Similar Yet Distinct
Most people consider foundations and endowments to be essentially interchangeable entities as both can be viewed as pots of money that exist to provide charitable support to nonprofits. But if you peel back the first layer of the onion, you will see structural differences between the two that can have important implications on their investment strategies.
They are the Same|
They are Different|
From an investment perspective, the exemption from most taxes and 5% payout rate are the strongest arguments for lumping foundations and endowments together. And most foundations have a perpetual or long-term investment horizon like endowments, which adds to the case for their pairing.
One major difference between foundations and endowments is cash flow. In some ways the endowment’s role in the budgeting process for a college can be viewed a “liability based investing”, or in other words a fixed amount of money that needs to be provided each year. If a school’s budget calls for $50 million in expenses and it has a $100 million endowment, it would likely pencil in $5 million of endowment contribution as a source of funds, and use that number or close to it for the next several years. That $5 million would represent a vital 10% of the school’s operating budget. The investment directive might be along the lines of “make sure we can cover $5 million a year or risk raising tuition, eat into the endowment, or firing teachers”. This is what we mean by a “liability based investing” mindset.
Foundations on the other on the other hand typically do not have “liabilities” in terms of cash flow as they tend to have little to no fixed expenses just the mandate to disburse 5% of assets to operating charities. So a $100 million foundation would have to pay out $5 million a year, just like the college endowment, but if the value of the foundation fluctuates, the fluctuation in value would be reflected in the amount of grants, which are far easier to adjust than a college looking to plug a budget line item.
Why this Difference Matters
The financial term for fluctuations in value is “volatility” often referred to as “risk”. Riskier investments must offer greater returns to investors to compensate them for the uncertainty of their outcome. Government bonds prices are very stable, but they offer investors a low return unlike biotech stock prices which can fluctuate wildly, and can lead to high returns or a big losses. The core approach to the risk/reward sentiment forms the basis for formulating investment strategies.
In the case of endowments, the liability nature of the budget contribution favors lower volatility strategies, while foundations could take on more risk with the expectation of higher returns as they do not typically have specific dollar amounts to fund.
Perhaps more subtle in the difference between foundations and endowments is the governance style. Most endowment oversight is done by an investment committee, often a subgroup of trustees who rotate through the board for a few terms. At larger endowments there are investment policy statements and asset allocation guidelines. The day to day management might be in-house, through consultants or outside money managers. There are layers of checks and balances befitting an institution with many stakeholders – students, faculty, and alumni. This type of structure is designed to be a clear roadmap for the management of assets. But, consider the fact that in order to make a significant strategic investment decision, it would have to be within the confines of the investment policy statement, signed off on by consultants and the investment committee. Of course, no trustee wants to be associated with an investment gone wrong and so tend to keep to tried and true methods of previous board members or peer institutions, and if things go awry they can blame the process.
While some foundations have the type of structure described above, there are many who do not. There are far fewer stakeholders in a foundation, typically only the trustees, who often are the source of the money in the foundation to begin with. Decision making can occur swiftly and the consequences – good or bad – do not have to be defended, explained, or justified.
Lastly, one of the ways that foundations differ from endowments is in their missions. While endowments have a single mission – to support an institution – foundations can have much broader mandates – fund the arts, provide funds to cure disease, protect the environment, etc. The reason we draw this distinction is the open-ended nature of some missions and the ability to align a foundation’s interests with its investments. For example a foundation focused on the environment might invest in a wind farm, which would align with the foundation’s mission, while an endowment making the same investment might have to weigh the investment against others in terms of the return to the institution.
We believe that foundations have a lot more freedom in their investment choices because they aren’t constrained by a liability mindset and overreaching governance.
Three of the largest foundations in the U.S. have investment portfolios that look nothing like the large endowments. The Bill and Melinda Gates foundation is nearly entirely in public stocks and bonds, the second largest, Lilly Endowment is almost all in Eli Lilly (NYSE:LLY) shares which have soared in the past ten years, and the Foundation to Promote Open Society whose investments are in a single hedge fund controlled by George Soros. Imagine if Harvard had no private equity or venture capital, Yale was all in a single stock and Princeton was in a single hedge fund.