When the Gates Foundation last year made a $10 million investment in Liquidia Technologies, a Research Triangle Park, N.C.-based drug company, it set off a firestorm of controversy in the nonprofit world.

The foundation is known worldwide for its charitable donations-indeed, Bill Gates has joined with Warren Buffett in famously pledging to donate at least half of his fortune to charitable causes. Yet here was an investment-in a for-profit company, no less. Venture capitalists, in fact, had already invested $50 million in the company.

But was it really an investment by the Gates Foundation, in the traditional sense? Not exactly. It was a so-called program-related investment, or PRI, which means that the investment was aimed at furthering one of the foundation's causes and counted toward its 5% charitable distribution.

PRIs are only available to foundations and not widely understood. The main purpose of these investments must be charitable, so most PRIs-which can take any form of debt, equity, or guarantee, etc.-have been designed as low-interest loans to nonprofits.

The U.S. Internal Revenue Service lists the following as typical examples of program-related investments:
Low-interest or interest-free loans to needy students.
High-risk investments in nonprofit low-income housing projects.
Low-interest loans to small businesses owned by members of economically disadvantaged groups, where commercial funds at reasonable interest rates are not readily available.
Investments in businesses in deteriorated urban areas under a plan to improve the economy of the area by providing employment or training for unemployed residents.
Investments in nonprofit organizations combating community deterioration.

But PRIs can take other forms, and extend to a much wider array of causes. The Gates Foundation investment in Liquidia, for example, was to support the company's development and commercialization of safer and more effective vaccines and therapeutics.

PRIs have been used to finance real estate for affordable housing, charter schools, community health centers and conservation organizations, among other things. They can be in the form of CDs in community banks to equity-like investments in for-profit companies, such as those that sell clean technology or deliver access to water in the developing world. They can also include the highest-risk tranches in massive development projects involving partnerships between governments and organizations, such as OPIC, banks, insurance companies and pension funds. They are considered by many to be the bedrock of the highest social impact do-good investing.

"[Senior lenders such as banks or insurance companies that receive market-rate interest] in these wedding-cake deals have enhancement from PRIs, and that's incredibly powerful," says Christa Valesquez, former senior fellow at the Initiative for Responsible Investment at Harvard University and former director of social investments at the Annie E. Casey Foundation.  "Who else is going to provide a safety net to be repaid behind and take half of what they are getting [in interest]? It's counter intuitive for everybody else."

In addition to providing financing for socially beneficial projects, PRIs provide leverage that can spark the involvement of market-rate private capital. In a speech to the PRI Makers Network (now the Mission Investors Exchange) conference four years ago, MacArthur Foundation President Jonathan Fanton said every PRI dollar spent on the foundation's housing preservation initiative had unlocked $70 from public and private sources.

"Since 2001, we have awarded $50 million to preservation-minded developers and lenders across the U.S.," he said. "By the end of [2007], these groups had used our dollars to marshal over $3.5 billion in new long-term financing-enough capital to acquire, improve and preserve 50,000 at-risk affordable homes."

"One to 70," he added. "[That's] dramatic leverage by anyone's count."

But here's the kicker: When foundations make investments that further their charitable goals, the principal must be recycled as yet another grant-or PRI. In this way, foundations can compound their do-good impact.

Is it any wonder that the Gates Foundation has increased its PRI budget from $400 million to $1 billion?

This is a two-part series about PRIs. In part one, we will trace their evolution as a form of social venture capital, focusing on their use in the nonprofit world. In part two, we will address the issues raised by using PRIs in the commercial world, and show how they are being used to transform for-profit companies and even entire industrial sectors.

