Foundation investing

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• endowments
• portfolio management
• asset allocation
• investment policy statement
• diversification
• risk management
• philanthropy
• tax benefits
• charitable giving
• long-term investing
• fiduciary duty
• prudent investor rule
• alternative investments
• socially responsible investing
• grantmaking
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What Is Foundation Investing?

Foundation investing refers to the specialized approach to managing the financial assets of charitable organizations, such as private foundations and community foundations. This falls under the broader financial category of portfolio theory and institutional asset management. The primary goal of foundation investing is to generate sustainable returns that support the foundation's charitable mission and grantmaking activities over an indefinite time horizon, while preserving the real value of the original capital. Unlike individual investment portfolios, foundation investing operates under unique legal and ethical considerations, including strict payout requirements and a perpetual time horizon.

History and Origin

The concept of foundations dates back centuries, with early examples often tied to religious or educational institutions that managed funds for charitable purposes. However, modern foundation investing, as a distinct discipline, began to take shape with the growth of large philanthropic endowments in the late 19th and early 20th centuries. A significant development in the legal framework governing institutional funds, including foundations, was the Uniform Prudent Management of Institutional Funds Act (UPMIFA). This act, promulgated in 2006, updated and replaced the Uniform Management of Institutional Funds Act (UMIFA) of 1972, providing modernized guidance for the prudent management and investment of charitable funds. UPMIFA has since been adopted by many states, establishing a framework that emphasizes a "total return" approach to investing and allows for more flexible spending policies, while still upholding the fiduciary duty of those managing the funds.¹⁵, ¹⁶

Key Takeaways

• Foundation investing focuses on managing assets for charitable organizations with perpetual time horizons.
• The primary objective is to balance current payout requirements for charitable activities with long-term capital preservation and growth.
• Investment decisions are guided by an investment policy statement and must adhere to specific legal and regulatory frameworks, such as UPMIFA.
• Foundations often employ diversification strategies, including allocations to traditional and alternative investments, to achieve their objectives.
• They often consider socially responsible investing (SRI) or impact investing alongside financial returns.

Formula and Calculation

While there isn't a single "formula" for foundation investing, a key calculation for foundations is their annual payout requirement. U.S. private foundations are generally required to distribute a minimum of 5% of the fair market value of their non-charitable use assets annually. This is often referred to as the "minimum investment return."

The formula for calculating the minimum investment return is:

Where:

• 0.05 represents the 5% payout requirement.
• Average Fair Market Value of Non-Charitable Use Assets is typically calculated based on the average value of the foundation's investment assets over a specific period, usually 12 months, excluding assets used directly for charitable purposes (e.g., office space).

Meeting this payout requirement while maintaining the long-term purchasing power of the endowment is a central challenge in foundation investing.

Interpreting Foundation Investing

Interpreting foundation investing involves understanding that it balances two critical, sometimes competing, objectives: supporting current charitable activities and preserving capital for future generations. Success in foundation investing is not solely measured by high investment returns but also by the foundation's ability to consistently meet its payout obligations, cover operational expenses, and grow its endowments to keep pace with inflation.

An effective foundation investment strategy will carefully consider the foundation's spending policy, risk tolerance, and long-term financial needs. Portfolio management decisions are made within the context of the foundation's mission, often leading to a focus on long-term investing and a disciplined asset allocation approach.

Hypothetical Example

Consider the "Evergreen Charitable Foundation," which has an endowment of $100 million at the beginning of its fiscal year. This foundation is a private foundation in the U.S. and, therefore, is subject to the 5% minimum payout rule.

1. Calculate Average Fair Market Value: For simplicity, assume the average fair market value of its non-charitable use assets over the past 12 months was $98 million.
2. Determine Minimum Payout: $$\text{Minimum Payout} = 0.05 \times \$98,000,000 = \$4,900,000$$
3. Investment Strategy: To meet this $4.9 million payout, plus cover its operating expenses (say, an additional $1 million), the Evergreen Charitable Foundation needs its investment portfolio to generate at least $5.9 million in income and appreciation. Its investment committee might decide on an asset allocation aiming for a total return of 6-7% annually, factoring in inflation, to ensure both current needs are met and the capital grows over time.

This example illustrates how foundation investing directly links investment performance to the foundation's capacity to fulfill its charitable mission.

