Why should US Foundations consider PRIs and Equity PRIs?

Authored by:

John E. Tyler III; General Counsel, Secretary, and Chief Ethics Officer; Ewing Marion Kauffman Foundation

Robert A. Wexler; Principal; Adler & Colvin

Program Related Investments (PRIs) are a tool traditionally associated with private foundations. That is because U.S. federal law imposes specific compliance obligations to regulate private foundation activities. Those laws recognize PRIs as exceptions to some of those obligations. As such, those laws encourage private foundations to use PRIs. While compliance positioning suggests applications limited to private foundations, the use of PRIs is not and should not be so limited. Their use by others can unlock and address opportunities to align market engagement with pursuing and achieving charitable objectives while still preserving and even growing capital.

What are PRIs generally?

Under United States federal tax law, private foundations can presume that grants to organizations exempt from taxation under 501(c)(3), which we generically call “charities,” satisfy compliance obligations under law. That is why most foundations focus so much on grants to charities. Foundations can also make grants to non-charities, including for-profit companies, as long as the foundation exercises what’s called “expenditure responsibility.” Of course, in both instances, grants are money given with no expectation of its preservation, growth, or return – at least in any way that financially benefits the foundation.

PRIs are a tool that the United States Congress has made available to foundations to get money to others while allowing the foundation to have and impose expectations that money can be returned to the foundation and even grown with interest, dividends, and/or capital gains. The foundation can then redeploy those funds again for its charitable purposes.

Among the still too few PRIs that foundations make, most are in the form of loans; some are guarantees. Even fewer are equity investments. All three and derivations of them are allowed.  

From a regulatory compliance standpoint, the essential core of PRIs is two-fold. First, the PRI must significantly further the specific private foundation’s charitable purposes under 501(c)(3) and but for that connection, the foundation would not make the PRI. Thus, “charitability” of purpose must dominate for the foundation, although not necessarily for the entire venture or enterprise. The second purpose reinforces the first: no significant purpose for the foundation in making the PRI may be the production of income or appreciation of value. Thus, “owner”-like financial interests may not be significant; not only may they not predominate, they may not be significant, which helps preserve charitability as the priority.

That emphasis on charitability allows private foundations to count their PRI payments towards their annual mandatory payout minimum. That emphasis also justifies not considering such payments as taxable expenditures and excepting them from requirements about prudent investing and caps on levels of equity or profits interests held in for-profit enterprises. Rules regarding self-dealing and co-investing still apply, however.

The main point for purposes of this article is the emphasis on prioritizing charitability under 501(c)(3) along with potential for return of and growth on funds provided as PRIs. For practical guidance on how to implement PRIs, please see our related PRI overview.

Why should foundations make PRIs, especially using equity?

Often grants are ideal for private foundations to pursue their charitable objectives and fulfill their responsibilities. Investing through the endowment facilitates preserving and growing its financial assets and might have some usefulness for pursuing charitable purposes and/or broader concepts of social good. Sometimes, however, the right tool is neither grant nor pure investment because the incentives and opportunities inherent in those tools are not quite right.

Sometimes there are opportunities to focus attention and dollars on solutions and outcomes that align charitability with market participation. Examples might include proving concepts around clean energy, biomedical devices, health care diagnostics and treatments, environmental remediation, tools for education, access to capital by the underserved, or economic development of economically disadvantaged areas and populations, among others.

A foundation might use PRIs because there is potential for money to be returned to and redeployed by the foundation. And why shouldn’t the foundation occasionally be the one to determine how those funds are used – especially to again further its charitable purposes? Moreover, the foundation can participate in economic upsides, which incidentally also can help protect against impermissible private benefit.

A PRI can align incentives of the recipient with the foundation’s charitable purposes, at least to some degree. It can also adapt incentives within the recipient because, unlike grant dollars that are not returned and for which there is no expectation of return, there are different notions of responsibility and accountability. Depending on how the PRI is structured, these incentives might facilitate or inhibit risk taking and resource allocations by the recipient.

Loans, especially if secured in some way, might tend to inhibit responsible risk taking. Guarantees might facilitate responsible risk taking by the recipient while also more directly encouraging others’ commitments and enabling mutual leveraging.

