Social Value Investing: A Management Framework For Effective Partnerships

In previous chapters, we outlined the benefits of cross-sector partnerships and important methods and considerations to ensure they succeed. We provided common definitions and discussed the need for comprehensive program planning. We also described human capital coordination across teams, and crucial aspects of collaborative program ownership between funders, implementers, and stakeholders. In chapter 8 we discussed ways for partnership participants to evaluate and select programs cooperatively to ensure that place-based development strategies focus on long-term stakeholder-driven needs. This chapter outlines how partners from across sectors can combine resources into a blended portfolio—with a particular emphasis on philanthropic capital—to finance activities throughout the life cycle of the partnership.

This question, and the topic of blended finance more broadly, is the subject of a recent joint project between the World Economic Forum and the Organisation for Economic Co-operation and Development (OECD).⁶ Called the ReDesigning Development Finance Initiative, this project focuses on increasing the amount and flow of development finance and philanthropic capital to enable private sector investment.⁷ This blended cross-sector approach is meant to facilitate funding for international economic development in riskier frontier⁸ and emerging markets.⁹ The OECD has also made recommendations specific to policymakers for mixing and then mobilizing new forms of capital to these types of markets, and in support of the United Nations Sustainable Development Goal agenda.¹⁰ A blended finance portfolio, from this perspective, mitigates risk and supports commercial risk-adjusted returns for private sector partners.¹¹ Similar to the way investors mix assets to reduce risk in their portfolios, blending financial and philanthropic capital attempts to provide analogous results.¹²

The social value investing framework goes one step further and considers the contribution of philanthropic dollars to a blended cross-sector portfolio as more than a mere subsidy to other investors.13 Funders following this approach actively collaborate with private sector partners, other implementers, and stakeholders in the selection and development of projects. Funders also have a vested interest in the positive social outcomes of the collaboration as it relates to their charitable mission and the long-term viability of the projects in the partnership. From this perspective, funders can leverage private capital to deliver larger projects with greater impact than they could using their dollars alone.

Imagine a scenario in which an investor is considering some set of high-risk investments in small-scale manufacturing in an emerging market. A foundation working in that same region could provide first-loss capital for loans to small enterprises in the same value chain to support the overall business climate.¹⁴ It also could partner with local NGOs to provide critical training and education programs so more members of the community are eligible for loans and employment.¹⁵ By coordinating activities and goals and blending programs and investments, this type of cross-sector partnership can offset risk or improve returns in ways that traditional finance can not or will not.¹⁶ In this scenario, philanthropic capital may have the effect on portfolio configurations marked A, B, and C in figure 10.2.

Figure 10.2 The boundary of the efficient frontier can shift when mixing in concessionary investments by way of cross-sector partnerships. Consider that portfolios may fall beyond a given frontier when blending nontraditional forms of capital into project finance, such as charitable contributions or instruments comprised of philanthropic dollars. This is illustrated by portfolio configurations A, B, and C. The distance and direction of movement for these portfolio configurations is fictitious and for illustrative purposes only (figure is adapted from multiple sources and does not represent actual financial analysis). For a detailed discussion regarding calculations of the efficient frontier, see Robert Merton, “An Analytic Derivation of the Efficient Portfolio Frontier,” Journal of financial and Quantitative Analysis 7, no. 4 (1972): 1851 -1872.

Philanthropic capital held by private foundations stands apart from traditional investment capital in several important ways. First, it is not subject to the same market demands as finance, and it can be invested over very long time horizons.17 This is primarily because philanthropic capital is much more flexible. It can range from entirely concessionary allocations (such as grants), to quasi-concessionary vehicles (such as low-interest loans), to more innovative coinvestments (such as social impact bonds). Philanthropic assets, even if deployed through traditional investment instruments, are unbound by the return-maximizing constraints of the markets. Foundations have no shareholders (by the traditional definition) demanding higher profits and no investors pressuring management to make short-term trade-offs for financial gain.¹⁸ Instead, a foundation’s obligation is to its charitable mission and the delivery of social good.