Practical Applications

Foundation investing is a specialized field with several practical applications:

• Strategic Asset Allocation: Foundations often develop sophisticated asset allocation strategies that include a mix of equities, fixed income, real estate, and alternative investments like private equity and hedge funds, aiming for long-term growth and diversification. The Council on Foundations, in partnership with Commonfund, conducts annual studies that provide comprehensive analysis of investment and governance policies and practices of private and community foundations, covering topics such as returns, investment objectives, and asset allocation.¹², ¹³, ¹⁴
• Mission-Related Investing (MRI) and Program-Related Investments (PRI): Many foundations engage in MRI or PRI, where investments are made not only for financial return but also to directly advance the foundation's charitable mission. This can include investing in affordable housing, renewable energy, or social enterprises.
• Compliance and Reporting: Foundations must comply with stringent IRS regulations regarding their income, expenses, and charitable distributions, as detailed in IRS Publication 526, "Charitable Contributions."⁹, ¹⁰, ¹¹ This includes careful tracking of investment gains and losses to ensure adherence to payout requirements and maintain tax benefits.
• Risk Management and Governance: Due to the perpetual nature of their capital and the importance of their mission, foundations place a strong emphasis on risk management and robust governance structures. This often involves an investment committee overseeing the portfolio management and adherence to the prudent investor rule.

Limitations and Criticisms

Despite its importance, foundation investing faces several limitations and criticisms:

• Complexity and Resource Intensity: Managing a diversified portfolio with long-term objectives and regulatory compliance can be highly complex and resource-intensive, particularly for smaller foundations that may lack dedicated investment staff. The globalization of capital markets has led to a surge in diverse and complex investment products, which can divert foundation board focus from consumption goals to chasing relative performance.⁸
• Pressure for Returns vs. Mission: While foundations prioritize their mission, the pressure to achieve sufficient investment returns to meet payout requirements and grow the endowment can sometimes overshadow mission-aligned investing, leading to a focus on traditional financial metrics over social impact. Challenges such as time constraints, lack of incentives, and unclear role clarity can hinder the adoption of impact investing among foundations.⁶, ⁷
• Market Volatility: Foundations are susceptible to market volatility, which can significantly impact asset values and make it challenging to meet consistent payout targets, especially in downturns. Long-term volatility in financial markets and difficulties in meeting target returns are among the top concerns for private foundations.⁵
• Balancing Spending and Preservation: Determining the optimal spending rate is a constant challenge. Spending too much can erode the endowment's purchasing power over time, while spending too little might limit the immediate impact of the foundation's philanthropy.

Foundation Investing vs. Endowment Investing

While closely related and often used interchangeably, "foundation investing" and "endowment investing" refer to the management of funds for specific types of institutions.

While a foundation often manages an endowment, not all endowments are held by entities formally structured as foundations. For example, a university may have a large endowment that supports its educational mission, but it is not typically referred to as a "foundation" in the same tax and legal sense as a private charitable foundation. Both types of investing adhere to prudent investor rule principles and long-term perspectives.

FAQs

What is the main objective of foundation investing?

The main objective of foundation investing is to generate sustainable financial returns that enable the foundation to fulfill its charitable mission over a perpetual time horizon, balancing current grantmaking needs with the long-term preservation and growth of its capital.

How does foundation investing differ from personal investing?

Foundation investing differs significantly from personal investing due to its perpetual time horizon, legal and regulatory requirements (like annual payout rules), and a primary focus on supporting a charitable mission rather than individual financial goals. It often involves more complex asset allocation strategies and a strong emphasis on fiduciary duty.

What is the role of an investment policy statement in foundation investing?

An investment policy statement (IPS) is crucial in foundation investing. It outlines the foundation's investment objectives, risk management guidelines, asset allocation targets, spending policy, and other parameters that guide investment decisions, ensuring consistency and adherence to the foundation's mission and legal obligations.

Are foundations required to invest in socially responsible assets?

While not always legally required, many foundations increasingly adopt socially responsible investing (SRI) or impact investing strategies. This involves considering environmental, social, and governance (ESG) factors alongside traditional financial returns, aligning investments with the foundation's philanthropy and mission.

How are charitable contributions to foundations taxed?

Donors who make charitable giving to qualified foundations may be eligible for tax benefits, such as deductions on their federal income tax returns. The specific rules and limitations for these deductions are outlined by the IRS in publications like Publication 526, "Charitable Contributions."¹, ²