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Beyond the 5%: Impact Investing and the Future of Foundations

Jeremy Gregg Philanthropy Leave a Comment

Image via Creative Commons (juxtapose^esopatxuj) at https://flic.kr/p/959DgD

Image via Creative Commons (juxtapose^esopatxuj)

Potentially transformative news appeared in The Chronicle of Philanthropy today in the article by Alex Daniels, “IRS Issues Rules Favorable to Foundations on Program-Related Investments.”

“The Internal Revenue Service has issued new regulations designed to encourage private foundations to make investments in areas such as education, health, and the environment that can result in societal benefits and simultaneously generate income.”

The article links to The White House’s own release on the topic, “Steps to Catalyze Private Foundation Impact Investing” (written by David Wilkinson, Director of the White House Office of Social Innovation and Civic Participation). The genesis for this change, according to Mr. Wilkinson, was:

“Traditionally, a foundation has viewed its financial resources as two distinct pots of capital: funds set aside for grants that further charitable purposes, but are not repaid; and funds dedicated to investments, which provide a financial return and maintain the value of the endowment as an ongoing source for future philanthropic activity. Increasingly, foundations are realizing the benefits of tools for funding charitable projects that do not neatly fall in one category or the other.”

From The White House:

“Today, the US Treasury Department and IRS finalized regulations that make it easier for private foundations to make Program-Related Investments (PRIs), which are investments – such as loans, loan guarantees, or equity investments – made primarily to accomplish a foundation’s charitable purposes, and not to generate financial returns. PRIs are one example of such a financing tool that is not a grant, nor just an investment, but is in some ways like both. Some private foundations have a long history of using PRIs to make charitable investments that are intended to produce significant charitable returns, but generally negligible financial returns. A private foundation’s PRIs count towards the annual distribution that the foundation must make each year and receive other tax-favored treatment. Therefore, PRIs have typically been treated as a part of a foundation’s grantmaking budget.

“The PRI regulations, proposed in 2012 and finalized today, provide nine new examples illustrating how a foundation can use PRIs to advance its charitable purpose. Many foundations have had misperceptions of the rules governing PRIs and many believed that expensive processes, such as specific IRS approvals or legal opinions, were necessary to safely use this tool. The new regulations, which closely follow the proposed regulations, illustrate the wide range of investments that might qualify as PRIs, including those accomplishing a variety of charitable purposes and utilizing a variety of financial arrangements. Thus, today’s guidance reassures foundations that a wide range of investments can qualify as PRIs and reduces the perceived need for legal counsel or IRS rulings in many cases.

“Beyond PRIs, some private foundations are making prudent investments for both charitable purposes and financial returns. As these mission-related investment practices gained popularity, philanthropy and impact investing leaders questioned whether it was permissible to make an investment for both a charitable purpose and financial gain through the foundation’s investment portfolio (rather than its grantmaking budget, as is generally the case for PRIs). Some indicated to the Administration that there was a need to provide clarity on this type of ‘double bottom line’ investing.”

Examples of Investments Now Acceptable as PRIs

The White House’s article offers much more detail on the real impact of this decision, including this robust offering (a PDF) of several examples of what the IRS considers “Program-Related Investments.” The examples start on page 16:

