Identify and Work with Investors

The distinction between buyers and investors should be made clear in the Milestone early on.

Where buyers are paying for a defined service or product, such as biodiversity credits or reduced storm water runoff, investors are providing an injection of funds at a certain point in the project to be repaid later with an additional financial return. In some circumstances, they could be the same, for example if a corporate offtaker wants to provide the upfront financing to enable the project, or if a financial investor seeks rights of first refusal on the ecosystem service claims, such as biodiversity or carbon credits.

When a buyer is paying only at the confirmed delivery of the service or product, then investment is often needed to pay for the upfront interventions, fees for developers and other early costs of the project’s operations. This will be debt or equity, and can sometimes be blended with grant funding.

This consideration leads directly from the development of your financial model (See Milestone 5).

Consider first what your forecasted free cash flow looks like across the lifetime of your project, both in terms of shortfalls in cash for operations (financing gap) and what surplus there is across the lifetime of the project (cash free for ‘servicing’ capital – repaying external financing and providing a return).

Free cash flow, sometimes called project-level cash flow, is a key component determining what types of capital you can access for the project, for example repayable grant funding, equity with impact investors or project financing from a traditional bank. Depending on the length of the project, you may also consider different types of capital, or prioritising flexible capital that reflects the different cashflow profiles (and risks) through the project’s lifetime.

As a pre-requisite to building your investment ask, it is advisable to be clear that external investment is the best option and that other options, such as government and philanthropic grant funding, upfront payment from buyers or use of funds from the key project partners are not possible or not as attractive for fully covering the financial gap.

Investors you approach will likely enquire about alternatives the project has considered to investment, and so consider preparing a developed response.

When you have confirmed what your financing gap is and whether external investment is the best option, you can define your investment needs in more detail, which are driven by your cashflow profile, (and also the conversations you will have with your potential investors).

Some basic questions that you ask to define your investment needs a little more are the:

• Size of the investment(s).

• Length of the investment(s), being the entire period of time that the investment(s) will be outstanding.

• Grace period, where no interest, dividends or principal repayments are required.

• Repayment plan (amortisation), including the start date of repayment, the distribution of repayments and over how many years.

At a high level, investments can be classified as either debt or equity based – though some forms of investment can combine features of both, for example quasi equity. Both represent an obligation to pay but often have different legal and financial connotations. For example, in case of defaults or bankruptcy, debt is repaid before equity, while equity can allow voting rights and greater involvement in the oversight of the business.

Some investor groups are capable of offering both debt and equity investments, but most will have a defined investment route that aligns to their risk appetite, preferred level of engagement and need for returns. Consider listing investor group types and their preferred routes, for example:

• Venture capitalists, angel investors and High Net Worth Individuals (HNWIs) often make an equity investment by purchasing preferred or common stock in the project’s legal entity.

• Business banks will offer debt such as term loans, revolving credit facilities and trade financing that is often agreed while using assets as security, to lower the risk of financial loss.

• Impact investors, who exclusively target investments with both a financial and environmental or social return, have been known to offer debt and equity investments with more favourable financial terms.

• ‘Crowd-funding’ investments from large groups of individuals, such as Local Climate Bonds and Crowdfunder campaigns, can also be either debt or equity, but project developers should be mindful of fairly representing the risk profile of these projects as these individuals are likely to have both a lower risk appetite and a lower capacity for due diligence compared to more established and sophisticated investors

It is important to note that engaging with investors is a regulated activity by the FCA, so for formal engagement you should speak with a regulated financial adviser that you can look up on the FCA website. This is especially important when approaching investors that are less knowledgeable about risks and returns.

You can calculate the rate of return by iterating the project’s financial model (see Milestone 5), aiming to reach a sufficiently attractive return while also accounting for other uses of surplus, such as cash reserves and community profit sharing. Most investors will want a copy of the financial model as part of their due diligence process to make sure the return is calculated in line with their financial methodology.

