Are You Looking to Make an Impact? Consider a Program Related Investment

As the impact investment space continues to grow, more and more players are entering the arena.  Investors and institutions are looking at the ways that they can disrupt traditional models to accelerate meaningful social change.  There are non-profit organizations as well as for-profit social enterprises that are tackling every major problem plaguing modern society including poverty, hunger, racial equity and healthcare access, to name just a few.  Many of these organizations are looking for socially-minded investors whose values align with their mission.  Now is the time for private foundations to get involved in the impact space by making program related investments or PRIs.

What is a PRI?
A PRI is a type of investment made by a private foundation with the primary goal of accomplishing its charitable mission.  It can take many forms, including equity, debt or a loan guarantee.  PRIs were codified as part of the US Tax Reform Act of 1969. This landmark legislation changed the regulatory landscape for private foundations in many ways.  Under the terms of the Act, certain excise taxes are imposed on private foundations for making “jeopardizing investments”, which are investments that jeopardize the foundation’s ability to carry out of its exempt purposes. However, the Act specifically carved out PRIs as an exception to the jeopardizing investment rules.

PRIs are treated more favorably than other types of foundation investments.  Unlike non-PRI investments, PRIs count toward the private foundation’s annual requirement to distribute, for charitable purposes, an amount equal to 5% of the fair market value of its assets,  other than those which are used (or held for use) directly in carrying out a foundation’s exempt purpose (known as the annual minimum distribution requirement).  This treatment reflects the view that PRIs are more akin to grants as they are motivated by the goal of accomplishing the foundation’s mission without regard to their return on investment.

Foundation managers looking to expand their impact may find that PRIs offer significant advantages over traditional grant-making. For example, grants are not repaid, whereas PRIs allow private foundations to make an impact, while generating some degree of financial return that can be recycled for use in a future grant or investment, thereby deepening the foundation’s impact. Traditional grants are also generally limited to charitable grantees (e.g., public charities), whereas PRIs can be issued to any entity pursuing a project that aligns with the foundation’s mission, including for-profit companies.

How do PRIs work?
To better understand how a PRI works, consider this hypothetical:
X is a private foundation with the mission of creating better living conditions for those living in poverty.  X decides to make a $1 million loan to Y, an organization that builds affordable housing for those living below the poverty line in the city of Z.  The loan is made at a below market rate, meaning that X could receive a better interest rate if it invested the funds somewhere else at a market rate.    X is making the loan for the reason that the loan furthers its mission.  As a result of the loan made by X, other investors begin to make loans to Y as well.  As a result, Y is able to build thousands of affordable homes for individuals living in Z.  Eventually, Y repays the loan to X.  Because of the repayment, X is able to use those resources again to make other investments or grants that advance its mission.  The funds are recycled for future use.

How does an investment qualify as a PRI?
To qualify as a PRI, an investment must meet a three-pronged test:

  • The primary purpose of the investment must be to further one or more exempt purposes of the foundation;
  • The production of income or the appreciation of property may not be a significant purpose of the investment; and
  • The PRI cannot be used to fund electioneering or lobbying activity.

The first two prongs of the test warrant further examination.  The first prong, commonly known as the “primary exempt purpose test,” is subjective in that it is specific to each foundation.  It is actually a two-part test.  First, the investment being considered must significantly further the foundation’s exempt activities.  Second, the contemplated investment must be such that the foundation would not make it but for its relationship to the foundation’s exempt purposes.

The second prong of the test states that the production of income or the appreciation of property cannot be a significant purpose of the investment.  This test is more difficult to prove and often generates some degree of confusion.  After all, it is not always easy to determine that return was not a significant motivator is making an investment.  The easiest example of an instrument that would pass this test would be a below-market loan to an organization.  However, PRIs are not limited to loans.  As the Internal Revenue Service and Treasury Department has indicated in previously issued guidance, there are a number of forms a PRI can take, including equity investments, and loan guarantees.  In the final regulations issued by the IRS regarding PRIs, a common element to all of the examples included is that they all have the ability to generate some degree of financial return.  The use of PRIs can be a very effective way of deploying philanthropic capital.

Who uses PRIs?
With all of the benefits of engaging in a PRI, it’s surprising to learn that many private foundations do not use PRIs.  In fact, according the National Center for Family Philanthropy, as of 2017, less than 2% of the country’s more than 87,000 foundations use PRIs.  The larger players in the philanthropic world use them regularly.  For example, the Ford Foundation, a widely recognized trailblazer in the sector, has established a $200 million dollar pool of resources within its endowment for use as capital for PRIs.  On an annual basis, it awards nearly $17 million in PRIs.  In 2020, the Gates Foundation allocated in excess of $10 million to PRIs. The largest foundations avail themselves of this strategic philanthropic tool regularly. But what about the others?  When PRIs are used in concert with more traditional means of philanthropy, it can lead to a more powerful strategy with greater impact.

If a private foundation determines that deploying capital through a PRI should be a priority, the foundation may need to allocate resources toward building a team with the financial and legal knowledge to engage in a PRI strategy.  Effecting a program-related investment requires a fairly significant level of due diligence in order to ensure that the criteria are fully met, and include expenditure responsibility oversight requirements similar to that required of certain foundation grants. In some instances, the use of third-party advisors may prove critical to an effective PRI strategy.  Given the potential for PRIs to have a multiplier effect on social impact, foundation board members and management who have not yet delved into the world of PRIs should consider evaluating whether impact investing through PRIs would enhance programmatic success.