Download Philanthropy + Finance= Mission Investing for Private Foundations

Philanthropy + Finance = Mission
Investing for Private Foundations
A Primer for Private Foundations: Program-related Investments,
Socially Responsible Investing and Impact Investing
In This White Paper:
Introduction1
Program-related Investments 1
Socially Responsible Investing
2
Impact Investing
3
Combining Different Strategies to Enhance
Mission Investments
4
Conclusion5
Additional References
5
Philanthropy + Finance = Mission
Investing for Private Foundations
A Primer for Private Foundations: Program-related Investments,
Socially Responsible Investing and Impact Investing
Introduction
Private foundations in the United States are increasingly
interested in exploring mission investing or more closely
aligning their asset base with their charitable purpose.
The discussion has accelerated as a result of two related
issues: First, the market downturn in 2008/2009 affected
the ability of private foundations to fund their programs;
second, due to the subsequent recession and government
spending cuts, social needs have grown while the capacity
of many traditional donors (including public entities) has
diminished.
A question we hear with greater frequency is whether
private foundations are investment companies that have a
negative five-percent cash flow to charities or whether they
are a mission-based business deploying assets, including
the mandatory distribution stipulated by the IRS, towards
specific social goals. The answers are as varied as the founders of these vital social institutions.
Let’s first look at the requirement that private foundations
distribute five-percent of their assets each year and how this
can drive the discussion about the purpose of the foundation. What we do know is that the mandatory five percent
distribution came into being with the Tax Reform Act of
1969, along with a host of rules prohibiting self-dealing,
jeopardizing investments, regulated grants to individuals,
restricted ownership of businesses and limited involvement in political campaigns. Congress was responding to
concerns prevalent at the time regarding the growing size
of assets in foundations and the role they played in society.
By strictly defining the minimum annual distribution that
a private foundation had to make, federal tax law may have
unintentionally changed the focus from mission-driven
funding or spending policies to a numerical calculation.
We believe that it is important to shift this emphasis from
the numerical, instead helping each organization to craft
their own answer to their short-, intermediate- and longterm intentions in order to build sustainable asset strategies
designed to support their vision for their charitable assets.
Enabling a foundation to clearly define its larger purpose
could influence time horizon(s) and types of investment
strategies, helping the foundation to be more effective.
There are a variety of strategies for private foundations to
consider as they explore how best to fulfill their mission.
For the purposes of this paper, we will look at some specific
avenues that foundations can follow as they seek to extend
their social objectives. These include: program-related
investments; socially responsible investing and impact
investing. We will define these different approaches from
our perspective, but it is important to note that these terms
can sometimes be used interchangeably in the literature.
We are choosing the order of discussion intentionally across
the continuum of risk-adjusted expected returns:
Program-related
Socially Responsible
Investments
Investing
Below Market Rate
Market Returns
Impact
Investing
Market + Returns
Program-related Investments
According to the IRS, the primary purpose of programrelated investments (PRI) is to accomplish one or more of
the foundation’s tax-exempt purposes. The generation of
income or appreciation cannot be a significant purpose in a
PRI. The investments must significantly further the foundation’s mission and may include those made in activities
functionally related to the exempt purpose. Like grants,
PRIs can be vehicles for providing inexpensive capital for
exempt projects.
Unlike grants, PRIs are expected to be repaid, often with
a modest or below market-rate return. Once repaid, the
assets are reused for other charitable purposes.
PRIs came into use after the passage of the Tax Reform Act of
1969, which also warned foundations away from investments
that could imperil their ability to perform their charitable
purpose. Section 4944 allows for program-related investments generating no or limited return as long as they fulfill
exempt social purpose and do not engage in any lobbying
or political endeavors forbidden to foundations.
Philanthropy + Finance = Mission Investing for Private Foundations
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PRIs come in all shapes and sizes. Examples include lowinterest loans to needy students, bridge loans to nonprofit
institutions, low-interest financing for charter schools,
low-income housing projects, nonprofits and businesses
that don’t have access to commercial funds at reasonable
rates. They can be used to fund capital projects, promote
economic development, aid historic preservation, help
organizations acquire property, create jobs or expand capabilities. PRIs may involve a range of financial structures
as long as rates are below market on a risk-adjusted basis.
The rate of return will vary depending on the assessment
of risk, generally based upon the borrower’s ability to repay
principal and interest over the term of the deal.
If a PRI ceases to be program-related due to a change in
circumstances, the foundation must determine whether the
investment jeopardizes carrying out its exempt purpose,
and follow the IRS rules accordingly.