Investors can calculate the rate of return in different ways. For example, with equity or quasi-equity the relevant metric may be the Internal Rate of Return (IRR) or Return on Investment (RoI). For traditional debt-based instruments, more commonly used metrics would be interest cover and debt service cover. Consider researching these separate metrics and come prepared to investor meetings with more than one measure of return.

To further develop your investment ask, it is vital to consider this rate of return in relation to the risk profile of the project, as investors generally seek higher returns when projects are riskier. When justifying your rate of return, you can build a picture of the project’s risk profile to the investor using:

• The stability of the rate of return – comparing the difference in the return metrics when assumptions are tested during the sensitivity analysis / scenario modelling in the financial model

• The risk management strategy – demonstrating what track record or precedent supports these assumptions, the likelihood of any of these assumptions failing, and what controls and mitigation measures you are using, which should be outlined in the business case

• The wider social and environmental outcomes – certain investors, particularly impact investors, will factor these outcomes into their view of the rate of the return offered.

Comparing your project to similar projects and their rates of return would be useful for getting a sense of the perceptions around what rates of return are acceptable, though this may be more difficult as this information is often kept private.

Other features of the investment ask to make this more attractive, dependent on the investment type chosen, to investors include:

• Seniority – If your project is using multiple sources of financing, you should be clear on who will be repaid in what order with the assets of the project if it becomes insolvent or dissolved. All else held equal, an investor will want to be ranked as highly as possible to prevent financial loss.

• Collateral offered – You can also pledge certain assets to an investor, such as shareholdings in other entities or leaseholds, to minimise their losses in case of default, for example land holdings or building leases. Note: if offering assets in your legal entity, its advisable to check that these have not already been committed as security elsewhere, for example with general pledges made by a parent company.

• Tax relief – Investors can access different tax reliefs depending on the investment structure, the project and its legal entity type. For example, individual equity investors can use tax relief from the Enterprise Investment Scheme (EIS) or Social Investment Tax Relief (SITR) scheme.

• Conditions – Conditions and other obligations can be written into the legal contracts of both debt and equity investments for standards and activities that the project is required to uphold. For example, offering regular reporting on the project’s environmental and social impacts.

• Financial guarantees – Third parties can guarantee a debt will be repaid to an investor if the project defaults. A financial guarantee can be customised to cover a range of liabilities, from those of the entire legal entity to only a subsection of the investment.

Many investors that are considering your project will likely value the environmental and social outcomes that it aims to deliver, and weigh these in its decision to invest or not. As with buyers (see Milestone 4), some investors will want to know how their financing is contributing to additional and permanent environmental outcomes. Consider building this narrative into the investment ask.

If you want the investment to be paid directly to the legal entity that is hosting the project’s operations, your choice of legal entity (See Milestone 6) may alter what type of investment is appropriate, or even possible. For example, as a company limited by guarantee does not hold share capital, it isn’t possible to sell any stake of the company to equity investors.

In some cases, it may be difficult or not possible to generate risk-adjusted, market-rate returns and secure financing from a single traditional lender.

In these instances, using different sources of financing can help, with ‘impact first’ concessional investors agreeing to different terms, such as with longer tenors, lower rates of return required or by subordinating their investment in terms of seniority. This can help to draw or ‘crowd-in’ commercial investors who do not make such concessions. Non-repayable grant funding or charitable donations can also be used to the same effect.

This general approach is called ‘blended finance’ and is often used in nature-based projects, but due to complexity is typically only used on larger projects that can absorb the associated design, administration and management costs.

The need for blended finance may be case through the lifetime of the project, or within certain timeframes, such as the implementation stage.

As with payments to/from buyers and sellers, it may be worth considering how the investment ask is affected by inflation. For example, if investment is drawn over several years to pay for staged capital works, is there a risk that inflation will increase these costs beyond the investment sum? How is this risk minimised through agreements with delivery partners or mitigated through the investment ask?

In addition to up-front financial investment, consider how an investor can contribute to the success of your project or future projects in other ways. For example by offering financial and commercial advice, raising the profile of your project with external stakeholders, or introducing you to other trusted service providers that you need, such as consultants or auditors.