Understanding philanthropic capital: How to invest in social causes and gain financial returns
Being an optimist and a pessimist at the same time may seem contradictory. But, I believe we can make real progress on some of the big issues that face us today including poverty, the environment, education and equality among others. However, I don’t believe the way in which we have approached these issues in the past will make the progress we seek.
As the focus in philanthropy shifts from activities to outcomes, and we all expect more impact from change efforts, we can expand how we think about financing this change and what instruments will be most effective. The world is changing at a faster rate than ever before, and even though we have focused on these issues for many years, there is still much work to be done. Have we been looking at these issues and their solutions through too small a lens?
In the past, most philanthropic capital has been distributed in the form of contributions to nonprofit organizations. These have high social return but no financial return. And traditional investments often have high financial return and questionable social impact. By thinking in a one-dimensional way, we have limited the range of solutions available and squandered opportunity by not engaging the full capital markets in making change.
In order to address the more complex issues that now exist, it’s time to shift the paradigms of how to address these big, complicated problems. And those shifts are happening all around us. No longer is it the sole realm for nonprofit organizations to tackle social problems; social enterprises and businesses are proving capable as well. Many investors no longer separate social and financial return when looking at how to best deploy their dollars. As many billions of dollars as foundations have in their endowments (estimated to be $850 billion), these pale in comparison to the trillions in mainstream capital markets (estimated to be $34 trillion).
Now more than ever, it is appropriate to bring a range of financial tools to create change and to think more expansively about how to support organizations beyond just providing monetary contributions.
Grants and contributions will always be part of the funding portfolio to support organizations working on important issues, but they can be one tool in a toolbox full of options to provide capital and support the work that makes a difference. Thinking more about stacking capital instead of a one-size-fits-all model can be more effective. Additional tools include Pay for Success/ Social Impact Bond Financing, Program-Related Investments, Mission-Related Investments, Impact Investing and Social Enterprise development. Each tool has different applications and strengths. With a variety of tools, we can think about the problem first and the tool second instead of approaching every challenge with only one funding solution. I will cover the first three tools in this installment. Tune in to the next installment for an explanation of Impact Investing and Social Enterprise.
Social investment tools
Pay for Success (PFS) or Social Impact Bonds (SIB)
These financial instruments use private capital for upfront investment in social programs where a governmental entity agrees to pay for specific measurable results after they are achieved. This money is the bridge financing or working capital that allows prevention programs to prove their worth in saving government funds by using outside money. Most government resources are used to provide intervention, such as incarceration or remedial education. PFS switches the model and focuses on prevention services, such as housing and job training or early childhood education, that provide both more effective and compassionate services to people as well as providing cost savings once they are delivered.
This tool was originally developed in the United Kingdom with the first deal closed in 2010. Since that time, there have been almost 50 closed deals using this model (payforsuccess.org/pay-success-deals-united-states). For PFS projects to work, a collaborative group of partners must come together, including: a governmental entity willing to purchase outcomes, investors willing to invest for a risk-adjusted return, an intermediary that raises capital and manages the project, program provider(s) that scale up programs and deliver outcomes, and an evaluator that can play the auditing role by measuring the projected outcomes. Projects in the US include a $10 million program in New York to reduce recidivism by delinquents on Rikers Island, a $7 million program in Salt Lake City to expand high quality preschools, and a $8 million program reaching the final stages in Denver to provide supportive housing and services for the chronically homeless.
Program-Related Investments (PRI)
Program-related investments are another tool that foundations can use to support organizations, both nonprofit and for-profit. These are investments made by a foundation in support of charitable purposes with the explicit understanding that those investments will earn below-market rate returns adjusted for risk and mission. These investments can be applied to the foundation’s minimum payout requirement and become recyclable capital, being redeployed once they are paid back. PRI were made possible as a result of the Tax Act of 1969, but have not been widely used. That is beginning to change. The IRS outlines a few conditions for these investments, and there are many ways to apply them. The PRI option can save organizations significant dollars in interest payments while offering access to capital that might otherwise not be available.
A foundation can offer a below-market rate mortgage to help an organization purchase a building and save on interest expense over the life of the loan. In Denver, the Alliance Center (sustainablecolorado.org) received a PRI from a donor-advised fund at The
Denver Foundation that will save the organization $4 million in interest over the life of the loan and the original capital of $7.5 million can be used again for another investment. In another scenario, a foundation can make a loan to a company that works with poor farmers to help them create a cooperative and market for their products that will eventually generate enough revenue to pay back the loan.
Another way to use philanthropic capital to advance community change is through Mission-Related Investing (MRI). This tool takes the endowment or long-term assets and aligns investments with the specific mission and social benefits of an organization. For example, if a foundation was funding in health prevention and education, the investment portfolio might contain companies focused on health food production instead of tobacco companies. The same might be true for an organization working to improve the environment. Investments could be focused on renewable energy and weatherization instead of fossil fuel production. Typical investment portfolios at foundations are much larger than their charitable distributions, so investing to support the work being done instead of contributing to the problem can address issues using two different avenues of capital, thereby increasing impact.
See Cindy Willard’s upcoming installment to discover more about Impact Investing and Social Enterprise.
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