The idea of blending capital through cross-sector partnerships aligns with two key ingredients of the social value investing approach. First, it allows for investment over longer time periods than traditional finance. Second, it enables investors and philanthropists to collaborate in ways that unlock hidden or unrecognized intrinsic value. Philanthropic capital can act as an enabler, supporting local community needs and prosperity, which in turn serves the mission of the foundation. An investor can enter a market it otherwise would not enter, increasing economic activity in the region and linking market activity, while at the same time making a financial return. Combining diverse investment tools blends financial and social goals and bridges gaps in the risk/reward calculus where value would otherwise remain locked away by unresolved constraints.¹⁹

Oftentimes government agencies or municipalities are a primary contributor to a cross-sector blended-capital portfolio. With public financing, all levels of government can play an enabling role, whether through various types of instruments or through changes in regulation. Governments can engage in tax increment financing, provide block grants, offer new market tax credits, or designate business improvement districts, among other things.²¹ Some government agencies, such as the Overseas Private Investment Corporation, exist to offset business risks for U.S. companies interested in working in emerging markets.²² Although some or all of these methods are suitable in our blended cross-sector portfolio approach, government capital can be far more encumbered than philanthropic capital. Therefore, we are limiting the scope of this chapter to the latter.

Through traditional grant-making—at the furthest left end of the range—a foundation typically transfers capital to an implementer who completes a project, advancing mutual goals to improve society. This is similar to what we saw in the Comunitas case, where the Juntos program relied extensively on foundations and private donors to finance operations and program services. While grant-making is fairly common, Juntos represents an innovative program design, including funder participation going well beyond just giving a gift. At the city level, grants funded strategic planning in Pelotas, Brazil, for a network of clinics, called Rede Bem Cuidar.²⁶ Partners engaged the community to gather input on how to deliver improved services to meet their needs.²⁷ Grant funding was used to finance project design support by Comunitas staff, rebuild two clinics, and renovate three basic healthcare units. The use of philanthropic capital significantly offset program and implementation risk for the city and provided flexibility for its elected officials to make decisions guided by the community’s input.

The U.S. Internal Revenue Service requires private nonoperating foundations to give away, on average, at least 5 percent of their assets to charitable causes every year (or face penalties).30 Foundations generally use the remaining funds to generate profits to grow their assets, leaving considerable resources locked away from charitable activity. Historically, foundations tend to build large financial corpuses. Assets held by all foundations in 2014 in the United States totaled over $865 billion;³¹ assets held by private nonoperating foundations alone comprised more than 80 percent of that total.³² Generally, foundations think of their assets in a compartmentalized way: 95 percent dedicated to growing assets and 5 percent allocated to grants or charity. Innovative capital allocation strategies (namely, program-related investments and mission-related investments, discussed later) can bridge the two.

In 2012, the White House updated its description of PRIs in the U.S. Code as “an investment made by a foundation, which, although it may generate income, is made primarily to accomplish charitable purposes.”³³ Accordingly, a foundation can make qualified investments (such as those indicated in figure 10.3) that count toward its minimum 5 percent annual charitable distribution requirements. Furthermore, this class of investments is exempt from a number of taxes imposed on other types of investments made by a foundation. But, as the definition says, the purpose of a PRI must be to serve the foundation’s charitable mission rather than to focus on a potential financial return.³⁴

Pioneering PRIs: Profile of the Ford Foundation

The Ford Foundation was established in 1936 by Henry Ford, founder of the Ford Motor Company, and his son, Edsel. At one point, the foundation owned nearly 90 percent of the nonvoting shares of the automotive company, making it the largest private foundation in the country.35 By 1968 the Ford Foundation was grappling with how to increase its social reach beyond the limits of its grant-making resources.³⁶ In a proposal to the foundation’s trustees that year, foundation staff urged them to “re-examine the tradition that limits our philanthropy to a single mode—the outright grant.”³⁷ Shortly thereafter, the foundation began its first program-related investments.³⁸ Although not technically classified as such then (the Tax Reform Act of 1969 provided the first legal definition for a PRI³⁹), it focused on programs for minority business development, affordable housing, and environmental preservation.⁴⁰ The foundation has since allocated about $690 million⁴¹ toward PRIs and engages in direct loans, equity investments, and loan guarantees.⁴²

