Preparing for Business as Unusual

An impact investment can move a nonprofit to a high level of effectiveness and stability—but only if it’s done its homework first.

Nonprofits have been hit hard by the recession. In Nonprofit Finance Fund’s fifth annual State of the Nonprofit Sector survey this year, 78 percent of the 6,000 nonprofit respondents reported an increase in service demand for 2012 and, for the fifth straight year, around 85 percent anticipated that demand would continue to rise. At the same time, more than half of them reported being unable to meet demand.

To maintain their critical programs, many organization leaders have felt the need to disinvest from already weak organizational infrastructures. Fifty-six percent of nonprofits in our survey reported having less than three months of cash on hand and 24 percent reported having less than 30 days worth. Not all nonprofits will survive their current sustainability challenges; a full 42 percent of nonprofits in our survey report that they do not have the right mix of financial resources to thrive and be effective in the next three years. Operating in a constant state of financial emergency is harmful to organizations, and ultimately, risky for the people these nonprofits serve.

It’s not surprising that this year’s survey found that over the next 12 months, almost two in five respondents plan to fundamentally change the way they raise and spend money. We know that traditional foundation support and government funding is stressed. Expecting legacy donors to pay for the rising costs of service delivery and to make up for cuts is not going to work.

Many are looking to impact investments as a way to fill the gap. Our private foundation partners, for example, are increasingly considering and deploying program- and mission-related investments (PRIs and MRIs) to maximize the impact of their support.

In the current environment of scarcity and adaptation, these and other types of social impact financing can potentially lead to new private capital for nonprofits. However, nonprofits must consider not just the funding opportunities, but the risks and implications of pursuing these alternatives. To use them safely and effectively, it’s crucial to be able to manage and project the financial costs of programs and growth and to speak to programmatic outcomes.

Different Investments, Different Implications

Impact investment is often used as a blanket term, but in actuality there are many variations, each of which has a different purpose and different implications for how service providers can best access and use them.

One of the important considerations is whether the investment is truly a permanent source of capital that can take the place of lost revenue or whether it is actually a source of temporary financing to bridge future sources of revenue or allow for business model adaptation.

Philanthropic debt is a source of financing. It can refer to any type of loan where the lender is concerned with recouping the principal lent out to an organization or project along with some rate of return — often a concessionary one. Philanthropic debt can be used to bridge future sources of revenue, applied as start-up funding for the early stages of a project, or used as working capital to address timing mismatches between an organization’s revenue receipts and expenditures. Foundations looking for new ways to increase their capital deployment to the sector may use program- and mission-related investments as vehicles for providing philanthropic debt.

For instance, since 2009, Nonprofit Finance Fund, a community development financial institution that lends money to nonprofits, has managed a $1 million zero-interest PRI from a New York-based arts foundation. We’ve used that PRI to make zero-interest loans to the foundation’s performing arts grantees in need of short-term (up to a year) working capital until grant and performance revenues come in. As the loans are repaid, we are able to lend them out again to other organizations. To date, we’ve lent and collected over $2.3 million against the initial $1 million.

Unlike grants, foundations make these funds available expecting them to be repaid. As a result, the criteria they use to make decisions around deployment of such funds are based not solely on programmatic goals and mission alignment, but also on the ability of a project or organization to repay the investment and, in some instances, generate investor return. These investments require nonprofit leaders to be able to prepare financial projections that provide a lender with confidence that there is a viable future source of repayment for this philanthropic debt.

Philanthropic equity, on the other hand, is most often a high-stakes, enterprise-level investment that is discrete from other forms of (still-important) funding, such as program and operating support. (See p. 42 for more.)This type of capital is invested in an organization or a project with the intention of increasing the sustainability of an enterprise (perhaps by funding cumulative deficits incurred en route to sustainability) and creating a dramatic increase in social benefit.

