Impact Investing: Time to Unleash PRIs

Impact investing has scored a lot of attention from the political establishment in recent weeks. On January 21, the White House hosted its third Pay for Success summit in Salt Lake City, Utah. Days later, New York Times columnist David Brooks lauded impact investing as the “most promising form” of social capitalism there is today and implored a variety of actors—high-net-worth individuals, investors, financial advisors—to get involved. Meanwhile, Congress continues to deliberate over the bipartisan Social Impact Bond Act, a $300 billion fund to support social ventures at the state level.

The one glaring omission in this recent activity, however, is the group with the capacity to tap into a pool of capital worth (literally) hundreds of billions of dollars: philanthropic foundations.

Foundations are known by most for their ability to heap large gifts (typically grants) on those who seek to improve society. But, regrettably, few outside the social innovation community know that foundations can also act as investors. The 1969 Tax Reform Act created a tool called program-related investments (PRIs), which allows foundations to give working capital to organizations in the form of loans, loan guarantees, or equity investments.

The criteria for qualifying as a PRI are simple. The recipient’s activities must “significantly advance the foundation’s charitable purpose.” In addition, according to the Act, monetary gain cannot be the prime motivator behind the investment, and the recipient cannot use the funds to engage in activities meant to influence legislation or elections.

The Ford Foundation was an early adopter of PRIs, and currently holds nearly $200 million in such investments. A handful of other major foundations—Gates, Packard, MacArthur, Skoll—have followed suit. However, as frustrated social entrepreneurs can attest, less than 1 percent of all foundations invest using PRIs. According to the most recent survey by the Foundation Center, the nation’s 10 wealthiest foundations hold more than $110 billion in assets, and the top 100 foundations hold an astounding $267 billion. This means that an extraordinary amount of capital is sitting stagnant in foundation coffers rather than investing in high-impact social ventures.

PRIs offer foundations a multitude of benefits. They go toward the 5 percent distribution requirement, and they avoid both the excess business holdings tax and the “jeopardizing investment” regulations. Most importantly, unlike a grant, PRIs generate a real financial return and help foundations diversify their holdings. This begs the obvious question: Why are so few doing it?

The answer lies in the current regulatory regime governing PRIs, which most foundations view as too costly and too risky. Obtaining a private letter ruling by the IRS is an expensive and time-consuming process. The current fee to apply for a ruling is $19,000, and attorney costs typically cause that number to balloon to double that amount and more. Rulings can also take several months (and sometimes closer to a year) to process. Further, most foundations do not have the financial and legal expertise on staff to shepherd the application. Rather than expose their tax-exempt status to such an uncertain process, most foundations simply choose to stay away.

Some mission-driven ventures have figured out a way to navigate these choppy waters. For instance, Riders for Health, an international social enterprise that works to provide reliable transportation for healthcare workers in Africa, offers a useful case study in how organizations can raise a PRI. It is also a cautionary tale in how challenging the process is.

The IRS has attempted to solve one of these obstacles by providing a series of examples of approved charitable activities that qualify for PRI investments. While this is a step in the right direction, it is not enough.

Last month, the Milstein Commission on Entrepreneurship and Middle-Class Jobs, a bipartisan task force of thought leaders from the public and private sectors, called on Washington to change these rules to free foundations to utilize PRIs. Organized by UVA’s Miller Center, the commission, co-chaired by Steve Case and Carly Fiorina, recommended that the IRS make official rulings on whether or not proposed investments fall within a foundation’s charitable purpose within 60 days of submission. The proposed change would also put the burden of seeking the IRS ruling on the nonprofits rather than the foundations.

The benefit to government is obvious: PRIs will bring needed working capital to companies that investors see as too risky for early-stage investment, but that may eventually attract substantial dollars from commercial lenders and venture capitalists. For instance, former MacArthur Foundation President Jonathan Fanton estimated that every dollar allocated to PRIs in MacArthur’s housing preservation program generated $70 in public and private investment. Expanding PRIs will also increase the pool of capital available to fund social impact bonds and other projects geared toward various social services—services the government is largely funding itself today.

As Capitol Hill braces for another budget battle, you can expect to hear both sides bloviate about their plans to expand economic growth and create middle-class jobs. Fortunately, a multitude of solutions exist outside the theater of Washington brinksmanship. If policymakers want to move beyond the rhetoric, PRIs are a good place to start.

Read more stories by Jeff Chidester.