Equity also might facilitate risk taking by the recipient because repercussions of failure can differ from loans. Given charitable pursuits and purposes, a private foundation might want those risks taken. Equity also can provide the foundation with a different type of oversight of management and ability to ensure accountability to its charitable objectives. As an equity holder, a foundation can have more of a voice in decisions about allocation of resources, including towards responsible risk taking and assessing progress towards charitable objectives. A foundation with equity has an opportunity to influence other owners, sometimes even as vocal support for management’s shared priorities. Such a foundation also has a seat at the table when subsequent capital injections into and outflows from the company are being evaluated, including especially their dilution or facilitation of charitable pursuits and results.

Of course, the foundation should ensure that it is knowledgeable, responsible, and careful to not unduly burden the entrepreneurs and managers it is supporting or to protect against inadvertently interfering with its charitable pursuits thereby cutting off its nose to spite its face!

So, why should others use PRIs, especially with equity?

The same considerations about using equity discussed in the preceding paragraphs about foundations apply to charitable and non-charitable investors as well.

Even though they do not have the same compliance obligations as private foundations, charities, endowments, and donor advised funds and their hosts, still must pursue charitable purposes and protect against impermissible private benefit. Using PRI approaches can facilitate both of those requirements. There is a certain discipline inherent in PRIs that these organizations can use to their advantage when appropriate, including channeling strategic thinking and direction while evaluating and forming relationships, setting frameworks for due diligence, negotiating expectations, and establishing parameters for reporting and accountability, among other things.

Of course, family offices, “impact” investors, and other non-charitable investors do not have the same legal responsibilities as private foundations and other 501(c)(3) organizations. But they nonetheless sometimes want to accomplish objectives that align with charitability. They sometimes realize that certain societal gaps and opportunities justify taking a different level of risk to address them. They sometimes want to align incentives (including economic) and direct/leverage resources towards those gaps and opportunities for which there may be financial upsides along with intended charitable results. The PRI’s emphasis on charitability can facilitate these objectives.

Additionally, Foundations can play a crucial catalytic role by structuring PRIs in for profit ventures as opposed to providing grants to charitable institutions. In for profit ventures, non-charitable investors who do not have the same legal responsibilities of foundations, may benefit from the catalytic role of the capital provided by foundations, whereas a grant to a charitable entity would not promote follow on investments by non-charitable investors.

Such non-charitable investors might adapt PRI mechanisms and mindsets to pursue social goods that, while not narrowly charitable, are not necessarily mostly profit-oriented either.

Why others benefit from at least a basic understanding of PRIs, especially equity?

One reason for others to understand PRIs is, as noted in the prior section, because the PRI mechanics and mindset can be adapted to other pursuits and purposes. Another reason is that hopefully more foundations will expand usage of PRIs as part of their toolkit for pursuing their charitable purposes. As that happens, especially if equity approaches are embraced, the likelihood is that other investors’ efforts will overlap with those of foundations – as each leverages the other. Because private foundation compliance with PRI requirements is not optional there is a third reason for others to better understand PRIs. Transactions that involve both foundations and others will become more efficient and less costly. Because no one really wants focus to be on the transactions themselves, understanding will permit quicker and better focus of attention and resources on their respective underlying objectives.

Is ‘Place-based’ investing a crisis response strategy for Impact Investors?

From the Covid-19 public health crisis to its subsequent economic downturn and rising protests against racial inequality in the US, the past few months have ignited impact investors to review their strategies both at the portfolio and deal levels. One particular conversation that Toniic and the Impact Terms teams have observed on the rise concerns “place-based investing”. We’ve been internally discussing the scope of what “place-based” means and struggled to hone-in on any fixed definition and strategy. In the spirit of the collaborative and curated approach of the Impact Terms Platform, we decided to extend an invitation to experts in our network to develop a better understanding of what “placed-based investing” means to them, what their place-based investment strategies include, and how they are empowering people disproportionately affected by the recent events, most notably ethnic or racial minorities.

This article is based on the most insightful inputs we gathered from our friends at five US-based organizations, including Blueprint Local, IFF, and Mission Driven Finance.

