Gates Embraces Philanthro-capitalism

The world’s largest private foundation bets big on venture philanthropy


In what may be a turning point in how private foundations do business, the Bill and Melinda Gates Foundation recently announced on its website (www.gatesfoundation.org) that it will begin extensive use of a venture philanthropy vehicle known as program-related investments as a way to leverage the Gates Foundation’s resources and to encourage broader financial support for its mission.

Although the $400 million program-related investments fund is dwarfed by the $3.5 billion in grants made annually by the Gates Foundation, the fact that the world’s largest foundation is dipping its big toe into the world of venture philanthropy may accelerate a nascent trend in philanthropy the way the Beach Boys “Pet Sounds” and the Beatles “Sgt. Pepper’s Lonely Hearts Club Band” revolutionized popular music forever.

So, what is venture philanthropy and how do program-related investments play a key role in it? The phrase “venture philanthropy” was coined in the 1960s as an alternative strategy to merely having foundations write grant checks and hope the recipients (usually public charities) would use the money wisely. The concept is borrowed from venture capital and uses loans and equity investments along with ongoing management and strategic assistance as a way to help the recipient organizations become self-sufficient.

THE PIONEERS

A tiny percentage of large foundations, such as The Ford Foundation and The John D. and Catherine T. MacArthur Foundation, have engaged extensively in venture philanthropy through the use of program-related investments for more than 30 years. For example, The Ford Foundation, through loans, gave Grameen Bank the necessary funding to demonstrate the viability of microcredit. It was not long before the bank showed a profit and for-profit investors jumped in with support. The incipient microfinance industry was helped along dramatically by The Ford Foundation’s willingness to loan Grameen Bank money when no one else would.

Although a handful of foundations were engaging in venture philanthropy before the late 1990s, it wasn’t until a pair of articles were published in 1997 and 1999 that the philosophical underpinnings of venture philanthropy were laid out.

The first, “Virtuous Capital: What Foundations Can Learn From Venture Capitalists,” by Christine W. Letts, William Ryan and Alan Grossman (Harvard Business Review, March-April 1997, at pp. 36-44), recommended that foundations adopt a venture capital mode, rather than their traditional scatter-shot grant-making model, in choosing recipients for their funds and helping those recipients implement their programs. The suggestion was that venture capitalists and grant-making foundations face similar challenges in evaluating potential funding recipients and in monitoring the results of their investments. But foundations often make narrowly focused, short-term grants.

In sharp contrast, venture capitalists have a comprehensive approach that involves monitoring closely, setting clear performance objectives and building sustainable organizations. By adopting the venture capital model, the authors argued, foundations can participate directly in promoting the success of the programs they fund.

The second article, “Philanthropy’s New Agenda: Creating Value,” was published in the November-December 1999 issue of the Harvard Business Review, at pp. 121-130. Authors Michael E. Porter (a renowned expert on business strategy) and Mark R. Kramer argued that most grant-making foundations serve as passive middlemen or mere conduits between the donors to a foundation and the causes they support. They say that foundations can promote social programs—and have an obligation to do so—because of the tax breaks they receive. But foundations need to determine how they can create the greatest social value with their resources, and they must measure the results. Porter and Kramer offered four ways for foundations to create social benefits beyond the immediate effects of grants.

Foundations could:

(1) use their expertise to select the best recipients for their funds, then measure the effectiveness of these selections;

(2) attract additional funding to these grantees by offering matching grants;

(3) actively partner with recipients to measure their performance; and

(4) conduct systematic studies of the long-term success of different types of projects and research new ways of addressing social problems.

Although the concepts raised in the articles made great sense, the authors failed to address how foundations might engage in venture philanthropy without tripping over the prohibitions of Internal Revenue Code Chapter 42. Only the foundations that already were engaged in venture philanthropy like the Ford Foundation and the MacArthur Foundation understood the complex tax requirements.

