Foundations: essential and missing in action
We need new ways of capitalizing social enterprise because individual social enterprises are not getting the right kinds of capital at the right time, principally because of the outmoded nature of the non-profit capital market. We must learn from, and collaborate with, the for-profit capital market, argues Jed Emerson, Senior Fellow with Generation Foundation, of Generation Investment Management. Blended value investing, one of the themes of the forthcoming Skoll World Forum, looks at ways in which financial instruments can be created to provide more, and more appropriate, funding for social change. But it’s not just a question of persuading mainstream investors to come to the table. Foundations, Emerson says, are both ‘essential and missing in action’. This needs to change, and change fast. As he points out, ‘People are dying while we try to figure this out, so we damn well better figure it out with more passion than we have in the past.’
The Skoll World Forum plans to look at how to harness the full range of financial mechanisms to support social change. Does that mean everything from grant funding to fully commercial financial instruments?
Basically the idea is to get people to understand that it’s not really a question of either grants or market-based solutions but of trying to understand the array of steps that you could take in between grants and market-based, risk-adjusted return capital, and how we can begin to think about these as the two ends of a spectrum for social capital.
Would you like to briefly outline this spectrum, starting with grant funding?
The first thing to say is that even with grants, there are different ways you can structure them – programme grants, general operating support grants, R&D type grants. And they can be multi-year, large grants or one-time, small grants. So even here, there’s a way to think about how the funds that are on the table could be better leveraged. I would then extend that capital spectrum out. Next to the grants category, you’ve got recoverable grants, which are basically like interest-free loans, usually unsecured and no penalty if you don’t pay them back.
And then you have various types of programme-related investment, which would give a 1 to 3 per cent return, secured or unsecured. Then you go beyond that to what I think of as blended value investing, which is where you are actually putting funds into non-profits and for-profits, with an increasing focus on the financial returns. The idea here is partly that philanthropic money can be used to leverage market rate investing, and it’s the combination of those two that creates real value.
Could you explain this a bit?
There are two problems with investing mainstream capital in social enterprise and social change. The first is that if you can get your funds back, it often takes a very long time. The second is that the risk you are asking the investor to carry is out of line with the possible return you are offering. For example, a PRI usually carries higher risk, but the financial return is usually a below market rate of 1 to 3 per cent – which is exactly why PRIs were created. They allow foundations to use their capital to go into areas where the mainstream market won’t go because the risk is too high, or because the long-term nature of the capital requirement means it takes a while to get the money back out.
So with, say, a loan guarantee, you might have philanthropic or government money guaranteeing some proportion of a loan, so the risk is more in line with the return you’d expect as a mainstream investor?
That’s right. And it covers situations where neither a loan nor a grant would be enough. For instance, if you need $50 million and are able to cover that as debt, a loan guarantee from a foundation may make it possible to secure those funds whereas raising $50 million in grants would not be possible. The whole idea is for us to find more ways to use different types of capital to create opportunities that would not be viable without one or the other at the table.
Could you give me a couple of examples of recent innovations that you feel are really exciting?
One great example is Nurcha (National Urban Reconstruction and Housing Agency) in South Africa, which provides bridge financing for the low-cost housing sector. The Open Society Institute pledged a loan guarantee of up to $50 million. Using that as a catalyst, Nurcha began to guarantee loans from South African commercial banks to low-cost housing developers and contractors. A bank lending money to a Nurcha-supported contractor was guaranteed to recover at least 60 to 70 per cent of the loan if the borrower defaulted. Basically, the OSI guarantee made it possible for the banks to make loans to non-profit development groups that they wouldn’t otherwise have made. Those loans in turn made it possible for housing groups to expand the entire affordable housing industry in South Africa. I think that’s a perfect example of how you can leverage and marry capital.
Another really great example of creative financial engineering is where people are taking microfinance loans from funds and packaging them as securities which can then be offered to third party investors. By taking that debt off the books of the microfinance fund, it almost recapitalizes the fund so it can engage in more lending activity.
You talk sometimes about an ‘efficient capital market’? What do you mean by that?
