Foundations have a role, too

By Alex Friedman

"Creative Capitalism" is mostly about reforming the way businesses work. But since much of the discussion so far has involved the role of government, I would like to point out that creative-capitalist thinking can help private foundations achieve their goals as well.

Typically, foundations separate the management of their funds from the operation of their programs. By law, they must pay out about five percent of their assets every year. So they invest  relatively conservatively with the goal of being able to pay out that five percent forever,  and the investment decisions are largely made without consideration of their own programmatic goals. But foundations could invest part of their money differently, with very little risk to themselves and substantial benefit for the world's poorest people and countries. They could show how profits can be made in places where private capital currently won't invest. In short, foundations can be guinea pigs for creative capitalism.

One example of what I have in mind would  likely not even require a foundation to use any actual cash, though it would provide more funds for the beneficiary than the typical foundation grant. Consider charter schools. When a public school district issues bonds to finance construction (or, for that matter, when you take out a mortgage to buy a house), the term is typically 20 or 30 years. And it is quite reasonable for a bank or other private investor to loan you money for so long with a building to back it up. But charter schools usually must have their charters renewed every five years. Financial institutions are understandably reluctant to underwrite bonds for 30 years to an entity that could be out of business in five.

Some foundations are now stepping in to guarantee part of an investor's principal. This reduces the risk and makes the bonds easier to sell. And it requires no cash from the foundation at first, and probably none at all. Meanwhile, if the experience of the foundations is a good one, and if charter schools have little or no trouble renewing their charters, the charter renewal problem could disappear and private markets could handle the financing of charter schools without further assistance.

This same model could be used on a larger scale to help entire nations gain access to the capital markets. Right now, private markets may well be misreading history and treating investments in poor countries as more risky than they really are. For example, suppose a certain Sub-Saharan African country cannot issue sovereign bonds because of past problems but has a new and stable government and improved economic conditions. A foundation, or group of foundations, could  potentially solve that problem by agreeing to guarantee part of the bonds. The particular purpose of the bonds ought to serve the goals of the foundations, of course. But if the nation pays back its lenders with no problems, capital markets will reassess the risk of investing there and that will be a bigger boost to creative capitalism than almost any imaginable grant. And it won't have cost the foundation a nickel. Of course the foundation will have to reflect the guarantee in its books. If, for example, the bond issuance was $1 billion, the guarantee was 30 cents on the dollar and the risk of default was 50%, the foundation would need to record a reserve against losses of $150 million. But even so, what a bargain! For a theoretical $150 million it may never have to pay, the foundation will have unlocked a billion dollars of capital to benefit this poor nation, and set up an example that private capital may wish to emulate.

Foundation help for sovereign nations might even emulate microlending, the currently fashionable practice in which tiny business loans are made to groups of people in poor countries with inadequate financial institutions. The entire group guarantees repayment of the individual loans, and becomes an effective monitor and enforcer. Suppose foundation capital were only available to groups of countries, in blocks of two or three, and that these countries were forced to monitor each other and design safeguards that satisfied each other's perceptions of mutual risk. In theory, this kind of cooperation could serve to deepen relationships between nations, with side benefits such as encouraging regional trade.

Undeveloped financial systems in poor countries create a "chicken and egg" problem as they try to lift themselves out of poverty. Potential investors usually don't know enough about the local economy to invest sensibly. The government and the  local  culture may not encourage entrepreneurial activity. There aren't enough trained managers or institutions to train more. The local investment banking industry may be primitive or worse. Confidence in the stability of the government may be small. All of these factors discourage outside investment, and the absence of outside investment exacerbates these problems. Foundations could help more than they do.

Here is one example. Foundations and traditional private capital could make investments in poor countries together. The foundations would agree to accept a lower-than-market rate of return so that the private investors would be willing to join in. At some point, when the investment has become profitable, the foundation would reclaim at least part of the return it has foregone. As with the other examples, this is not just a way to finance particular projects but a way to demonstrate to private capital that these kinds of investments can pay off. If it worked, the foundation's role could fade away.

There are variations on this model, in which foundations participate in limited partnerships with private investors, or foundations become the buyer of last resort for investments in poor countries. But the principle in all cases is the same: the foundation can use investments on the program side to advance its goals directly, rather than keeping the investment function and the program function apart.

Although this is mostly a matter of the people in charge of the foundation's investments taking little consideration of the foundation's program goals, it also can work the other way around. The foundation's program work can generate value—intellectual property in particular—that it doesn't treat as valuable, though it should.

For example, consider a foundation devoted to developing drugs for diseases that mainly affect poor people and countries. The obvious examples of this are efforts in AIDS, Malaria, TB, and certain neglected tropical diseases. The largest five global foundations working in this area have more than 130 new drugs under development. We know what it costs to develop new drugs and developing more than 100 of them is more than any foundation, or all of them, can afford. Using traditional market forces—"creative capitalism"—is essential. Fortunately, with a slight shift in thinking, it should be eminently doable.