Legalizing Philanthropic Investment
Although PRIs can be traced back to 13th century England, their origin in this country is said to be a revolving-loan fund endowed by Benjamin Franklin to provide start-up capital to artisans and young tradesmen. Rather than bestowing gifts, the idea was that repaying loans at 5% would ensure that the funds would be available for future generations. According to Global Impact Investing Network CEO Luther Ragin, who described this fund at a PRI Makers Network conference in 2006, the trust's default rate was so "staggeringly" low that the value of the endowment had mushroomed nearly 17-fold by 1990, when the cities of Philadelphia and Boston split the remainder of the trust.

According to Investing for Social Gain: Reflections on Two Decades of Social Investments, a l991 report by the Ford Foundation, another early social investor was American George Peabody, who invented a limited-dividend company to develop and manage low-income housing projects in England. The slogan for other wealthy Americans and English who invested in 19th century housing reform projects at a 5% fixed rate was "philanthropy at five." 

Fast-forward to the late l960s, when Louis Winnick, a former deputy vice president at the Ford Foundation, received a grant proposal from a group that offered to provide minority youth with on-the-job training for their work on the rehabilitation of a building. "The project was going to end up creating an asset that would generate revenue," he was quoted as saying in a Ford Foundation report. "It occurred to me that we could have done this as a loan."

Foundations are not only required to maximize investment returns, they are also prohibited from taking risks that jeopardize the value of their endowments and thus their grant-making ability. Modern portfolio theory, or MPT, permits riskier investments as long as they are made with care and are within the purview of a broadly diversified portfolio, and some foundations today devote a small portion of their endowment to PRIs. But this was the late l960s, before MPT was institutionalized or became mainstream.

As Winnick explored the economics of making "soft loans" to minority businesses and ventures like low-income housing, he teamed up with John G. Simon, the Taconic Foundation president and a Yale Law School professor, who looked into whether foundations could legally set aside the fiduciary obligation to maximize returns to make investments focused on social goals. Ultimately, when the PRI was established in the Tax Reform Act of l969, the law effectively gave foundations an alternative to straight investments and giving away money by allowing foundations to engage in low-return social investments-as long as their primary purpose was charitable.

Social Venture Capital
Like modern portfolio theory, venture capital was not mainstream in the l960s. But by establishing the PRI as an alternative to a grant as part of their required charitable distribution budget, foundations could engage in social venture capital. In effect, a foundation could make a risky social investment that otherwise might be considered a jeopardizing investment, and the worst-case scenario was that it would fail-and the foundation would then write it off. From a financial perspective, this is arguably equivalent to making a grant, which it would have made anyway.

Nothing ventured, nothing gained.

In its first two years of making PRIs, the Ford Foundation's 1991 report says, it made loans to ventures ranging from "cattle feeding, fruitcake baking, and steel joist manufacturing to fast-food franchising, publishing, public transportation and catfish raising." After reviewing the investments, a consultant admonished the foundation to "stop thinking of a PRI as some sort of interminable experiment" and suggested the hiring of professional loan officers.

The foundation's losses on these early investments, which it made to inexperienced entrepreneurs in poor neighborhoods, amounted to 35%. In conventional venture capital, by comparison, the general rule of thumb is that investors will make a killing with one investment in 10, and that the rest of a VC's investments will either limp along as the so-called living dead (and perhaps contribute some financial return) or end in total bankruptcy.

But Ford's early PRIs 40 years ago also included a five-year $600,000 loan that helped launch the Harvard Community Health Plan, something that later became known as a health maintenance organization.

"One of the early lessons learned from successful loans was that they were most often in fields we knew very well-we knew the people and the players from our grant-making experiences," said a program officer in Ford's l991 report. "Many of our early losses were with the types of ventures that, in retrospect, we probably had no business being in because we didn't know the field."

That experience has been replicated by other foundations that began making PRIs as direct investments only to abandon them and make investments in intermediaries-a strategy that most foundations pursue today with PRIs. Between them, Ford and the MacArthur Foundations have invested hundreds of millions of dollars building the virtually invisible $30 billion industry of "community development finance institutions," or CDFIs-the community banks, credit unions, loan funds and venture capital funds that serve minority and low-income people.

