Can philanthropy learn from the military?

The relationship between the military and the philanthropic community can be described as one of understanding and trust: we don’t understand them and they don’t trust us. Perhaps they can learn from each other, suggests Our Man in Geneva, Arthur Wood.

At the height of the Cold War the British ambassador was summoned in to the Russian Foreign Ministry. The Americans had just realigned their strategic nuclear forces and a well tested ritual was about to be played out. The Russian leaned forward: ‘Do you realise we could wipe your country off the map with nine nuclear missiles?’ he said. ‘That’s strange,’ replied the British ambassador. ‘By our calculation, it’s seven.’

In 1988, as a then defence analyst, I had the privilege of watching in the Banqueting Hall in London, as some degree of sanity was restored to MAD (Mutually Assured Destruction) as Marshall Victor Kulikov – the general in charge of the Warsaw Pact – shook hands with his Nato opposite number to mark the end of the Cold War from the general’s viewpoint (albeit it was somewhat ironic that this handshake was performed under the window through which Charles I was sent to be beheaded).

In 1988 I had the privilege of watching 

Marshall Victor Kulikov shake hands with his Nato opposite

to mark the end of the Cold War

More than 25 years on, in a new sector watching the outcome of the Rio Summit earlier this year and reflecting back, I could not help but think that the human race continues its march to Mutually Assured Destruction – only this time it is a ‘Warming Peace’ dominated by the Irrationality of the Rational, as opposed to the Cold War Rationality of the Irrational.

The inability of our global institutions to address the issues at hand is palpable. We do not now face the possible destruction of London, Moscow or New York within 13 minutes – but now the probable destruction of most coastal cities in the world in our grandchildren’s lifetime.

To the sceptical – many of whom like large amounts of ice in their martinis before dinner – I would suggest taking look at the NASA website. And, as you peruse the figures, leave your ice out in the summer heat. If you discover a new property for water let us know – if not, an eight-metre rise in the global sea level by 2100 is the minimum climate change effect we can expect.

Do we know the exact impacts? No – here analysts disagree – but it’s a bit like discussing rationally the effects of a limited nuclear exchange and ignoring the nuclear winter that would simply starve us all to death.

In economic terms the loss to climate change is currently estimated at about 5 trillion dollars annually (or 10 times the cost of the combined Iraq and Afghan wars over 10 years).

As a backdrop, let us consider the insurance against the possible insanity of man against his fellow man: the US military alone will spend in 2013 a proposed 800 billion dollars – for the most part this is a contingent spending for what can and is argued as a prudent political possibility.

How might we compare this to the ‘insurance premium’ we should pay for the global issues we actually do face?

It is only when you look at the actual annual cost of the externalities we are bearing as the human race – and let me just pick three issues: climate, 5 trillion dollars (source TEEB); sanitation, 650bn dollars (WHO, WSP); road safety, 65bn dollars (GPRS) – that you begin to realise the utter inadequacy of the amount and nature of the capital we apply to defending ourselves against these and other issues that already affect all mankind.

Will governments and our international institutions step up to the mark?

If Rio, Copenhagen, the inability to deliver the Millennium Development Goals, etc, is anything to go by then the long-term evidence  suggests quite clearly that only the travel agents will continue to hit their targets.

The second, more fundamental reason this will not occur is that the current crisis is structural as well as cyclical. The demographic time bomb of ageing in the West means that before my kids are my age, 60% to 70% of the populations of Germany, Japan and Italy will already be over 64 years of age.

Italy’s national debt will not be the 125% everyone is fretting over but about 330%. If the Germans of 2050 have three people retired for every one worker, then who is going to pay for the Italians?  The international government spending on aid already looks as if it has peaked. All this means less money from Western governments, not more under the current paradigm.

 

If you treat people like rats…

Meanwhile, on the demand side, in the developing world 50% of the population is below 23. History again tells us that this will lead to unrest, unless we provide hope and sustainable economic development. Our generals are already discussing this, and the social sector sings of youth empowerment but our politicians remain reactive not proactive, as ever.  The bottom line is that if you treat people like rats, they will grow whiskers and bite you. Or, as the Conservative prime minster Disraeli also noted, ‘If the cottages are not happy, the palace is not safe.’ 

So, practically, what about the private sector capital we deploy to face these threats – solving these trillion dollar issues – since logically eradicating the externalities is success? Let me use again the defence analogy to demonstrate the paucity in scale and sophistication of our sector’s response.

Total American foundations’ core funds (that is, not what is allocated but total core invested funds) amount to about 600bn dollars – equivalent to about 75% of annualUS defence expenditure.

