New US rules could be a game-changer for impact investment

Program related investment regs can change risk profile and open up asset structuring possibilities.

In today’s low interest rate, high volatility financial markets, why hasn’t impact investment yet become a serious theme for responsible investors? One reason is that where impact investment is defined as financing ventures that create positive social and/or environmental change, risk is a key deterrent. Ventures that propose to serve the world’s poor and low-income populations are especially needed, but imply a high level of risk that is hard to cover through purely market-based pricing schemes. Structured impact investment vehicles, like Deutsche Bank’s new Eye Fund use an equity first loss tranche or other credit enhancements to redistribute risk on a portfolio level. To date, however, there have been too small a number of organizations able and willing to provide these enhancements to support potential investor interest. The Obama Administration recently announced a significant change in the rules governing the types of program related investments (PRIs) that can be made by foundations that addresses this challenge and has the potential to catalyze millions of dollars of new impact investments. The Administration’s proposal does not alter existing regulations, but it does provide additional, highly specific examples of activities that may permissibly be engaged in by non-profit organizations.Until July 18th, the US Treasury Department is taking comments on the proposed rule change: Federal Register: PRI Examples
It is also important to note that Treasury has stated that US taxpayers may rely on these new examples as of now, even though the comment period remains open. What makes the simple addition of these new examples so important? The answer derives from the fact that most US non-profits, including foundations, are established as tax-exempt 501c-3 organizations. In order to ensure that tax exemptions are granted only for worthy causes, the law establishes definitions of related and unrelated business activities permissible for non-profits. Failure to comply with these restrictions can trigger excise taxes, penalties and even loss of tax-exempt status. Regulatory uncertainty therefore acts as a major constraint on innovation for impact. Under existing regulation, non-profits have been cautioned by their attorneys to refrain from doing anything that is not explicitly authorized. Offering or supporting profit companies or services, regardless of how relevant these may seem to the organization’s mission has not enjoyed this explicit authorization. When it comes to impact investment, foundations believe themselves limited to making grants
or supporting studies and research related to social enterprise or the impact investment ecosystem. The examples cited in the old regulations permit foundations to make grants to non-profits organizations, but taking equity, making loans or partnering with for-profit organizations are not explicitly addressed. As a result, most foundations focus exclusively on making grants to non-profit organizations for fear of endangering their tax status. The proposed amendment to PRI regulations will empower foundations in two ways. First, the rule change offers an expanded list of permissible and “exempt” activities, together with a clarification of the principles that govern these exemptions. Additional clarity paves the way for foundations to fund a wider range of interventions without fear of excise taxes, lost exemptions or forced dissolution. Equally important, these changes should alleviate board and donor concerns with respect to their exercise of standards of care and prudence on behalf of a foundation. Second, a more flexible definition of mission includes a broader range of acceptable counterparties, formalizing venture philanthropy as distinct from charity or investment. What makes the expanded definition of permissible and exempt activities and counterparts so exciting? First, foundations may now confidently use PRIs to support a wider array of instruments, including debt, equity and guarantees, in addition to grants. Second, for-profit ventures, including social enterprises, also would be able to obtain loans, guarantees or equity from philanthropic sources, which has been almost impossible to date. The amended regulations explicitly allow these sponsor and instrument options to be supported through PRIs, which should be a game-changer for all of us. Although the new Treasury Department examples address many of the current obstacles faced by venture philanthropists,investors should be aware of at least two issues that warrant discussion during the regulatory comment period. First, hybrid structures (B-Corps and L3Cs) are not mentioned specifically as acceptable counterparties for foundations. Implicitly, if foundations can work with both non-profits and for-profits, they can also work with hybrid corporate structures that pursue double or triple bottom lines. Explicit reference to these structures could be helpful in encouraging a shift toward sustainability. Another seeming oversight is the lack of an explicit example related to structured impact investment vehicles. We know that in order to attract more private capital for innovative new impact investments, the twin hurdles of risk management and pricing need to be lowered. Foundations with their capital endowments and long time horizons seem like ideal candidates for supporting innovations with potentially high social and/or environmental returns. Often early stage and potentially disruptive, the risk and uncertainty surrounding both financial and non-financial returns makes it hard for these triple bottom-line innovators to find capital. If foundations take advantage of this regulatory change to get creative in providing risk mitigation and credit enhancement products, the multiplier effect of philanthropic capital will rise substantially. For example. instead of a making a single $10 million grant that serves tens of thousands, foundations can make a $10 million PRI that catalyzes $100 million or more in private investment and reaches hundreds of thousands of people. To help assure that these regulations are issued with maximum productive value, please read and where needed comment on the proposed PRI rule change before the July 18th deadline.

Lauren Burnhill is the former Chief Investment Officer of ACCION International, and is currently Managing Director of One Planet Ventures (OPV). She writes regularly on impact investment. Her detailed comments for the Federal Register can be found on her blog: The Money in the Middle