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Podcast: Key ESG Considerations for Family Offices and Foundations


Time to Listen: 9:44 Practices: Asset Management, Finance, Tax, Supply Chain Compliance & Corporate Social Responsibility

In this Ropes & Gray podcast, asset management partners Isabel Dische and Melissa Bender, and tax and benefits counsel Morey Ward, provide an overview of key considerations for family offices and foundations as they consider whether, and how, to integrate ESG factors and/or impact investing into their investment processes.

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Isabel Dische Isabel Dische: Hello, and thank you for joining us today on this Ropes & Gray podcast, the latest in our series of podcasts and webinars focused on ESG and corporate social responsibility issues. I’m Isabel Dische, a partner in our asset management group based in New York and co-chair of our institutional investor practice. Joining me today are Melissa Bender, a partner in our asset management group in San Francisco, and Morey Ward, a counsel in our tax & benefits group in Washington, D.C. Today’s podcast is intended to be an overview of certain considerations for family offices and foundations as they consider whether and how to integrate ESG factors and/or impact investing into their investment processes. We are not trying to convince you why you should, or should not, undertake ESG or impact investing (or if either is even permitted for you or your clients). Rather, today’s discussion is intended to provide a high-level overview of some key considerations you may want to have in mind as you think about this space. With that, Melissa, can you give us some background?

Melissa BenderMelissa Bender: Sure, as most of you are aware from the news alone, interest in ESG has been growing dramatically over recent years and there is a definite trend toward investors doing more in this space. In a global survey last year by UBS, 38% of family office respondents said they are involved in sustainable investing, an increase of over 4% from 2017. Different explanations have been floated for the heightened interest. There are academic papers supporting the thesis that incorporating ESG into an investment process improves returns, but also there’s a sense that younger investors are demanding more attention to ESG and asking for more ESG-, impact- or thematic-investing options. Regardless of the reasons for heightened interest, if a private foundation or family office is interested in pursuing an ESG or impact strategy, a first question is whether that strategy is permitted. Morey, do you want to walk us through how a foundation or family office should think about that question?

Morey WardMorey Ward: Sure, a first key question here is understanding the objective. Does the family office or foundation want simply to incorporate ESG risks and opportunities into its investment process, or would it like to do more, for example, using its investment decisions to achieve a social or environmental outcome (which we refer to as “impact investing” – that is investing to achieve an impact other than investment returns), or adding a socially responsible overlay (for example, by excluding certain investments)? A second key question is the source of funds for the investment. For example, is the family office going to invest funds belonging to individuals or will it invest funds belonging to one or more private foundations that are managed by the family office? This distinction is important because there are particular legal considerations that attach to investment decisions for private foundation assets.

If the funds belong to individuals, the issues are relatively straightforward, since there’s nothing prohibiting someone from making a personal choice to sacrifice returns for a greater positive impact. Of course, the family office investment manager must keep in mind any investment policies that govern investment decisions for the family members investing through the family office and will need to carefully consider how ESG considerations or an impact strategy can be integrated into an investment portfolio. On the other hand, if the assets belong to a private foundation, the investment decisions of foundation trustees and directors are regulated in three different ways:

  1. The written intent of the donor;
  2. State laws regarding the fiduciary duty of managing assets of a charitable trust or corporation; and
  3. Federal tax law.

With respect to the first point, if the foundation’s funds have been contributed subject to a donor’s explicit written instruction that the directors or trustees may take the foundation’s charitable objectives into account in making investment decisions, then the foundation’s managers have a lot of flexibility in making investments for mission-related objectives, even if the investments increase risk or sacrifice financial return.

On the second point, private foundation assets are governed by state prudent investor rules. As a general matter, foundations formed as nonprofit corporations are governed by the Uniform Prudent Management of Institutional Funds Act, known as “UPMIFA.” UPMIFA requires those making investment decisions for a charitable foundation to consider several factors that a prudent investor should consider and provides that the charity’s mission may be an appropriate factor to consider as part of that process. Foundations formed as charitable trusts are subject to a similar prudent investor rule under a statute called the Uniform Prudent Investor Act. The UPIA prudent investor rule is generally understood to permit a trust-form foundation to incorporate ESG factors into its investment portfolio. However, there is some lingering uncertainty about whether impact investing is permitted under the UPIA. There are ways to address this concern, but it is an issue that merits consideration by the foundation’s managers.

