Private Equity: Foundation Investment Strategies And Trends

Private foundations are a type of charitable organisation that is funded by an endowment – a single donation from an individual, family or business. They are tax-exempt, but do not qualify as public charities. Private foundations are allowed to invest in private equity funds, but this does not mean that they should. Private equity is considered a high-risk asset class, and financial experts largely agree that only sophisticated investors should get involved. Private foundations must also be careful not to violate IRS rules on excess business holdings and jeopardising investments.

Private foundations can invest in private equity funds, but they should be careful not to violate IRS rules

Private foundations are generally allowed to invest in private equity funds. However, they must be careful to avoid violating IRS rules, such as those regarding excess business holdings and jeopardizing investments.

To stay compliant with excess business holding rules, a private foundation and its disqualified persons must hold 20% or less of the voting stock of any business enterprise. Private equity funds are typically structured so that investors, as limited partners, have no voting control. Therefore, private foundations usually do not violate these rules when investing in private equity.

Navigating the jeopardizing investment rules can be more complex. Private foundations must avoid making investments that jeopardize their ability to carry out their charitable mission. While there is no precise percentage of private equity allocation that is allowed, small allocations of 5% or less are generally considered safe. Larger foundations with access to sophisticated investment managers may allocate up to 15-20% to private equity.

Private equity is a high-risk asset class that may generate unrelated business income taxed at a higher rate. It may also require additional tax filings and compliance costs for international reporting. Therefore, private foundations should carefully consider their investment strategies and ensure compliance with IRS rules when investing in private equity funds.

Private equity funds are considered high-risk, high-return investments

Private equity funds are considered high-risk investments, but they also have the potential for high returns. Private equity firms buy and manage companies, aiming to overhaul them and earn a profit when they are sold. These firms pool investor money with other sources of borrowed financing to acquire equity ownership positions in small companies with high growth potential. The investors are typically wealthy individuals and institutional investors, such as pension funds, mutual funds, and insurance companies.

The high-risk nature of private equity investments stems from several factors. Firstly, there is a high barrier to entry, with investment minimums typically ranging from $250,000 to $25 million. This means that large sums of money are committed, and a negative return on investment can lead to significant losses. Secondly, there is liquidity risk, as private equity investors are expected to keep their funds with the firm for several years, with an average holding period of around 4 to 7 years. This lack of liquidity can be challenging for investors who may need to access their funds quickly.

Additionally, private equity investments face market risk, as many of the companies they invest in are unproven startups or mature companies that are underperforming. There is a high failure rate among these companies, and even a single ineffective management team or a failed product launch can lead to substantial losses for investors. Furthermore, private equity firms may use significant amounts of debt to finance their acquisitions, which can result in costly interest payments over time.

Despite the risks, private equity has gained traction due to its potential for high returns. From 2000 to 2020, private equity outperformed the Russell 2000, the S&P 500, and venture capital. Private equity produced average annual returns of 10.48% over a 20-year period ending on June 30, 2020. The key advantage of private equity lies in its "buying to sell" strategy, where firms focus on acquiring undervalued or under-managed businesses, increasing their value, and then selling them for a maximum return. This strategy allows private equity firms to realise gains quickly and move on to new opportunities.

Private foundations are encouraged to invest in public securities

Private foundations are typically funded by investing their endowment, which may include new contributions from a limited group of donors. They are tax-exempt and do not pay income tax, meaning that investment gains can be directed entirely towards charitable purposes.

Private foundations must always meet the basic requirement of an annual "disbursement quota", which means that most must give at least 5% of their assets to other registered charities each year. Therefore, any investment strategy must consider this requirement.

Private foundations are allowed to invest in private equity funds, but this is considered a high-risk strategy. Private equity funds are known to have a large dispersion of returns, and while one fund may perform well, another may perform poorly. Private equity funds may also generate income that is subject to unrelated business income tax (UBIT). This can have a significant impact on the overall investment return, and can force private foundations to file state income tax returns in each state in which the private equity fund operates.

Financial experts largely agree that only sophisticated investors should invest in private equity.

Private equity funds are not traded on an exchange

Private equity is often grouped with venture capital and hedge funds as an alternative investment. Investors in this asset class are usually required to commit significant capital for years, which is why access to such investments is limited to institutions and individuals with high net worth. Private equity firms buy companies and implement changes to earn a profit when the business is sold again.

Capital for the acquisitions comes from outside investors in the private equity funds the firms establish and manage, usually supplemented by debt. Private equity funds have a finite term of 10 to 12 years, and the money invested in them is not available for subsequent withdrawals. The funds typically start to distribute profits to their investors after a number of years. The average holding period for a private equity portfolio company was about 5.6 years in 2023.

Private equity funds are considered high-risk investments with the potential for great financial returns. They are known for their large dispersion of returns, meaning that while one private equity fund might perform well, another fund might perform poorly. Private equity funds may generate income that is subject to unrelated business income tax (UBIT). Although private foundations typically 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%.

Financial experts generally agree that only sophisticated investors should invest in private equity. The average retail investor, who includes the people running most private foundations, should probably avoid private equity as they are not highly skilled investment managers.

Private equity funds are managed by general partners

The GP contributes 1% to 3% of the fund's capital to ensure it has skin in the game. In return, the GP earns a management fee, often set at 2% of fund assets, and may be entitled to 20% of fund profits above a preset minimum as incentive compensation, known in private equity jargon as carried interest.

The management company (or fund manager/investment advisor) employs the investment professionals responsible for allocating capital and managing investments. The management company is generally affiliated with the GP, but they are not the same entity. The GP will enter into a management agreement with the management company. Under this agreement, the fund pays the management company fees to employ the investment team, evaluate opportunities, manage the portfolio, and manage all day-to-day operations.

This structure allows the management company to work across multiple funds while still having a GP for each fund. Over time, the same management company could be affiliated with several funds.

Frequently asked questions