Can private foundations invest in hedge funds?
Yes, as a general rule private foundations are allowed to invest in hedge funds. However, before moving forward with an investment, foundation managers should verify it will be compliant with the rules for excess business holdings and for jeopardizing investments. Most hedge fund investments comfortably stay within the bounds of these rules.
To avoid complications with the excess business holding rules, the foundation must, along with its disqualified persons, generally hold 20% or less of the voting stock of any business enterprise. Hedge funds are typically structured so the investors, as limited partners, do not have any voting control of the underlying operating business. Therefore, private foundations, in their capacity as limited partners, do not have any voting control of the underlying businesses, which prevents entanglement in the excess business holding rules. Furthermore, any business entity that derives 95% or more of its income from passive sources (interest, capital gains, dividends, etc.) is automatically in compliance with the excess business holding rules. Many hedge funds solely invest in standard financial instruments (stocks, bonds, securities, etc.) which only generate income from passive sources. So even if a hedge fund somehow passes voting control along to its investors (very unlikely), then it still has a strong chance of staying within the rules if it trades in typical financial instruments. All in all, it is quite unlikely that an investment in a hedge fund would cause a private foundation to violate the excess business holding rules.
The jeopardizing investment rules also require consideration but more often than not they are relatively easy to comply with. Private foundations are not allowed to make jeopardizing investments, meaning they should not make investments that jeopardize the foundation’s ability to carry out its charitable mission. The definition is admittedly vague but the sentiment is clear—private foundations should not take undue risk with their investments. Essentially this means that when choosing investment positions, private foundations should follow mainstream investment strategies and beliefs. For example, taking big risks on controversial investments like penny stocks and pork bellies is a big no-no while investing in tried-and-true asset classes is just fine. Here in the 21st century hedge funds as an asset class have gone mainstream and can be found in the tool box of many investment professionals. Seeing that hedge funds as an asset class is well-established, the act of investing in them does not violate the jeopardizing investment in and of itself.
However, it is conceivable that the IRS could consider too large of an allocation to hedge funds as being a jeopardizing investment, especially if the underlying strategy is radical or ultra-risky. Private foundations should carefully consider the size of any allocation to hedge funds as too much of a high-risk asset class can quickly go from a good thing to a bad thing. There isn’t a magical allocation percentage of hedge funds within a portfolio that is allowable. That said, a small allocation to hedge funds is surely within the bounds of standard financial advice—an allocation of 5% or less wouldn’t cause anyone to bat an eye. For the very largest foundations it is not uncommon to see large allocations to hedge funds up to 15% or more. On the other hand, these very large foundations have internal and external access to sophisticated investment managers. Private foundations should make sure they are following well-established financial best practices before raising their hedge fund allocation to this level or higher.
Although private foundations are allowed to invest in hedge funds, it doesn’t mean that they should invest in them. Hedge funds are an incredibly diverse asset class with a wide array of strategies from ultra-risky to very conservative and safe. Hedge funds are known to have a large dispersion of returns, meaning that while one hedge fund might have great results another fund might perform poorly. Furthermore, some hedge funds may generate income that is subject to unrelated business income tax (UBIT). Although private foundations normally only pay a nominal tax of 1.39% on investment income, unrelated business income is taxed at the regular corporate income tax rate of 21%. This relatively high tax rate can have a significant impact on the overall investment return. Furthermore, UBIT can force private foundations to file state income tax returns in each state in which the hedge fund generated income (foundations normally don’t have to file any state income tax returns). Additionally, if the hedge fund has international operations the foundation may be obligated to file headache inducing forms with the IRS relating to international reporting (read expensive compliance costs!).
Financial experts largely agree that only sophisticated investors should invest in hedge funds. Your average retail investor, which includes the folks running most private foundations, should probably stay away from hedge funds because they are not highly skilled investment managers.
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