Josh Cleveland

In Search of Innovation: Flexible Capital

The quest for sustainable models for social enterprise inevitably leads to the issue of funding.

In her keynote at SoCap10, Julie Sunderland of the Gates Foundation addressed some critical challenges to innovative funding tools known as “program-related investments.” This sparked lively dialogue among the SOCAP audience and led me to a conversation with Matt Bannick, Managing Partner and Will Fitzpatrick, General Counsel of Omidyar Network on what happens next. We spoke about the need for both innovation and calculated risk when investing in social enterprises.

From Omidyar’s perspective, innovation in philanthropy can be amplified through a “flexible capital” approach, one that at times leaves the familiarity of grant making and enters the field of investing. This approach considers a variety of funding instruments as potential tools to address a social problem. And importantly, it involves flexibility, risk-taking and openness on behalf of the funders in the space.

In this post, I’ll use this lens of equity program-related investments (PRIs) to guide a discussion on innovation in funding.

A valuable tool?
Apart from being a mouthful without the helpful acronym, PRIs are pretty simple. PRIs allow private foundations to make for-profit investments in alignment with and in pursuit of charitable purpose. Financial returns on investment are permitted and dedicated back to the foundation’s philanthropic mission. From an IRS perspective, the investment must fit within the foundation’s tax-exempt purposes, count toward foundation’s qualifying distribution requirements and is not subject to 20% excess business holding restriction or prudent investment standards.

Sounds like a good idea. But PRIs, and especially equity PRIs (the type that Omidyar Network has come to embrace) have not taken off like one might think. Take these statistics from the Foundation Center 2009 Foundation Yearbook; The Foundation Center 2009 PRI Directory; ON analysis as demonstration:

  • $44 billion in foundation capital was deployed in 2008
  • 1% of that capital came in the form of PRIs
  • Most of those PRIs – about 95% – are debt based and less risky than their equity PRI cousins
  • This leaves only five hundredths of 1% of foundation investments in 2008 in equity-based PRIs

Why aren’t PRIs used more widely? Grants are great for addressing public goods issues or programs focusing on disadvantaged populations. But as Matt pointed out, businesses are much more likely to get to scale than nonprofits. Take it from a 2007 Bridgespan report: only 144 nonprofits (other than hospitals and colleges) founded since 1970 have grown to at least $50 million in annual revenue. That’s less than 150 in 40 years. Ask the same question about for-profit businesses and your answer would likely be in the thousands or tens of thousands. Equity PRIs enable foundations to better address some problems with a greater, more flexible variety of funding instruments.

Since 2005, Omidyar Network has invested 15% of its foundation capital in equity-based PRIs-just over $24 million. Some notable equity PRIs made recently by Omidyar include BRAC, MFX Solutions, Bridge Academies International and the SONG Fund.

Making the Organizational ShiftHow can organizations begin to adopt a more “flexible capital” approach? What does it take for a foundation to use PRIs effectively?

When we dove into the shift from 100% grant-based philanthropy to a blended grant and PRI (and even mission-related investment (MRI)) strategy, Matt and Will acknowledged external challenges, but also focused primarily on a substantial internal shift:

1) Culture and legacy. “If you only have grants as a tool to address problems, there’s a temptation to use grants as a tool to address every problem,” noted Matt. “While many people associate philanthropic organizations with grants, philanthropy isn’t just about giving money away; it’s about scaling positive social impact. Investments are another way to do that.” Staff members must think outside existing boxes. “Grants are often seen as being less risky than PRIs because you know what will happen from a financial perspective: the money is gone without expectation of a financial return,” Will said.

2) Talent. Making PRIs requires investment professionals who have strong business backgrounds and adequate training in for profit investing and can perform the needed due diligence and analysis required for a PRI. Investment leads must be supported by legal and finance teams that have experience with these financial tools. Omidyar has focused on building a team with this capacity.

3) Incentive structures. The IRS mandates that foundations must give away 5% of the value of their net investment assets annually, which may discourage officers from pursuing PRIs. The potential for returns can actually act as a disincentive, since it affects whether a foundation meets the 5% requirement. The due diligence required makes for a slower approval process. Omidyar does not face this challenge as it regularly grants or invests well in excess of the 5% rule.

The Payback
Omidyar has some ambitious goals for its flexible capital approach. “Currently 99% of foundational capital goes into grants. Is that really the right mix to solve the huge societal problems we’re tackling? It’s an open debate,” said Matt. “Our flexible capital approach enables us to think about funding in terms of solutions – not just grants or for profit investments.” When foundations have access to more tools to address social problems, new options open up.

These tools enable Omidyar to support organizations throughout their lifecycles and for different types of programs. The organization might provide a grant to a non-profit, then later support a for-profit spinoff or program with a PRI, building on preexisting due diligence, relationships, and collaboration. New varieties of partnership also emerge. In West Africa, Omidyar supports BRAC’s local microfinance operations through a PRI, while providing grant funding to finance BRAC’s health programs to provide basic care and fight deadly diseases such as malaria, tuberculosis, and cholera.

Omidyar’s work in PRIs has led to experimentation with other new funding tools, such as “mission-related investments” or MRIs: investments made directly from the foundation’s endowment. MRIs are not subject to the IRS definition of charitable purposes, but must meet the prudent investor standard, in the context of the foundation’s portfolio of investments as a whole (excluding PRIs). These new tools are opening doors for both funders and entrepreneurs in the social enterprise space.

What’s next?
The challenges that Julie outlined in her SoCap10 keynote are real. Nonetheless, some forward-thinking funders are pushing ahead with innovative approaches. My hope is that the work of Omidyar Network, as well as that of the Packard, Ford, Rockefeller, Soros, and Gates foundations (all pursuing some variety of PRI strategy) continues to position PRIs at the forefront of flexible capital solutions.

Of course, many more questions remain. Do PRIs take away from traditional money for grants? Do they encourage organizations to deviate from their missions by pursuing financial returns? When you’re trying to start something new, it’s an open debate. Matt and Will note that they’re figuring it out as they go. As funders develop new strategies to maximize social impact, we’ll welcome this discussion on NextBillion and look forward to covering other organizations taking innovative capital approaches.