An Impact Investing Guide for Private Foundations
Putting assets in service of mission can take many forms. Here are four distinct approaches to consider in your efforts to foster positive change in our environment, health and society.
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Imagine that your foundation is dedicated to eradicating childhood asthma in your home state. One day, you are listening to the local news during your morning commute and you hear a report about an aging coal-fired power plant where the sulfur dioxide emissions are so bad as to be implicated in the high incidence of childhood asthma in the neighboring towns.
A week later you are reviewing your foundation’s investment portfolio and realize that you own a good chunk of shares in an energy company — the very same energy company that owns the power plant. In fact, the dollar amount of the company’s stock in your investment portfolio is almost equal to the dollar amount you are putting into your childhood asthma eradication efforts.
Moral Dilemma: What to Do?
It’s a common conundrum for private foundations: Many foundations that are established to solve society’s most pernicious problems have investments as their lifeblood. Their assets need to be invested in profitable businesses in order to sustain operations and grow. So what happens when a foundation’s mission is directly contradicted by its own investments? What if the very ills a foundation fights are exacerbated or even caused by the behavior of business entities found in its own portfolio?
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It can sometimes seem as though the foundation’s assets and its grantmaking programs are in direct opposition to each other, or at the very least, failing to work together to accomplish a charitable mission. And since many foundations invest 95% of their assets while distributing about 5% for charitable purposes, it’s even conceivable that the damage done by the investments exceeds the good accomplished by the distributions!
Over the last decade, more foundations have been attempting to address this issue and get all of their horses pulling in the same direction. These foundations want their investments to enhance their philanthropic efforts or at least not run counter to them. If their 5% for their minimum charitable distribution requirements are regarded as the “do good” portion of their foundations, the goal for the other 95% might at least be conceived as “do no harm.” Hence, their adoption of “impact investing,” a widely popular investment strategy that aims to generate a positive social or environmental impact in addition to providing a financial return.
Growth of the impact investing sector has exploded in the last 10 years. The International Finance Corporation (IFC) (opens in new tab) reports that $2.3 trillion was invested for impact in 2020, which is equivalent to 2% of global assets under management. And a Global Impact Investing Network (GIIN) study (opens in new tab) reveals a 42.4% increase in the sector from 2019 to 2020. Impact investing is a broad tent as well; many different individuals, businesses and organizations claim a seat under its canopy, each employing different tools and approaches.
As private foundations ideally aim for 100% of their endowment assets and grant funds to serve the greater good, we examine four distinct approaches they can take for impact investing, ranging from fiscally conservative to financially risky:
• Community Investing
• Socially Responsible Investing
• Program-Related Investing
• Social Venture Capital Investing
A ‘Safe’ Introduction: Community Investing
One of the easiest ways to dip a toe into impact investing waters is by simply moving your money from a traditional bank to a community development financial institution (CDFI), such as a community bank or community credit union. These financial institutions are common throughout the United States, and you have probably heard of them without realizing that they have a social mission tied to their financial products.
CDFIs are government-regulated and government-insured, just like other financial institutions. They offer checking and savings accounts, money market accounts, certificates of deposit and all the other usual services you’d expect from a traditional bank. They provide market-rate (or very close to market-rate) interest to depositors and from a consumer’s perspective, are comparable to commercial banking institutions, albeit with a less extensive network of ATMs.
The real difference between traditional banks and community banks is what they do with the money on deposit. Rather than lend it out to large corporations outside the local vicinity, community banks invest it locally through loans for affordable housing projects, home mortgages in low-income areas, and new businesses. Many low-income neighborhoods have benefited from CDFIs that use their deposits to build that same community, rather than siphoning funds out for the benefit of outside parties.(1) The Calvert Foundation, for example, directed Calvert Community Investment (CCI) notes to help rebuild communities in the Gulf Coast region devastated by Hurricanes Katrina and Rita. These same notes offer investors a range of terms, including interest rates that vary up to 2% payable at maturity.
Community investing can be a relatively low-risk cash management strategy, an easy way for a foundation or philanthropic individual to put more financial assets in the service of a charitable mission. To look for a CDFI in your community, go to www.cdfifund.gov (opens in new tab) for a listing of CDFIs by city and state.
Socially Responsible Investing
The concept of socially responsible investing (SRI) has been around for more than 30 years. It began with a simple idea: Don’t hold the stock of companies that actively work against your values. So an environmental grantmaker might screen “big oil” out of its portfolio and a health grantmaker might avoid “big tobacco.” Other common screens filter out companies that have interests in gambling, alcohol, pornography, dealings with repressive governments or defense contractors. Because this approach focuses on what an investor does not want to hold in his/her portfolio, tools that help them filter their investments have been dubbed “negative screens.”
Critics point out that while employing negative screens to eliminate “sin stocks” may help an investor sleep better, they don’t necessarily accomplish much else. The companies that are screened out are usually very large and very profitable, and a few conscientious investors selling their stock or just declining to buy it will not affect their share price. And by screening out a whole host of potentially profitable sectors, an investor employing negative screens may be limiting their ability to earn returns on par with the market as a whole. As most investment advisers benchmark performance against broad market measures, portfolios employing negative screens are widely thought to underperform.
