Prudent Investing For Private Foundations

As Joel Fleishman wrote in The Foundation: A Great American Secret, "[F]oundations, along with the organizations that they support, are the great secret of the dynamism of America's civic sector."¹

Not many people realize it, but some of the most familiar and necessary aspects of our everyday life were created by a foundation. The 911 emergency telephone system, Pell grants, and public broadcasting networks such as PBS (Public Broadcasting System) and NPR (National Public Radio) all began from an idea formed by a foundation. There are thousands of foundations currently working at making our world a better place, and behind every foundation is a wealthy family or individual who made the decision that "enough is enough." Rather than spend their money on personal pleasure or investments or simply squirreling it away, they chose instead to make a difference.

When it comes to investing, private foundations and other nonprofit organizations share some basic objectives with most other prudent investors, whether individuals or businesses. Charitable groups seek such universal goals as principal protection, an acceptable level of risk, reliable income and the potential for long-term growth.

But because of the nature of their missions and their tax-exempt status, nonprofits that invest are unlike almost any other entity. They must conform to requirements both legal and philosophical, taking care to ensure that their search for investment returns stays within the bounds of government regulations as well as their own values. There's a different level of oversight all around when you're talking about a nonprofit. With regard to private foundations, care must be taken to ensure that both the investments chosen and the ways in which those investments are spent don't in any way jeopardize the tax-exempt status of the foundation.

Many people, even financial professionals, aren't aware of the complex nature of the rules governing private foundations. For starters, what type of private foundation is it? Was it established in corporate or trust form? Is it an operating foundation or a nonoperating foundation? The answers to these questions are important. While a careful consideration of risk is at the heart of any investment strategy, nonprofits are required to invest in such a way that it does not jeopardize their underlying functions or conflict with the requirements of the laws that regulate them. For example, each year private non-operating foundations are generally required to distribute 5% of their prior year's value, with certain adjustments, for charitable purposes

The Investment Policy Statement

An important step in the creation of a private foundation is the development of a formal investment policy statement (IPS). The IPS is a sort of "living constitution," a vital document that enables regulators to determine whether the organization is staying within its proper investment framework. The IPS outlines an organization's objectives, the purpose of its investment fund, and whatever constraints might preclude certain types of holdings. The policy statement's timeline sets out the nonprofit's time horizon and its willingness to accept investment risk.

Three basic factors help determine the overall investment strategy: the organization's income (from donations, grants and other sources), its spending, and the return on investment it needs to support that spending. Income takes into account not just how much money comes in each year relative to overall portfolio assets, but also how predictable that income is, how much control the foundation has over its income, where the money has traditionally come from, and what changes may lie ahead. A spending analysis looks at how much an organization is spending each year as a percentage of assets and, if that organization is spending more than the required 5%, whether it has the flexibility to withstand a time of crisis without disrupting its underlying mission. Taking into account the foundation's profiles for income and spending, required return is the minimum return on investment the organization needs in order to sustain its operations while meeting any minimum annual gifting amount. Having this figure in mind can help the investment committee decide whether a highly conservative approach (such as holding only U.S. Treasuries) can meet those objectives. If not, what other types of investments might earn a higher return while remaining within the organization's risk tolerance?

Knowing the Constraints

Another key consideration in forming an organization's IPS is determining what types of investments may not belong. For example, "a private foundation may not make investments that might jeopardize its tax-exempt status." ² While jeopardizing investments will vary from case to case, the Internal Revenue Service has scrutinized margin trading and futures, among others. Each jeopardizing investment is subject to a 10% penalty tax on the value of the investment, which can be imposed on both the foundation and its managers. Additional amounts will be due if the investment is not disposed of immediately

We have seen clients come to us with a private family foundation chock-full of illiquid private equity and hedge funds. If these assets are deemed "jeopardizing" by the IRS, the potential for compounded penalty taxes is enormous. This is why it's so important that people understand the complexities surrounding permissible private foundation investments

Setting a Framework

The first step for the decision makers of any private foundation before it selects assets for the organization's portfolio, and even before it decides on a specific investment strategy is to establish a framework around which that strategy will be built. To arrive at that framework, the decision maker should provide detailed answers to these questions:

What is the purpose of the private foundation? In clear, direct language, the organization lays out its reason for being, the mission or missions it hopes to accomplish, and the work it aims to support.