  • What does “place-based” investing mean?
    All 5 organizations define place-based investing as a focus on communities:

“Long-term investing consistently and systematically in communities with the goal of encouraging an inclusive economy” – David Robinson Jr., Blueprint Texas

“Investing with a geographic lens in addition to other impact goals, and building an interconnected portfolio of companies that reinforce each other and the power of community” – David Lynn, Mission Driven Finance

“Long-term commitment to a community; ensuring capital and development decisions are made at the invitation of and in service of community.Yi Wei, IFF

“Investing in local communities over time – investing with folks who know the community, are part of the community, and investments that help build wealth in local communities.” – Executive Director of a large US Foundation

  • What are the investment strategies they are deploying?
    Most focus on building wealth in local low-income communities.

Mission Driven Finance uses debt and debt-like structures in the sectors of education, health, jobs, and community development.

IFF helps non-profit organizations own their real estate, which in turn gives them more control over staying in place and stronger programmatic outcomes.

Blueprint Local/Blueprint Texas targets whole neighborhoods (as opposed to one-off deals) and focuses on undervalued assets and companies that have the potential to grow and reinvigorate neighborhoods.

  • Is there a focus on empowering people disproportionately affected by economic and racial disparities?
    Most responded that they are committed to continuing to provide capital to underserved communities and organizations unable to access affordable capital from traditional sources. One organization, which is currently adjusting its strategy, will be specifically targeting opportunities in Black communities.

We are interested in further developing this article and invite you to collaborate with us. Please share comments in the section below or reach out to our team to expand on this topic. 

Re-Thinking Corporate Governance in the context of COVID-19 and crisis bailouts

This article and all the articles tagged Tactics or Ideas are opinion articles and therefore only reflect the view of the author. 

Corporate governance is the framework of rules and practices by which a board of directors ensures accountability, fairness, and transparency in a company’s relationships with all stakeholders (financiers, customers, management, employees, government, and the community.  Corporate governance framework consists of (i) explicit and implicit contracts between the company and the stakeholders for distribution of responsibilities, rights, and rewards; (ii) procedures for reconciling conflicting interest of stakeholders in accordance with their duties, privileges, and roles; and (iii) procedures for proper supervision, control, and information-flows to serve as a system of checks and balances (business dictionary)

The COVID-19 context, a global and painful health and financial re-shift, presents an opportunity for implementing greater incentives towards broader stakeholder engagement. The restructuring of portfolio holdings presents such an opportunity – as financial restructurings take place, corporate governance restructurings are also possible and should be on the table.  Diversification of thought and perspectives makes for better risk mitigation and thereby better financial and non-financial results. The current context presents an opportunity to explore different corporate governance structures including, steward ownership structures.

The response to the 2008 financial crisis was mostly significant-sized bailouts and financial restructurings, and one could argue, not enough of non-financial restructurings.  When corporations emerged from the negative impact of the crisis they indulged/engaged in significant share buybacks. This crisis is showing us that such a strategy has delivered questionable value for stakeholders as we witness market volatility and lower share prices.  We can all agree that big shocks – climate, conflicts, pandemics, and financial, have become more frequent so there will not be as much time between this and our next crisis. The Great Depression was the last major global event before 9/11 caused a seismic dislocation. Since 9/11, however, we have been experiencing global-level shifts with greater frequency. 

Currently, more bailouts are underway, and it is likely that after the crisis is over and profits soar again, we will see more share buybacks.  Is it time for rethinking crisis restructurings away from just financial considerations? Are we well placed to push for consideration around governance frameworks that create the necessary “infrastructure” for informing how entities are run with all stakeholder interests accounted for? As the shocks that require restructurings and “bailouts” become more frequent, should operating frameworks be structured to include inputs from a diverse set of players?  Is it time to ask that any corporation that wants a share of restructuring and bailout funding be required to, over a period of time, transform its ownership/governance structure to one that enables more diverse opinions? In private markets investing, particularly in impact investing, are financial and governance restructurings a minimum response given investor focus on delivering financial and impact returns.

Is it time to implement more ownership structures like steward ownership, as mentioned above, to help protect more diverse stakeholders in normal and pandemic times? Steward-ownership refers to a set of legal structures that instill two core principles into the legal DNA of a business: self-governance and profits serve purpose. These structures ensure that control (voting rights) over the business is held by people inside the organization or very closely connected to its mission. Voting control in steward-ownership forms is not a saleable commodity. Profits in steward-ownership are understood as a tool for pursuing the company’s purpose. After paying back capital providers and sharing economic upside with stakeholders, the majority of profits are reinvested in the business. Steward-ownership forms include an asset-lock, which prevents the proceeds from a sale from being privatized.  This structure aligns decision making power with active stakeholders close to the business, instead of remote investors or shareholders. 