In recent years, investors and their advisers have taken a new approach to socially responsible investing, one that involves “positive screens.” Instead of shutting out objectionable companies, a positive screen actively seeks out companies demonstrating the kind of corporate social responsibility that philanthropic investors would like to encourage. The primary positive screens are around environmental, social and governance (ESG) practices, collectively known as “ESG screening.” Rather than focus on what you don’t want companies to do, ESG screening selects companies based on the positive things they are doing.
Some recent studies challenge the widely held belief that one needs to accept lower returns in exchange for socially responsible investing (SRI). ESG-screened companies disprove the myth that SRI isn’t profitable. Some previous research has found no statistically significant difference between the performance of traditional funds and SRI funds. In fact, as The Forum for Sustainable and Responsible Investment (opens in new tab) reported, a 2012 meta analysis by DB Climate Change Advisors of more than 100 academic studies found that incorporating environmental, social and governance data in investment analysis is “correlated with superior risk-adjusted returns at a securities level.”
Beyond being good philanthropy, ESG screening is increasingly accepted as just good business. ESG investing has become more mainstream over the past decade, fueled by rising investor interest and recognition that social and environmental impacts are creating material financial risks for companies and investors. In other words, polluting the environment to make a quick buck today is what investors might call a “short-term play.” That is, it’s not going to be an effective strategy over the long haul as governments, consumers, and investors increasingly penalize companies with poor ESG practices through loss of business, lawsuits, bad publicity, and costly clean-up.
Done well, investing in ESG-screened funds can be a natural part of a private foundation’s investment strategy that carries no more risk than traditional investing in the stock market.
Banker to Your Grantees: Program-Related Investing
When we think of a private foundation supporting a charitable cause, most of us think in terms of grants —money given away with no expectation of it ever coming back. But foundations can also make loans and provide loan guarantees in support of their mission. Such loans are defined by the IRS as program-related investments (PRIs) and are an increasingly common tool among private foundations.
PRIs come out of the foundation’s grantmaking purse and as such, they qualify toward the foundation’s 5% minimum distribution requirement. However, while grant dollars go out the door never to return, PRI dollars are generally recovered in part or in whole, and may even earn some return for the foundation in the form of interest or appreciation.
To qualify an investment as a PRI, the foundation must satisfy three requirements laid out by the IRS:
- The primary objective of the PRI must be to significantly further the foundation’s charitable mission.
- The production of income or appreciation of property must not be a significant motivating factor.
- The investment must not attempt to influence legislation or elections; a PRI may not be used to support candidates for office or lobby elected officials.
Collectively these requirements suggest that if the foundation were driven purely by financial considerations, it wouldn’t make the PRI because the loan or investment will usually have some downside that makes it unattractive to commercial investors: High risk, low return and illiquidity are common traits among PRIs, so much that one might even consider PRIs “bad investments for a good cause.” Evidently, the IRS concurs: Because PRIs fulfill a foundation’s charitable purpose, they are exempt from the normal rules that prohibit the foundation from making so-called “jeopardizing” investments.
Foundations use PRIs creatively in myriad ways. Most first experiment with them in the form of a loan to an organization they already know well, oftentimes a prior grantee. For example, they may offer their community church a very low-interest loan to finance the construction of a new facility. Or they may provide a no-interest line of credit to their favorite art museum to help smooth out the bumpy financial times between blockbuster shows. They even may co-sign a loan to allow a housing agency to access funding from a commercial bank, which, absent a default, doesn’t require them to put a dime out the door.
Graduating to the Big Leagues: Mission-Related Investments
Traditionally, philanthropists give away money and investors make money. The former want to create change and the latter want to pocket it. You’d think that the two goals would be incompatible, but a new hybrid of philanthropy and private equity investing blurs the lines, allowing foundations to do well by doing good.
Similar to private equity investing, foundation donors make investments in private companies or venture capital funds — the difference being that these investments go beyond mere financial returns to provide social and economic benefits. Foundations that engage in mission-related investing (MRI) use their endowment funds to invest in profit-seeking solutions aligned with their mission. These often are social, environmental and economic challenges that cannot be easily met through grants alone.
The determination as to whether these “social venture” investments are PRIs or MRIs depends on whether they exist primarily to return a financial profit or to accomplish a social good. Let’s take two examples for that foundation fighting childhood asthmas:
In our first example, the foundation becomes aware of a promising drug that’s in development. It’s only effective against a rare variant of childhood asthma, so it doesn’t have much commercial potential and is therefore unlikely to make it into production. The foundation could provide a seed money loan for the drug’s development and this “poor investment for a good cause” would qualify as a PRI and count toward its 5% minimum distribution requirement.
