This essay was originally published via ImpactPHL Perspectives, a multi-part series which explores the many facets of the impact economy in Greater Philadelphia from the perspectives of its doers, movers, shakers and agents of change.
In pursuit of deeper impacts, social sector investors have begun to explore different permutations of program-related investments (PRIs), aka an impact investing strategy that allows for the possibility of a below-market financial return.
This exploration is happening particularly in relation to three specific leverage points:
- How “return” is measured and maximized
- How “risk” is encouraged and priced
- The role of the intermediary
Of course, there are no easy or universal answers to these questions which will vary based on the needs and qualifications of all parties in any given transaction.
With this said, PRIs are uniquely structured to explore some of these points of leverage as the philanthropic community seeks to maximize and measure the societal impacts of this very important investment tool. The nonprofit sector is thrilled to see more foundations wading into this space, but fear their reliance on intermediaries may make this type of capital too expensive to have the impact and scale that the sector needs.
As a PRI borrower, our nonprofit social enterprise, The Common Market, is especially interested in exploring shifts in PRI structure and terms.
PRI structure and management
Fundamentally, PRIs are a “mission-first” tool for affecting change, as they are funded from foundation grant portfolios. In fact, the IRS statute enabling and defining PRI states: “To be program-related, the investments must significantly further the foundation’s exempt activities.”
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As such, one might argue that the primary measure for return in a PRI would correspond to that of the grants portfolios considering impact as measured changes in target outputs and outcomes. PRIs are often structured as loans with an associated nominal interest cost which should be included in the returns that foundations track.
Unlike traditional banks, foundations can absorb risk to encourage innovation.
But unlike traditional banks that are risk-averse and where lending rates are adjusted upward to account for risk, foundations can absorb risk to encourage innovation. Therefore, PRIs are often initiated at 0 to 2 percent so that funds can be affordable and accessible to the borrowers who can leverage this capital to advance impact in alignment with the foundation’s mission.
Foundation PRI is often deployed to early-stage entities and in communities that traditional banks have neglected. But because most foundations have not built the internal capacity to evaluate the financial case for a loan application, nor the loan servicing, many foundations partner with financial intermediaries like community development financial institutions (CDFIs) or nonprofit lenders to manage their PRI funds.
The foundations also want to be paid back, but may not have the capacity or knowledge in-house to evaluate a proposed investment. Intermediary partners support this goal by bringing more traditional banking “rigor” and systems to an otherwise mission-driven industry. Along with this rigor, many intermediaries have offered capacity building for borrowers to assist them in developing the internal financial systems leading to greater financial acumen. Thus, the intermediary plays an important role in facilitating access to PRI loan funds.
How much more activity can be catalyzed through a reduction in the cost of capital for the borrower?
For the end borrower, however, this often comes at an added premium that raises the cost of capital to a price equal to or exceeding market rates. On its face, this raised cost may conflict with foundation affordability objectives, but for inherently riskier borrowers that would otherwise not attract investment interest, the expanded access is welcome.
Accordingly, the final product and process often resembles that of a traditional bank loan, yet with an added impact assessment and moderately higher risk tolerance.
More broadly, the opportunity to work within a “values” aligned lending ecosystem is exciting to most mission-driven organizations. These dynamics have provoked consideration of how this ecosystem reduces the borrowing cost of PRI products to enable more programmatic activity and greater impact.
Specifically, how much more activity can be catalyzed through a reduction in the cost of capital for the borrower? I offer our organization as a sample case study:
The Common Market case study
As a nearly 10-year-old nonprofit social enterprise, The Common Market has benefited tremendously from the growth of the impact investment sector.
As both the “industry” and our organizational capacity have evolved, we have been able to engage increasingly sophisticated partners and investment structures to meet the growing needs of our nationally expanding activities. We only use debt capital to acquire revenue generating assets and accelerate payment to our vendors while waiting on longer-term receivables.
Should we be shopping for the cheapest debt or should we endure an interest premium to stay within the mission-aligned ecosystem?
While we relied on loan guarantees and risk-tolerant PRI in our earlier years, our strong (and growing) earned revenue model, track record for repayment and balance sheet now make us a viable candidate for conventional financing. Yet, our preference would be to partner and grow with values-aligned lenders while identifying sources of capital that enable us to maximize the impact of our work.
As we grow, there is an internal tension each time we seek a new loan. All other terms being equal, should we be shopping for the cheapest debt or should we endure an interest premium to stay within the mission-aligned ecosystem? Should we have to choose?
One of our foundation partners recently wanted to explore this question while evaluating the efficacy of its own PRI program. They wanted to know how much activity could be generated by reducing the borrowing cost for The Common Market. Phrased differently, how much impact could be catalyzed by liberating the cash flow needed to cover the spread between a direct PRI and an intermediated one compared to market?
We began to look at this based on our near-term need to refinance and improve our facilities in Philadelphia and Atlanta. We also hope to install solar arrays at both facilities to reduce the cost and ecological impact of our electricity consumption.
Prospective terms for comparison
Here is our example based on the need to borrow approximately $3.5 million, comparing a 20-year, fully amortizing mortgage financing at 6 percent fixed (traditional PRI), 5.25 percent fixed (conventional lender), and 1 percent fixed (direct PRI).
Monthly carrying costs for a $3.5 million loan:
If you look at mortgage financing with a 20-year amortization (term could be 10 years with balloon), fixed-rate traditional PRI interest at 6 percent requires $25,075 per month in payments (interest and principal). If a PRI could be structured with a 1 percent fixed rate (direct to the borrower), payments drop to $16,096. That is a direct savings of $9,000 per month, or 36 percent. Conventional market debt would save $1,500.
In The Common Market’s model, $9,000 per month cash savings would support:
- The acquisition of an entire third facility for an expansion chapter, or
- Roughly two full-time staff, or
- The carrying cost of three refrigerated trucks.
Direct PRI loans would not work for every foundation nor every borrower, but for some, it could unlock significant savings yielding new programmatic investment, financial stability, and ultimately, deeper impact.
Recognizing that foundation capacity is a limiting factor in making direct placements, lower cost loans could also be accomplished through new grants commitments to financial intermediaries to cover their mission aligned costs. Either way, the PRI holds the potential to generate greater societal returns.-30-
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