For decades, co-operatives have relied on a unique ownership model to gain access to member capital. However, many co-ops are turning to alternative funding sources and debt instruments to expand member investment.
Capital underpins co-operatives. From financial institutions to fisheries, members come together to pool capital, allowing them to achieve more than they could alone. But the other side of the capital coin is that when co-operatives can’t get enough, either because of regulation or long-standing practice, they may get bogged down – or fail to get off the ground in the first place.
The co-operative ownership model introduces unique considerations when accessing capital, and the co-operative principles – particularly democratic member control and member economic participation – influence the choice of capital structure.
The problem of securing capital while guaranteeing member control is one of the five themes of the International Co-operative Alliance’s Blueprint for a Co-operative Decade. Historically, co-operatives have been funded by withdrawable share capital provided by members and retained earnings (or reserves comprising undistributed earnings).
Growth in co-operatives means they often outstrip the funding ability of members and retained earnings; and start-up co-operatives have been seeking alternative funding. These developments have prompted the question of how to access external capital, or additional member capital, while adhering to co-operative principles.
Fortunately, experience from around the world illustrates a range of options for accessing additional capital while retaining member control of the co-operative. In addition to the basic or qualifying member shares, many co-operatives have introduced additional classes of share or debt instruments to attract more member investment.
Other co-ops have introduced member share requirements based on usage and have developed mechanisms that allow members to share in the appreciation of the value of the co-operative. This takes the place of the traditional member shares, valued at par and redeemable upon withdrawal from the co-op.
Co-operatives have also attracted non-member investment through a range of structures and debt and equity instruments. By reserving all, or a majority, of voting rights for co-operative members, external capital can be raised while preserving member control. Examples can be found in large and small co-operatives and start-ups in all regions of the world. Not all examples, however, have been successful. In some cases, a majority of members concluded that their interests would be better served by conversion to the corporate model. In other cases, co-operatives were not financially successful after attracting outside investors, leaving the failed business in the hands of external creditors. A further consideration is that even when members retain legal control, outside investors may still exercise influence over the co-operative.
While access to capital is a challenge for any business, particularly a start-up, recent experience among co-operatives in many countries demonstrates that these challenges are far from insurmountable, and show that accessing additional member capital, or capital from external sources, and adhering to co-operative principles is not an either/or proposition.
There are many options and structures that preserve democratic control by ensuring all or a majority of the voting rights in a co-operative enterprise remain in the hands of their members.
1. Capital Planning
The starting point for co-op leaders, as with the leaders of any business, is the development of a sound capital plan or strategy as a component of the overall strategic plan.
In the near term, capital options may be constrained by the legal framework and, if so, this indicates that in the longer term it should be a priority for individual co-operatives and associations to convince policymakers to enact the legislative amendments necessary to provide for a wide range of capital options.
Capital planning for co-operatives incorporates all of the elements required in any business – needs, sources, and contingencies – plus the added dimension of preserving co-operative principles.
There is a range of approaches seen in practice that require leaders and the membership to address some fundamental questions about the structure and philosophy of their co-operative.
Is a traditional capital structure based on withdrawable member shares and retained earnings adequate to meet the needs of the co-operative? Availability of a range of options does not require their use, so co-operatives may be perfectly able to operate on a very traditional basis. If innovative alternatives are to be pursued, then a number of questions have to be considered.
Is the membership able and willing to make additional investment in the co-operative? If so, then the debt or equity instruments must be structured to be attractive to members while still preserving democratic control. Debt instruments and multiple share classes can preserve the one-member, one-vote structure while attracting investments of different amounts by individual members.
If non-member investment is to be sought, there must be a balance between making the instrument an attractive investment and preserving member control. Debt instruments, multiple classes of shares, and tiered or holding company structures all offer ways that this can be achieved.
But it is important to note that even though de jure member control may be maintained, outside investors may exercise significant de facto influence over the co-operative.
For this reason, co-operatives may wish to limit outside investment to levels well below legal control.
2. Debt Instruments
Debt instruments are the least controversial as they do not entail voting rights (except in bankruptcy, winding-up, or reorganisation), and in substance they vary little from the bank debt and credit from other lenders most co-ops already use.
There is a number of innovative approaches in use around the world that co-operative leaders can look to as examples. These include hybrid instruments – subordinated debt that can be classified as equity under IFRS – sold to members or non-members.
The attractiveness of such instruments for financial co-operatives has decreased, thanks to more stringent rules under Basel III, but hybrids may still be structured to qualify as Tier 2 capital. For non-financial co-operatives, such hybrids can help deal with the lack of permanent capital and provide instruments that will be recognised by banks and investors as equity, making it easier to meet lenders’ leverage ratio criteria and debt covenants.
For larger co-operatives, issuing debt securities rated by a credit rating agency potentially expands the investor base to include institutional investors, such as insurance companies and pension funds, that may be restricted in their investments in unrated securities by either regulation or policy.
This will require meeting capital markets governance and disclosure standards, but this should not be a major issue for most large co-operatives. In some countries it may be necessary to educate ratings agencies and institutional investors about the co-operative model.
Both large and smaller co-ops can use private placements of debt securities. These instruments would be issued under capital markets provisions, which generally have reduced or no specific requirements for instruments placed with a small number – often fewer than 50 or even 20 – of qualified or exempt investors.