First, it’s important to understand that efficiency may be a relative term. If you look at mainstream for-profit capital markets, if you look at the disasters of Enron and other things that have happened over the past years, I’m not saying the for-profit capital market is always efficient or effective, much less god’s gift to social value. But I am saying the social sector could learn a lot from the way for-profit capital markets are organized.
The entire process by which capital moves in the for-profit arena is much better defined. All the players understand the terms. You can have different players look at different deals, and each achieves the same general analysis of those deals. And that allows for liquidity, it allows investors to come in and out of investments, and be clear how long they have to invest before they see a return.
By contrast, non-profit or social enterprise organizations are penalized if they have too much money on their balance sheets, because many funders then say ‘you don’t need our money’. It’s like saying to a business, ‘At the end of every year we expect you to spend down all your investment capital, because that’s the only way we know you need more money from us.’ It’s insane. It undermines the ability of social entrepreneurs to build efficient, effective, high-impact delivery vehicles for the work they do. So I think the first inefficiency is the way the capital is structured, and our requiring non-profits to raise funds year in and year out.
Is that a problem with grant funding per se, or with the narrow view that’s taken of grant funding?
I think it’s all part of a larger mistake that we make when we think about the work that we’re putting dollars into. We think about it as charity, not as investing in value. We need to go beyond the social and moral agenda and see ourselves as actually creating value. Until we do that, neither the language nor practice is going to change, and we’re just going to keep getting the same semi-loose solutions that we’ve had in the past, that aren’t really sustainable, and that don’t really address the fundamental challenges to organizations.
Going back to the inefficiencies of non-profit capital markets…
There’s a tendency to judge the value of a foundation’s performance on the size of its assets, not on the degree to which it’s effective in allocating or investing those assets. We have this truly surreal situation where foundations are structured to hold on to as much of their assets as they possibly can, and use only 5 per cent in grants to pursue their mission. I think that’s an extremely inefficient way to create change. If we could figure out a way to tap even 50 per cent of the assets that are currently locked up in foundations in the US and Europe, we would address a significant part of the capital challenge social entrepreneurs are facing. Every year we come back to this stupid discussion about whether payouts should be 5 per cent, 6 per cent or 7 per cent, and we never really ask what leverage we are getting from the other 95 per cent.
What role does the blended value idea play in this?
That’s part of what blended value investing addresses. If the foundation wants to maintain its corpus for the future in order to address future needs, we don’t have any choice but to explore better ways to structure that capital so that it can create social or environmental value and be returned to the foundation over time. If we don’t do this, we’ve lost the game completely. If all we’re doing is managing financial performance, I don’t think we’re really fulfilling our fiduciary responsibility as trustees and managers of these resources. I would go as far as to say that the public should not support the philanthropic ‘right’ of foundations if all they’re going to do is make grants. I think there are better ways than just putting all the money in the pot and giving it out very slowly over time.
Do you also use the term efficient capital market to suggest a much more varied capital market, where different sorts of finance would be available at different stages?
Yes. We’ve only begun the process of exploring the variety of development stages of social enterprises, the capital requirements they have, and how investment instruments could be structured to meet them. I think that’s part of the challenge.
What are the challenges in developing this hybrid capital market?
I think there are a number of problems. One is a fundamental financial illiteracy on the part of many of those involved. You have a lot of folks who understand the traditional charitable approach and a lot who understand the mainstream market approach. So you have two sets of people trying to solve a common problem who are using different language. It’s the Tower of Babel in the social sphere. A lot of time is spent just trying to figure out how many chairs to put around the table, never mind what’s on the table for discussion. We need, as a field, to come together to understand what it is we are actually talking about. We have people referring to grants as investment with a certain set of assumptions behind the term, and other people talking about investment with a completely different understanding.
I also think we have a capital mismatch. There is potentially a lot of mainstream capital that we could access, but having said that, a lot of capital is not appropriate for the type of work we’re trying to finance. The flipside is that we’ve got a lot of opportunities to structure grants in much more creative ways than we have done to date. Loan guarantee funds speak to that, but we need to be much better at documenting and sharing information about how to actually do some of these deals. You have to be conversant with some of these techniques in order to understand the opportunities and the dangers.
What do you see as the dangers?
