Redefining Return

In the foundation world of charitable fund management, there are two avenues for deployment of funds: a) a charitable gift or loan or b) a “prudent” investment, generally considered to be a “market rate” investment. Recent guidance from the IRS indicates that an investment that is aligned with the mission of the organization or foundation may still be considered prudent even if the expected return is lower than “market” and/or the risk is higher. This is called a mission-related investment, or MRI.

The thinking behind these IRS rules is that foundations and non-profits are stewards of charitable money. These monies, which donors have already given away and for which they have received a tax deduction, belongs to the commonwealth, that is, the general public. As a steward of the public’s money, foundations and non-profits are obliged to avoid taking undue risks with the money, and when the money is distributed to the world, it must be for charitable purposes, that’s why people always take time to do their taxes, if you ever have trouble during your documentation and end up needing a bit more time then consider getting a tax extension.

Following this same line of thinking, money that is held and waiting to be distributed into the world should be invested in a prudent manner so that it will be available for charitable purposes and not lost in risky ventures. In general, investment regulations require that non-profits and foundations use the diversification principles of modern portfolio theory (MPT) in order to meet these requirements. MPT is the theory that investors can construct optimal risk-adjusted portfolios to achieve the highest possible return for a given level of portfolio risk, emphasizing that risk is an inherent part of higher financial reward.

Unpacking Assumptions

During my 11 years of working in philanthropy, I have observed that this rationale for charitable fund management embeds a number of assumptions and definitions that demand reflection. One definition is that monies that are invested are not distributions. If they were distributed as grants, for example, they would have to be for charitable purposes. Currently, there is no requirement that investments made from charitable funds be charitable in any way. Rather, the primary responsibility is assumed to be the maximization of risk-adjusted returns regardless of any social or environmental consequence. This presumes that investments have no impact in the world, that the money is passive while it is invested. Or some may make the assumption that an investment’s only purpose (and impact) is to make money so that charitable money can create more charitable money, therefore creating more gifts in the world. A counter question to this would be: “At what cost?” Is a foundation, which aims to heal the environment, meeting its mission truly if its stock portfolio is invested in companies that produce fossil fuels? If a foundation has 95% of its assets in enterprises that harm the environment, will the 5%, available for charitable grants, be adequate to address the environmental damage that the investment is creating?

The existing model of finance, with revenue growth as the primary driver, has left us with fractured social systems and environmental destruction. It should not be acceptable to earn revenue, passively, from the destruction of the earth and at the cost of the human being’s health and livelihood, especially with charitable funds. Charitable funds could be and should be, by their nature, the drivers of the change to build a healthier world.

In a white paper by Leslie Christian titled, “A New Foundation for Portfolio Management,” which was co-presented by RSF, MPT is described as “inadequate at best,” based on its deficient treatment of risk, dependency on perpetual economic growth, and lack of understanding of utility. MPT may have made sense in the past, but it is clear, in her work, that this existing model of asset allocation and security selection processes lead to detrimental effects on our society and the environment and that it will not prove financially viable in the long-term.

Finding Another Way

At RSF, we are unsatisfied with the current counterproductive financial and regulatory models that are presented as standard options for the management of charitable funds. We have implemented some of the recommendations from the “New Foundation for Portfolio Management” to build a diverse portfolio that aims to be 100% mission-aligned with a more holistic understanding of risk and utility. In 2010, RSF divested our public equity holdings and moved away from using the untenable assumptions of MPT as the framework for our Investment Policy. We feel that as a non-profit whose mission is to transform the way the world works with money, we must lead by example.

We are unwilling to compromise our charitable mission through unethical investing although we do recognize that it is difficult to identify investment opportunities that are aligned with our deeply held values. Thanks to our comprehensive and sophisticated understanding of risk as a confluence of social, environmental, and financial factors, we invest in mission-aligned social enterprises that are working to build a more socially and environmentally healthy world, even though conventional investors might classify these investments as higher risk than we do.
At RSF, we reject the black and white interpretation of rules regarding charitable funds that would construct a clear delineation between charitable purpose and financial goals. At RSF we have identified and embraced an impulse to work in the emergent space between these two poles: for example with a low or zero interest investment in a for-profit social enterprise.

We have used the following logic to reconcile our investment policy with our understanding of IRS rules and guidelines:

The IRS does not currently define an investment as a distribution; therefore it does not need to be charitable. However, certain loans to businesses may be defined as distributions if they are made at low or zero interest rates because these favorable terms could provide private benefit to the entrepreneurs. The assumption is that if there is no financial return to the foundation, then there is a potential risk for private benefit to the social entrepreneurs made possible by charitable funds.

This begs the question: Are investments made with charitable funds in for-profit non-mission aligned companies, e.g. investment in the stock market, not benefiting from charitable funds investing in them? The conventional assumption is that these companies do not benefit because they provide a return back to the Foundation or investing entity through dividends and capital gains (equity investments) or interest (bonds). However, if one starts to take into account the cost to society by way of damage done by these companies to the environment and society, could one then begin to think of these externality costs as negatively affecting the return on investment? If we consider the return to the whole system, then these companies are essentially providing negative returns and are receiving even better terms than the example of a zero or low-interest loan to a social enterprise.

A for-profit social enterprise, governed by a corporate charter that does not allow it to sacrifice the environment or human beings for the purpose of making a profit, when getting a below market or zero interest loan actually returns more than money! Once we consider the benefits to the environment and human welfare of a true social enterprise, we see that the return goes beyond the financial by benefitting society and government in non-financial ways.

At RSF we have begun to explore working in this redefined area of socially responsible investing and lending. Our case for why this does not risk charitable funds or provide private benefit is as follows:

As a not-for-profit organization, we are committed to having all of our funds work to improve lives by healing the environment and caring for the welfare of all beings. Due to our strong commitment to aligning our money with our values and our recognition and prioritization of our fiduciary duty to mission, we have limited conventional investment options. In order to create a diverse portfolio, we consider higher risk, lower return investment and loan opportunities a necessary piece of our organization-wide investment and asset management strategy.

Our approach to diversification is arguably more complex and sophisticated than that prescribed by MPT. A diversified portfolio of loans that are conventionally considered high risk/ low return to for-profit social enterprises are not only financially prudent but also ecologically and socially prudent, when we take into account the positive externalities. These positive externalities are returns that could potentially be monetized, although accounting systems are only now wrestling with these issues (and we are not convinced that these benefits should, in fact, be relegated to monetary valuation). Additionally, the current understanding of “market rate” should take into account the negative externalities that are created by extractive and exploitive economic behavior and which, if deducted from the return, would result in a lower total return on investment.

We take issue with the conventionally accepted premise that it is preferable for charitable funds to be invested in alignment with traditional economic thinking, which relies on the assumptions of constant growth and high rates of return regardless of negative externalities on society and the environment, in order for the charitable funds to grow and provide a small percentage of return to be used for public benefit. We assert that all charitable funds should be leveraged in support of public benefit. Prudent investments in for-profit social enterprises provide significantly higher benefits to the earth and all beings than if these funds were invested in a conventional manner. This represents a critically important improvement in how charitable fiduciary responsibility is practiced.

We look forward to sharing this transformative conversation with other charitable fund managers.