The Theory of Open Capital

Open Capital - and Asset-based Financing

There are only two ways of raising Money : Debt and Equity. Right? Wrong.
There are only two forms of tenure: Freehold and Leasehold, Right? Wrong.

Out of the primeval Capital swamp there is emerging a new animal - the "Capital Partnership" - based upon a curious hybrid of a commercial company and a partnership, known as a Limited Liability Partnership (LLP). The LLP is already beginning to make its mark in the commercial world - examples include a recent initiative by the AIM listed company Numerica and a new property portfolio investment scheme by the well known businessman Tom Hunter - but has implications for financing enterprises of all types, in particular those in the field of public investment.

During the early 1990s, professional partnerships such as Arthur Andersen became concerned that their individual partners' acceptance of liability for their firm's actions put them individually at risk of bankruptcy. Long before Enron, the City persuaded Jersey's Parliament to draw up an Act creating the LLP -and the British Government, fearing an exodus of professional partnerships to Jersey, passed the Limited Liability Partnership Act in April 2001. For the first time anywhere in the world, it became possible to form a corporate body -an entity with a legal existence independent of its individual members - which had both collective limited liability and the mutual, co-operative characteristics of partnerships.

There are now over 7,000 LLPs around the country. In part, the growth is because they're so easy to create: two designated members must complete an application downloaded from the Companies House website, and pay £95. There is no Memorandum of Incorporation, no Articles of Association and no Shareholder Agreement. In fact there isn't even any requirement for any written agreement at all - although only the most trusting dispense with them - since simple "default" provisions based upon partnership law apply.

The LLP has two key attributes: firstly it is an "Open" Corporate body (NOT legally a partnership as one would expect from the name) in which any stakeholder, whether or not they are Investors may become Members, thereby aligning their interestswith other members. Secondly, the LLP makes it possible for those who invest Money in an enterprise or in Capital assets such as Land to be members of a "Capital Partnership" alongside the users of the Capital or Capital Asset thereby replacing the usual adversarial contracts between those who finance an enterprise or asset and those who utilise it.

In essence, all these stakeholders are brought inside the partnership, so their interests are aligned; it's quite a change from traditional structures, which pit stakeholders in competition against each other. The LLP delivers an ideal combination of the collective and the individual; it's flexible and easy to establish while its partnership characteristics are robust enough to make it attractive to the private sector.

To understand how an LLP operates, it's best to consider a theoretical example. Let's say that Bloggside Regeneration holds a brownfield site, while Bloggshire Islamic Community Arts (BICA) needs a workshop in which to train local people to produce patterned Islamic tiles for the growing UK market. BICA becomes the first 'occupier member' and Bloggside Regeneration becomes the 'capital member' of the new Bloggside Community LLP, with BICA paying Bloggside Regeneration a peppercorn land rent.

A new workshop, costing £100,000, is acquired using money from a Community Development Finance Institution (CDFI), which becomes the LLP's second capital member. The CDFI then receives two per cent of BICA‚s total revenue: as a 'capital rental' paid for the use of finance, equivalent to those paid for the occupation of land, this payment does not count as interest, making an LLP an acceptable financial structure for strict Muslims. Hence, rather than a contract whereby a debtor organisation pays interest to a creditor, or an investor buys part-ownership of a company in the form of shares, both financier and beneficiary join a partnership whose revenues are then shared. In time, BICA may acquire ownership of the capital asset by making payments over and above the required capital rental. The rental payments will then decline with the outstanding capital.

This is not merely a concept: the Hilton Group entered into a revenue sharing "Capital Partnership" in late 2002 in respect of a portfolio of hotels and raised £350m for a period of 27 years on exactly this basis. It will be seen that a hugely potent application for LLP‚s is their ability to draw in investment for public projects, offering an alternative to private finance initiatives. By drawing the users and stakeholders of a service into its ownership, LLPs could build community links and ensure that the aims of a service's financiers are aligned with those of its providers and users.

A theoretical example best demonstrates how an LLP could do the work of a PFI: drawing private cash into a public project, with the promise of repayment from the public purse over many years. Let's say that Bloggshire Local Education Authority (LEA) funds ten schools held by five different boroughs, which require a £20 million refurbishment. The boroughs transfer the schools' land to an LLP named Bloggshire Land Partnership (BLP) and the school buildings to another named Bloggshire Schools Partnership (BSP), becoming capital members of both. BLP then becomes a capital member of the new Bloggshire Education LLP, while BSP becomes an occupier member and agrees to pay BLP a peppercorn rent for use of the land. BSP, which will carry out the refurbishment, then negotiates an agreement by which Bloggshire LEA pays BSP £800,000 annually, linked to inflation. BSP is divided into ten million 'partnership interests' -or shares -each valued at two pounds, and these are offered for sale to Bloggshire residents. Buyers become capital members: priority buying rights could be given to parents, government "baby bond" money could be used to purchase interests on behalf of pupils, and institutions such as the teachers' and Bloggshire LEA employees' superannuation schemes could also invest. It is open to Bloggshire LEA to repay the Capital simply by buying back "shares" in the market which it would do over the expected life of the building: equally, any investor will find it very straightforward to sell to another interested in a secure "index-linked" investment of this type.The rate of 'rent' paid for use of the capital could be set perhaps 4 per cent above inflation. This would be unaffected by Bank of England interest rate decisions; it's not lending, but taking a proportionate share of gross revenues. With risk spread among the partners, it would be less risky than shares, more profitable than gilts, and more accountable and transparent.

Another interesting consequence of this model is of a new form of tenure ie a right to occupy the property INDEFINITELY for as long as one pays the "rental". Once within a "Community Land Partnership" there is no need ever to sell the land again although the "owner"/ financier may change, and the occupier/capital user may change.

So that's it then: the "Public Sector Borrowing Requirement" is a myth.

All that is necessary is to find investors prepared to share in the revenues generated by productive assets such as schools, hospitals and railways on the basis that they receive an agreed inflation linked rental in respect of the Capital used.

As John A Wheeler said: "Behind it all is surely an idea so simple, so beautiful, that when we grasp it - in a decade, a century or a millennium" - we will all say to each other, how could it have been otherwise? How could we have been so stupid for so long?"

That is the measure of the "Open" form of Capital currently emerging - simply a proportional "share" of revenues for a period of time

Chris Cook
April 2004