These are investors who, due to their high net worth as individuals, or by virtue of being institutional investors, are considered sophisticated enough to make an informed decision without all of the regulatory requirements that apply to public issues. This offers the opportunity to place debt instruments within the community or with other co-operatives and financial institutions without the expense of a public issue.
Smaller and start-up co-operatives may be able to take advantage of special regimes for securities issuance. These regimes may be targeted at smaller entities more generally, or co-operatives specifically. They provide investor protection through disclosure requirements but are less onerous in terms of transactions and compliance costs than the usual capital markets requirements. These regimes may provide for issuance of debt and equity instruments.
One cautionary note is that, as for any business, excessive debt leaves a co-op vulnerable to downturns.
Selling an equity stake to non-members can be controversial within a co-operative structure. However, there are numerous examples from around the world of minority interests being sold in a holding company structure or in subsidiaries, while still retaining majority co-operative control.
These options are easiest for larger co-operatives, which are best able to attract external investor interest.
Preference or non-voting shares can be used to preserve member democratic control while creating one or more classes of shares that can attract member or non-member investment by participating in the appreciation in value of the co-operative. The attractiveness of these shares increases if they are liquid. Many larger co-operatives have publicly traded preference shares, but even smaller co-ops can provide liquidity through an internal market. With advancing technology, this can be easily provided through an online platform, creating a private electronic marketplace.
Recent innovations in capital raising generally, such as crowdfunding, have positive implications for co-operatives. Online platforms such as Microgenius provide a virtual marketplace that brings together potential investors and co-operatives wishing to issue debt or equity.
There are many innovative share structures that have been adopted by co-operatives to raise additional member capital or to attract non-member investment. New-generation co-operatives have linked the equity contribution to usage, which has been particularly useful in start-up co-operatives in capital-intensive businesses. Co-operatives adopting a closed structure and shares that participate in the increase in value over time can enhance the attractiveness of member investment by providing an internal market for these shares.
4. Co-operative Investment
There is scope to enhance the use of co-operative investment options. These can include direct investment by one co-operative in another, a centralised funding vehicle that can access the capital market on behalf of member co-operatives, and funds established and/or administered by co-operative associations.
One potential option to lever the co-operative investment is establishing a fund that could be structured as a private equity fund, mutual fund, unit trust, or exchange-traded fund. Such a fund could invest in the debt and/or equity of co-operatives, providing investors with the ability to acquire a diversified co-operative portfolio investment by purchasing units in the fund.
Co-operative or mutual financial institutions, large non-financial co-operatives and co-operative associations might be the sponsors of such funds, providing an initial critical mass. By opening the fund to other institutional and retail investors, the initial investment by the sponsors could be levered. With investment limited to debt, non-voting equity-type instruments, and minority holdings of equity, the fund’s investments would not threaten the co-operative ownership of investee co-operatives.
The requirements for establishing a private equity fund, mutual fund, unit trust, or exchange-traded fund vary in accordance with national securities laws.
While there are many examples of funds that operate internationally, they generally require registration and compliance with the local requirements in each country in which units or shares are sold to investors.
The fundamental precondition for raising co-operative capital is an enabling legislative framework. Providing a full range of options to co-operatives allows each to individually choose the best approach.
Depending on specifics, this may mean relying on the traditional model of nominal-value withdrawable shares and retained earnings. However, there should also be options to raise additional member and non-member capital through debt and equity-like instruments, and to adopt corporate and share structures to facilitate this while retaining democratic control of the co-operative.
Countries with well-developed capital markets that do not already have in place special regimes for co-operatives (and other smaller entities) to issue securities, under a less burdensome regime than the standard capital markets regulation, should consider them. There are examples from around the world of streamlined regimes that still provide the requisite investor protection while reducing compliance costs.
Direct policy interventions need to be carefully considered and appropriately designed to avoid the well-known pitfalls. Encouraging co-operative development is seldom successful in top-down programmes. Focus on training, awareness of the co-operative model, and the member involvement needed for effective governance are more likely to succeed than financial grants and concessional loans.
Where financial assistance is provided, there should always be a significant member commitment accompanying any external support. A focus on building necessary infrastructure is more likely to succeed than providing general or un-targeted financial support.
Tax incentives can encourage co-operative investment but they, too, have to be carefully considered and designed to avoid any unintended consequences.
There is a fiscal cost that governments may find difficult to justify, particularly in challenging economic times, meaning that existing tax incentives might be lost when they are needed most. There is also a risk that co-operatives will end up as hostages to tax incentives, as co-operatives’ competitors may lobby against other policy measures on the grounds that co-operatives already enjoy favourable tax treatment.
International standard setters, such as the Basel Committee on Banking Supervision and the International Association of Insurance Supervisors, need to expressly take into account the co-operative and mutual ownership models when introducing new, or revising existing, prudential guidelines. Similarly, national authorities need to do the same when taking steps to implement these international standards.
The unique equity structure of financial co-operatives has proven resilient, but the absence of common equity as issued by joint-stock companies may present challenges for any capital-linked prudential standard. Rather than seeking work-arounds after the fact, standard setters should consider the co-operative and mutual ownership models at the outset.
- This article is taken from A Survey of Co-operative Capital. The full report is available here.
In this article
- Basel Committee on Banking Supervision
- Financial economics
- International Association of Insurance Supervisors
- International Co-operative Alliance
- Online platforms
- Rochdale Principles
- North America
- United Kingdom
- Top Stories