How to Use Donor-Advised Funds to Make Impact Investments

(Illustration by leremy/iStock)

The UN Sustainable Development Goals—those 17 audacious targets for tackling the world’s thorniest problems like inequality, climate change, and poverty—face an equally audacious financing gap: $2.5 trillion annually.

Unlocking capital of this magnitude, according to World Bank President Jim Yong Kim, requires matching viable social innovations and projects with millions in risk capital, billions in development assistance, and trillions in national and global public and private investment.  Unfortunately, some of the most promising market-based solutions that address the SDGs—for-profit companies, products, and projects—die on the vine before they have the chance to trigger this capital domino effect, due to a lack of properly-aligned sources of risk capital.

At the same time, donor-advised funds (DAFs)—a philanthropic vehicle managed by a wide variety of public charity sponsors that allows donors to retain advisory rights—have skyrocketed in popularity and currently hold over $85 billion in charitable assets waiting to be deployed. Savvy philanthropists have begun using DAFs to make not only traditional grants with no expectation of financial return and traditional investments with no expectation of social impact, but also impact investments that hold dual promise of advancing the charitable mission and providing financial return. Data on DAF granting and investing patterns is difficult to track, but based on our work in the field, research, and interviews with other experts, we understand that the number of donors who recommend impact investments—and the sponsors who facilitate such investments using DAFs—are few and far between. We believe there’s a vast missed opportunity to use DAFs for making impact investments in support of market-based solutions to the UN Sustainable Development Goals—across a wide variety of charitable purposes.

To describe this under-used mechanism available to donors, we draw from our own experiences in corporate venture investing at the Autodesk Foundation and facilitating investments as a philanthropic investment intermediary at PRIME Coalition, as well as from the experiences of our peers and partners in the field. While we focus specifically on the nuances of supporting early-stage innovation, we believe similar principles and suggested actions could be applied across asset classes, pending thoughtful action by donors and their sponsors alike.

Beyond providing the potential for financial return to the DAF, investment in early-stage innovation can align long-term interests of the entrepreneur and donor toward impact, help signal that the investee is or could be a viable and attractive investment, and unlock public or private investment from other sources. Through assertive partnership with their fund sponsors, we hope donors begin to thoughtfully mobilize the latent $85 billion in DAFs toward commercially viable companies and projects, which in turn will deploy products and services toward social and environmental impact at greater scale and speed than the nonprofit sector would otherwise.

Here are five things you can do starting today:

1. Understand Donor-Advised Funds

Donor-advised funds are a unique philanthropic tool that allow donors to establish and fund a charitable account with a sponsoring organization that will be used later to support charitable activities. Donors receive an immediate tax deduction and maintain advisory privileges over both the fund’s investments and ultimate distribution for charitable purposes. In return, the sponsor gains control and authority over management of the funds.

(Image courtesy of the authors)

There are over 1,000 DAF sponsoring organizations in the US, and they fall loosely into three categories—national charities that are often affiliated with financial institutions, community foundations, and issue-specific charities. Few sponsoring organizations focus on facilitating impact investments; Most only offer impact investing options opportunistically, and in response to assertive demands from their DAF clients.

The mutual involvement in making and executing recommended actions among the donor and sponsor requires that both parties understand the legal rules, definitions, mechanics, and considerations associated with investing DAFs for impact.

2. Know the Law

The legal interpretation of impact investing with DAFs can be confusing, even to those most in-the-know. This is due in large part to the market’s nascent nature, which leads to a lack of precedence-forming transactions, as well as the absence of clear guidance from the Internal Revenue Service. While private foundations and public charities are guided by less ambiguous legal rules and definitions, DAFs occupy space between the two. For example, DAFs lack a minimum distribution requirement, leading critics to call them simply a mechanism for “warehousing wealth.” Conversely, donor-advised funds must carry out expenditure responsibility, an activity specifically linked to grantmaking and program-related investments for private foundations that requires ensuring funds are spent for charitable purposes.

Regardless, in direct response to a rising demand from their donor clients, forward-looking sponsoring organizations are facilitating impact investments by applying three principles: establishing impact investing policies at the firm-level, reacting to donor requests, and applying similar rules to DAF investments as those followed by private foundations.

