terms of the Community Investment Program Trust Deed. The governance board would be responsible for working with local community groups to develop enhanced accounting and governance practices. Support would be sought from Federal and State Government to build community capabilities.

The Way Forward

This paper has outlined the benefits of developing a partnership between local government and superannuation funds.

Through the establishment of a Community Futures Investment Initiative and Community Investment Funding Vehicle we have identified one mechanism by which capital investments could be made.

However the potential for partnership in no way guarantees that progress will be made. Local government and superannuation funds have very different cultures. There is little knowledge from the respective parties on how each operates, and the constraints each faces.

In order to progress this discussion we are recommending the establishment of a Local Government- Superannuation Investment Forum.
We believe that there is a need to establish structures to enable communication between local government and superannuation funds. The functions and activities of the Forum should be subject to negotiation.

One of the core functions of a Local Government- Superannuation Investment Forum could be to review the understanding of different State Local Government Acts relating to the operation of local government and where necessary prepare submissions highlighting the conditions necessary to enable local government to engage in innovative financing of community futures.

We believe there is value in establishing a demonstration project that would have the objective of providing a learning opportunity for both superannuation funds and local government, and could showcase:

• Alignment of mission of local government and super funds,
• The ecosystem of actors and agency required to connect to fine grain of investment opportunity at the local government level
• A way of working based on place-based approaches

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