Finally, we need to consider federal tax laws. One key rule in this context is the prohibition on so-called “jeopardy investments.” A foundation is subject to a penalty excise tax if it invests its assets in a manner that jeopardizes its ability to accomplish its exempt purposes. However, a foundation will not violate the jeopardy investment prohibition if it makes a program-related investment—or “PRI”—which meets certain requirements. PRIs are investments used by private foundations to achieve their philanthropic goals. Because PRIs may generate some return or at least a return of the original investment, they are viewed as a complementary strategy to traditional grants. PRIs come in many forms, but are often interest-free or below market-rate loans or equity investments in an organization that is pursuing a program that furthers the foundation’s charitable mission. The IRS has also provided guidance on the circumstances under which mission-related investments, which are typically structured to generate a higher rate of return than PRIs, will avoid problems with the jeopardy investment prohibition. I should note just in passing that there are other federal tax issues that foundations should consider when making impact investments, including provisions related to self-dealing, lobbying, excess investment holdings, and unrelated business income tax.

As a general matter, family offices have a lot of flexibility to invest family foundation assets based on ESG factors and to make impact investments, but a key issue for foundation managers is process. State and federal laws do not attempt to second guess whether an investment was good or bad in hindsight. The central issue is whether investment decisions for the foundation were made consistently with the donor’s intent and in compliance with state and federal laws at the time the decision was made. So, the legal analysis is going to focus on the process undergirding the investment decision, information available at the time of the decision, and the thoroughness of the analysis conducted. Foundations making ESG investments need to do so as part of a reasonable investment policy and with careful deliberation and due diligence.

Isabel Dische: So having concluded that your family office can incorporate ESG considerations and/or an impact strategy into its investment program a next question is, how do you engage? And approaches vary here. For example, does the family office want to simply incorporate ESG risks and opportunities into their investment process or do they want to do a bit more? Some of our clients focus on investments in a particular space – such as clean energy, health care or education – an approach commonly referred to “thematic investing.” Others will apply exclusionary screens to exclude investments in so called ‘problematic’ industries, such as tobacco or fossil fuels. Still others remain open to investing in any industry but try to apply a positive selection filter so that they only invest in issuers that meet a defined ESG ranking hurdle that they’ve set in advance. Each approach has implications for the investment process (and must be considered in light of the considerations Morey mentioned earlier in this podcast as, for example, you may conclude that incorporating ESG risks and opportunities is permitted, but thematic investing might be more problematic).

Melissa Bender: And related to that, Isabel, is the question of how the family office wants to hold itself accountable. For example, there are a number of investment frameworks and industry associations in the ESG and impact space that offer a more formal framework for thinking about these issues. One group that we often see clients consider joining is PRI, which was begun in 2005 by the United Nations to promote responsible investment.

Isabel Dische: Even having landed upon an approach and decided whether or not to adhere to any industry initiatives such as PRI, you also need to give thought to how you will incorporate that approach with any third party asset managers with whom you invest. Do you want to ask that those managers also have an ESG policy and/or adhere to PRI? Should those third party managers incorporate any particular exclusions – for example, so you do not have indirect exposure to tobacco stocks? Your approach will depend on your objectives and may also depend on your relative negotiation power in the relationship and where your ESG objectives rank as compared with other issues you’d like to press. As the correct balance is very institution- and fact-specific, it is beyond the scope of today’s discussion. We would however be happy to discuss any questions with our listeners directly.

Melissa Bender: Thank you, Morey and Isabel, for joining me today for this discussion. And thank you to our listeners. For more information on the topic we discussed today, or other topics of interest to the ESG and impact investing community, please visit our website at www.ropesgray.com. And of course, if we can help you navigate any of these areas, please don’t hesitate to contact any one of us. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. Thanks again for listening.

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