Does a private foundation always have to be just a “foundation”? Or can it try something different? Something more daring?
Most private foundations follow the standard “invest-then-grant” mode of operation. They run two distinct enterprises: (1) an investment enterprise focused on generating financial gains (profit) from the foundation’s endowment, and (2) a grantmaking enterprise giving those gains away to nonprofit (social benefit). As a result, the standard model for foundations is a bit schizophrenic.
Some foundations now add a third enterprise that is intended to bridge this gap, popularly called “impact investing,” where the goal is to generate both profit and social benefit through the placement of investment capital. But nearly all foundations that are engaged in impact investing still operate with a split personality — with grantmaking, impact investing and traditional investments all handled by separate staffs with separate goals and incentives.
Healing the philanthropic schizophrenia would require operating a single enterprise, operated solely for social benefit, making enough money to cover its expenses and needed reinvestment, and growing enough to keep its market value ahead of inflation. Now that would be interesting…
Can you do all this within the legal confines of a foundation? I think the answer is unequivocally, “Yes.” You wouldn’t even need to go into any “gray” areas of law.
(Although caveat: it would be important to get both legal and accounting counsel before trying this yourself!)
The trick is to rigorously observe both the spirit and letter of relevant law and then be as transparent as possible with all the foundation’s stakeholders. This is not only possible, it defines the best of good business practices.
The Basic Parameters
Private foundations in the U.S. operate under several standard restrictions and requirements. Six of the most commonly noted include:
- Foundations, like other 501(c)(3) organizations, must operate exclusively for exempt purposes (no private inurement).
- Restrictions on self-dealing between private foundations and their substantial contributors and other disqualified persons, such as foundation management;
- Requirements that the foundation annually distribute income for charitable purposes (5% of assets for private foundations);
- Limits on their holdings in private businesses (usually less that a 20% interest, sometimes 35%);
- Provisions that investments must not jeopardize the carrying out of exempt purposes; and
- Provisions to assure that expenditures further exempt purposes.
Again, a responsible foundation would want to observe all of these restrictions in the course of its operation. Even those restrictions that look like they might be real limitations, such as a distribution requirement or excess business holdings, turn out to be easily dealt with in practice.
Because with these restrictions, come some useful advantages:
- The regulatory expectation that there are positive investment returns in foundations. Whereas other nonprofits are expected to have continual revenue shortfalls that require public donations to offset, foundations are expected to have net income every year that only need to be partly offset by “charitable distributions.”
- Program-related investments (PRIs) count as “charitable distributions” as long as they are structured with a charitable concession, which is generally left to the foundation to define and defend. Reaching the 5% minimum distribution is embarrassingly easy for a foundation making a substantial number of PRIs. The IRS wants to make sure that people aren’t using foundations to enrich themselves and get a tax break while doing so, and it wants to make sure that foundations are honestly in the business of providing money for social benefit and not just building an impressive endowment. These are reasonable concerns given a history of people trying to use foundations to cut corners on taxes. But there is enormous flexibility for foundations that are happy to live within the spirit and letter of the law.
- There is no upward limit on the return on a PRI, as long as there was a clear concession (with an exempt purpose) built into the initial terms.
- Getting returns that equal or exceed inflation from a socially beneficial portfolio or enterprise should not be difficult for people who are enterprise-minded. Inflation is an exceptionally low hurdle rate, even after allowing for failed projects within a portfolio of activity.
Of course, where there are advantages, there usually are a few disadvantages, as well:
- The prohibition on excess business holdings means that foundations can’t operate as a holding company for wholly owned enterprises, either for-profit or nonprofit. There are good regulatory reasons for this prohibition, but it does eliminate certain investment strategies that might otherwise be attractive from an impact standpoint. The prohibition does not extend to charitably purposed enterprises that the foundation operates itself, so-called “direct charitable activities,” since it’s the foundation’s own tax status that is at risk if it violates law or regulation.
- There is a small excise tax on non-PRI investment income (2%) that other charities don’t face. Usually doesn’t shift investment calculation, though.
- The IRS has standing to get into your business practices much more than with any for-profit entity. So, strategies that can’t easily handle high degrees of transparency may be better left in the for-profit world.
- Raising further “equity” for the enterprise is largely precluded. Number, timing and relationships among donors is restricted. Some of these barriers go away if the enterprise qualifies as an “operating foundation” rather than a private foundation. But I’m not assuming that such an approach is necessary or even appropriate in many circumstances.
As you can guess, taking steps outside the norm requires a foundation to have very disciplined accounting practices, so that all expenditures and investments get put in the right accounting “bucket” for IRS reporting, cost management, and programmatic effectiveness.
(And, of course, always avoid making “taxable expenditures” – engaging in legislative and political activities, making grants to individuals without prior approval of the IRS, making grants to organizations (other than public charities) without exercising adequate control and supervision over the use thereof, and providing grants for non-charitable purposes — since significant excise taxes result for both the foundation and individual managers.)
A Heron Takes Wing
In the mid-1990′s, I was asked to join the staff of the F.B. Heron Foundation, with the specific task of helping them answer the question, “How can the foundation put all of its assets in service to its charitable mission?” In short, how could it heal the schizophrenia in conventional philanthropy, and have all parts of the foundation pursue a single goal: social benefit?
