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.
The 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 had 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 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, which can lead to high returns or a big losses. The core relationship between risk and reward forms the basis for formulating investment strategies.
In the case of endowments, the liability nature of the budget process favors lower volatility strategies, while foundations could take on more risk with the expectation of higher returns.
In addition, foundations may have different investment time frames, the $50 billion Gates foundation wants to contribute all its money in the 10 years following Bill Gates’ death. Imagine Harvard saying they want to have everything wrapped up in 40-50 years. Foundations also have more latitude in choosing their investments – think of the $14 billion Eli Lily Foundation, which is all in shares of the company of the same same name (NYSE:LLY). Imagine Stanford’s endowment in a single company!
One of the similarities we referred to above that both foundations and endowments are pursuing investment returns to fund their charitable missions. At the end of the day both endowments and foundations use their investment returns to fund their missions. For colleges, the endowment’s mission broadly stated is to provide financial aid to students, for foundations it is much the same except the financial aid that they provide might go to fighting poverty or eradicating disease. For both foundations and endowments, the better they do investing, the more money is available for important causes.
There are a lot More Foundations than Colleges
There are about 2,000 colleges in the US, compared to about 100,000 foundations. FoundationMark tracks all foundations over $1 million, close to 45,000. So there are over 20 foundations for each college. Imagine 180 colleges in the Ivy League!
Different Tax Forms
From Foundation Advocate’s point of view the most important distinction between endowments and foundations is that they file different tax forms. The tax form that colleges file is the same one that all operating charities file, like the United Way or your local library. Foundations are subject to far greater disclosure requirements. Foundations must report the fair market value of their holdings, report on capital gains and interest income and many other line items that endowments do not. The reason this matters is that it provides FoundationMark with the ability to estimate performance.