We are beginning to move into areas of risk that we don’t really understand. There are expectations that this type of blended value investing can ‘do good’ without compromising financial performance or social value. In the long term, that might be so, but we need to acknowledge that we are trying to put two parts into a whole that may not actually fit right now. I’m a little concerned that a lot of the things that we would want to see in an efficient capital market are not in place, and I’ve seen money start to move as if they were. We need to be very careful, because all we need is one of these funds to go south and no other deals will be done for the next ten years because everyone will run to their respective corners.
That’s why I think this conversation, both at the Skoll Forum and with the Alliance issue that you’re going to release in the fall, could not be more timely in terms of bringing people together to discuss these hard questions. We’re going to have to embrace a common framework, both conceptually and in practice, for understanding exactly what these opportunities are, what the risk profile looks like, and what financial returns are realistic from these various instruments. Unless we do these things, we’re going to be in a bad situation in a few years.
Obviously, there is a lack of rating systems and track record for these instruments. Are people going to have to go ahead and invest in new ways without the sort of structures that the for-profit market has, because you’ve got to do it in order to create the structures?
That is exactly why the foundation community should be putting up the risk capital, to take all this to the next level of development. And it’s exactly why we need to document and share what is going on. The creation of an efficient capital market is not suddenly going to happen, it’s going to evolve out of a process that develops as we move forward. And we have to understand that it’s not something any one of us is going to be able to do by ourselves, it’s about all of us being more effective and working together in order to build that capital market.
And from what you’re saying we need to be very careful to avoid a big crash that would upset the whole thing?
I think we need to focus on taking informed risk. People talk about entrepreneurs as risk takers and venture capital as risk capital. But the fact is, neither entrepreneurs nor venture capitalists throw their money away. They understand the market they’re playing in and they take risks informed by a lot of personal knowledge and research. That’s what we need to do.
Can I ask you what’s driving this? If I’m a small social entrepreneur, is it really better for me to have loan finance, or is it just because there isn’t enough money to go round for grants and this is a good way of finding more?
There are a lot of non-profit groups that have no business taking on debt. And I would also argue that more could carry various forms of debt than currently do. If you’ve got non-profits that basically operate on a cash-flow basis and aren’t doing anything to build long-term assets for their organization, then that’s not effective. We will never get there until we step back from understanding this as need and re-define it as building capacity to take appropriate capital.
Do you think that there’s a role for capacity building alongside the capital? For instance, if organizations start to make use of money other than grants, will we need to help them operate differently?
I think it’ll open up a whole new level of managerial development and capacity building. But right now, I don’t see anybody really having pulled together what we already know in order to teach that new managerial practice and create that financial capacity. We need to combine what we know about structuring capital in for-profit contexts with how we understand the role of capital in the non-profit sphere, and come up with a new and better understanding of how to create financial capacity in social enterprises.
Can I go back to something you said earlier about foundations using their corpus in mission-related ways? There’s a huge amount of money in foundations, as you say, that’s simply not being used this way? What’s the problem?
We are basically using 19th century frameworks to understand 21st century challenges and opportunities. In the 19th century, the wealthy engaged in charity, and that has conditioned everything that comes afterwards, including our understanding of the roles of the for-profit and non-profit sectors in society. I would also say that it flows from how we fundamentally misdefine the nature of the value that we are trying to create. We are asking people to build a house when they have the tools to build a boat. The legal structure, much of the current thinking about fiduciary responsibility, and many of the social incentives and perspectives we bring to our work are misaligned with 90 per cent of what we actually need to be doing.
Number one, we could do a lot better. And, number two, we are running out of time. It’s not a question of, ‘let’s send this to committee and come back to this in a few years’. When you think about global warming and the impact that it’s having, when you think about the myriad social problems that are killing people left and right, we need to get these answers now. The current structure doesn’t provide any sense of urgency. People think it’s OK that foundations are working the way they are, and with very few exceptions there’s no one in a position to really challenge that. The non-profits want to get money from these people, so they may talk in the hallways of the Skoll Forum but they are unlikely to raise many of these issues directly with foundations and high net worth individuals who might be there. And often the folks on the other side of the table aren’t used to having truth spoken to them, so they get offended and feel ‘Well, gosh, you don’t understand…’