In the world of nonprofits and endowments, investment managers face a unique set of circumstances. Unlike private client assets, these organizations’ assets exist to support a mission. Operating under the assumption that the organizations will exist in perpetuity, planning over a very long time horizon is critical. These imperatives can present both challenges and opportunities for those charged with growing these assets.
Specific aspects of nonprofits and endowments must be taken into account to manage portfolio risks while still growing assets. In some cases, managers may be limited to certain investment and spending choices spelled out by donors. In other instances, mission-based needs may overwhelm the portfolio during periods of market volatility or inflation, forcing managers to maintain liquid, stable assets.
Adding to the challenges, laws enacted in recent years—primarily the Uniform Prudent Management of Institutional Funds Act, also known as UPMIFA, and Sarbanes-Oxley—have created a more complex regulatory environment for nonprofits. UPMIFA, in particular, requires that investment managers and boards identify the sources of their endowment funds and the restrictions that apply to them, and then adhere to a standard of management that takes into consideration specific factors if relevant to a particular institution. Sarbanes-Oxley requires public disclosure of information about the organization as well as its finances and investments. It is vital that boards provide the proper oversight in meeting the obligations of these two laws.
At the same time, nonprofit and endowment assets present opportunities for investment. Organizations that exist in perpetuity can benefit from investing in long-term, illiquid assets such as private equity and timber. The ongoing nature of their business also allows them to benefit from fresh donor pools with each new generation. They may benefit from contributions and bequests from donors moved by its mission as well. Additionally, the groups’ tax-exempt status permits more investment flexibility and gives them the ability to focus on total return instead of current income when considering portfolio distributions.
With these challenges and opportunities in mind, where does one begin when managing nonprofit and endowment portfolios? Like all disciplined investment programs, the process starts with a well-crafted statement of investment objectives that are incorporated into an investment policy. Most organizations want to grow their investments over time, maintain their purchasing power and generate income/return to support operations. In the past, this generally meant investing a meaningful portion of the portfolio in equities for growth and a meaningful portion in bonds for income.
During the past few decades, however, the structure of the global economy has changed significantly, altering the investment landscape to include more markets, many of them in the emerging world. At the same time, the endowment model (the investment program popularized by Yale University endowment fund manager David Swenson) stimulated increased interest in utilizing alternative investments to achieve growth and manage risk. Suddenly, a whole new array of investment choices became available to both large and small nonprofits and endowments. Alternative investments—especially private equity, venture capital and real assets—have been the primary driver of investment returns for large endowments during the last 20 years.
A comparison of asset allocation and investment returns for large and small endowments reveals interesting differences. Large endowments invest only 10% of their portfolios in fixed income, compared to 30% for small endowments and 20% for all institutions. Large endowments moved away from the fixed-income market, preferring to utilize hedge funds to manage portfolio risk and the total return available from growth assets (e.g., equities, private equities, real estate) to generate cash distributions each year. Because they had limited their allocation of the more stable asset class of bonds, large endowments experienced distress during the financial crisis. Although there is more than one way to manage portfolio risk while creating returns for distribution, bonds can be effective assets in protecting against price declines.
Larger endowments have about three times the exposure to hedge funds as smaller endowments and generally have a wider array of investment choices in this arena. While returns for the average hedge fund have been sub-par for the last few years, these types of investments can and should be considered for nonprofit portfolios since many have demonstrated utility in stabilizing returns. However, unlike bonds, they do not mature at par, do not provide regular income and usually have limited liquidity.
Private equity, venture capital and real assets represent more than half of the allocation to alternatives for large endowments but only a quarter of the allocation to alternatives for small endowments. If you add together the amounts invested in both public and private equities, both large and small endowments appear to have similar levels of equity exposure (55–60%). However, during the last decade, private equity as an asset class has outperformed public equities by almost three percentage points per year. Over the course of 10 years, the impact on total portfolio returns has been significant.
Endowment Investment Returns
Source: NACUBO-Commonfund Study of Endowments, 2012
Endowment Investment Breakdown, Fiscal Year 2012
Source: NACUBO-Commonfund Study of Endowments, 2012
Why the difference in allocation? It is partly due to the availability of these investments—especially those offered by top-performing managers—to the smaller institutions. Another reason is the reluctance of smaller institutions to sacrifice liquidity in order to achieve a higher return. Limiting liquidity risk in this way can have very significant advantages. In fact, this is the primary reason smaller institutions achieved much better returns than their larger counterparts in 2008–09. The huge price drops in illiquid private equity and real asset investments created a cash crisis for many large institutions, which then were forced to liquidate positions in the secondary market at deep discounts. A comparison of the three- and five-year returns of the large and small endowments details the impact of those steep price declines on portfolio returns.
While smaller institutions may have limited access to private equity, alternatives can provide similar long-term growth and income as well as liquidity and inflation risk management. Publicly traded equity, REITs and MLPs are a few of the options available to investment managers.
Although nonprofit and endowment investment managers do face a unique set of circumstances, like private client assets, these organizations’ assets must be invested in accordance with each organization’s unique investment policy guidelines. Boards and investment committees must work closely with their investment managers to ensure portfolios are accurately addressing the organizations’ needs, goals, and objectives.
Hedge Funds and Private Equity are not appropriate for all investors. Hedge Funds and Private Equity investments can be speculative and may involve a high degree of risk, including the possible loss of all or a substantial amount of the investment.
The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and First Republic Trust Company of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.
This document is for information purposes only and is not intended as an offer or solicitation, or as the basis for any contract to purchase or sell any security, or other instrument, or to enter into or arrange any type of transaction as a consequence of any information contained herein.
Although information in this document has been obtained from sources believed to be reliable, we do not guarantee its accuracy, completeness or fairness, and it should not be relied upon as such. This document may not be reproduced or circulated without our written authority.
Past performance is not indicative of future results. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.
The investment services and products mentioned in this document may often have tax consequences; therefore, it is important to bear in mind that First Republic Bank and its affiliates do not provide tax advice. The levels and bases of taxation can change. Investors' tax affairs are their own responsibility and investors should consult their own attorneys or other tax advisors in order to understand the tax consequences of any products and services mentioned in this document. Accordingly, you and your attorneys and accountants are ultimately responsible for determining the legal, tax and accounting consequences of any suggestions offered herein. Furthermore, all decisions regarding financial, tax and estate planning will ultimately rest with you and your legal, tax and accounting advisors. Any description pertaining to federal taxation contained herein is not intended or written to be used and cannot be used by you or any other person, for purposes of avoiding any penalties that may be imposed by the Internal Revenue Code. This disclosure is made in accordance with the rules of the Treasury Department Circular 230 governing standards of practice before the Internal Revenue Service.
Investment and Advisory products and services are not deposits or obligations of, or insured, guaranteed or endorsed by any bank, Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency, entity or person. The purchase of securities involves investment risks including the possible loss of principal.