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.