Nonprofits and the Emerging Social Capital Market

Last week’s Social Capital Markets Conference was an amazing experience.  You really felt as though you were at the beginning of something pretty innovative.

The financial market collapse of the last year has given the emerging social capital markets, where social impact and money converge, a voice and credibility.  Indeed some social investments, like those in the microfinance arena, have actually far outperformed the financial returns of the traditional capital markets in the past year.

Will it last?  And will money begin to flow more readily to organizations and projects that promise a social return?  Will, as some at SoCap forecasted (or perhaps hoped), impact investing become a significant part of a normal investor portfolio in the next five years? Will social impact become a necessary and prevalent part of the traditional capital marketplace? Who knows.   This whole space is evolving, and it is much too soon to understand how it will all play out.

One thing, however, that was lacking in last week’s conversations, and is worth a larger discussion, is how nonprofits, those organizations that have been creating “social impact” since before it was cool, fit into this emerging market. As I mentioned in earlier post, attendees to the session I moderated, “Growth Capital for Nonprofit Social Entrepreneurs,” appeared hungry for information, tools, advice, insight about how their organizations could play in this emerging space.

If you think of the overall market as a continuum with traditional charities on one end and traditional businesses on the other, the social capital marketplace, then, is everything in between.  It most certainly includes social businesses–businesses that not only make a profit, but also contribute some sort of social impact (like wind farms or organic groceries).  And there are emerging investment vehicles that can provide investors a financial return (sometimes equivalent to a traditional market rate return) in addition to a social impact return.

But the social capital market must also include new financial vehicles for nonprofit organizations. In order to effectively provide the public goods that for profit businesses (both traditional and social businesses) can’t or won’t provide, nonprofit organizations require seed funding, growth capital, capacity capital, loans, equity, grants, operating revenue and so on.

Although there was some discussion of these financial needs, the nonprofit side of the social capital market discussion was not as prevalent last week. And indeed some at the conference, including conference co-f0under, Kevin Jones, refer to nonprofits as “our cousins” in this space.  Indeed, the keynoter at the first SoCap conference  last year encouraged the audience to “set aside” nonprofit organizations because they were not what that conference was about.  And I have had a few conversations with leaders in the social business space who have told me: “Innovation will never come from the nonprofit side.  It must come from the social business side.”

But nonprofit organizations are very much part of this conversation and this emerging market. Social impact is not a new thing.  As much as those of us assembled at SoCap last week would like to believe that we are pioneers in all things, we are not.   Many of the financial vehicles emerging in this new space are exciting and new.  But creating social impact through entrepreneurial efforts is not new.

Nonprofit organizations have been around for a long time.  And their reason for being has always been to create some sort of public good that was not addressed by the market.  That is not to say that it has been done right.  Many would agree that the nonprofit sector and the philanthropy that funds it are dysfunctional, even broken.  And I think most of us would agree the government sector is fairly broken as well.

But we cannot discount and dismiss either sector.  In the true spirit of the social innovation space, we must recycle and reuse the nonprofit and government sectors, just as we are refashioning the private sector.  We must reconfigure the assets of all three sectors to turn them into more effective, more productive, higher functioning sectors that can work with, not separate from, each other to create solutions.

What does that look like?  It means that venture philanthropy funds are sharing investor prospects with social venture funds and vice versa.  It means that investors interested in a social return have portfolios that include not only social businesses, but also nonprofit deals.  It means that foundations are investing in both for profit and nonprofit social impact organizations.  It means that the SoCap conference list of attendees and speakers come equally  from all three sectors (public, private, nonprofit).  It means that the majority of nonprofit organizations that have an interest in and capacity for growth have access to growth capital and management expertise to scale.  It means that a nonprofit that is solving social problems is just as sexy and gets just as many resources, respect and mind-share as a social business that is doing the same. It means that those working on changing laws to help social entrepreneurs look at both for profit and nonprofit structures, incentives and restrictions.

The creation of the social capital market is a bold, chaotic, possibly insane, but potentially game-changing endeavor that has the power to completely rework how money flows through the market to shape society. Let’s not get bogged down in dichotomies and factions, rather let’s take a bigger picture view of the essence of what we are attempting to do.  And that is to completely reconfigure, and create a productive convergence among, the three sectors. Now that would be innovative.

Tags: capacity capital, government, growth capital, investors, nonprofit, Philanthropy, SoCap, social business, Social Capital Markets conference, social entrepreneur, social return

A Call for Mission Related Investing

In order to maintain their legal status, foundations are required to distribute 5% of their earnings each year to nonprofit organizations.  This 5% is determined by a 2-5 year rolling average of earnings.  In years like these when earnings are very low foundations have less to distribute, which makes ideas like mission-related investing more appealing.  Mission-related investing is when  a foundation uses part of it’s corpus (the 95%) to invest in social enterprises that are related to the foundation’s mission.  For example, a foundation interested in the environment could invest part of their 95% in wind farms, thereby receiving a social return in addition to a financial return and extending the reach of their mission despite an economic downturn.

