As an organization, you face unique challenges in managing your investments, particularly when it comes to meeting mandatory spending requirements. Other institutions can reduce spending during economic downturns, but your foundation may have less flexibility. You may even be forced to withdraw assets that could significantly hinder the achievement of your long-term investment objectives and overall mission. For a foundation or endowment to succeed in the long run, it is critical to have an investment strategy in place with a strong emphasis on preserving your capital and take action when opportunities arise to recuperate returns.
When in a sailing regatta, having a consistent start in the race requires prioritizing your main goals. Ideally, we want to be moving at full speed, on the line, with clear air, preferably heading toward the favored side of the course. An ideal situation rarely happens, so adjustments are made while waiting for an opening to improve position.
In the last several years, private foundations have adjusted their strategies to include alternative investments, especially hedge funds. Hedge funds are designed to “hedge” or mitigate the extreme ups and downs associated with frequent buying and selling on the stock market and can be a beneficial addition to your portfolio when evaluated correctly.
Solving Recent Investment Challenges
Like the sailing analogy, ideally, your organization should fund its annual spending rate completely from returns on investments. But when the combination of interest and dividends fall below 5%, spending capital is reduced, and you may find yourself selling off some principal to avoid losses instead. It will be necessary to find other ways to maintain the 5% spend during market downturns. Without the ability to pull back on required spending, the wrong move can put your mission in jeopardy.
Hedge funds offer the ability to do well in various economic climates because they offer a variety of strategies, making them an attractive addition to your portfolio. Management strategies can enable hedge funds to mitigate the negative impact of a volatile market, so you can maintain spending power. A foundation or endowment may maintain diversified assets that provide multiple funding sources during different market cycles by using alternative hedging strategies. You’ll be better positioned to meet annual spending requirements and organizational goals.
Adding hedge fund investments to your portfolio means considering a range of issues, such as:
- Limitations regarding insiders who could benefit from the foundation’s financial transactions
- Tax code preventing the organization’s ownership interests in excess holdings
- Fiduciary obligations of the endowment’s mission and goals
- Issues surrounding liquidity
If you don’t have financial experts to assess your situation, you may find yourself choosing counterintuitive investments that may result in negative consequences to the board or managers. There are a few essential points to bear in mind involving knowledge about the ever-changing laws applied to private foundations and their operations.
Avoiding Hedge Fund Investment Pitfalls
First, organization insiders may not engage in financial transactions with one another, as it would result in self-dealing. Creators of a foundation trust, directors, officers, or contributors and their family members cannot hold more than a 20% ownership interest or voting power. Restrictions also apply to those having interest in an entity with more than 35% ownership or voting power. Penalties are involved whether or not you understand the act of self-dealing or if it results in benefits to the foundation.
It is important to follow regulations regarding sales and exchanges, leasing and lending arrangements, use of income, assets, or facilities, and excessive compensation for services. Be careful if there is outstanding capital or if a partner is indebted to anyone at the time of a donation or investment.
A foundation may pay reasonable compensation for banking, brokerage, and investment advisory services. That means payment to a hedge fund management service must be considered competitive.
A foundation’s level of ownership in private equity may be limited by the IRS’s excess business holdings rules. Exceeding the maximum allowed ownership percentage in a business leaves you subject to penalties. These excess business holdings rules apply only to investing in a fund with companies that actively conduct a trade or business, including the production of income from the sale of goods or the performance of services. Experts make sure you remain in compliance with excess business holdings rules.
When considering an investment in a hedge fund, a private foundation must not jeopardize the foundation’s ability to carry out its primary purposes. This rule shields private foundation assets from excessive risk to maximize both capital and income available for charity. The foundation’s managers may consider the expected return, the risks of fluctuating price levels, and the need for portfolio diversification. Investment decisions are made on a case-by-case basis, taking into account the foundation’s portfolio as a whole at the time of the investment. Foundation financial managers must maintain records documenting care and prudence.
Certain types of investments have a higher degree of risk and are subject to closer scrutiny by the IRS, including securities purchased on margin, commodity futures, and puts, calls, straddles, warrants, and hedge funds. You’ll want to avoid any penalty imposed for making a jeopardizing investment. However, your foundation may have been issued a private letter indicating direct and indirect investments in hedge funds that are non-jeopardizing based on one or more of the following factors:
- The hedge fund investment fit into an overall prudent investment plan
- The hedge fund’s assets were sufficiently diversified
- The hedge fund investment provided sufficient liquidity
A hedge fund interest meeting your annual five percent minimum distribution requirement is subject to regular valuation. Suppose an investment in a hedge fund doesn’t have the liquidity to make periodic cash distributions and constitutes a large proportion of the foundation’s investment portfolio. In that case, the foundation may face a serious cash flow problem. Your organization must have other income-producing assets to draw from to make necessary grants, pay taxes, and operating expenses.
A foundation may unexpectedly be subject to unrelated business income tax (UBIT) at for-profit tax rates to acquire an interest in a hedge fund or derive income from a trade or business unrelated to the foundation’s purpose.
Growing Interest in Hedge Funds
The growth and management of endowments have led to the formation of many hedge funds over the years. One of the main investment strategies over the past decade has been private placements, also known as an Initial Public Offering (IPO). An IPO is a common and lucrative strategy for many hedge fund investors, especially when the company is new, has big expectations, or has already obtained significant media coverage.
The securities markets do not restrict hedge fund managers, so they can invest in commodities and foreign countries, particularly in emerging economies. Companies like Clearbrook can offer this advantage along with valuable advice.
Hedge fund investing for endowments is only one of the options out there, and this opportunity requires considerable knowledge and expertise. Clearbrook Global provides detailed research and advice when it comes to choosing the type of investment you want to make. Experts can help you improve your financial position and speed portfolio recovery in 2020.
Sources:
50 South Capital, Norther Trust, How Hedge Funds Can Potentially Help foundations and Endowments Meet Spending Requirements, https://cdn.northerntrust.com/pws/nt/documents/wealth-management/how-hedge-funds-can-potentially-help-foundations-endowments.pdf
Investing in Hedge Funds, Guidance for Private Foundations, https://foundationsource.com/resources/hub/resource/investing-in-hedge-funds/
Getting Good Starts, Part One http://www.umass.edu/rso/sailing/STARTS1.htm