Example 11. X is a business enterprise that researches and develops new drugs. X’s research demonstrates that a vaccine can be developed within ten years to prevent a disease that predominantly affects poor individuals in developing countries. However, neither X nor other commercial enterprises like X will devote their resources to develop the vaccine because the potential return on investment is significantly less than required by X or other commercial enterprises to undertake a project to develop new drugs. Y, a private foundation, enters into an investment agreement with X in order to induce X to develop the vaccine. Pursuant to the investment agreement, Y purchases shares of the common stock of S, a subsidiary corporation that X establishes to research and develop the vaccine. The agreement requires S to distribute the vaccine to poor individuals in developing countries at a price that is affordable to the affected population, although, the agreement does not preclude S from selling the vaccine to other individuals at a market rate. The agreement also requires S to publish the research results, disclosing substantially all information about the results that would be useful to the interested public. S agrees that the publication of its research results will be made as promptly after the completion of the research as is reasonably possible without jeopardizing S’s right to secure patents necessary to protect its ownership or control of the results of the research. The expected rate of return on Y’s investment in S is less than the expected market rate of return for an investment of similar risk. Y’s primary purpose in making the investment is to fund scientific research in the public interest. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, Y’s purchase of the common stock of S is a program-related investment.
Example 12. Q, a developing country, produces a substantial amount of recyclable solid waste materials that are currently disposed of in landfills and by incineration, contributing significantly to environmental deterioration in Q. X is a new business enterprise located in Q. X’s only activity will be collecting recyclable solid waste materials in Q and delivering those materials to recycling centers that are inaccessible to a majority of the population. If successful, the recycling collection business would prevent pollution in Q caused by the usual disposition of solid waste materials. X has obtained funding from only a few commercial investors who are concerned about the environmental impact of solid waste disposal. Although X made substantial efforts to procure additional funding, X has not been able to obtain sufficient funding because the expected rate of return is significantly less than the acceptable rate of return on an investment of this type. Because X has been unable to attract additional 17 investors on the same terms as the initial investors, Y, a private foundation, enters into an investment agreement with X to purchase shares of X’s common stock on the same terms as X’s initial investors. Although there is a high risk associated with the investment in X, there is also the potential for a high rate of return if X is successful in the recycling business in Q. Y’s primary purpose in making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, Y’s purchase of the X common stock is a program-related investment.
Example 13. Assume the facts as stated in Example 12, except that X offers Y shares of X’s common stock in order to induce Y to make a belowmarket rate loan to X. X previously made the same offer to a number of commercial investors. These investors were unwilling to provide loans to X on such terms because the expected return on the combined package of stock and debt was below the expected market return for such a package based on the level of risk involved, and they were also unwilling to provide loans on other terms X considers economically feasible. Y accepts the stock and makes the loan on the same terms that X offered to the commercial investors. Y’s primary purpose in making the investment is to combat environmental deterioration. No significant purpose of the investment involves the production of income or the appreciation of property. The investment significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the investment and Y’s exempt activities. Accordingly, the loan accompanied by the acceptance of common stock is a program-related investment.
Example 14. X is a business enterprise located in V, a rural area in State Z. X employs a large number of poor individuals in V. A natural disaster occurs in V, causing significant damage to the area. The business operations of X are harmed because of damage to X’s equipment and buildings. X has insufficient funds to continue its business operations and conventional sources of funds are unwilling or unable to provide loans to X on terms it considers economically feasible. In order to enable X to continue its business operations, Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. Y’s primary purpose in making the loan is to provide relief to the poor and distressed. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.
Example 15. Y, a private foundation, makes loans bearing interest below the market rate for commercial loans of comparable risk to poor individuals who live in W, a developing country, to enable them to start small businesses such as a roadside fruit stand. Conventional sources of funds were unwilling or unable to provide such loans on terms they consider economically feasible. Y’s primary purpose in making the loans is to provide relief to the poor and distressed. No significant purpose of the loans involves the production of income or the appreciation of property. The loans significantly further the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loans and Y’s exempt activities. Accordingly, the loans to the poor individuals who live in W are program-related investments.
Example 16. X is a limited liability company treated as a partnership for federal income tax purposes. X purchases coffee from poor farmers residing in a developing country, either directly or through farmer-owned cooperatives. To fund the provision of efficient water management, crop cultivation, pest management, and farm management training to the poor farmers by X, Y, a private foundation, makes a loan to X bearing interest below the market rate for commercial loans of comparable risk. The loan agreement requires X to use the proceeds from the loan to provide the training to the poor farmers. X would not provide such training to the poor farmers absent the loan. Y’s primary purpose in making the loan is to educate poor farmers about advanced agricultural methods. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.
Example 17. X is a social welfare organization that is recognized as an organization described in section 501(c)(4). X was formed to develop and encourage interest in painting, sculpture, and other art forms by, among other things, conducting weekly community art exhibits. X needs to purchase a large exhibition space to accommodate the demand for exhibition space within the community. Conventional sources of funds are unwilling or unable to provide funds to X on terms it considers economically feasible. Y, a private foundation, makes a loan to X at an interest rate below the market rate for commercial loans of comparable risk to fund the purchase of the new space. Y’s primary purpose in making the loan is to promote the arts. No significant purpose of the loan involves the production of income or the appreciation of property. The loan significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the loan and Y’s exempt activities. Accordingly, the loan is a program-related investment.
Example 18. X is a non-profit corporation that provides child care services in a low-income neighborhood, enabling many residents of the neighborhood to be gainfully employed. X meets the requirements of section 501(k) and is recognized as an organization described in section 501(c)(3). X’s current child care facility has reached capacity and has a long waiting list. X has determined that the demand for its services warrants the construction of a new child care facility in the same neighborhood. X is unable to obtain a loan from conventional sources of funds including B, a commercial bank because of X’s credit record. Pursuant to a deposit agreement, Y, a private foundation, deposits $h in B, and B lends an identical amount to X to construct the new child care facility. The deposit agreement requires Y to keep $h on deposit with B during the term of X’s loan and provides that if X defaults on the loan, B may deduct the amount of the default from the deposit. To facilitate B’s access to the funds in the event of default, the agreement requires that the funds be invested in instruments that allow B to access them readily. The deposit agreement also provides that Y will earn interest at a rate of t% on the deposit. The t% rate is substantially less than Y could otherwise earn on this sum of money, if Y invested it elsewhere. The loan agreement between B and X requires X to use the proceeds from the loan to construct the new child care facility. Y’s primary purpose in making the deposit is to further its educational purposes by enabling X to provide child care services within the meaning of section 501(k). No significant purpose of the deposit involves the production of income or the appreciation of property. The deposit significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the deposit and Y’s exempt activities. Accordingly, the deposit is a program-related investment.
Example 19. Assume the same facts as stated in Example 18 (above), except that instead of making a deposit of $h into B, Y enters into a guarantee agreement with B. The guarantee agreement provides that if X defaults on the loan, Y will repay the balance due on the loan to B. B was unwilling to make the loan to X in the absence of Y’s guarantee. X must use the proceeds from the loan to construct the new child care facility. At the same time, X and Y enter into a reimbursement agreement whereby X agrees to reimburse Y for any and all amounts paid to B under the guarantee agreement. The signed guarantee and reimbursement agreements together constitute a “guarantee and reimbursement arrangement.” Y’s primary purpose in entering into the guarantee and reimbursement arrangement is to further Y’s educational purposes. No significant purpose of the guarantee and reimbursement arrangement involves the production of income or the appreciation of property. The guarantee and reimbursement arrangement significantly furthers the accomplishment of Y’s exempt activities and would not have been made but for such relationship between the guarantee and reimbursement arrangement and Y’s exempt activities. Accordingly, the guarantee and reimbursement arrangement is a program-related investment.