In our second example, the foundation becomes aware of a terrific new company that’s developing an inexpensive, electric car capable of going 500 miles before recharging. This is a very exciting investment opportunity for a whole host of reasons. From a financial standpoint, an extended-range, inexpensive, electric car has tremendous market appeal; from a mission standpoint, it’s also attractive because car emissions contribute to childhood asthma. Clearly, investing in this start-up would be compatible with the foundation’s fiscal goals and mission objectives. However, because the venture foremost is considered a good investment from a financial standpoint, it qualifies as an MRI and not a PRI.
Keep in mind that MRIs, unlike PRIs, are subject to jeopardizing investment rules and that a private foundation can be subject to excise taxes for making imprudent investments. For this reason, involvement in any of the activities outlined here and below should be based on a well-considered investment policy that includes a thoughtful asset allocation strategy among different classes of risk.
3 Main Approaches to Mission-Related Investments
Mission-related investments (MRIs) may be made in a variety of ways. For instance, you can buy stock in a well-established company that’s aligned with your mission, you can invest in a social investment fund, and you can conduct angel investing in start-up companies that have a social mission.
1. Buying Stock in Well-Established Companies
An obvious investment choice for a foundation dedicated to environmental conservation might be a tech giant that’s developing more affordable solar panels. But what about a granola manufacturer that buys Brazil nuts, which only grow in healthy rainforests, at above-market rates in order to incentivize forest preservation?
2. Social Investment Funds
A foundation willing to take some risk with a portion of its investment capital can become an investor in one of the tiny but growing crop of “social investment funds.” Traditional venture funds raise capital from private investors and select a portfolio of young companies in which to invest. They provide not only funding to the young company, but also expertise and connections, all in exchange for an ownership stake and often, a seat on the board of directors.
Social investment funds take this same approach, but focus on finding and funding potentially profitable businesses with a social mission. Managed by professionals who charge a service for their fees, these funds seek target companies, known as “social enterprises,” that focus on providing positive social impact as well as financial returns. Examples might include technologies that provide clean water, facilitate remote access to health care, or improve public safety. And social venture funds aren’t limited to technology start-ups. They can support fair trade suppliers, companies that provide healthy, organic school lunches, car-sharing services, and much more.
Social investment funds are often dedicated to a specific issue. For example, Good Capital’s Social Enterprise Expansion Fund (SEEF) provides growth capital to social enterprises that address the root causes of inequity in the U.S. and around the world. Another fund, Root Capital, aims to grow rural prosperity in poor, environmentally vulnerable places in Africa and Latin America.
Because the concept of social venture investing is still in a nascent stage of development, these funds often lack traditional track records and transparency. New tools have been developed to help social investors track and evaluate the social impact of their investments, such as the Global Impact Investment Ratings System (GIIRS, pronounced “gears”). Some funds (and some funders) are rigorous in defining and measuring the social impact of their portfolio companies while others seem to be satisfied with the idea that they are “supporting good work.”
3. Angel Investing
“Angel investors” are “first-in” funders who personally evaluate individual investment opportunities and use their own funds to invest directly. Where social investment funds rely on the expertise of a professional management team, angel investing might be considered the “do-it-yourself” approach to social investing.
Angel investors typically take on very high risk in early-stage companies in the hopes of a commensurately high reward if one of their companies turns out to be the next Google. For private foundations and individual philanthropists who are willing to put in the time and effort themselves to grow social enterprises, an angel approach to social investing can be attractive because it allows them to use not only their money, but also their networks and expertise to help a young social enterprise get up and running.
In some cases, angels band together to form networks or loose affiliations that share the work of doing due diligence on potential investments. Each member then decides if he or she wants to take part in the investment. A well-known social angel network, Investors Circle, is an environmentally focused, international group of angel investors founded in the early ’90s. Today, there are many such networks, including Toniic (opens in new tab), an international group of social investment angels founded by KL Felicitas Foundation donors Charly and Lisa Kleisner. There are also communities of angels that come together on “Investor Days” around the country to hear pitches for start-up social enterprises, sponsored by entities such as the Unreasonable Group in Colorado and Impact Engine in Chicago.
For the foundation that looks closely at its current investment portfolio and finds a lack of alignment with its grantmaking objectives, there are many options to put both pools of assets to work for positive social outcomes. From relatively low-risk cash management options with community development financial institutions to high-risk angel investing in social enterprises, every philanthropist can become an impact investor. The key to success is to take an incremental approach, starting with a small portion of assets at first and then expanding as you gain experience and confidence.
(1) – As a result of the Community Reinvestment Act, commercial banks must also lend a certain amount within the communities in which they operate. These commercial banks accomplish this, among other ways, by investing in or lending to community banks, which in turn actually lend within the community.
This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
Jeffrey D. Haskell, J.D., LL.M. is a leading expert in the areas of private foundation law, compliance and taxation. He is chief legal officer for Foundation Source (opens in new tab), the nation’s largest provider of management solutions for private foundations. Mr. Haskell has worked with Foundation Source since its inception in 2001. He leads a team of attorneys and accountants who provide legal and tax support to the firm’s foundation clients and their closest advisers.
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