For example: In 1989, MacArthur made a PRI to the Center for Community Self Help, a Durham, N.C.-based CDFI that, among other things, promotes responsible lending and has created a secondary market in responsible mortgages. At the time, it had $7 million in capital. Then, in the early 2000s, Ford made a $50 million PRI to Self Help-something one observer said was "a tad eye-opening for a lot of the world." Today, Self Help has over $1 billion in assets.

Even more eye-opening, perhaps, was the performance of CDFIs during the financial crisis. The Annie E. Casey Foundation has committed 5% of its endowment, or $125 million, to social investments. According to Valesquez, who directed Casey's social investments at the time, most of those investments are PRIs.

"When the foundation lost 25% [in 2008], our little piece of the portfolio was the only one making money," she says. "We had interest payments coming in. We had principal payments coming in. We had distributions from equity funds.

"CDFIs are incredible stories," she adds. "Their track records are fabulous. That was most of Casey's [social investment] portfolio, and the portfolio continues to perform."

Paving The New Way
But if PRI-backed institutions proved their mettle by weathering the storm and maintaining a modicum of access to capital, the financial crisis has also reinforced the value of having a tool like a PRI available when the market seizes up.

"The financial crisis created a few challenges, and PRIs were the tools we turned to," says Debra Schwartz, director of program-related investments at the MacArthur Foundation.

Even before the crisis, MacArthur was developing a linked-deposit product with MB Financial Bank, a small community-minded bank in Chicago, that would allow unbanked arts organizations such as theater companies with cash flow problems to access capital. The idea was that a deposit by MacArthur would serve as a reserve the bank could draw on if there was a loss on the loan. The bank, in turn, was responsible for the underwriting, origination, and servicing of the loan, as well as the first 5% loss.

But then the financial crisis hit, and the banks pulled back on their lines of credit with very strong arts organizations that already had banking relationships.

"The program ended up being a lifeline in a much broader way than we imagined," says Schwartz, who says MacArthur expanded the program to accommodate the demand. She points out that the question is how to keep capital flowing where it needs to go at times when it's hard for even plain vanilla transactions to happen. "And that's where the value of PRIs really shines," she says, "because we can take outsize risks."

According to Schwartz, people focus on PRIs as instruments with below-market returns. But they are really about above-average risk.
"And we are willing to [take those risks] because we do it in areas where we feel we understand risks perhaps a little differently," she says. "We are not saying that everybody should do this. But we are committed to using our risk-taking ability and putting it out there to keep expanding opportunities for everybody else."

 

PRIs For Maximum Social Impact
Will PRIs move foundations away from serving the very, very poor? Certain nonprofits, after all, fear that the commercialization of the third sector will cause it to forget its roots in charity.

 

But experienced PRI makers argue that the opposite is true because these "soft PRI dollars" (usually below-market rate, higher risk on a risk-adjusted basis and/or "patient" up to as much as 25 years) enable projects to leverage the big bucks from banks, insurance companies and pension funds-and thus stretch scarce grant/PRI resources to solve problems at scale.

San Francisco-based Low Income Investment Fund (Liif) President and CEO Nancy Andrews explained how this works at a 2006 PRI Makers network (now Mission Investors Exchange) conference.

When Liif was asked for a $2 million loan a couple of years before to finance a homeless shelter, it could have deployed its own resources. But in order to stretch them as much as it could and thereby maximize social impact, Liif sought the State of New York Mortgage Agency (Sonyma) for the shelter. "This amounts to a guarantee," she said, "and if Sonyma guarantees a loan, banks will happily make the loan ... and Liif would not need to use its own capital."

But the deal was too risky for Sonyma to guarantee. So Liif then offered Sonyma a 10% guarantee-or, as Andrews puts it, "a guarantee on the guarantee." This was first-loss capital, and Sonyma bit the bait. With Sonyma's guarantee in hand, Liif raised $2 million in financing for the shelter from the United Methodist Fund. And when the final tally came through, Liif put up a $216,000 guarantee.

