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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 1 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 3 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 5 Disclosures Investment Products: NOT FDIC Insured NO Bank Guarantee MAY Lose Value Abbot Downing, a Wells Fargo business, provides products and services through Wells Fargo Bank, N.A., and its various affiliates and subsidiaries. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. This information is provided for education and illustration purposes only. The information and opinions in this report were prepared by Abbot Downing. Information and opinions have been obtained or derived from information we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Abbot Downing’s opinion as of the date of this report and are for general information purposes only. Abbot downing does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report. This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the strategies mentioned. 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