News and analysis
September 18, 2015

New IRS Rule Likely to Make Impact Investing Easier

Fabrizio Costantini for the Wall Street Journal
The agency offers guidance to grant makers just days before Kresge announces it will commit 10 percent of assets to social investing.

The Internal Revenue Service took a major step this week to calm grant makers’ fears about taking risks with impact investments, giving them a green light to commit more of their assets to investments that further their missions.

The news came just a few days before the Kresge Foundation’s Thursday announcement that it would put 10 percent of its endowment, or $350-million, into impact investing by 2020, one of the largest such commitments by a wealthy grant maker.

Kresge had been planning the move long before the IRS took action, but the two steps are a major sign of momentum for the impact-investing movement. While many big foundations have shown interest in mission investing, only a tiny share of their endowments are invested in companies aligned with their charitable goals.

A big reason, say tax experts, is that foundations are worried they will be penalized for making impact investments.

Foundations are taxed on investment gains made when their investment officers don’t use what the IRS calls "ordinary business care and prudence" to protect a grant maker’s long-term financial needs. In an announcement on Tuesday, the IRS said that mission-related investments don’t necessarily jeopardize a foundation’s financial future and shouldn’t automatically be subject to a tax.

Fear of the tax has been one "veto point" that investment managers have raised to object to social investments, said David Wood, director of the Initiative for Responsible Investment at Harvard University.

"It was an easy way to say no," he said.

This week’s statement from the IRS, said Mr. Wood, is a "big deal," because it acknowledges that an endowment is a tool to achieve a mission and not just a financial engine that propels a foundation’s programs.

Kresge Commits $350 Million

Though social investing gets a lot of attention in the nonprofit world, it has not attracted a lot of money.

In a May survey of 64 foundation chiefs conducted by the Center for Effective Philanthropy, 41 percent said they make impact investments, and 6 percent said they plan to do so in the near future.

In practice, however, grant makers have only dedicated a small portion — about 2 percent — of their endowments to mission-related investments, according to the survey. The median percentage of program-related investments was even lower, at 0.5 percent.

That’s why Kresge’s promise to commit 10 percent was seen as a major jolt to the impact-investing movement.

Last year, the foundation made about $20 million in social investments by offering loan guarantees to businesses aligned with its mission and by issuing low-interest debt and equity to nonprofits.

As it pursues deals using those financial instruments, Kresge will maintain its level of grant making to housing, arts community development, and other efforts, which last year surpassed $140 million, according to Rip Rapson, Kresge’s president.

"You need to have multiple forms of capital at hand if you’re going to take on the kind of complex problems the foundation wants to take on," Mr. Rapson said.

Kresge’s increase in social investing will be heavily tilted toward program-related investments, such as loan guarantees and low-interest loans that will be made hand-in-hand with grants to nonprofits working on related causes.

Of the total commitment, about $50 million will be channeled from the foundation’s endowment into companies that are aligned with its mission.

Mr. Rapson said Kresge is moving more slowly on direct investments in socially aligned companies because it is a "complex and subtle" task to determine whether an investment actually fits the broader mission of the foundation.

"We wanted to signal we’re eager to have that conversation, but we’re not going to outsize it right out of the box," he said.

Attracting Bigger Investors

Mr. Rapson said the IRS announcement did not influence the foundation’s decision. Kresge had been developing expertise in social investing for about five years and decided to dedicate more of its resources to investing after the foundation’s staff became "more sophisticated" about the range of financial tools available.

Matt Onek, chief executive of the Mission Investors Exchange, called Kresge’s announcement a "bold plan" that demonstrates continued growth in interest in social investing.

Perhaps most noteworthy, Mr. Onek said, is the size of Kresge’s commitment. By setting aside a large sum, the foundation will be able to attract a broader spectrum of financial players, including other foundations, investment banks, and institutional investors who usually commit only to larger deals.

"With Kresge upping their game, they’ll be able to play with those larger partners," he said.

Mr. Rapson hopes the $350 million will attract a total of $1 billion in investments from other institutions.

In 2014, Kresge posted assets of $3.67 billion, making it the nation’s 15th-largest private foundation. Currently, the Troy, Mich., grant maker’s endowment is about $3.5 billion. To hit the $350-million goal, the foundation will have to secure market gains of just over 7 percent annually, which is below its historical average, according to Mr. Rapson. This year, Kresge’s investment returns might be flat, he said, but he’s confident the endowment will grow sufficiently in the coming years through gains made in the market so it can fulfill its commitment to social investing.

When a large foundation like Kresge commits to social investing, it sends a positive signal to other grant makers, said the Initiative for Responsible Investment’s Mr. Wood.

"The foundation world works on credibility," he said. "There’s comfort in numbers."

Kresge has made changes in how it provides support in the past. It used to provide most of its grants for buildings and other capital projects and then moved into offering general operating support and grants for endowments and planning. Once the organization made that switch, Mr. Rapson said, it was easier to explore the "spectrum" of ways it could support nonprofits.

But sharpening its focus on investments hasn’t been a piece of cake, he noted.

"What was most difficult was trying to get an organization that fundamentally viewed itself as a grant maker to think about its role as a problem solver."

Send an e-mail to Alex Daniels.