“Avoidance screening” has been practiced by professional
investors for decades (and by individuals for hundreds of
years). Avoidance screens are typically values-based. The
most common avoidance screens include those for tobacco,
alcohol, environmental impact, human rights (Sudan and
Burma), animal welfare and weapons manufacturing. However, customized screens are also used to avoid investments
that conflict with a foundation’s mission. Foundations may
also choose to incorporate positive screens, seeking companies whose activities advance their charitable purpose
or capture positive ESG characteristics (See below). They
can customize screens to be specific to their organization
and/or utilize investment vehicles designed to incorporate
a social philosophy into their investment strategy. Major
SRI investment strategies include the following:
■■
Private foundations claim PRIs on their Form 990 as charitable activities. This means that PRIs are counted as part of
a foundation’s minimum payout in the year of distribution.
They remain on the balance sheet as an asset until repaid or
written off. Adjustments may be made to the carrying value
of the PRI if the probability of the collection of principal
or interest changes. Return of PRI principal is effectively
a return of a grant and must be redistributed.
Other organizations or individuals may use the term PRI to
describe a below-market-rate investment for a charitable
purpose, but there is no legal requirement for them to use
the term.
Socially Responsible Investing
Socially responsible investing (SRI) describes an investment strategy seeking to balance financial return with
social good in the public markets. There are a number of
social investment strategies practiced by public and private
foundations (and many different motivations for doing
so). The solutions may be as simple as excluding one or
two objectionable stocks from a portfolio or as complex as
combining “avoidance” and positive investment screens
with community development vehicles and corporate
engagement strategies.
2
■■
Environmental, social, governance (ESG). This
type of investment strategy seeks companies with
superior characteristics in the areas of environmental
stewardship, social practices (such as giving back to
their communities) and corporate governance. It
is based on the belief that exceptional practices in
ESG are likely to lead to better investment results
over time. Companies that are proactively engaged
in understanding and embracing changes that are
taking place in the world and their communities may
be more likely to offer superior long-term investment
opportunities.
Corporate engagement. Active ownership has been
a major tenet of social investing since the 1970s, but
corporate governance issues and climate change
have brought this idea into the mainstream over the
past decade. Today, foundations around the world
are engaging directly with management on key
governance and sustainability issues to seek outcomes
favorable to stakeholders and society. Engagement
can include dialogue, shareholder resolutions and
voting proxies on issues relevant to their mission.
A commonly held belief is that social screening will limit
your investment return. However, many studies have
shown that socially responsible investing has competitive
market returns.
The studies suggest that conventional investment factors provide the returns and that social factors don’t have
much impact on portfolio alpha. Some studies suggest, for
example, that ESG factors can help performance. These
include the following:
Philanthropy + Finance = Mission Investing for Private Foundations
Environment. Several studies support the notion that
companies that manage environmental risks most effectively
tend to generate higher returns than their industry peers. For
example, an Erasmus University study, which covered the
1995-2003 time period, concluded that stocks of companies
with high environmental ratings markedly outperformed
poorly rated ones during the period under study.1 Perhaps
good environmental management is an indicator of good
corporate management and can help reduce the risk of
profit disappointments due to environmental problems.
Social factors (employee relations). Employees matter
to business performance. Yet, the human resource policies
and practices of many companies are not widely followed
by the general investment community. So it is no surprise
that investors who screen stocks based on human-resources
criteria may be compensated with higher returns. Indeed, a
recent study analyzing the relationship between employee
satisfaction and long-run stock returns found that a portfolio of Fortune Magazine’s “100 Best Companies to Work
for in America” from 1984–2005 outperformed the overall
stock market by four percent annually.2
Corporate governance. One recent study found that
companies that received high governance scores outperformed those with low scores over three-, five- and ten-year
periods.3 Another study showed that firms with superior
corporate governance policies notably outperformed those
with weak governance in the decade of the 1990s.4
It is worth noting that the trend towards SRI is not isolated to just individuals or institutions seeking to invest
with their values. In a survey conducted by The Economist Intelligence Unit in March 2009, 82 percent of asset
managers agreed that sustainability factors will become
significantly more important in their research, portfolio
management and manager selection process over the following three-year period. Moreover, a study by the Social
Investment Forum notes that one out of every nine dollars
under management in the U.S. is subject to some type of
social or environmental screen.5
However, foundations that place extensive screens on their
assets, effectively eliminating one or more economic sectors,
may want to analyze the impact of eliminating a particular
industry over time and assess how to best counterweight
that outcome.