3. Understand the Investment Types

Taxonomy matters, and unfortunately impact investing as a field continues to be plagued by confusing language. On a daily basis we hear words including: prudent vs. charitable, investment vs. distribution, mission-related vs. program-related, financial-first vs. impact-first, and market-rate vs. concessionary. Often the terms aren’t mutually exclusive, and they take on different meanings in business practice and in regulatory code.

 

For the purposes discussed here, we use a simpler set of definitions. While these terms aren’t widely used in practice, they delineate the types of investments you can make with a DAF:

• Prudent, non-impact investment: Investment bound by the state prudent investor laws, without consideration of impact.
• Prudent impact investment: Investment bound by the state prudent investor laws, intended to generate impact.
• Charitable impact investment: Investment that meets IRS charitability requirements, intended to generate impact.
• Charitable non-investment: Gift or grant distributions (charitable grants) intended to generate impact but not financial return.

By nature of the donor-sponsor relationship described above, it is up to the DAF sponsor to determine in which bucket a recommendation falls on a case by case basis. This determination stems from a number of factors, including expectations of financial return, direct or indirect impact, liquidity, risk, and whether the underlying company or project might have a difficult time raising money from non-philanthropic sources.

The vast majority of donors using DAFs today issue one-time, non-recoverable grants to nonprofits. These charitable non-investments accounted for nearly $16 billion in 2016, according to the National Philanthropic Trust. While charitable non-investment (grant) capital supports critically important local and national charities, we believe that in specific cause areas that are well suited for market interventions, for-profit companies, projects and products could make larger social gains and also hold promise for additional commercial investment. Also in 2016, the $85 billion in DAF assets that did not head out the door as grants often became passively invested in prudent, non-impact investments consisting of money market accounts or investment products lacking any impact orientation. While this capital (in theory) went to create financial returns that ultimately support greater charitable activity, by not investing in impact, it did not go as far as it could.

Savvy individual, family, and corporate donors are making impact investments using their DAF assets with an expectation of both social or environmental impact and financial return. These investments could take the form of both prudent impact investments and charitable impact investments, depending on the donor’s preferences and their sponsor’s policies related to prudent investments and its ability to process qualified charitable investments. This delineation might vary slightly by sponsoring organization and often occurs on a deal by deal basis.

Charitable impact investments prioritize impact return over financial return, and primarily take the form of recoverable grants, concessionary loans, or high-risk equity. Very few sponsors conduct these transactions, and rarely without issue-area-expert intermediaries guiding the way and/or serving as the public charity recipient. For example, in the area of early-stage innovation that could mitigate climate change, PRIME receives grants, recoverable grants, or loans from DAFs as a public charity recipient and re-distributes that capital to qualified, charitable, for-profit programs. Sponsors look to variations of program-related investment definitions as a guiding principle to determine whether the investment’s primary purpose is charitable, whether the investment significantly furthers the sponsor’s charitable purpose, and whether the investment wouldn’t be made but for this charitable mission. Those investments that aim to achieve impact but do not pass the sponsor’s charitability threshold may be, by default, subjected to state prudent investor laws.

Charitable impact investments are a nascent form of grantmaking for DAFs, and there are a number of pitfalls savvy donors should avoid. We’ve included a shortlist of questions donors might consider asking themselves to avoid crowding out traditional investment, supporting commercially unviable ventures (rather than promising organizations lacking risk capital), or cannibalizing critical grant support:

• Why is a charitable investment intervention optimal instead of or in addition to a grant?
• What is the specific capital gap being addressed? Do I believe that no one else—governments, development banks, traditional investors—can fill this gap?
• Are the reasons this investment wouldn’t be done otherwise surmountable with an injection of charitable investment?
• Are there already incubators, accelerators, or other players that push potential investments or do we need a new pull mechanism, like a prize, application, or competition?
• What are the appropriate social outcome targets to use as a screen for selecting among many investment options?
• Why will charitable investment spur additional investment from the market-rate/fiduciary/institutional/commercial investment community? Is my charitable investment a “bridge to nowhere?”
• How can I continue to support the business in a success scenario, after it graduates from being qualified as charitable?
• How can I help my DAF sponsor get comfortable with the charitability of the transaction? Are there public charity intermediaries with whom I can partner?

