Helping smallholder farmers in Ghana get the best price for their crop. Encouraging sustainability-minded fish suppliers to create new products for the market. Collaborating with world-class biotech companies to develop vaccines for the developing world.
While these are efforts that take place in the for-profit world, they are some of the strategies that foundations are beginning to embrace to pursue their charitable missions. It may seem counterintuitive. But these activities make use of a little-known and poorly understood tool that is only available to foundations.
These so-called program-related investments, or PRIs, unlike the rest of the terminology floating around the impact investing world, are legally defined—and do not apply to all social investments. Their main purpose must be charitable, and they can count toward a foundation’s charitable mission—as long as they are aligned with a particular foundation’s specific mission.
Here’s the kicker: When foundations make investments that count toward their charitable mission, the principal that is returned must be recycled as yet another PRI, or grant. In this way, foundations can compound their do-good impact.
“I’m super excited about the tool,” says Julie Sunderland, director of program-related investments at the Gates Foundation, which increased its PRI budget from $400 million to $1 billion. “I think [PRIs] are really powerful. I like the focus on programmatic goals and programmatic intent. Holding ourselves to those standards provides a real powerful screen for us in terms of identifying investments that we think can really make a difference.
“You can do some real creative things,” she adds.
Even though they are investments, PRIs are not limited to the for-profit world; indeed, until recently, most have involved low-interest loans to nonprofits and real estate projects like affordable housing, charter schools and community health centers. They’ve been used to leverage commercial capital in multimillion-dollar community development projects. And together with grants, they were used to build an entire $30 billion industry of community development finance institutions, or CDFIs—the mostly loan funds that serve minority and low-income people.
This is the second in a two-part series about PRIs. In the first article (“The Untapped Power of PRIs” in the November/December 2012 issue of Private Wealth) we traced the evolution of PRIs as a form of social venture capital, focusing on their use in the for-profit world. A key emphasis was the extraordinary leverage they can provide in attracting commercial market-rate capital to address social problems.
In this article, we address the issues raised by using PRIs in the commercial world and show how they are being used to tweak and transform for-profit companies and even entire sectors.
Seeking The Third Way
In 2010, the Gates Foundation made a $10 million investment in Liquidia Technologies, a Research Triangle Park, N.C.-based nanotechnology company. As a PRI, it could count toward the foundation’s required charitable distribution. But this was an investment in a for-profit company—one that had already garnered $50 million in commercial venture capital.
It set off a firestorm. If foundations spend their charitable dollars on profit-maximizing ventures, some worried, what might happen to the nonprofit sector—and, more importantly, the charitable roots that define philanthropy? Others complained that rather than making the investment as a PRI, Gates should have done it as a “mission-related investment,” or MRI, using its “corpus” (or endowment) dollars. The idea, which is gaining currency, is that foundations get a tax break to serve the public good, so they should invest at least part (if not all) of the other 95% of their assets in alignment with their mission.
But there is a reason that markets work one way and grant-making works another way. “The goal,” one lawyer explains, “is to craft something that straddles the line between the two to be more effective.”
Indeed, PRIs have always been about finding a third way. “It’s interesting for us to see how we can take models that work in the private sector and tweak them to support our program initiatives,” says Christine Looney, senior investment program officer at the Ford Foundation. Many of Ford’s PRI funds are channeled through nonprofits to for-profit enterprises like small businesses, and most support its asset-building work (affordable housing, employment opportunities, livelihood and financial services), where there is potential for scale.
PRIs are not appropriate for all possible foundation program goals. “It has to be where the need exists to scale, and more investment-oriented solutions lend themselves to that,” says Raul Pomares, senior managing director at Sonen Capital LLC, a San Francisco-based investment firm specializing in impact investing. “I’d hate to see a foundation come up with a PRI for driving [public] policy.”
His associate, Justina Lai, who recently left the Rockefeller Foundation, where she worked on PRIs, adds that foundations are not set up to make either PRIs or grants. “Foundations are set up to solve problems,” she says. “The question is what problem you are trying to solve and what tool within the foundation toolbox is the best to solve that problem.”
One of the Gates Foundation’s primary concerns is global health, and a problem it’s trying to address is the lack of access in the developing world to life-saving vaccines. At a Bottom Billion conference at Seattle Pacific University two years ago, Sunderland said that Liquidia’s technology could cut the cost of individual vaccines from $5 or $10 to $1.50.