Less than 2% of [American foundations']

core funds are aligned

with mission related investment

Some 98% of this capital ('the capital that cares' encouraged by a tax break) is unaligned with social mission. What do I mean? Less than 2% of these core funds are aligned with social purpose into what is called mission related investment (MRI). Most of the funds are simply invested in the traditional way, avoiding negative impact where possible but with no proactive social impact (oh, and – as an aside – the for profit bankers who manage these funds take the equivalent of 20% of everything we give away in fees). 

Of the 600bn dollars, the US foundations give away circa 45bn dollars (around 5%) in grants.

This is roughly the equivalent of just one USAF defence programme – the B2B Bomber.

Let’s dig further. Ninety-eight percent of the 45bn dollar allocation is made in bi-lateral grants – generally small in size, unleveraged and an un-annuitised capital market tool. This, to put it simply and without lengthy explanation, creates some pretty anti-social side effects: because it results in a sector that is estimated by McKinsey to spend between 23 and 48 cents on the dollar raising capital, and that is highly fragmented with incentives to compete, not collaborate.

Of the 2% remaining that is invested in for profit financial tools for social purpose – which US foundations are allowed to do (program related investment – or PRI) – this equates to about half the cost of one B2B bomber.

Then only 5% of this 2% – or 20m dollars – is actually invested by foundations in social equity vehicles. Or to complete the defence comparison, about 1% to 2% of the cost of one B2B bomber.

In total, American foundations’ core funds amount to about 600bn dollars. They give away around 45bn dollars of this in grants - roughly the equivalent of just one USAF defence programme, the B2B Bomber
 

Humanity needs a new appproach

The message above is stark if we seek to condemn the four horsemen of the apocalypse to the dustbin of history. We must now face up as humanity to the complex issues and challenges measured in trillions of dollars – yet if we remain on the current course we will continue to see declining capital deployed into bilateral solutions in small, sticky-tape solutions based primarily on the thinking of 1903 (foundations) and 1944 (Bretton Woods).

To address these issues we can and must adapt how we apply through social entrepreneurship the modern tools already at our fingertips and identify how we can leverage society’s subsidy more effectively though impact investing.

In short, we must do what the military does well – collaborative, focused systems-thinking, based on delivering tangible, defined outcomes. When they are given unclear goals by politicians you see the mess. Equally, Western politicians and military may want to ask the question that maybe ‘soft power’, delivered through a better funded and empowered civil society, may be more effective in retaining a stable world. 

Having attended a number of conferences recently (Tallberg rather than Rio), I do see a new language and new collaborative models being proposed or discussed, and new impact finance models  and legal hybrids being proposed which speak to this. Let’s hope the rhetoric translates into real action and money.

To give you an example, one clear solution – and one where you can help – would be to realign the core funds of foundations to more mission related investment. Ergo, align those funds already encouraged by a tax break with a social mission (many will ask why this is not the case already) and increase the leverage of the funds that are given away by ensuring a greater percentage of program related investment (which in turn will pump prime the impact investing market and social entrepreneurship).

Some foundations already are moving in this direction such as KL Felcitas and the ever-innovative Heron Foundation. Mainstream movers like Gates are now at 8% PRI versus the industry standard of 1% to 2% – so this is encouraging, but more can be done to match Melinda’s rhetoric.

This redeployment (and leverage) of social capital through realigning a percentage of core funds into MRI and leveraging collaborative capital using the recently proposed IRS rules for the application of  PRI would have a profound effect – by beginning to deploy large scale capital to impact investing - specifically when leveraged and linked to some of the new hybrid legal and financial tools that would facilitate collaboration and scale with the for profit world focused on the delivery of social mission. It’s what is know as the move to ‘outcome models’ in development jargon.

My proposal is that a minimum of 20% of

all foundation core funds be invested in

mission related investment

Now, the cry would go up that this is far too difficult. And, if viewed in the traditional bi-lateral, not-for-profit model/for-profit model as we design these solutions one by one, issue by issue within silo by silo – history again speaks as to how hard this is.

However, it can be argued that the framework for much of this collaborative revolution has already been laid and that one simple legislative adaptation could pump prime this. Indeed, people are being canvassed for their views as you can see in this blog from Jonathan Greenblatt, the director of social innovation at the White House, requesting input.

My proposal is that a minimum of 20% of all foundation core funds have to be in investments in mission related investment – governed by the existing program related investment code ensuring its social focus, by 2020 – so, “Twenty by Twenty Twenty”. This would be a 2.5% asset allocation shift per year to 2020, hardly brutal. What is often misunderstood is that the use of PRI does not go against making money – only the primary mission has to be social and sub market at point of commencement.

