At Brown Brothers Harriman (BBH), we frequently speak and write about investing with a long-term time horizon: As a more than 200-year-old partnership, we manage assets for numerous multigenerational families, and our proprietary investment teams and external partners spend their days seeking out high-quality businesses that can compound intrinsic value for years or even decades.
Few entities, however, have longer time horizons than endowments and foundations (E&Fs). Such institutions, built to outlast their mortal stakeholders and stewards, operate on a timescale denominated in centuries. In an ideal world, their intended time horizons are nothing short of infinite.
One might think that the natural long-term orientation of E&Fs makes their approach to investing even more straightforward. After all, what does quarterly or yearly volatility matter to an endowment focused on 20- or 30-year returns? Despite this distant time horizon, however, E&Fs also bear a variety of unique organizational characteristics and financial obligations, including annual spending to support the operating budgets of their parent institutions. The primary purpose of a typical E&F investment portfolio is therefore twofold in nature, providing a stable stream of funds to support near-term operations while preserving (and ideally growing) institutional capital in perpetuity. These twin priorities are inherently difficult to balance, and satisfying both requires a thoughtful, differentiated investment approach. Not only does BBH count many E&Fs as clients, but our taxable clients, Partners and employees often serve as advisors, donors and trustees to many more, making these nuances an essential component of our investment thinking.
Stable Funding vs. Purchasing Power Preservation
All tax-exempt entities rely to some extent on endowment assets to execute their missions. These institutions include schools, museums, foundations and a wide variety of other nonprofits. Such institutions are also generally characterized by their regular spending mandates and investment programs overseen by a formal investment committee (IC), typically populated by investors and other knowledgeable financial services professionals who collectively bear fiduciary duty for protecting the assets of the organizations they serve.
For certain institutions, these spending requirements are mandatory. To maintain their tax-exempt status, U.S. private foundations must make annual distributions1 that often amount to 5% or more of investment asset value; endowments, while not subject to the same laws, typically spend at least 4% to 6% of a rolling average of asset values each year to support their operating budgets. In addition to these minimums, state laws such as the Uniform Prudent Management of Institutional Funds Act (UPMIFA) contain optional subsections (adopted by New York and California, among others) that require ICs to monitor their spending rates based on a combination of expected returns, expenses and inflation. Spending formulas differ across institutions, but almost all E&Fs base some portion of their spending on the value of their investment portfolios. E&Fs also vary in the degree to which the organizations they serve depend on them for operational support: Whereas some E&Fs are often treated as “rainy day” funds and provide minor budgetary smoothing, others fund as much as half or more of their institutional operating budgets.
Due to the reliance on investment portfolios to support operations, tax-exempt institutions must ensure that their assets can predictably and consistently support annual outlays. While short-term, unrealized portfolio depreciation can usually be ignored in a long-term-oriented portfolio, significant downturns in investment portfolios can substantially affect endowment spending, even if that portfolio depreciation is never realized. When an endowment’s asset value declines, the organization can either maintain its spending in absolute dollars or percentage terms; the former risks spending a much larger portion of the endowment than is prudent, while the latter risks absolute underspending that fails to meet budgetary needs.
To illustrate this trade-off, consider the example of a $100 million endowment that spends roughly 5% per year, or $5 million, to support its institutional budget. In the event of a major downturn during which the endowment temporarily loses 30% of its value (bringing net asset value to $70 million), continuing to spend 5% would only provide $3.5 million for the budget, creating a material shortfall.2 On the other hand, if the institution in question decides to continue spending $5 million to stabilize its budget, it will spend over 7% of the endowment’s new value and may need to realize less-liquid investments at a loss to fund operations. Neither situation is ideal and can only be prevented through a combination of more sophisticated spending formulas and a portfolio that is intentionally sensitive to drawdowns. Ordinarily, lower-volatility, income-paying assets like fixed income would be one potential solution to such needs.
At the same time, however, most E&Fs are designed to function in perpetuity. Thus, without investing in assets that deliver returns beyond the rate of spending plus inflation (which is estimated to be considerably higher in the education sector, often reaching 3% to 4%), the funds an institution accumulates today will lose purchasing power and become gradually less effective in supporting future constituents. In contrast with stable, predictable assets like fixed income, the investments that are best-suited to growing over time in excess of inflation include various forms of equity – which can be less liquid and more volatile.