In 2008, Vision Spring, an organization with a mission of ensuring that everyone in the developing world has access to eyeglasses, began a five-year campaign to exponentially expand its impact. It raised $1.8 million in philanthropic equity to expand operations, and by 2011 was selling nine times more reading glasses than it had been in 2007 and had driven down the cost of eyeglass production by over 53 percent. Philanthropic equity is intended to be transformative and its application is accounted for separately from regular revenue. While philanthropic equity likely sounds attractive to many, it is not always easy to access and generally requires of an investee the ability to measure and demonstrate outcomes that suggest the transformative impact enabled by the application of such equity.

The ability to measure outcomes is also a central capacity for participation in outcomes-based financing models where payments are predicated on achieving results rather than on delivering services. In recent years, the sector has seen mounting interest in pay-for-success transactions — a type of impact investment that incorporates outcomes-based funding. In pay-for-success, private capital is used to finance prevention or intervention programs where successful outcomes enable cost avoidances or savings for the government that can be monetized to repay the upfront investment. The government repays investors only if the outcome is achieved, so the investor takes on risk. This arrangement allows for the testing and scaling of prevention and intervention services, which the government often lacks sufficient discretionary funding to support.

In Utah, 600 at-risk children in the Granite and Park City school districts will have access to high-quality preschool via a pay-for-success investment structure. In the public-private partnership that financed the school, a commercial bank and a private family foundation will contribute $1.8 million to fund the upfront costs of the program. The investors will be repaid from Salt Lake County, with interest, from anticipated savings in special education costs — if the preschool program is successful in generating those savings by reducing the number of children requiring special education services compared with a comparable group of children not receiving the preschool services.

In outcomes-based finance models like these, we see a shift from a funding relationship to a contractual agreement, where an investor is acting more as a purchaser buying social outcomes, as opposed to a donor paying for services delivered. While many rightly look at such social impact financing with a critical eye, such mechanisms have the potential to improve our society’s capacity to deliver better outcomes more efficiently, while also bringing new capital to bear for addressing social problems. Pay-for-success arrangements could provide much-needed flexible, multiyear funding to promising preventative services and the scaling of proven interventions. Such funding has the potential to make programs stronger by requiring less time and resources diverted away from programs to fundraising and by enabling planning and mid-course corrections in pursuit of positive outcomes — in essence, a way to ensure that staff have flexibility to innovate and adapt to achieve valuable results.

What Nonprofits Need to Know

Impact investment capital is not grant funding. Each type of investment capital described above requires adaptations in the ways in which nonprofit leaders seek capital, pitch their need, and ultimately utilize funds.

Nonprofits need to know and be able to articulate three specific things in order to access and use impact investments.

First is a clear sense of what the economics and community benefits of the project or enterprise will look like after the impact investment funding has been spent. Nonprofit leaders should establish a long-term vision of what will be achieved by taking on philanthropic debt or equity before they seek this type of funding. Too often, we’ve observed organizations seeking financing without fully considering what it will ultimately enable — is it a bridge to future payment streams or a changed business model that increases sustainable, earned income? A clearly articulated end goal also will make for a more compelling investment ask.

Second is a clear sense of the investment perspectives and priorities of each potential investor being approached. There is no established set of risk/return metrics that applies to all impact investors. As such, knowing whether a potential investor is primarily concerned with repayment of the investment or the project’s ability to demonstrate long-term impact or enable scaling is critical.

Finally, be able to clearly articulate in 15 seconds what the investor is putting money into and what they’ll get out of the investment. What is the value proposition for the investor as well as the organization’s constituents?

Ultimately, being prepared to use impact investments requires that nonprofit leaders are able to make a clear and compelling case for the value that impact investments will bring to the organization, the constituency being served, and the investor.

Investment Readiness

Most impact investments necessitate attention to the organizational systems and infrastructure that support the mission work. Upfront grants to build out systems or support pre-development work may be necessary to enable potential investors — be they private or government — to gain comfort that an organization is well-positioned to repay an investment and/or achieve the desired outcome.

NFF prepares nonprofits for success in an outcomes-based funding environment by helping nonprofit leaders assess their readiness for impact investments in four areas: intellectual, financial, human, and social capital.