Prudent impact investments are governed by state prudent investor laws, and as such must prioritize financial return over impact. Common prudent impact investments include public Environmental, Social, and Governance (ESG) stocks, funds, and pools; and fixed-income products like green bonds. Sponsors who offer impact investing opportunities tend to provide prudent options, typically in the form of a handful of ESG funds and pools that are either created by the sponsor or the market. The state prudent investor laws include exceptions that some sponsors are applying to impact investing—such as donor intent and program-related assets—but in general, prudent impact investments must be made “in good faith” and have a risk-return portfolio that meets both the state standards and the sponsor’s investment policy.

Financial gains from both prudent impact investments and charitable impact investments return capital the same way as a prudent, non-impact investment: directly to the donor’s individual donor-advised fund or pooled account to be re-invested or distributed to other social enterprises and nonprofits.

4. Next Steps in Your DAF Journey

Selecting a Sponsor

Impact investing options differ widely among sponsors, so selecting the right sponsor can make all the difference on your impact investing experience. Before setting up your donor-advised fund account, we recommend exploring the services and policies of each sponsor you’re considering.

A few features and questions to pay attention to:

• Donor ability to advise impact investments. Does the sponsoring organization allow its donors to bring forward impact investing opportunities?
• Availability and quantity of impact investing options. Does the sponsoring organization provide pre-vetted impact investing options to its donors? Do these options align with your short-term and long-term charitable goals?
• Extensiveness of impact investing options across asset classes. What does the sponsor offer today and what can you expect to see in the future?
• Ability to recommend additional managers. Does the sponsoring organization allow you to recommend additional fund managers? Is there a minimum fund size, and if so, how significant is it?

Choosing Investments With Your Sponsor

Often donors aren’t aware of the available impact investing options, either because those investments are limited in scope or not advertised by the sponsor. Successfully building impact investing into your DAF portfolio requires a collaborative relationship between donors and sponsors, which donors should expect and demand.

A few actions to take:

• Ask your sponsor to see what options are available for prudent impact investments and charitable impact investments. Does your sponsor allow you to bring forward investment recommendations or does it only provide pre-vetted options? How does your sponsor determine charitability?
• Discuss fee structures. What management costs does your sponsor require to administer impact investments?
• Connect with other donors at the sponsoring organization who are thinking about or already investing in impact. What challenges and opportunities are your peers seeing when it comes to impact investing?
• Start simple by recommending a recoverable grant to a nonprofit intermediary that already supports market-based solutions. Does this financing arrangement meet both your charitable goals and the risk tolerance of your sponsoring organization?
• Consider changing sponsors if your sponsoring organization is not assertively offering you the options and services you seek. What other sponsoring organizations may be better aligned to fully support your charitable goals?

Supporting the Field

If you’re in the advantageous position of having familiarity with both DAFs and impact investing options, you can help build out the field of philanthropic investing so that others not only follow your lead but avoid the pitfalls we outlined above.

Important actions to take:

• Build an investment philosophy and portfolio-level guidance on when you make impact investments vs. charitable grants. Further define and share your investment evaluation criteria and decision-making processes.
• Bring impact investing opportunities to your sponsor to facilitate on your behalf. Donor initiative plays a critical role in encouraging sponsors to expand their impact investing options.
• Create an impact investing alliance with other donors at your sponsoring organization. Is it possible to, as a consortium, test and offer new impact investing opportunities to other donors within the community? What challenges and opportunities are your peers seeing when it comes to impact investing?

5. The Right Steps Forward

There are a number of places to look for best practices:

• Start a dialogue with other donors active in impact investing. Join a membership group like Mission Investors Exchange, Confluence Philanthropy, the Global Impact Investing Network, The ImPact, or others dedicated to bringing impact investors together by sector, investor type, and geography. Speak to other DAF clients using impact investing to further their charitable mission.
• Reach out to impact investment intermediaries. Read about the work of organizations like PRIME Coalition, Social Finance, Root Capital, or others that have facilitated many charitable impact investments, and reach out to these groups directly.
• Learn about philanthropists who have been implementing impact investing practices for years without DAFs. Learn about best practices among foundations and other donors that have been making impact investments for decades.

We feel both privileged and impatient as practitioners in this nascent market. Our industry is ripe for growth and change. Fortunately, donors have the power to make this change happen by following the steps outlined in this guide. Unfortunately, many of the SDGs require immediate action, and the world is spinning toward irreversible climate change, conflict over dwindling natural resources, humanitarian crises, and growing inequalities. We hope those with the financial resources, especially those with DAFs, will take action.

Read more stories by Ryan Macpherson, Emma Kulow & Sarah Kearney.