It’s important to understand that the investment would not have the same social impact as an MRI. Foundations are not only required to maximize investment returns, they are also prohibited from taking risks that jeopardize the value of their endowments and thus their grant-making ability. Although riskier investments are permitted as long as they are made with care and are within the purview of a broadly diversified portfolio, these are fundamentally investments that must meet fiduciary obligations. This means that even if environmental or social issues are factored into their analysis, the rationale for incorporating them must be about their impact on profit—not charity. PRIs, in contrast, unlike the rest of impact investing, must be rooted in charity.
Odd Bedfellows
The challenge for equity PRIs is an IRS requirement that the foundation has a so-called “mission collar” on the company, backed by an opinion letter assuring there is no “mission drift” from the foundation’s charitable purpose. For this reason, a foundation must maintain the possibility of an exit—not because the investment may go bad, but because its charitable component has become far diminished. If this happens, PRI investors negotiate put options (buyout agreements) up front with a co-investor—something that Sunderland confirms that Gates has done. Looney says the requirement has forced Ford to turn down deals it’s interested in because it could not find an exit.
It’s not easy.
“Imagine you are a straight commercial investor,” Omidyar Network’s general counsel Will Fitzpatrick explains, “and you see a deal that is really appealing to you, but there’s a foundation in there that wants to come in with PRI dollars. Even though reputationally that might be attractive, you think, ‘What do you mean there’s a charitable default clause that says if the company changes its model too much, you can just pull your money out anytime? That’s not equity investing. They just don’t get it.’ And then from the other side, of course, the foundations get incredibly uncomfortable. You’re raising capital, but oh my God: You’re getting Kleiner Perkins money! They’re going to force profit maximization and it’s going to be a total disaster from the mission side, and we’re going to get embarrassed. No, no, no—we don’t invest with people like that.”
There are different ways for a foundation to monitor that risk, ranging from taking a governance role on one end to writing specific social covenants indicating, for example, that 25% of the farmers that a bank makes a loan to must make under $2 per day. “I like to negotiate our opinion letters that are somewhere between the two,” Omidyar’s Fitzpatrick says. “Not so much detail that a company has to consider its PRI investment every time it makes a business decision, but also with some parameters drawn out.”
The Ford Foundation, which writes specific social covenants into all of its PRIs, takes the opposite point of view. “Many would say that if you’re making a $100 loan, you know you’re supporting somebody who is poor,” Looney says. “But not all microfinance recipients are poor. We want to actually know the person’s poor because that’s who we want to work with.”
In practice, this means companies can find themselves rewriting their mission statements so that they align with the foundation’s charitable purpose. At the board level, one investee says, this has the potential for setting the PRI investor apart from the rest of the company’s investors and can create board difficulties and management problems.
“Here is not only an investor with a different perspective,” he says, “but one that actually has a legal contract that a company be run in alignment with its principles. Even if everybody put in the same amount of money, normally all these investors would have to argue and persuade and reach consensus. But in practice, the PRI investor has a much more prescriptive investment agreement.”
According to the Gates Foundation’s Sunderland, the trick is to understand what a company or fund is trying to achieve and what the foundation is trying to achieve, and making sure those aspirations line up. “If you are investing alongside a venture capitalist,” she says, “you have to be real careful in terms of that partnership to make sure the incentive does not undermine the potential for financial return.”
The foundation managed to accomplish this by making its investment contract very specific. It allows Gates to obtain “global access rights,” which will allow it to partner with another company to distribute low-cost vaccines in the developing world.
In the meantime, there’s a good chance that Gates does not interfere in the rest of the company’s operations.
PRIs That Strive For Change
What does a venture capital fund designed to enhance ocean conservation through sustainable fisheries have in common with a permit bank in Cape Cod that buys and rents fishing quotas to local small-scale fishermen and a “school in a box” that charges $5 per month for a world-class primary school education in the slums of Nairobi?
Each one is designed to promote positive changes in entire industries. And all three received catalytic financing in the form of PRIs from foundations.
I n March 2005, the Packard Foundation and California Environmental Associates launched the Sea Change Investment Fund, based in San Francisco with the goal of helping companies that sell only fish caught through sustainable methods. “We found that while there were fishermen who would go out and fish sustainably, the distributors would drop it all in with what a [trawler] caught, decimating the seas,” Cliff Riffle, Packard’s program operations manager, said in a profile of the fund published at the Packard Web site at the time. “We decided we needed to work with new distributors.”