This was largely uncharted territory at the time. Sure, there were plenty of foundations engaged in making PRIs as well as grants. But Heron’s board was really asking the philanthropic enterprise question, not just adding another charitable tool to its quiver. So, we started by laying criteria that matched foundations in general, but might be especially compelling if considered from an enterprise perspective. Beyond maintaining a exclusively exempt purpose, a philanthropic enterprise would need to be:
- Financially stable or growing. The value of the initial investment in the enterprise (the endowment) should either grow or remain the same in real terms over the long term. We couldn’t just spend down the endowment by making grants and count that as sufficient social benefit. (It should match other foundation’s ability to operate perpetually.)
- Income earning. The enterprise should earn income (profit) in the competitive marketplace. It’s peers were other income earning enterprises. Of course, those earnings might later be used for grants, but they could also be reinvested in the enterprise for further growth.
- The value of the enterprise need not be liquid. The social benefit could be embedded in the activity, not just whether it freed up money to support other nonprofits’ activities.
- Governance is primarily enterprise focused. The board of the enterprise should spend the absolute minimum time on conventional financial management of the endowment — which takes a significant chunk of the time of most foundation board members — and instead be primarily focused on the enterprise as, well, an enterprise. This is the case with market-oriented enterprises, and should be the case at Heron, too.
The first thing that struck me about these criteria was that they placed Heron into an emerging class of organizations that I have come to call “for-benefit” enterprises, which seek social benefit through commercial activity. Whether the board thought about it that way or not, that was the option that Heron was actively considering.
The board showed their seriousness about these criteria by taking the first step themselves: they moved the endowment out of actively managed funds and placed it into passively managed index funds. By doing so, they met all of their fiduciary duties of care with regard to the endowment, and reduced the time required for management of those funds to a few hours per month. They could then turn their full attention to programmatic matters and considering what kind of enterprise the foundation should become. And so could I.
A “Private Community Investment Trust”
Heron’s grantmaking programs at the time were largely focused on helping low-income families begin building assets as a pathway into the mainstream. It sought to invest in families and communities in a way that helped them help themselves. Ideally, those investments should be recoverable to some degree so that they could be reinvested into a new set of families and communities in need, and so on. This, too, was to be the focus of Heron’s philanthropic enterprise, the board insisted. The foundation/enterprise was to be:
- Privately managed and financed,
- With a community focus,
- Using an investment and financial tool set, and
- Having a long-term presence, perhaps perpetual.
As a placeholder phrase, we called this potential future of Heron a “private community investment trust” (PCIT). Although it didn’t quite roll of the tongue, it gave us a fresh reference point that didn’t have the imagination-killing baggage of calling it a “foundation.” But what next…?
We restricted ourselves to options within financial services, an industry that is exceptionally easy for a philanthropic enterprise to enter and operate, and which was consistent with the foundation’s existing focus. At the time, Heron was making grants to a number of community development financial institutions (CDFIs) that worked on housing or business development in low-income communities. The board and staff respected the work of these organizations, were interested in expanding support of them through PRIs, and ultimately saw them as something of a template for Heron’s own potential enterprise. While the board considered a number of options, the following three can serve as examples of the range. Heron could become:
- A fund of community funds. The most conservative of the approaches, this would involve converting most grantmaking into PRIs (say, to CDFIs) and converting most of the corpus into investments in funds with targeted benefits to low-income populations (MRIs), maintaining sufficient diversification to meet fiduciary requirements. There wouldn’t be as much need of direct investment expertise, but more along the lines of being able to assess the strategies and portfolios of investment managers.
- A peer CDFI. Heron could work in the gaps of the CDFI industry, making or syndicating investments in communities that other CDFIs find too difficult or too large. Heron wouldn’t have to compete with any existing grantees, but it would erase the fundamental distinction between between grantee and grantor, a relationship that I find particularly appropriate for a philanthropic enterprise. Deal-making expertise would need to be very high on staff.
- A national credit union. Moving beyond being just an investor and all the way into retail financial services, this would have been the most radical and risky of strategies, but would allow the foundation to interact directly with the low-income families and communities that it seeks to benefit. This would also require the most nimble legal work to make sure that the letter and spirit of the law is observed.
The Heron board chose the first option, which was almost certainly the correct decision for them at the time and was the one that I recommended… although some nights I dreamed… (For Heron’s recent shift in strategy, click here.) This strategy option allowed them to move incrementally with the staff and board they had, learn along the way and never have to take the big risks that can sink an enterprise.
On the down side, at least from the perspective of an enterprise purist, Heron hasn’t fully met the four criteria it set for itself. For example, I believe that their grantmaking has generally exceeded their net income in most years and over time. But as usual, perfect can be the enemy of the good. Heron has rightly earned its reputation as a leader in the impact investing field, through a decade of steady innovation and excellent execution.
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The notion of philanthropic enterprise isn’t particularly new. But given the enormous social and technological changes that society is currently experiencing, the potential for new approaches is staggering.
I would like to explore one such possibility as a creative exercise, which combines several of the themes present in this blog, and the facts and experience outlined here.
But that will have to wait until Part 2…