The Gates Foundation’s two most recent social investments, part of a $400 million budget of “program-related investments” (PRIs) established in 2009, create corporate governance challenges, peculiarities that apply to such investments made by any US foundation but which are not well understood. On February 9, Gates made its first equity PRI when it invested $2 million, part of a $4 million equity financing in Inigral, a San Francisco-based company that will build closed Facebook systems for schools. The idea: Since most community college students work, this gives them a way to network, which may help with college retention. Other investors were Retro Ventures and the Founders Fund, whose principals include venture capital veteran Larry Mohr, PayPal founders Peter Thiel, Ken Howery and Luke Nosek, and Napster founder/former Facebook president Sean Parker. On March 4, Gates made a second equity PRI of $10 million in Liquidia, a Research Triangle Park, North Carolina-based nanoparticle company whose technology could cut the cost of individual vaccines from $5/$10 to $1.50. The investment allows Gates to obtain “global access rights,” which will allow the foundation to partner with another company to distribute the low-cost vaccines. Liquidia already had $50 million in backing, including a $25 million Series C venture financing in April 2010 from several top tier venture funds. Gates senior program officer Julie Sunderland, who runs the PRI program, spoke in general terms about the foundation’s social investments at the Bottom Billion conference at Seattle Pacific University last month and in a follow-up interview with Responsible Investor. But an understanding of PRIs and their equity components in particular can help read between the lines and shed light on the inner dynamics of these and other equity PRIs, as well as the strengths and limitations of the Gates approach.In the US, it’s possible for wealthy individuals to shelter most income from taxes by establishing a foundation. To qualify for tax exemptions, foundations must make annual “distributions” (usually grants, or gifts) in alignment with their specific charitable purpose amounting to 5% of the value of their corpus (endowment.) In managing the corpus, they must comply with prudent investor rules, meaning they generally must maximize the value of those investments and not take un-due risks that could threaten the corpus and therefore its distributions. The distributions, after all, are meant to benefit society. Impact investing arguably got its start in the philanthropic world (in the US anyway) during the late 60s with the invention of “program-related investments,” or PRIs. The idea is that instead of grants, foundations can make investments that further their charitable mission. Since these investments can count toward their 5% distribution, any financial return must be recycled as grants — or more PRIs. In this way, foundations can compound their social or environmental impact. But here’s the hitch: Since the main purpose of the investment must be charitable, most PRIs (which can take any form of debt, equity, guarantee, etc.) have been designed as low-interest (below-market) loans. Between them, the Ford Foundation (which pioneered PRIs) and the MacArthur Foundation have invested hundreds of millions of dollars building the virtually invisible $30 billion industry of “community development finance institutions,” or CDFIs—the community banks, credit unions, loan funds and venture capital funds that serve minority and low-income people in the US. In l989, for example, MacArthur made a PRI to the Center for Community Self-Help, a Durham, North Carolina-based CDFI that, among other things, promotes responsible lending and has created a secondary market in responsible mortgages. At the time, it had $7 million in capital; today, it has over $1 billion.
But while most PRIs historically were made to the CDFI industry, they are now being used as the riskiest tranche in complex deals to attract other investors to complex hybrid projects that address homelessness, affordable housing, education and rebuilding inner-city neighborhoods. In a speech to the PRI Makers Network three years ago, MacArthur Foundation president Jonathan Fanton said every PRI dollar spent on the foundation’s housing preservation had unlocked $70 from public and private sources.
Although there is growing interest, most foundations have not made PRIs. In 2007, less than 1% of the $44 billion deployed went to PRIs—most of that as low risk loans. Only an estimated $20 million was invested in equity—just 4% of the dollars spent on PRIs and less than five tenths of one percent of total dollars distributed. Since PRIs qualify as part of a foundation’s distribution, their primary purpose must be charitable. As such, the biggest challenge regarding equity PRIs is an IRS requirement that the foundation has a so-called “mission collar” on the company, backed by an opinion letter assuring there is no “mission drift” from the foundation’s charitable purpose. In practice, this means that program officers may write rules into their investment agreements precluding the company from doing anything outside the program related purpose, and companies and funds can find themselves rewriting their mission statements so they are in total alignment with the foundation’s charitable purpose.
At the board level, this can set the PRI investor apart from the rest of a company’s investors and can create board level difficulties and management problems. Here, after all, is not only an investor with a different perspective—but one that actually has a legal contract that a company be run in alignment with its principles. “Even if everybody put in the same amount of money, normally all these investors would have to argue and persuade and reach consensus,” one experienced fund manager says. “”But in practice,the PRI investor has a much more prescriptive investment agreement and also sits on a moral high horse in a diverse Board of Directors and feels there is no need to convince, answer and make their case on the merits.” From the foundation’s perspective, there are essentially two ways to deal with an equity investment’s potential mission drift. First, it can proscribe precisely what the company can do; for example, it can only sell vaccines to people earning less than $1 per day. A less constraining approach is to take a seat on the investment committee (if the investment is a fund) or even an observer’s seat on the board (as Gates has done in the case of Liquidia.) Oddly enough, a foundation’s biggest worry may be how to deal with the company’s mission drift if it is acquired. For this reason, a foundation must maintain the possibility of an exit—not because the investment may go bad but because it has become not charitable enough. In the event this happens, PRI investors negotiate put options (buyout agreements) upfront with a co-investor—something Ms. Sunderland confirmed that Gates has done. The other issue is price. Investments do not qualify as PRIs if a foundation pays the same price as a commercial investor. To qualify, a foundation can take slightly less favorable terms or throw in a grant that in effect subsidizes the foundation’s capital. Foundations have certainly made equity PRIs alongside other such impact investors, but Ms. Sunderland said the Gates Foundation thinks it’s important to invest alongside a “financially-oriented” investor “good at growing a company.” Although she would not discuss structure, she said that while the foundation makes an effort to get a price as close as possible to that of its commercial co-investors, it was more successful in that regard with Inigral. “In Inigral we’re investing alongside venture capital firms but venture capital firms that have similar socially-minded objectives and charitable objectives,” she said. “With Liquidia, we’re investing alongside firms that are in it for purely market decisions. Our primary purpose is charitable,” she added, “but we don’t want to be the dumb money. We want to negotiate rigorous terms.”