Intellectual capital in this context means the ability to collect data that measures the work being done through your programs and connect that work to the outcomes the organization seeks to achieve. Rich intellectual capital requires that regularly collected data is analyzed against outcome targets and used to make continual program improvements. Operating in this manner may require technology investments and changes in the way that staff approach data capture, as well as a review of management’s role in creating a data-driven culture. Moving beyond apparent effectiveness of programs to demonstrate actual outcomes may also require the participation of a third party evaluator. We know from our survey that nonprofits are most likely to invest in tracking programmatic outcomes when they are funded to do so, and that this funding is most effective when it allows for learning and adaptation rather than being punitive about failure.

Human capital addresses the people resources needed to effectively deliver, and perhaps grow, programs. This involves considering the current staff’s ability to deliver services; the senior leadership team’s depth and breadth of experience; the effectiveness of administration support for the enterprise (e.g., finance, communication, HR, IT, legal); the ability to attract, develop, and retain the “right” staff — those with relevant qualifications, cultural competencies, and skills needed to deliver and support programs, collect outcomes metrics, and potentially scale programs; and the board of directors’ ability to contribute significant strategic and analytical support to the organization.

Social capital relates to an organization’s ability to network and collaborate with various stakeholders in a multiparty transaction as well as other providers in the community to seek positive outcomes for individuals and complex problems. It considers the organization’s track record engaging the targeted client population, as well as the quality of relationships with community stakeholders such as government agencies, community groups, and consultants. Social capital might also refer to an organization’s willingness to share knowledge about its successes and failures.

Financial capital refers both to management’s understanding of the organization’s current business model as well as the actual dollars necessary to support a viable, well-capitalized organization. Inherent in this understanding of current and future business models is an appreciation for the impact of growth or change on future financial capital needs as well as the organization’s ability to repay debt as needed. An organization with strong financial capital is not just well-capitalized in terms of its balance sheet, it is one where management has easy access to clear financial data and reports, regularly incorporates such reports in strategic decision-making, has a solid understanding of the organization’s program economics and full cost of running the enterprise, and uses scenario planning to consider future risks and pro formas to model out future projections.

While the considerations above will be relevant to organizations to varying degrees based on their particular circumstances or funding opportunities, undertaking an assessment that considers these four types of capital will enable all nonprofit leaders to develop strategic action plans that prioritize where investments of time, staff, and financial resources are most needed to position their organizations for successfully pursuing impact investments and outcomes-based funding.

Leveraging Preparation

Roca is an organization based in Chelsea, Mass., that targets high-risk young men using a highly refined intervention model to break cycles of incarceration and poverty. It is a good example an organization that has developed all of these types of capital.

Roca has demonstrated an ongoing and relentless focus on program improvement, working through three iterations of its theory of change over 10 years. During that time it invested in creating a data-driven culture and organizational infrastructure, utilizing outcomes-tracking software with dedicated staff, and continuing focus on real-time measurement about its program’s impacts including a third-party evaluation that provides a continual feedback loop for program improvement. Roca’s experience adding a second location in Springfield, Mass., in 2010 and building up to its current $9.5 million budget has enabled it to learn what scaling entails. Detailed financial modeling with a focus on cost per outcome has enabled the organization to assess its potential to scale impact and secure multiyear support from 80 funding sources.

In 2012, Roca was selected as the service provider for an upcoming Massachusetts Social Innovation Financing Pilot also known as the Pay for Success contract to reduce recidivism among 17- to 24-year-old young men. While the work that Roca has undertaken to-date may seem daunting to many, it means the organization is confident enough that it will be able to generate the social outcomes necessary to trigger government repayment (with interest) of upfront investors that Roca itself has decided to enter the pay-for-success transaction as an investor. In this way, if its programs are successful, it will be able to generate an entirely new source of earned revenue from the investor interest. While this may seem a faraway possibility for many, it is emblematic of the opportunities that impact investing can create.

This is a call to action — to rise and meet the opportunity that a shifting environment provides. While impact investments are not appropriate for every organization, nonprofits that understand their place in the interconnected systems affecting their constituency and who can provide data supporting outcomes, will be poised to tap into new sources of capital — a prized opportunity in an operating reality of scarce resources and amplified demand for quality services and high-impact programs.

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