Yesterday, Erin, Michele, and I attended Investor2Invest: An Afternoon of Connecting to Impact organized by ImpactAssets, SV2 – Silicon Valley Social Venture Fund, and Toniic. While listening to the different panels, I considered my own thoughts about impact investing.
Impact investing used to be seen as investing for a blended social and financial return somewhere along a spectrum with social return on one end and financial return on the other. Foundations would invest more on the social return end and others would invest more on the financial return end. That may be partly true, but of course, it’s much more complicated.
A high social return may not be inconsistent with a high financial return. And it’s common to find investors who desire a high social return but without giving up on maximizing a financial return. While many investment firms and financial managers claim there is no need for a trade-off, they are generally focusing on a specific area of impact investments, which may soon be dominated by big investment banks and investment management companies. Whether the “social return” component becomes a simple add-on benefit and/or marketing ploy remains a major concern.
It’s critically important that the area of impact investments focused primarily on a high social return not be lost in the discussions.
Nonprofits – Investing and UPMIFA
The Uniform Prudent Management of Institutional Funds Act (UPMIFA) applies to entities organized and operated for exclusively for charitable purposes. It provides in pertinent part that in managing and investing an institutional fund (generally, a fund held for charitable purposes but not including program-related assets held primarily to accomplish a charitable purpose rather than for investment), the following factors, if relevant, must be considered:
(A) general economic conditions; (B) the possible effect of inflation or deflation; (C) the expected tax consequences, if any, of investment decisions or strategies; (D) the role that each investment or course of action plays within the overall investment portfolio of the fund; investments; preserve capital; and (E) the expected total return from income and the appreciation of (F) other resources of the institution; (G) the needs of the institution and the fund to make distributions and to preserve capital; and (H) an asset’s special relationship or special value, if any, to the charitable purposes of the institution.
Foundations that make program-related investments (PRIs) understand the idea of investing for mission-related impact without a significant purpose of the investment being the production of income or appreciation of property. This restriction, however, doesn’t mean that the foundation can’t achieve a substantial financial benefit from the PRI. In such deals, the foundation typically is willing to take a greater financial risk for the expected financial return than would a commercial investor. But PRIs remain a very small part of the foundation world’s strategy for advancing mission. The vast majority of foundations make grants to meet their annual qualifying distribution requirements (generally 5% of their investment assets) and do not make any PRIs.
Moreover, for most foundations that are not designed to spend-down their assets, grants (and PRIs) only make use of a small portion of their overall assets. Some of the panelists at the event specifically discussed what foundations should consider doing with the other 95%. Typically, foundations don’t consider mission-related impact when investing their endowment and other investment assets. And when they do, they may think about it only in terms of negative screens (e.g., no fossil fuel companies). State and federal prudent investment rules may be perceived as a barrier to giving mission more consideration in investment decisions, particularly if the financial returns may not be as competitive as those for more traditional investments.
In 2015, the IRS released Notice 2015-62, which provided that “under section 4944 of the Internal Revenue Code, private foundation managers may consider the relationship between a particular investment and the foundation’s charitable purpose when exercising ordinary business care and prudence in deciding whether to make the investment.” Section 4944 deals with jeopardizing investments (which specifically exclude PRIs) for which there are significant penalties. Notably, this conforms the standard under federal tax laws with the state prudent investment laws under UPMIFA which generally provide for the consideration of the charitable purposes of an organization or certain factors, including an asset’s special relationship or special value, if any, to the charitable purposes of the organization, in properly managing and investing the organization’s investment assets.
With greater recognition by, and education of, the foundation sector, Notice 2015-62 should increase mission-related investing by foundations and substantially increase the impact that they make with all of their assets and not just the 5% they are required to distribute each year.
Many charities, like foundations, also have significant investment assets to be prudently invested. Unlike private foundations, public charities are not subject to Section 4944 jeopardizing investment rules. But they may be subject to state prudent investment rules that do not all provide clear guidance on the applicability of mission in the making of investment decisions.
Under the California Nonprofit Public Benefit Corporation Law, the board, in making investment decisions and managing the corporation’s investments, must “[a]void speculation, looking instead to the permanent disposition of the funds, considering the probable income, as well as the probable safety of the corporation’s capital.” This law was modified in 2016 to confirm that compliance with UPMFA, to the extent applicable, would be deemed compliance with the foregoing provision under the Nonprofit Public Benefit Corporation Law. Accordingly, public charities formed as California nonprofit public benefit corporations presumably can factor in mission to make an investment decision that might otherwise have a lower return to risk profile than a pure financial investor might prudently accept.
Many tax experts believe that public charities may also make investments in for-profits that follow the private foundation PRI rules. Private foundations are generally subject to greater restrictions than public charities so this intuitively makes sense. There are also rulings that have supported the ability of a public charity to invest in a for-profit in order to further the charity’s charitable economic development mission rather than for profit or gain. See Impact Investing by Public Charities (Arnold & Porter).
Individuals and Others
As noted above, many investment banks and companies market impact investments to their clients as if they will not accept a lower than competitive financial return. And there are impact investment funds that outperform similar-sized traditional funds, evidencing that investors can get both a strong social and financial return. This should convince a much greater percentage of the investor community to understand and take advantage of this win-win option, and we’ve all been observing that trend. See Impact Investing Trends: Evidence of a Growing Industry (Global Impact Investing Network); Report On US Sustainable, Responsible And Impact Investing Trends 2016 (US SIF Foundation).
But there remains a need to create a greater market of individual investors who are willing to make a concession on the financial return for an opportunity at a particular social return. They might be willing to accept more risk than pure financial investors, in some cases, including by holding onto their investments for a longer period. The nonprofit community is familiar with this tradeoff, but it seems largely foreign or uninteresting to the big investment banks and companies that appear to be ready to dominate the space while missing the opportunity to influence and offer to the broader public investment products that focus on lower financial returns for the possibility of higher social returns addressing some of the vexing problems for which a pure market solution will not be sufficient.
On a more individual level, a panelist reminded us that an unexamined portfolio may be supporting causes completely contrary to the investor’s values. The vast majority of investors have no idea that they may be invested in companies whose values and directions are not aligned with their own, and simply educating and activating them on making demands of those companies or divesting such investments can result in powerful change.