Friday, February 1, 2019

Philanthropic "First Loss" Investments and Private Benefit


In the world of high finance, "first loss investments" refer to the pool of equity  designated to absorb the initial losses generated by a pooled fund.  Other investors take on less risk because they are preferred relative to the first loss investors.  A preferred investor has a first line of defense against loss  -- composed of equity funding from other investors -- and as a result, might invest in a project it would otherwise pass on.   According to this Financial Times article, Private Foundations are increasingly serving as "first loss investors" to attract private money financing of public goods and services that would otherwise generate insufficient returns to attract private investors.  The article describes charitable first loss investments in a San Francisco Bay area project designed to provide affordable housing:

The idea works as follows. Investment ideas that pursue [public goods and services] — such as education, or environmental sustainability — don't usually achieve high enough returns to entice private capital. But if philanthropic capital takes the bulk of the risk, then private money will flow in. . . . For US foundations, losses themselves have a kind of value, because they count towards requirements to distribute (or "lose") 5 per cent of their holdings each year, so as to remain tax-exempt. At a high level, you can see a conceptual substitution between tax "losses" on the one hand and charitable "first losses" on the other.  The investment fund [in the San Francisco Bay area] is already lending $6.5m to the East Bay Asian Local Development Corporation. The ultimate logic is that the  [private foundation] concessionary capital (also known as "catalytic capital", also known, as above, as "first-loss capital") allows the loans provided by the fund to be cheaper than the market would provide. These loans, to developers, will allow them in turn to provide more affordable housing in developments that "also include market-rate units".  As you may have noticed, the entire principle is analogous to what a range of government subsidies aim to do. As the Impact Alpha article notes, those earning 60 per cent of the average median income are eligible for federal Low Income Housing Tax Credits. The philanthropic approach targets those who earn more, but are still struggling to find affordable housing.  

When the government provides subsidies, it potentially benefits private businesses or investors as much as it benefits the targeted political demographic which it intends to subsidise in some way. This is why private interests try to influence or capture the government's decision-making process.  The same thing is also true of charity. Or, as we should now start referring to it, "loss-absorbing capital".

Hmmmmm.  The second paragraph of the quoted passage makes me wonder whether first loss investing generates impermissible private benefit. The whole notion of "impact investing" revolves around the pairing of charitable and profit-making goals and that combination always raises private benefit concern vis-vis the charitable "subsidy."  

Darryll K. Jones

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