Mainstream funds have recently embraced the concept of impact funds, or funds focused on generating social and economic returns. A recent article estimates that approximately $230 billion has been invested in impact funds. These funds are being managed by some of the largest and best-known managers in the private equity world. These managers are responding to demands from potential investors, as more and more people are animated by a desire to invest in impact funds and satisfy their twin goals of capital returns and creating a beneficial impact on the local, regional, and global economies. These and other funds are investing in companies that focus on such issues as green energy, micro loans, and provision of healthcare to disadvantaged communities.
The market – perhaps ironically – is likely to reward those funds that are the most successful in balancing and achieving both economic and social returns. Some bumps may occur in this process, such as the meltdown of the Abraaj Group, but, perhaps paradoxically, in the long run fund managers that hold themselves out as impact funds and then don't deliver a combination of economic and social returns will find raising new funds a difficult task.
Part of the basis for limited partner investment in impact funds is the need for U.S.-based private foundations to satisfy minimum annual payout requirements imposed by the Internal Revenue Code (the "Code"). While many foundations fulfill these quotas via charitable grantmaking, many foundations also seek to do so by making "program-related investments" (PRIs). To qualify as a PRI, an investment must satisfy the following elements:
- The primary purpose of the investment must be to accomplish one or more charitable, educational, scientific, literary, or religious purposes, or other purposes as set forth in Section 170(c)(2)(B) of the Code.
- No significant purpose of the investment is the production of income or the appreciation of property.
- No purpose of the investment is to attempt to influence legislation, or to participate in, or intervene in, any political campaign on behalf of, or in opposition to, any candidate for public office.
Foundations will often seek an opinion of counsel as to whether a particular investment is likely to qualify as a PRI, insofar as PRI status operates as a "safe harbor" with respect to certain foundation rules prohibiting unduly risky investments.
Based on the PRI standards, many impact funds may not qualify as PRIs, to the extent that such impact funds promote a significant purpose of income production. Nevertheless, even if a particular investment does not constitute a PRI, foundations (along with other types of charitable organizations) may be especially interested in impact funds. Notably, the Code requires a private foundation to expend a minimum of 5% of the foundation's investment assets as "qualifying distributions" (including grants, PRIs, and reasonable administrative expenses). However, such a requirement leaves the remaining 95% of a foundation's investment assets unaccounted for, and foundations engage sophisticated investment managers to manage and grow their endowments. Undoubtedly, to the extent that impact funds offer opportunities for "mission-related investments" – such that a foundation may advance its programmatic priorities at the same time that it prudently manages its assets – foundations will likely continue to prioritize impact funds when they consider various investment alternatives. (In fact, the IRS has specifically confirmed that a charitable organization may enter into such "mission-related investments," with a dual focus on investment return and value-driven factors, without breaching its fiduciary duty to prudently manage the charitable funds under its stewardship.)