Why This Matters

“Foundations can deploy a wide array of financial tools to achieve their charitable goals.”Dave Wilkinson
Foundations are only required to donate 5% of their assets per year. The remaining 95% is focused on for-profit investments … some of which actually go against the purposes of the foundation’s grantmaking, as was the case for MacArthur Foundation in 2014 (article) and the Gates Foundation in 2007 (article).

In other words, for every $1 that a foundation donates … it invests $19 in the market.

So why does this announcement from the IRS matter? Simply put: it has the potential to exponentially multiply the amount of capital available for social impact.

How Much Capital are We Talking About?

According to the latest information from the Foundation Center:

Total No. of Foundations
87,142
Total Gifts Awarded
$55,262,883,393
Total Assets
$798,176,136,705
Total Gifts Received
$56,240,796,586

The column on the far right is particularly intriguing. For all of the money that foundations are donating each year, even more money is being put into foundations by their wealthy benefactors.

What Could this Capital Do?

Let’s imagine that only 1% of the $798B+ in combined foundation assets was invested in microloans for the poor. In other words, into the portfolios of companies like KivaAccion, PeopleFund (DISCLOSURE: where I used to work), and others.

That would be another $7.9 BILLION dollars in capital available for poor people to lift themselves out of poverty. In fact, it would increase the total global portfolio of such funds by nearly 10%, according Citi’s 2014 Microfinance Barometer (which reports that “A growing and solid base of microfinance providers … (own) a global loan portfolio amounting to USD 81.5 billion.”).

These loans would be repaid to the foundations, who could then re-invest the capital in more loans, donate it as grants to charities, or invest it in other vehicles. And along the way, it would provide critical financial access to many of the estimated 2.5 billion people who still do not have a formal account in a financial institution.

All WHILE generating a profit for the foundation, unlike a traditional grant!

Beyond the 5%
We are entering a new era in the world of institutional philanthropy, where traditional grantmaking is only one tool for foundations to advance social good.

I see few things that could more significantly impact our sector than having donors — particularly institutional grantmakers — transition their self-identity from that of “donor” to “financier.” The former too easily falls into short-term charity; the latter leads to long-term impact.

If donors, nonprofiteers, and social entrepreneurs could see themselves as partners in a shared mission to advance society, t’would be a merrier world!


Written by Jeremy Gregg, managing director of Gregg Partners. Gregg Partners is a Texas-based fundraising consultancy that specializes in grantwriting for nonprofits.

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