ImpactAlpha, May 10 – Not long ago, I decided to change my leaky kitchen faucet myself. How hard could it be? I turned the water off and was deep into the job when I realized that, between the sink and the wall, it was impossible to loosen the old faucet.
I was about to call a plumber. Then I noticed my neighbor in his driveway. Peter has every tool; more importantly, he knows where they are. He quickly pulled from his toolbox a right-angle thingamabob with an extension bar. My Saturday was saved.
Investors sometimes have a problem finding the right tool for the job as well. Or rather, the financial tools they’ve always used aren’t what’s needed now. Early-stage climate innovations that may not pay off for decades? Not a good fit for venture capital. Working capital for smallholder farmers that feed the vast majority of the populations in many countries? Too risky for most banks. Medical breakthroughs to treat neglected diseases that primarily afflict patients in poor countries? Not interesting to most biotech investors.
It turns out one group of mission-driven investors may have a tool to help fix such market failures and capital gaps. For 50 years, philanthropic foundations have expanded the use of “program-related investments.” (The year 1968 is remembered for many things; one more: first IRS-approved program-related investment, by the Ford Foundation.) Simply put, program-related investments, or PRIs, are loans, equity investments, or guarantees made by a foundation to a for-profit or a nonprofit in pursuit of its charitable mission, rather than to generate income.
One outcome of the welter of IRS guidelines is that “charitable purpose” is required to be the primary rationale for every PRI. That means impact should be baked into the conception, the execution and (by logical extension if not actual practice) the evaluation of every program-related investment.
The corollary is that financial returns must not be the “significant purpose” of the investment. (A common misconception is that program-related investments must be concessionary; on the contrary, it’s perfectly legal to make a killing, as long as that wasn’t the primary intent). That frees PRIs from the straight-jacket of financial expectations that many investors use as an excuse for not doing anything that deviates from well-worn paths.
ImpactAlpha has made a sub-specialty of reporting on program-related investments, including a deep dive into the PRI portfolio of the Bill & Melinda Gates Foundation, long conversations with Debra Schwartz, managing director of impact investments at the John D. and Catherine T. MacArthur Foundation, and an ongoing project with Larry Kramer, president of the William & Flora Hewlett Foundation, to assess available data on PRI performance.
Anecdotal evidence suggests there are some use-cases for which PRIs are, or can be turned into, a workable tool. The David and Lucile Packard Foundation made a $10 million loan, at one percent interest, that allowed EcoTrust Forest Management to attract more commercial investors to a sustainable forestry fund for the Pacific Northwest. The Gates Foundation has invested in biotech companies with promising approaches to neglected diseases; in return it requires a “global access agreement” that commits them to make their products affordable in low-income countries. The MacArthur Foundation created an arts and culture loan fund which invested in certificates of deposit as collateral for loans to nonprofit theaters and other arts organizations. Banks now provide one-year lines of credit and bridge loans to arts nonprofits.
Threading the needle
In such use-cases, PRIs have been an essential, perhaps irreplaceable, form of capital for bridging gaps and reversing market failures. Flexible and patient capital — high-risk or low-return or both — is often what’s needed to build markets failed by traditional institutions. Those who sniff at such concessionary or below-market investments should remember that program-related investments in many cases have seeded the pipeline for future commercial-grade investments (think Nancy Pfund’s DBL Partners).
“Increasingly, impact investing proponents proclaim that the market can ‘do it all,’ that we can finance significant impact without giving up anything in terms of risk or financial return,” MacArthur’s Schwartz wrote last year. “But this rosy view has a blind spot. It overlooks the fact that catalytic capital — sometimes in concert with public subsidies and grants — is often needed to make high-impact transactions suitable and attractive for a broader range of investors.”
That program-related investments require threading of the legal needle by foundations may surprise casual observers who might assume all philanthropic assets are pointed toward mission. It’s of course reasonable for the IRS to insist that tax-advantaged charitable funds should have a charitable purpose. The real rub comes because foundations are under separate IRS rules to pay out a minimum of 5% of their assets (roughly speaking) in grants each year.
The IRS guidance allows foundations to count their program-related investments against that minimum payout. Any principal returned from a PRI must be regranted; any income can go back to the foundation’s endowment. (Wonks: dig deeper in Stanford’s Paul Brest’s good PRI primer.) In short, PRIs are a klugey hack, even leaving aside the unsettled questions about the actual performance of PRIs as a whole, their efficacy vis a vis grants and concerns about organizational capacity and transaction costs.
In a world awash in capital, consider how little money is deployed in this way. Some rich guy or gal gets a tax break for giving away a lot of money. Of that amount, perhaps 5% a year goes out the door toward a charitable mission. Of that 5%, a tiny amount is invested in program-related investments. Fewer than 1% of foundations invest using PRIs, according to one estimate, and the median percentage of foundations’ program and grant budgets directed toward impact investing more generally is about half of one percent, according to another survey.
Is that any way to run a capital market?
The impact investing and philanthropic ecosystems are beginning to respond. Some foundations are using grants and other mechanisms to back market-making mechanisms. Others are moving beyond their grant budgets to commit more of their endowments to mission-driven investments. A growing number of billionaires are foregoing the foundation structure altogether and creating impact-oriented limited-liability corporations with more flexibility to make investments. Financial engineers are blending different types capital to parse risks and returns in new ways.
Program-related investments are at best a transitional mechanism for addressing capital gaps and market failures. It’s time for a much broader range of investors to step up to build — and fund — the right tools for the big jobs ahead.