This simple amendment would create a capital pool of 125bn dollars to be invested in sustainable social impact investment providing a return – one would hope of course that this could be achieved voluntarily and quicker (though I have seen the issue in various forms debated since I entered the sector in 2005). On a positive note the managing partner of the Omidyar Network, Matt Bannick, made a call earlier this year at the Commonwealth Club in California for a 5% allocation, which he noted would unleash $29bn – the equivalent of all early stage VC money in the US. It is also understood that key foundations are looking to move to outcome models – all this is to the good.

From a US government perspective, the IRS has also issued – as per Jonathan’s blog – new PRI guidelines to provide further clarity on PRI investment. There are clear mirror moves in the UK and Luxembourg. It is also worth noting that this proposal, if married to an L3C type structure (now tabled at Congress having passed 11 US jurisdictions and a UK Equivalent being discussed at governmental level called an SELLP) would also create collaborative structures with the for profit world, but with a legally hard-wired social mission. As a major plus this would actually be revenue neutral to government (some say positive), certainly if married to social impact bond structures – by definition revenue positive. This is based on extrapolating the impact of extending a very similar US housing program (the Community Reinvestment Act) across philanthropy, which to the metrics folks has been audited by the Congressional Budget office for many years.

One assumes that this proposal may raise objections and challenges from some of the current bankers (the foundations) to the social sector. However, the bottom line is that this would still leave 80% of foundation core funds aligned for profit maximisation – the fundamental question for them would be the possible opportunity loss of income on the 20% invested in social investment versus the undoubted huge social impact such a capital investment would create compounded by the co-operation it would spur with the private sector who are also deterred currently by a lack of scale, who would then come into play.

It would also create a powerful signal to the mainstream bankers for them to engage mainstream capital markets – they currently sign public commitments measured in billions but the reality is that the money does not flow. Behind closed doors they note lack of economies of scale and that if our own core community does not put their money where their social mouth is, why should they?

So what would be the ‘loss’ of reallocating at a pure investment level?

One can make the periphery points as some would argue that these uncorrelated investment structures would actually improve the risk return of the portfolio. One can also make a case that investing in African development is a better asset than many to be found in Europe.

If we wish to address the threats

we and our grandchildren face we cannot

continue tinkering with a system designed in 1903

Research carried out by the Heron Foundation in 2007 indicates an opportunity loss of between 30 and 50 basis points between an MRI portfolio and a profit maximization portfolio. Let’s be less optimistic and clear about the maths - at a proposed 20% asset allocation shift to impact investing investment from profit maximisation investment in foundations for each 1% return you lose on the portfolio costing 1.25bn dollar per 1% but in turn would mobilise 125bn dollars of social capital which by definition would be focused on social mission. (and regulated as such).

This in turn would mobilize substantive private capital – in line with the US affordable housing market example let’s just say three times – that’s half a trillion dollars mobilized – and one that by extrapolating Congressional Budget Office analysis is probably revenue neutral  to government and will drive economies of scale and the skills of the commercial sector  into our sector. There are indeed already impact investing models such as the social impact bond which mean that the higher social impact you create, the higher IRR attained. Interestingly, investment in those products is going into the core funds not the grant fund of many foundations.

It should also be noted that if the status quo of the foundation world is seen as sacrosanct, the next 40 years will also see the largest transfer of wealth in human history (the flip side of the ageing demographic) – with 3% of the population in the US transferring 60% of a 41 trillion dollar pool. So, with smart facultative legislation the total core funds of foundations going into grants certainly should not decline – in essence what we seek here is a simple realignment of the new funds coming in.

 

A return to common sense

These proposals and others which seek to mobilise large-scale capital are a return to common sense – the application of what we already do in commercial environments – but applying them to social purpose. Evolution not revolution.

Ultimately, if we wish to address the threats we and our grandchildren face we cannot continue tinkering with a system designed in 1903, crystallized in the US tax system in 1921.

Our current defence posture to the onslaught of the social problems is completely inadequate. It means we have to think how we mobilise hundred of billions of dollars. It is like pitting a Sopwith camel which was invented, like modern philanthropy, at the beginning of the century against a B2B stealth bomber As one final ironic twist the B2B was launched the same year 1989 as Chris Rea’s prophetic Road to Hell - and the threat for which it was designed hunting SS23/24 missiles was effectively over.

Today, our approach given the scale of the threats we face is more akin to the proposal of the Danish People’s Party in the late 1970s: to scrap the Danish defence budget and replace it with a tape saying, “we surrender” in Russian. To quote Disraeli again: “Action may not bring happiness but there is no happiness without action.”  I wonder what the ambassador would say. Probably that if you do not pay for the price of deterrence – you will end up paying a far higher price later.

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