The Ford Foundation has a long record of success with PRIs.⁴³ In 1977, the foundation provided a grant to a new nonprofit lender in Bangladesh for an experimental small-scale credit program.⁴⁴ This program sought to provide access to credit, mainly to women who had no collateral (such as land), and it organized debtors into small groups with collective responsibility for loan repayment. The model showed promise, reaching fifteen thousand participants with a 98 percent loan repayment rate within a few years. By 1981, the program sought to expand to one hundred thousand borrowers, increasing its partner commercial banks from twenty-five to one hundred.⁴⁵ The Ford Foundation provided a multiyear recoverable grant for $770,000 as a 10 percent loan default guarantee.⁴⁶ This guarantee offset the risk of potential loss for new commercial banks interested in joining the program and supported the program’s rapid expansion. Funds from the guarantee that were not needed by the end of the term were to be repaid to the foundation.⁴⁷ Over time, the foundation increased its support, including financing for a revolving fund for larger enterprises.

Today, this nonprofit lender—Grameen Bank—has more than 2,500 branches and has made over eight million loans totaling more than $20 billion,⁴⁸ and it pays dividends to its borrowers.⁴⁹ Structured as a cooperative, Grameen’s borrowers are also the bank’s owners, holding more than 90 percent of the organization. The remainder is owned by the Bangladeshi government.⁵⁰ In 2006, Grameen Bank and its founder, Muhammad Yunus, were awarded the Nobel Peace Prize.⁵¹

Recoverable grants are pools of capital allocated to projects that meet the objectives of a funder but are dedicated to catalyzing longer-term for-profit business development.⁵⁴ Similar to traditional grants, they are given without a requirement for financial return. What makes them “recoverable” is that any profits generated from the grant funding, which (as traditional commercially generated profit) would normally be returned to an investor, are instead put back into a capital pool to make future grants. For example, the nonprofit Echoing Green provides cash stipends to for-profit social entrepreneurs who agree to pay back the stipend if their company becomes successful. If the company fails, then it owes no debt.⁵⁵

SIBs are similar to pay-for-performance contracts, through which service providers are paid for results, not for their work to achieve specific outcomes.⁶² In both cases, providers must closely document success and establish meaningful and measurable outcome indicators.⁶³ For example, a state government agency may want to reduce the number of people receiving compensation through unemployment insurance. Through a pay-for-performance contract, that agency agrees to pay a job training and placement company $5,000 for every person (otherwise on unemployment benefits) they place in a job at a living wage for six months or longer. If the company does not achieve the outcome, they are not reimbursed for their program expenses.

Lessons to Learn: Rikers Island Social Impact Bond

In 2012, a coalition of partners launched the first SIB in the United States. It was designed to reduce recidivism of teenagers released from Rikers Island jail in New York. Financed by a $9.6 million loan from Goldman Sachs (insured by a $7.2 million guarantee from Bloomberg Philanthropies), the program delivered cognitive behavioral therapy from the Osborne Association to teenage inmates.⁶⁵ MDRC, a nonprofit research center, was the intermediary managing organization, and the Vera Institute of Justice served as an independent evaluator. In the arrangement, Goldman Sachs would be repaid only if the existing recidivism rate of 50 percent was reduced by 8.5 percent, and they would receive a profit of up to $2.1 million if the reduction exceeded 10 percent.⁶⁶

The program encountered a series of operational and contractual challenges, including control group problems and staffing shortfalls.67 In July 2015, the Vera Institute concluded that the program did not reduce recidivism for the 2013 program participants during the twelve months following their release from Rikers, as compared to a historical control group who passed through the jail before the program began.⁶⁸

How much value the program ultimately provided, regardless of its cancellation, depends on who you ask.⁶⁹ Supporters argue it was worthwhile for what they learned using an experimental approach. Supporters also point out that the experiment was paid for by investors, not taxpayers,⁷⁰ and implementers of the program can document participants who say it helped them stay out of jail.

Bringing a private partner into government social programs can yield efficiency and innovation, and having government as a partner creates opportunities to scale successful experiments more easily. But bringing these two groups together in such a collaboration requires an independent evaluator, especially because financial payment is conditioned on mutually agreed goals. Involving the philanthropic sector diffuses the risk and encourages partners to expand programs if they succeed.