"That's 10-to-1 leverage, and a lot of social good," she says. "This is an ideal situation for a small foundation."
But while PRI-funded guarantees are used to free up capital, they can also reduce its cost. According to the Guide to Impact Investing, a 2011 report by Lisa Richter and Lucy Bernholz that targets health funders, charter schools and charter school management organizations (CMOs) can save up to 50 basis points for every level of improved bond rating due to credit enhancement. Case in point: The Gates Foundation has provided guarantees to CMOs in Texas and California.

In Texas, its $30 million guarantee matched $30 million in local philanthropic support and a partial guarantee from the Local Initiative Support Corporation, a national CDFI, to provide credit enhancement for up to $300 million in bond issues by KIPP Houston and other quality CMOs.

In California, its $8 million guarantee matched an $8 million guarantee from the Schwab Foundation and a $1 million guarantee from NCB Capital, another national CDFI, to provide credit enhancement for a $93 million bond issue by Oakland-based Aspire Public Schools.

In its 2009 and 2010 annual reports, the Gates Foundation estimated cost savings of $10 million in Texas on a $67 million bond financing and almost $12 million in California over the 35-year life of the bonds.

But here's the kicker: Guarantees ultimately only count as part of a foundation's required distribution if the funds are actually used.

The MacArthur Foundation has used a guarantee to solve a different type of social problem altogether-one that Debra Schwartz, director of program-related investments, calls a "permanent math problem."

The problem that has kept her awake at night is the availability of affordable housing-an issue that became particularly acute in the wake of the financial crisis, when the market for low-income-housing tax credits (LIHTCs) plummeted over 50% due to factors exogenous to the market itself. "A huge number of projects that were perfectly good investments could not access that tax credit equity," she says, and the money that was there was "picky and tough."

The math problem relates to Section 8 rent subsidies that HUD pays to cover the difference between the cost to operate a building and the amount a renter can afford to pay (limited to 30% of his or her income). "These are low-income elderly people that live on Social Security disability," she says. "They do not have enough money to put up even half the cost of operating the building they live in."

In 2007, Congress failed to appropriate money for its contractual obligations with respect to Section 8 subsidies. But with a weak real estate market, the cost of operating many of these buildings was also higher than the market rate rents available if the building was not in the subsidy program. In other words, the subsidized rents were higher than the market rate rents. And investors panicked. They began to demand huge escrows equal to the difference between what HUD was supposed to pay during the course of these 20-year contracts and projected market rents.

"Investors were basically making a decision not to invest in fully occupied buildings because they worried that Congress would abrogate its contracts," Schwartz says, explaining why MacArthur offered to provide a guarantee against this policy risk if investors eliminated the need to capitalize these very large reserves.

The result: the Enhanced Tax Credit Fund, seeded by MacArthur's $20 million unfunded guarantee, which raised $140 million from one subordinate investor (Mass Mutual) and senior investors including JP Morgan Chase, MetLife and United Bank to help finance the preservation and renovation of 18 Section 8 LIHTC properties in difficult markets like Findley, Ohio.

"If Section 8 blows up and disappears, we will have so many more problems," Schwartz says, alluding to the fact that 1.5 million households (many of them elderly) live in housing with this long-term subsidy. "We don't want to over-subsidize. We just want to make it easier enough to get the money raised that we need and to direct it where we want it to go."

In effect, MacArthur is back-stopping the federal government, and if the guarantee is drawn on, it will be a PRI. But without MacArthur's guarantee and Mass Mutual's subordinate equity, the transaction would not have happened. "Market rate impact investments don't come out of nowhere," Schwartz says. "In general, they are engineered."

A former investment banker, Ellie Winninghoff is a writer and consultant specializing in impact investing. Her work can be viewed at dogoodcapitalist.com and she can be contacted at [email protected].