Scott Collier, Managing Director of Triton Ventures, has thought a lot about mission-related investing, and I’ve asked him to do a guest blog on the topic.  Scott has been a venture capital investor since 1991. He has experience in all aspects of venture capital fund formation and management and the associated growth, financing and exit strategies for a diverse range of companies.  Scott serves on the board of the Entrepreneurs Foundation of Central Texas and is an active participant in microfinance and social enterprise initiatives, primarily focused on financing for social business. Here is his post:

From the largest foundation to the smallest donor-advised fund, the philanthropic world tends to manage assets in a way designed to preserve fund corpus while generating enough growth and/or income to achieve the 5% grant level necessary to maintain tax-free status. However, what has evolved from this mindset is a bifurcated structure where grant programs are expected to be the sole means of performing the mission while the asset management function focuses on optimizing returns.  In fact, people speak of a firewall between these two activities.  Unfortunately, this leaves much of the talent (and operating expense) dedicated to investment work that does nothing to further the organization’s mission.

More problematic, asset managers can and do end up making investments that generate a good rate of return but support companies that happen to work at cross purposes to the mission.  This sort of problem was brought to light a couple of years ago when the LA Times questioned why the Gates Foundation would invest hundreds of millions of dollars in companies generating toxic pollution blamed for sickening people living in communities receiving tens of millions in Gates-funded medical aid. Setting aside the moral implications of this situation, it’s irrational to allow the two parts of any organization to work at such obvious cross purposes.

What seems to make sense is a holistic view of foundation management that considers all investing to be mission related investing with the result that all cash outflows balance risk, return and mission impact. This approach implies five categories of investment along the continuum of philanthropy:

1. Program Grants: Currently maintained at a nominal 5% of total assets, these investments are absolutely certain to produce a negative 100% financial return.  So perhaps it would make sense to take this allocation to a lower percentage to make room for other investments that carry better returns (you can’t do any worse after all) and a different type of impact.  Perhaps even a more lasting and healthy impact.
2. Program Related Investments: Nell had an excellent post on this topic.  Deployed as loans at below-market yields, the risk-adjusted returns over time might be zero or negative but still better than the negative 100% generated by Program Grants.  Structured correctly, a PRI is counted by the IRS in the required 5% and if it were taken to a level of just 10 or 20 percent of the Program Grant spend it could transform the relationship that foundations have with their investees.  After all, in the right situation, a loan to support a move to self-sufficiency can be healthier for the recipient than a handout that creates a cycle of dependency.
3. Mission Related Investments: This category comprises mission-directed investments that fall outside the limits of what can be considered part of a foundation’s 5% qualifying distributions.  In aggregate these MRIs would target, on a risk-adjusted basis, just a return of capital or perhaps a small return beyond that, but still a below market return in exchange for driving a substantial mission impact.  Investments in this category could provide a tremendous boost to the nascent social business space.
4. Mission Aligned Investments: After evaluating for ROI potential, investments would get priority in this segment given the degree to which they enhance the mission.  A good corporate citizen in a country where the foundation does work might be enough to tip the balance in favor of investment.  Over time this could become a significant percentage of the income-producing portfolio and given the magnitude of dollars involved it could encourage corporate behavior to move in positive directions.
5. Mission Neutral Investments: The lowest social standard of the five, investments in this category would be held after ensuring that a reasonably sound “doing no harm” standard is upheld.  Verification of the standard would of course be subjective and based on limited insight into the business, but perhaps even such a sniff test is better than no test at all.

So consider a typical foundation that during the course of a year has 95% of its assets spread among the usual allocation of bonds, equities, and a smattering of alternative assets, leaving 5% to be distributed as grants.  If this allocation produced a 9% blended return on the investment portfolio, then net of Program Grants the overall annual rate of return would be 3.55%.

Now consider what happens if this foundation makes 2 small changes:

1. Program Grants are reduced to 4% with 1% going to PRIs that generate a negative 10% annual rate of return, and
2. 2% of the 95% portfolio goes into MRIs that only return capital.  The remaining 93% remains allocated in the same proportions as the 95% was before with the same 9% rate of return.  These changes produce a 4.27% rate of return: an overall improvement of about 70 basis points.

Starting with a $10 million foundation and compounding this difference over 10 years, this new allocation would mean the foundation would end up about $1 million larger than if it had stuck with the traditional 95/5 split.  More importantly, such a foundation would have been deploying 7% of its assets in mission-focused work instead of 5%, a $3 million aggregate difference over 10 years.  About 40% of that money would have been in the form of loans which, properly chosen and structured, enable local ownership and sustainable employment capable of going beyond where charity too often ends.  Replicated gradually across the trillions of dollars locked up in philanthropic corpus, such a rethinking of foundation asset management and mission investing could produce dramatic results.

Tags: financial return, foundation, Gates Foundation, Mission-Related Investing, PRIs, social return, Triton Ventures