Packard’s PRI in the form of a low-interest, $10 million loan provided seed funding, attracting an additional $10 million in private equity to the double bottom line fund. Although the fund’s initial intention was to focus on distributors, it found it did not have enough capital. It switched gears, choosing to make an impact in the market by supporting small and growing companies offering branded products based on sustainably caught seafood. Among its investments: Wild Planet Seafoods in McKinleyville, Calif., which sells canned tuna, shrimp and sardines; Look’s Gourmet Food Co. in Bar Harbor, Maine, which sells seafood chowders, bisques and sauces; and Ecofish Inc. in Dover, N.H., whose salmon, cod, shrimp and tuna products are sold under the Henry & Lisa’s Natural Seafood brand.
To make sure the companies’ products were actually based on sustainably caught seafood, the fund created a nine-member conservation committee that included, among others, a Stanford University professor; a program officer from Packard; and representatives from the Environmental Defense Fund, the Ocean Conservancy and Ecotrust, a Portland, Ore.-based nonprofit specializing in sustainability. All deals went through this conservation committee first, and it had the right to refuse further consideration by the fund’s investment committee.
Then, at the due diligence stage, the staff and conservation committee created binding conservation terms regarding each company’s sourcing practices. These became the fund’s covenants associated with each investment.
“[Sourcing] is what each company’s supply chain is built on,” says Monica Jain of Manta Consulting, who is currently running the Fish 2.0 contest linking impact investors to seafood businesses, explaining why the environmental covenants will probably outlast the fund’s ownership. “It is durable in that sense.”
Whereas the investment fund is about creating change by supporting companies that can make a major presence in the consumer market, the Cape Cod Fisheries Trust (CCFT) is a model for ensuring that some of that supply comes from small-scale fishermen. Because of its success, it is now beginning to be replicated in other communities in the U.S.
The CCFT was founded in 2005 to help small-scale fishermen on Cape Cod prepare for a change in fisheries management that threatened their livelihood. In order to ensure sustainable fisheries, the plan was to implement a system called “catch shares,” where federal fishing quota permits would be bought by CCFT and then leased to small fishing operators.
Larger companies and bigger well-capitalized fishermen typically outbid small-scale fishermen for these permits, which can cost well over $200,000.
To implement the catch-shares program, a fund was capitalized with two PRIs and other financing to enable CCFT to buy quota from retiring fishermen and rent them to the younger generation. The key PRI, a low-interest loan from the Ford Foundation, consists of interest-only payments and a balloon at the end. It also includes a social covenant that spells out the eligibility criteria for fishermen to whom CCFT loans the quotas. Among other things, fishermen must be owner/operators, live on Cape Cod, and provide fair wages and profit shares to their crew.
This is one of the first programs like this in the country, and CCFT director Paul Parker says he has seen the concept replicated and expanded. “There are state and federal revolving loan funds where people have taken our business model or adapted it,” he says.
Although its strategy is to back the right social entrepreneurs, the Omidyar Network’s goal is to maximize social impact by innovating in entire sectors. That can mean investing in companies at low returns that create infrastructure for a particular sector’s ecosystem. And it can also mean investing in a social business whose founders’ vision is mind-numbingly bold.
In 2009, it used a PRI to lead the first round of financing for Bridge International Academies, a Nairobi, Kenya-based chain of nursery and primary schools. Co-founders Jay Kimmelman, Shannon May and Phil Frei (all Americans) set out with the incredible goal of educating 10 million children in the developing world.
“[Potential investors] thought they were crazy,” says Marie Leznicki, vice president of marketing and brand strategy at Bridge. “And it wasn’t just that they wanted to educate 10 million children. It was the scale and the speed.”
Bridge opened its first academy in 2009. In January, it opened 50 new schools and enrolled 30,000 new students. It has 134 academies, almost 55,000 students and just over 2,000 academy staff. It expects to open 100 new schools this year.
Leznicki says they went into the project approaching educational administration in the same way McDonald’s approaches hamburgers. “Everything we do is with the intention of scaling,” Leznicki says. “Everything is done with technology and it’s all linked together.”
For example, school lessons are scripted and delivered to teachers on Nooks. The company is cashless, and all payments are mobile. Academy managers use smart phones to admit and enroll students, message with parents, and manage the academy.
“This frees up academy managers to do the stuff that is more important,” Leznicki says, “like spend time with community leaders and parents.”
Less than a year after Omidyar’s equity PRI, the company was so successful that it was able to raise funds from commercial investors. This second round was led by Learn Capital (in which Pearson LLC is a limited partner), a venture capital fund specializing in education. And in March 2012, it raised funds again—this time from investors including Khosla Ventures and NEA, the oldest and largest venture capital firm in the world.
A former investment banker, Ellie Winninghoff is a writer and consultant specializing in impact investing. Her work is linked at dogoodcapitalist.com. She can be contacted at ellie.winninghoff@gmail.com.