What are the investment objectives? This is an expression of your underlying goals of investing rather than your specific strategy. A detailed statement of objectives might, for example, outline such goals as achieving average returns that at least keep pace with the organization's spending as well as inflation, in order to support long-term spending capabilities. How you implement those goals is the strategy, which comes later.

What is its risk tolerance? If the value of a portfolio's assets were to drop by a given percentage, how would that affect the organization's ability to serve its purpose? The answer to this and related questions can go a long way toward helping a private foundation stay within prudent bounds.

What are the liquidity and spending policies? Whatever its overall investment portfolio may be, a nonprofit needs a certain level of readily available (liquid) assets. That level is determined by how much is spent each year. It's important to know your liquidity needs up-front, as such considerations will directly affect potential investment choices.

Staying True to Values

A private foundation, because of its particular values and mission, may also decide it doesn't want to invest in certain areas for philosophical reasons. For example, an organization devoted to promoting environmental causes may seek to avoid investing in companies or industries seen as major polluters, while a health-related foundation could choose to shun the manufacturers of products that may contribute to sickness or disability. In the past, screening out undesirable but potentially profitable investments—a process known as socially responsible investing (SRI)—was widely regarded as a well-meaning but money-losing proposition. Even a decade ago, if someone mentioned SRI, the typical response was, "Will you still be able to get performance?" Thanks to a growing interest in SRI in the United States and worldwide, that has changed. Today, an investor committed to staying within a framework of social or environmental values can choose from a variety of mutual funds and other investments. Increasingly, this process includes not only screening out companies or industries one views as undesirable but also employing sophisticated strategies that actively include promising investments that promote one's values. You've got an array of options. What we're finding is that we can build social-minded investment strategies that can be competitive on the basis of yield and total return.

The Importance of the Fiduciary Standard

In a February 2009 New York Times article detailing the potential fallout from failing to uphold the fiduciary standard in private foundations, Lynnley Browning notes: "Under an obscure tax rule, private foundations can be penalized for failing to vet their investments properly, to heed red flags or to diversify prudently. While foundations are exempt from federal income taxes, they are subject to this excise tax, intended to keep them from taking outsize risks that could threaten their very survival."³

To avoid such pitfalls, a key partner for a private foundation's decision makers is the financial services organization that handles assets and investments on the group's behalf. Such organizations, including U.S. Trust, act as fiduciaries, meaning they are required to act in the best interests of the client in all investment recommendations and decisions and may be authorized to make decisions on financial matters. While all fiduciaries, whether representing individuals or businesses, must act in the interest of their clients, those working on behalf of private foundations must also take into account both the financial health of the organization and its charitable purposes. To do that, the fiduciary should be familiar with the investment policy statement and aware not only of the organization's financial profile but also its operations, programs and services. The fiduciary helps establish an appropriate financial strategy within the bounds of the foundation's mission and goals.

We will examine an organization's IPS or existing portfolio and spot problems that could get the foundation in hot water with the IRS, such as highly leveraged illiquid investments. Our compliance group can work with the foundation's decision makers to update the guidelines. In that sense, we can take some of the pressure off the organization so it can focus on more important things, like helping those who are in need.

While the process of setting, executing and evaluating a private foundation's investment strategy can be onerous, in the end the decision makers, the fiduciary and the regulators are all working to achieve the same basic goals. They're helping keep private foundations healthy, stable and ready to fulfill their missions to create a better world.

To learn more about other philanthropic solutions, please contact your U.S. Trust® advisor.