Can private foundations invest in private equity funds?
Yes, as a general rule private foundations are allowed to invest in private equity funds. However, when thinking through this question it is worthwhile to consider the IRS rules for excess business holdings and for jeopardizing investments. Staying within the parameters of these rules is relatively straightforward.
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. Private equity funds are almost always structured so the investors, as limited partners, do not have any voting control of the underlying businesses. 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, private equity funds typically have very large market capitalizations with the average fund being capitalized at well over a $1 billion. So even if a private equity fund somehow passed voting control along to its investors (very unlikely), then it would still take a massive investment for a foundation and its associated disqualified persons to control 20% of the fund. All things considered, it is very unlikely that an investment in private equity funds would cause a private foundation to violate the excess business holding rules.
The jeopardizing investment rules are a little bit more difficult to navigate, but overall, they are still 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 private equity as an asset class has gone mainstream and can be found in the tool box of many investment professionals. Investing in private equity in and of itself does not violate the jeopardizing investment rules because the investment class is well-established.
However, it is conceivable that the IRS could consider too large of an allocation to private equity as being a jeopardizing investment. Private foundations should carefully consider the size of any allocation to private equity 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 percentage of private equity within a portfolio that is allowable. That said, a small allocation to private equity 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 an allocation of private equity in the 15 to 20% range. 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 private equity allocation to these levels or higher.
Although private foundations are allowed to invest in private equity funds, it doesn’t mean that they should invest in them. Private equity is considered a high-risk asset class with the potential to provide great financial returns. However, private equity funds are known to have a large dispersion of returns, meaning that while one private equity fund might have great results another fund might perform poorly. Furthermore, many private equity 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 private equity fund operates (foundations normally don’t have to file any state income tax returns). Additionally, if the private equity 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 private equity. Your average retail investor, which includes the folks running most private foundations, should probably stay away from private equity because they are not highly skilled investment managers.
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