Predictions that social impact investing will become the new venture capital got a big boost from a pair of federal regulatory changes this year. One affects foundation investment decisions, and the other affects decisions by pension funds governed by the Employee Retirement Income Security Act (ERISA). Both changes make it easier to target impact investments—those that generate social or environmental impacts alongside financial returns.
Private investor enthusiasm about impact investing has picked up steam in recent years, a trend documented in the 2015 survey conducted by J.P. Morgan and the Global Impact Investing Network (GIIN). All told, survey respondents currently manage $60 billion in impact investments worldwide. They reported committing $10.6 billion in new capital in 2014, up 7 percent from the previous year. And they anticipated upping the ante by 16 percent this year.
Major financial institutions have taken notice. BlackRock, the world’s largest asset management firm, launched BlackRock Impact early this year to focus on impact investing. Prudential has committed an additional $1 billion to socially responsible businesses by 2020. And Bain Capital hired former Massachusetts Governor Deval Patrick last spring to found a new social impact investment business.
Impressive as this momentum appears, impact investments still represent less than one-half of 1 percent of the all the assets managed globally. As a movement some predict will replicate the success of venture capital, impact investing has a long way to go. And government can help by creating a more favorable regulatory environment.
That’s where the recent regulatory changes come into play. They remove barriers that have discouraged foundations and pension funds from seeking out impact investments. Today their stakes represent just 6 percent and 2 percent respectively of all impact investments, according to the J.P. Morgan-GIIN survey. Those figures are poised to increase.
On September 18, the IRS issued new guidance for foundations’ mission-related investments. Under the old rules, foundations worried that they would suffer tax penalties for making impact investments, especially those that produced returns below market rates. Henceforth, foundations are free to invest endowment assets in mission-driven organizations that align with the foundation’s charitable purpose. And they need not fear tax penalties if they choose to accept a lesser return from an investment with a strong mission component.
“In other words, a foundation can prioritize its mission over the demands of finance and need not fear tax consequences for taking risks or rates of return that other investors are less willing or unable to take—so long as this is done prudently, without placing the foundations ability to carry out its mission in jeopardy,” explained David Wood, director of the Initiative for Responsible Investment at the Harvard Kennedy School.
While it may take time for foundations to adjust to the new guidance, the effects on asset allocations could be enormous over the years ahead.
A month later, on October 22, Department of Labor (DOL) issued a bulletin rescinding a 2008 rule that subjected so-called economically targeted investments—aka impact investments—to extra scrutiny, all but eliminating them from consideration by pension fund managers. The change reverts to a 1994 rule stating that “fiduciaries may consider (social and environmental) goals as tie-breakers when choosing between investment alternatives that are otherwise equal with respect to return and risk over the appropriate time horizon.” In short, the ruling means that pension funds may invest in organizations with a social mission as long as the investment is financially prudent—the fundamental obligation pension fund fiduciaries. "Investing in the best interests of a retirement plan and in the growth of a community can go hand in hand," said US Secretary of Labor Thomas E. Perez.
Even a relatively small percentage increase in pension fund impact investments would add up to billions in new capital. Funds governed by ERISA manage roughly half of the $18 trillion in US pension assets. But ERISA rules also have a powerful spillover effect on the trillions managed by state and local governments, and by religiously affiliated organizations.
The DOL bulletin also aimed to clarify that pension funds should consider factors potentially influencing risk and return, including social, environmental, and governance issues. Thus, these issues “are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices.”
In Wood’s view, “This affirmation of (social, environmental, and governance issues) is just as newsworthy as the actual reversion to the 1994 guidance.” The change “acknowledges that (social, environmental, and governance) considerations are a fundamental part of the investment landscape.”
The steps taken by the IRS and the DOL are consistent with the recommendations of the National Advisory Board on Impact Investing and the Accelerating Impact Investing Initiative, a cross-sector coalition working to improve and expand the market for impact investments through changes to public policy. And there’s more public policy can, and should, do. For example, the National Advisory Board recommended that Congress provide tax incentives that modestly lower corporate tax rates for qualified impact businesses, lower capital gains rates for investors supporting qualified impact businesses, allow impact investors to write off losses as a charitable tax deduction, or allow individuals to deduct contributions to US impact initiatives.
Meanwhile, don’t expect the new guidance from the IRS and DOL to open the floodgates of foundation and pension investments. It will take years to develop new investment strategies and products that build on these changes. And obstacles remain, including lack of foundation and pension fund experience in evaluating and managing impact investments, and a dearth of investable opportunities.
But as venture capital pioneer Sir Ronald Cohen and Harvard Business School Professor William Sahlman wrote two years ago, “We believe we are on the threshold of a major change not unlike the early days of the modern venture capital industry.” The recent regulatory changes are significant steps in that direction.