KEEPING WITHIN BOUNDS

So, what are the rules? Let’s go back in time to 1969, when the Tax Reform Act of 1969 put in place the private foundation excise taxes of Chapter 42 to curb perceived abusive behavior by foundations. One of the most important Chapter 42 excise taxes aimed at limiting a foundation’s speculative investments is the prohibition against “jeopardizing investments” set forth in IRC Section 4944. Excise taxes are imposed under this section not only on the private foundation but also potentially against the foundation managers. Tax penalties can be severe.

No category of investment is to be treated as a per se violation of IRC Section 4944. A jeopardizing investment is one for which a foundation manager has failed to exercise ordinary business care and prudence under the facts and circumstances prevailing when the investment was made. An investment in venture philanthropy typically does not meet the standard. Fortunately, under IRC Section 4944(c), there’s an exemption to the jeopardizing investment excise tax rules for program-related investments.

A program-related investment is an investment that has all of these characteristics:

(1) The “primary purpose test”—The primary purpose is to accomplish one or more charitable purposes.

(2) The “production of income test”—No significant purpose of the investment is to produce income or capital appreciation. (3) The “political purpose test”—No purpose of the investment is to influence legislation or take part in political campaigns on behalf of candidates.

Qualifying program-related investments also can help satisfy a foundation’s 5 percent minimum annual distribution requirements under IRC Section 4942.

Program-related investments come in all shapes and sizes. Common-examples include:

(1) loans to, or investments in public charities supporting low income housing projects;

(2) loans to or investments in businesses owned by economically disadvantaged groups in areas where commercial investment or reasonable rate loans are not readily available; and

(3) international loans to, or investments in not-for-profit and for-profit organizations work on solutions to world hunger.

Program-related investments can be structured through direct investments, generally in the form of low-cost loans or the use of financial intermediaries. Direct investments require the foundation to exercise significant due diligence and to document extensively. Most smaller foundations don’t have the expertise to structure a direct investment, and those that attempt it often request a private letter ruling.

Usually, smaller foundations will eschew direct investments and choose to invest through intermediaries for their program-related investments. Intermediaries, such as community development institutions and other seed organizations, receive grants and borrow funds from private foundations, then make loans to smaller organizations to fund particular projects.

While many intermediaries are themselves not-for-profit organizations, some are commercial enterprises pursuing objectives that the IRS considers charitable, such as combating urban blight. The advantages offered by financial intermediaries include staff capacity to evaluate potential recipients and familiarity with the needs of particular regions. Intermediaries also often develop technical expertise in certain programming areas, such as low-income housing.

There is a new way that foundations can engage in program-related investments through an entity known as the L3C, which has been adopted by statute in several states but has yet to be approved by the IRS.

The purpose of the L3C is to bring together a mix of entities (foundations, other not-for-profits, trusts, endowments, pension plans, individuals, corporations and governmental bodies) – to achieve social objectives while operating in accordance with for-profit metrics. Like an LLC, an L3C has the liability protection of a corporation and the flexibility of a partnership. Unlike most LLCs, an L3C is explicitly formed to qualify as a program-related investment for a foundation.

The IRS or Congress is expected to weigh in officially on the federal tax consequences of L3Cs as soon as 2010. Unless and until there is federal approval, foundations seeking to invest in an L3C should obtain a PLR.

THE GATES EFFECT

Clearly, although program-related investments can be a powerful force for social change, lack of general awareness and confusion over the most effective way to implement it from a tax and practical perspective should mean that most foundations won’t use this tool in the near future.

That’s where the Gates Foundation comes in.

The $400 million commitment to program-related investments by the world’s largest foundation supported by the two wealthiest men in the world—Bill Gates and Warren Buffett—should be just the kick in the pants needed to bring program-related investments into the mainstream of foundation philanthropy.
 

Hide comments

Comments

  • Allowed HTML tags: <em> <strong> <blockquote> <br> <p>

Plain text

  • No HTML tags allowed.
  • Web page addresses and e-mail addresses turn into links automatically.
  • Lines and paragraphs break automatically.
Publish