Impact Investing
When is an investment an impact investment vs. a socially
responsible investment? Impact investing tends to be
private investment intended to drive both financial and
mission outcomes. Impact investing defies the traditionally
binary nature of capital allocation, where capital is either
invested to optimize risk-adjusted returns or distributed
to optimize social objectives. Impact investing merges
those two motivations and recognizes that they are not
necessarily mutually exclusive.
Impact investors have a variety of expectations in this
nascent market, including their expectations for returns.
Several foundations have allocated assets to this approach
and have written extensively on their experiences, including The Ford Foundation, F.B. Heron Foundation, Annie E.
Casey Foundation, W.K. Kellogg Foundation, KL Felicitas,
and Rockefeller.6 Their websites are wonderful repositories
of their experiences.
While most of the money being used for impact investing
is going into areas such as helping to reduce poverty and
improving the climate, it is not philanthropy. Investors
expect at least a return of their capital with an adjustment
for inflation and, in many cases, a lot more than that. For
that reason, impact investment is at the opposite end of
the spectrum from PRI, where the expectations of a return
are minimal to zero.
The Global Impact Investing Network, a nonprofit group,
has noted that impact investments currently amount to
about $50 billion. It estimates that this area could grow
to $500 billion by 2014, putting it at roughly one percent
of all managed assets. Over the next 10 years, this group
anticipates that impact investing could reach $1 trillion.7
Given this rate of growth, we also are likely to see a change
in the types of investment vehicles available to those interested in impact investing. Currently, these vary from
socially targeted venture capital to community investing
and microfinance. However, as interest in this type of investment grows, we would expect to see an increase in the
availability of publicly traded vehicles in a similar manner
to the way in which hedging strategies have become more
widely available through hedge mutual funds.
Philanthropy + Finance = Mission Investing for Private Foundations
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Impact investing issues for private foundations to
consider:
If a private foundation is considering allocating assets to
impact investing, there are a number of issues that need to
be considered. These include:
■■
■■
Understanding benchmarks—given the return
expectations for this type of investment, it is worth
noting that measuring returns against a benchmark
can be challenging. Like benchmarking hedge funds,
the benchmarks may represent a collection of
instruments or vehicles, not a specific strategy. It is
important to compare the strategy risk characteristics
for returns and the means of intended and actual
social impact. There is a wide variance of returns for
obvious reasons. The good news is that we are seeing
rapid growth systems designed to track and manage
social performance. The due diligence and monitoring
process will be critical to financial and social success
(double bottom line). Impact Reporting and
Investment Standards (IRIS) is working to standardize
and facilitate the creation of industry benchmarks.
The Global Impact Investing Rating System (GIIRS)
will utilize IRIS definitions. Standardization will help
investors sort through the range of results.
Understanding risk—manage impact investments with
great care! Like private equity, these investments are
illiquid and can be risky. Because the area is so new,
the impact funds can lack the traditional track records
and transparency that private foundations may be
used to. The risks are similar to venture or high-yield
debt: heightened reputational and legal risks, and
possible political risks in global/emerging markets.
Additionally, while many speak of these opportunities
as a potential pathway out of poverty, others are
concerned about the potential for exploitation.
Other factors that private foundations and those who
manage private foundations should consider are that
impact investments:
■■
■■
■■
■■
4
Meet state prudent investor standards and IRS
jeopardizing investment
Involve a combination of programmatic and financial
skills
May necessitate additional staff training/talent
acquisition for rigorous due diligence and ongoing
portfolio management
Could be complex and time consuming, and may
involve legal/other fees
■■
■■
May require long-term monitoring, reporting,
restructuring and an exit strategy
Could be illiquid, meaning that the assets may not
easily be accessible if the foundation needs to draw on
them to meet other funding requirements, including
the required annual five-percent distribution
Combining Different Strategies to Enhance
Mission Investments
How should foundations assess mission investments that
do not qualify as PRIs either because making a profit is a
significant purpose of the investment or the social objective
is not significant versus the objective the foundation has
stated in order to secure its tax exempt status? Fortunately,
there is a legal framework for such an assessment. The
investment activities of private foundations are subject
to federal tax law and state fiduciary law. If the investment
is analyzed within the context of the foundation’s overall
investment policy, then it may well fall within the prudent
investor standards set by the prevailing state statutes:
UPMIFA8, UMIFA9 or UPIA.10
According to the IRS standard, assessing social considerations alongside traditional financial analysis does not
render such investments as jeopardizing investments. The
IRS (2010b) defines jeopardizing investments as those that
“show a lack of reasonable business care and prudence in
providing for the long- and short-term financial needs of
the foundation for it to carry out its exempt function.”