We pose these questions to invite expert thought pieces of examples of structures and case studies from different jurisdictions (see our style guide).

“From now on, it’s in the best interest of our management to put our social mission first, even if that means slowing down our growth. Everyone working in the company is incentivized, first and foremost, to make decisions that benefit not just the owners of the company, but all other stakeholders, the environment, and society at large. After this change, we can finally—confidently— say that our company will always be a force for good in society.”: Juho Makkonen, Sharetribe Co-Founder and CEO 

Covid 19 is a lesson in why alternative investment structures are needed

This article and all the articles tagged Tactics or Ideas are opinion articles and therefore only reflect the view of the author. 

Covid-19 is teaching us many lessons that take the form of “that thing we used to do, or that idea we used to feel safe thinking, turned out to not be that good an idea after all.”  Covid 19 is teaching us the value of resilience and flexibility.   

Companies that need cash and wish to borrow to survive the crisis have no idea when their cash flows will once again become predictable.  Companies that thought they had predictable cash flows and have borrowed against those predictions are now stuck with fixed payments they can’t meet.  

The core problem with traditional debt for social enterprises is agreeing to fixed payments against variable revenue streams, negotiated early in a company’s life when revenue is most unpredictable.  Many enterprises in the countries where Covid-19 lockdown measures have been implemented are going to fail. It’s not true that “no one saw this coming.” Covid-19 specifically, yes; but unpredicted swings in revenue early in the life of a company?  Both foreseeable and foreseen.  

There is an alternative, but it’s been practiced only at the fringes.  This global crisis presents the opportunity to reconsider how we structure early stage investments.  For the many companies in trouble, Revenue-Based Finance (RBF) approaches are among the most promising ways to restructure debt to assure repayment in the long run.  Little has changed about the long-term prospects of most of these companies; yet many have total uncertainty about near-term revenues. A return to revenue growth is likely, but the timing is completely unknowable.  This type of situation is a perfect recipe for the use of RBF.

For new financings, the benefits of RBF have never been clearer.  If a crisis can quickly slow the economy once, it will happen again — why not design our financing structures for flexibility and resilience?  Revenue-Based Financings are investment structures that link the returns to the investor with a company’s revenue. This type of structure is in the interest of both the social enterprise and their investors.  There are many ways to structure RBF and you can learn more about structuring options at impactterms.org  

Because the payments due to investors from RBF structures vary with company performance, they are designed to handle exactly the kind of stress and uncertainty we are seeing in this crisis (and others like it in the future). A company that borrowed using an RBF structure, instead of traditional debt would not be forced to make payments that they can’t afford but if they miss put them in default. Its action also saves the investors in the company. Yes, the investors’ returns will likely decline as payments get pushed to the future, but that’s a much better problem than losing their whole investment.

One investor using RBF both for restructuring and new investing is Capacity Capital, a new fund investing financial and social capital into small revenue-generating growth businesses, especially the overlooked and underestimated.  For example Capacity Capital recently made an investment in RentSons, a company that helps people link up with “helping hands”. Rent Sons had a mix of existing debt obligations that, as is common in debt structures, did not offer the company the flexibility they needed to manage downturns in the business cycle.  They now have the flexibility they need thanks to Capacity Capital restructuring those old debts and providing new financing in a combined RBF financing.  

Through a new RBF investment they are providing RentSons additional growth capital and restructuring their old debn

For investors and companies that have used traditional debt and are facing likely default, this is a great time to consider restructuring the debt using an RBF structure.  When the timing of cash flows is uncertain but the company’s prospects are still strong, the traditional option is equity. However, the investor has to believe they will one day be able to sell that equity.  By restructuring into an RBF structure, the company can have the flexibility they need to recover, and the investor can have a realistic path to recovery and profit.  

It will take some time before we have enough perspective to look back and draw final conclusions from this experience, but one clear lesson we can learn today is the value of flexibility and we can put that lesson to work today by using Revenue-Based Financing and the other alternative investment structures featured on ImpactTerms.org