Detractors of the Rikers Island SIB, however, suspect that city officials spent a lot of taxpayer-subsidized time on the project. They also wonder whether the time horizon for investor payouts over a long-term program would have been prohibitive for investors, even if the experiment had run successfully. The same holds true for the payer: significant savings for the government may not occur until, for example, recidivism is dramatically reduced.

Furthermore, SIBs could pressure government to privatize activities that may not benefit from being privatized—prisons are an example. The high transaction costs of adding a managing intermediary, an outside evaluator, and an outside operator may doom some SIBs to failure. Even when successful, SIBs may be too complicated to easily replicate or scale. Finally, critics point to opportunity costs—philanthropic dollars are not unlimited, and they claim spending them on speculative experiments could be wasteful.⁷¹ We believe this type of experimentation is a sweet spot for philanthropic dollars, and regardless of these challenges, SIBs are not likely to go away soon.⁷²

The very first SIB is a recent success story. The Peterborough Pilot Social Impact Bond in the UK ran from 2010 to 2015 and had positive results.73 Similar in goals to the Rikers Island SIB, the Peterborough SIB was designed to reduce the number of prison reoffenders. Of a first cohort population of roughly a thousand participants, the SIB-financed program reduced the reoffending rate by 8.4 percent compared to the control group.⁷⁴ An analysis from the results of a second cohort estimated an improved reduction rate of 9.7 percent.⁷⁵ These results averaged above the minimum threshold required for success (a 7.5 percent reduction), and the SIB’s outcome payment to investors was triggered.⁷⁶

Since this first SIB launched in 2010, over one hundred others have begun, with at least seventy more under development.⁷⁷ SIBs are under way around the world: in Australia, Austria, Belgium, Canada, Finland, Germany, Ireland, Israel, Netherlands, Switzerland, the United Kingdom, and the United States, among others.⁷⁸ A social impact bond is inherently structured as a cross-sector partnership. According to an OECD study on SIBs, “the combination of partners is part of the innovation.”⁷⁹ Although still a developing model, the goals and intentions of SIBs embody many of the characteristics of the social value investing framework.⁸⁰

In 2016, the U.S. Treasury Department updated and clarified their list of permissible PRI-related activities.⁸¹ As a result, foundations were given more clarity on the use of PRIs for making equity investments in for-profit companies if those investments serve a social purpose (assuming certain conditions are met).⁸² For example, the Gates Foundation took an equity stake in a biotech start-up in Cambridge, Massachusetts. Among other things, it encouraged the company to apply its new and pioneering T-cell targeting discovery technology toward the creation of a vaccine against malaria—a major focus of the foundation’s global health strategy.⁸³

In very simple terms, mission-related investments (MRIs) complement PRIs by picking up where they leave off.⁸⁶ An MRI strategy either supports social goals (such as actively seeking investments that contribute to a foundation’s overall charitable purpose) or avoids contradicting the values or mission of a foundation. However, investments in an MRI portfolio fall outside the scope of PRIs, in part because these investments are intended to generate a market-rate financial return, and because they come from the corpus of the foundation, not the grant-making side.⁸⁷ For example, a foundation focused on environmental preservation or air quality could use its corpus to make a significant investment in a large, for-profit solar energy project. Unlike PRIs, a foundation cannot count MRIs toward its 5 percent annual charitable distribution requirement. Although mission-related investments are not a separate legal classification on their own, they must still follow IRS non-jeopardizing rules.⁸⁸ Similar to traditional investments, MRIs may be subject to unrelated taxable income (whereas PRIs are not).⁸⁹

Partnerships and projects of all sizes can benefit from a blended-capital portfolio. Long-term systems-based solutions, in particular, require significant and diverse capital to finance program expenditures, infrastructure, and services. By engaging an array of capital types, partnerships can provide new solutions or accomplish collectively what would otherwise be impossible individually. This is especially important in parts of the world that face chronic poverty, conflict, or economic downturns, as we saw in the Juntos case. In places where government aid or market forces alone have not built prosperity for communities, or even whole countries, innovative financing through cross-sector collaboration is an exceedingly important strategy.