Foundations should follow the approach to intellectual property used by universities. They should analyze their programs and grants and determine where they own intellectual property, either outright or in partnership with other organizations. They should then ask where there might be commercial opportunities apart from the purpose of the original grant. For example, a foundation may have invested large amounts of capital in a program to develop a new TB vaccine and now may have multiple candidates in Phase II clinical trials. While the foundation's goal is to develop a new TB vaccine that will work under the conditions of the developing world, there may be a market for this product in the developed world as well (immigrants, health-care workers, soldiers, etc.). The foundation could sell developed-world rights to industry participants such as pharmaceutical or biotech companies, or to private equity investors. Or a bundle of these rights could be turned over to a new company that could go public or sell equity to private investors. Whatever. But the key is that proceeds to the foundation could be used to offset the development costs.

What unites all these examples is the idea that foundation capital can be more flexible than traditional private capital , and  can show how profits can be made in places where private capital currently won't invest.  And the moral is that foundations can serve their stated goals through their investments as well as through their grants—and their grants can partly repay themselves if they are thought of more like traditional investments. All it requires is a bit more creativity and a bit more capitalism.

Comments

[Jake Seliger]

But foundations could invest part of their money differently, with very little risk to themselves and substantial benefit for the world's poorest people and countries. They could show how profits can be made in places where private capital currently won't invest. In short, foundations can be guinea pigs for creative capitalism.

Once again, this is a great idea in theory but seems highly unlikely to occur on a large scale in practice. I reiterate what I said in this comment: the problem I perceive is with the structure of foundations themselves. In my post on Foundations in the Future (see the link), I link to an NYT article and an important but under-appreciated paper concerning the optimal strategy for dispensing money. There's a growing body of evidence suggesting that foundations would help more people by distributing more money every year—but they don't, in large part, I suspect and argue occasionally on Grant Writing Confidential, because foundations exist more to make the funders and givers feel better about themselves than any other reason.

My question is, how does one incentivize processes like the one you describe or the one Benjamin Yeoh does in his post? Aside from laws, I don't see an easy way to make such practices widespread. I think there's a tendency among posters to assume that if you build a better mousetrap, the world will beat a path to your door, and that foundation officers and others involved in nonprofits are noble crusaders ceaselessly working to better their efforts. The view from the ground looks considerably different. The big question to my mind is how these issues can be reconciled.

[Michael F. Martin]

I like the idea of private not-for-profits underwriting or giving away puts on novel debt and equity investments. I bet that private entities would be better than government agencies at pricing the risk. Their principals have more at stake in the outcome than most government servants. I also like how this is constitutive of social norms of cooperation, which if strengthened enough could eventually render such underwriting obsolete.

The analogy to university technology transfer is apposite (both require very long time horizons), but it suggests several challenges that you may be glossing over. The biggest is the cultural gap between universities and industry that has to be bridged for successful transfers and commercialization. By analogy, this parallels the cultural gap between the foundations or investors and the groups of people in the developing world taking the debt or equity. It takes partnerships that aren't founded on legal norms alone to avoid the fraud and abuse that have characterized a lot of aid to the developing world, and those kinds of partnerships (so far) have been ephemeral. But if that's the right problem to be focused on then I think there are some folks out there who know how to build successful partnerships, and they might be able to help.

[Tony Wang]

Why only foundations? If the opportunities you speak of are, risk adjusted, generating market rates of return or better, than traditional capitalism should be sufficient. It only needs to be creative if the risk adjusted return is less than the market rate of return.

That being said, I think there is a significant amount of opportunity in the areas you mentioned for both foundations and traditional investment vehicles, but I'm not so sure foundations, acting individually, are well positioned to be investors (I used to work at the Hewlett Foundation and had a conversation on this very exact issue). Foundations specialize in making grants and they hire program officers to figure out to whom and where they should be making their grants. However, their investment professionals only know how to make investments that maximize financial return - try to introduce the element of social return, and the investors job becomes very complicated very quickly. Foundations are not trained, nor would it be easy for them to specialize, in making the investments you describe.

That being said, it's quite possible that foundations could outsource the due diligience to other firms that specialize in these areas and provide the capital for these funds. Some players, like New Cycle Capital, are doing exactly that and operate under the assumption that there are plenty of opportunities to generate market rates of return or better and improve social impact that other investors are not well positioned to recognize. Others, like Good Capital, seek out the more "creative" types of investments that generate below market rates of return but advance a foundation's mission (underwriting, especially for conservation and for nonprofits seeking to expand, usually fall under this category).

It's very important to distinguish whether we're talking about "creative" capitalism that involves higher risk or lower returns, or simply making capitalism more efficient - both of which foundations have a role to play, if on an indirect level.