Reconciling these conflicting needs and the assets available for investment is central to the role of any E&F IC. For an institution to execute its mission successfully and consistently over the long term, its portfolio managers must avoid mortgaging the future to fund the present – and vice versa.
At BBH, we seek to balance the competing priorities of stability and growth by allocating a larger portion of E&F portfolios to equity-related assets (75% or more relative to fixed income), including private assets and marketable alternatives. We define marketable alternatives as those strategies that can generate investment returns that are independent of overall public equity market performance, including event-driven, long/short and turnaround/distressed investments. Such strategies are well-suited to E&F portfolios due to their intended ability to generate a different return pattern regardless of market conditions, supporting the stable spending policies previously discussed while ideally also generating equity-like returns. Due to their tax-exempt nature, E&Fs are typically better able to invest effectively in such strategies, which can be higher turnover and tax inefficient.
We believe the inclusion of private investments also merits some additional explanation. One potential advantage conferred by a typical E&F’s unique time horizon is that of the illiquidity premium. In exchange for locking up capital for longer periods of time – which endowments can often afford to do in ways that individuals cannot – E&Fs can extract higher returns than those offered by shorter-term, more liquid alternatives. Examples of such illiquid, higher-return asset classes include private equity and private real estate (although as with any investment, manager access and selection within these asset classes can make all the difference).
In determining how much to invest in private markets, however, it is important to recognize that an overreliance on private equity and other illiquid investments is not without risk. Even with a multigenerational timeframe, tax-exempt institutions occasionally do face unexpected and near-term liquidity demands. During the 2008 recession, some illiquid-heavy endowments were forced to liquidate high-performing public equities to meet the contractually obligated capital calls of their private equity managers. Others were forced to take on debt to backstop institutional budgets, and nearly all endowment portfolios emerged materially off-model and overweight to private equity.
In general, we believe this approach to liquidity – sacrificing some near-term flexibility for the sake of returns and predictability – is appropriate given the time horizon advantage of most E&Fs. That said, we also believe that the ideal liquidity profile for any endowment or foundation is highly institution-specific and should be chosen in light of several different considerations.
- How reliant is the institution on its endowment to fund operations? Some nonprofit institutions rely primarily on fundraising, grants and other revenue sources to pay their operating expenses, allowing their endowments to accrue as long-term rainy day funds that supply only a small percentage of their annual budget. Other institutions rely more heavily on endowment spending to support operations, with the majority of annual spending derived from endowment payouts. In the latter case, liquidity is far more important; in the event of a downturn or externally triggered budget crisis, locked-up capital will be inaccessible to serve as a stop-gap, forcing the institution to consider debt or severely underfund its operations.
- How easily can spending be adjusted in a downturn? In addition to being less reliant on their endowments for budgetary needs, some institutions are more flexible than others in their ability to temporarily reduce spending without disrupting their core missions. Those that can afford to cut costs during a downturn – whether by trimming staff or paring back programming – or to lean on additional grants or fundraising to cover shortfalls, as described earlier, can likewise afford less liquidity.
- What are the institution’s liquidity sources? With the aforementioned qualitative considerations in mind, institutions should conduct a full accounting of their current sources of liquidity, project their future distributions and commitments and stress test their projected liquidity in a variety of scenarios. How much liquidity is derived from grants vs. operations? Lines of credit? What are the expected distributions from and commitments to private investments? Institutions should be comfortable that they can maintain enough liquidity, even in a market downturn, to service all their commitments.
Ironically, very few for-profit entities operate with the same permanence of the endowments and foundations they serve. However, at BBH, where we have just celebrated our 200th birthday, we consider a permanent time horizon to be one of our founding principles, and we invest our nonprofit clients’ capital accordingly. Unsurprisingly, this approach is driven by the same equity-biased portfolios and multidecade focus on capital preservation that we pursue for our taxable clients. At the same time, however, effective endowment investing also requires thoughtful attention to near-term concerns like spending, liquidity and stability – which often vary on an institution-by-institution basis. BBH seeks to balance both as we steward our E&F clients to their own bicentennials and beyond.
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1 The minimum “distributable amount” is calculated by the Internal Revenue Service based on the minimum investment return of the foundation, reduced by the sum of any income taxes and increased by certain other adjustments.
2 This is a simplified spending model based on end-of-year values; most institutions “smooth” spending by utilizing three- or five-year averages.