Engaging in a rigorous and diligent investment process,
optimizing financial returns and furthering their social
cause, can help a foundation avoid a violation of the jeopardy investment rule.
The regulations pertaining to mission-related investments
(MRI)—impact investments with expected market rates of
return—are the same as those for conventional investments.
Because MRI is a term of art rather than a regulatory term,
no special regulations or exemptions apply. Therefore,
regulations governing private foundation jeopardizing
investments apply to MRIs. In addition, both private and
public charities are subject to state fiduciary laws.
The determination of whether a foundation has shown reasonable business care and prudence is based on conditions
at the time of the investment. The guidance for formulating
and documenting an investment and social thesis for both
PRIs and MRIs aims to filter investment opportunities
down to those most likely to perform, and helps prove
that a foundation has taken reasonable business care and
prudence in selecting its investments.
Philanthropy + Finance = Mission Investing for Private Foundations
Conclusion
Endnotes
There are many tools for foundations to engage in effective
philanthropy and drive social change. Mission investing is
part of that toolkit, offering the opportunity to potentially
shape and scale desired social outcomes as a complement to
effective grant-making and other philanthropic activities.
Success requires planning, blending program and financial
teams, rigorous investment processes and building applicable social metrics.
1
Nadja Guenster, Jeroen Derwall, Rob Bauer, Kees Koedijk, Erasmus University,
“The Economic Value of Corporate Eco-Efficiency,” 2006
2
Alex Edmans, Wharton School, University of Pennsylvania, “Does the Stock
Market Fully Value Intangibles? Employee Satisfaction and Equity Prices,”
2009
If your private foundation is exploring additional means
and methods to further the mission, please contact your
Abbot Downing relationship manager. The Philanthropic
Services team works with relationship managers and their
philanthropic clients to understand, analyze and advise on
customized strategies that blend philanthropic and financial
experience, aligning mission and vision with economic and
market opportunities.
5
Paper prepared by Nancy Baxter, Senior Philanthropic
Investment Manager, Wells Fargo Philanthropic Services
and Blaine Townsend, Wealth Management Investment
Manager, Nelson Capital Management.
Additional References
3
The Correlation between Corporate Governance and Company Performance, by
Lawrence D. Brown and Marcus L. Caylor, Institutional Shareholder Services
Oxford Handbook of Corporate Social Responsibility, 2004
4
Corporate Governance and Equity Prices, working paper #8449, by Paul
Gompers, Joy L. Ishii and Andrew Metrick, National Bureau of Economic
Research, 2001
Report on Socially Responsible Investing Trends in the United States, Social
Investment Forum, 2007
6
http://www.fordfoundation.org/; http://www.fbheron.org/index.html ; http://
www.aecf.org/ ; http://www.wkkf.org/ ; http://www. klfelicitasfoundation.org/ ;
http://www.rockefellerfoundation.org/
7
Global Impact Investing Network, http://www.thegiin.org/cgi-bin/iowa/home/
index.html
8
UPMIFA is the acronym for the Uniform Prudent Management of Institutional
Funds Act, which California adopted effective January 1, 2009, and which
replaced the Uniform Management of Institutional Funds Act (UMIFA).
UPMIFA provides rules about how an endowment fund can be invested and
spent.
9
Uniform Management of Institutional Funds Act (UMIFA) is a uniform law
which provides rules regarding how much of an endowment a charity can
spend, for what purpose, and how the charity should invest the endowment
funds.
10
The Uniform Prudent Investor Act (UPIA) was enacted in 1992. The biggest
change to existing trust law resulting from this act was that it permits
fiduciaries to utilize modern portfolio theory to guide investment decisions.
Therefore, a fiduciary’s performance is measured on the performance of the
entire portfolio, rather than individual investments.
“The Stakes go up in Social Investing: New Controversies,
New Evidence,” Lloyd Kurtz, October 14, 2010
“Risk, Return and Social Impact: Demystifying the law of
Mission investing by U.S. Foundations,” Anne Stetson and
Mark Kramer, October 2008 FSG Social Impact Advisors
“Investing for Social and Environmental Impact, a design
for catalyzing an emerging industry,” Monitor Institute,
2009
“Where Money Meets Mission: Breaking Down the Firewall Between Foundation Investments and Programming,”
Jed Emerson, Stanford Social Innovation Review, 2004
Philanthropy + Finance = Mission Investing for Private Foundations
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