Can private foundations invest in private equity funds?
Private foundations are permitted to invest in private equity funds, but these investments come with a unique set of challenges and regulatory considerations. Foundations must navigate rules concerning excess business holdings, jeopardizing investments, and unrelated business income tax (UBIT), while also addressing the practical complications posed by private equity’s illiquidity. When carefully managed, private equity can offer significant returns and diversification opportunities, but foundations must weigh the risks and ensure compliance with IRS regulations.
Navigating the Excess Business Holdings Rules
The IRS imposes strict limitations on the amount of ownership private foundations can have in privately held businesses, a restriction collectively referred to as the excess business holdings rules. The restrictions apply to both private foundations and their “disqualified persons,” a category that includes substantial contributors to the foundation, foundation managers, family members of those insiders, and other legal entities where disqualified persons have significant interests. In most cases, private foundations and disqualified persons are collectively prohibited from owning more than 20% of the voting stock or equivalent ownership interest in a business enterprise.
Private equity funds, however, are typically structured as limited partnerships or similar entities. In these structures, investors—including private foundations—hold limited partnership interests and have no direct control, voting power, or management authority over the portfolio companies owned by the fund. This lack of control generally reduces the risk of violating the excess business holdings rule. Moreover, private equity funds often have massive market capitalizations, frequently exceeding $1 billion. For example, even if a fund were to grant voting control to its investors (an unlikely scenario), a foundation and its disqualified persons would need to invest an astonishing $200 million in a billion-dollar fund to surpass the 20% ownership threshold.
Despite these built-in safeguards, foundations must remain vigilant. While private equity funds are usually compliant, unique situations may arise where the fund’s structure or an individual portfolio company’s ownership changes in ways that create excess business holdings. For example, a foundation’s indirect interest, combined with holdings from disqualified persons, could inadvertently exceed the ownership threshold.
If such a violation occurs, the IRS would require the foundation to divest the excess interest. This process can be costly or complicated, particularly in volatile market conditions. Additionally, the IRS can impose a punitive excise tax equal to 10% of the value of the excess holding. If the foundation fails to correct the violation within the timeframe specified by the IRS, an additional excise tax of 200% may be imposed on the uncorrected holdings.
To mitigate these risks, private foundations should carefully analyze the ownership structure of private equity funds before making an investment to ensure compliance with the excess business holdings rules. Foundations should also engage with investment managers to confirm that their interest does not involve undue voting control or influence over the fund’s portfolio companies.
The Jeopardizing Investments Rule and Risk Management
The jeopardizing investments rule prohibits private foundations from making investments that could threaten their ability to carry out their charitable mission. Simply put, foundations must act like prudent investors—carefully weighing risk, volatility, and overall impact on financial stability. Failing to adhere to these guidelines isn’t just unwise—it can lead to substantial penalties, including punitive IRS excise taxes.
Private equity, now a mainstream asset class, remains particularly popular among institutional investors, but it poses unique challenges for private foundations due to its higher risk, illiquidity, and long-term investment horizons. Excessive exposure to private equity could be perceived as imprudent, especially if it threatens the foundation’s financial stability. The key to compliance lies in adopting a balanced approach, evaluating private equity investments within the context of the foundation’s broader portfolio to ensure sufficient diversification and long-term financial stability.
For private foundations, an overconcentration in private equity might quickly jeopardize their overall health. An allocation exceeding 15% or 20% of the investment portfolio is possible, but there must be good, documentable reasons for doing so. Foundations should carefully justify such decisions, ensuring they are backed by sound rationale and thoroughly documented to demonstrate prudence.
To comply with these standards, foundations should conduct thorough due diligence, including comprehensive risk assessments and analyses of expected returns. They should also align private equity investments within a clearly defined written investment policy that reflects the foundation’s risk tolerance and ability to manage volatility. By taking a disciplined, well-documented approach, foundations can prudently incorporate private equity into their portfolios while avoiding undue risk and remaining firmly within the bounds of the jeopardizing investments rule.
Unrelated Business Income Tax (UBIT) and Compliance
Private equity investments often introduce complexities related to unrelated business income tax (UBIT), which differs significantly from the taxation of traditional investment income, such as dividends, interest, and capital gains. Traditional investment income is generally only subject to a 1.39% excise tax on net investment income. In contrast, UBIT applies when foundations derive income from private business profits unrelated to their tax-exempt purpose, and such income is usually taxed at the much higher corporate income tax rate of 21%. This stark difference in tax treatment underscores the importance of distinguishing between passive investment income and income that qualifies as unrelated business taxable income (UBTI).
UBIT from private equity funds is commonly triggered in two scenarios: income generated from operating businesses within the fund and income arising from debt-financed investments. Operating income from businesses actively managed by the private equity fund is generally categorized as unrelated business income and is subject to taxation at the corporate income tax rate. Similarly, when private equity funds utilize leverage—a common practice—income earned on debt-financed investments can also be classified as unrelated business income.
The financial and administrative burden of UBIT introduces additional costs and compliance tasks that private foundations must carefully navigate. Unlike traditional investment income, which benefits from favorable tax treatment, UBIT can substantially erode the net returns of private equity investments due to its higher tax rate and associated administrative complexities. Foundations must file Form 990-T to report any unrelated business taxable income and calculate the resulting tax liability. Beyond federal obligations, UBIT can trigger state income tax requirements, particularly when private equity funds operate across multiple states or internationally. The nuances of state-level taxation, such as varying filing thresholds and tax rates, can further complicate compliance, adding to the administrative workload. If the fund has international operations, compliance can become even more challenging, with “headache-inducing” international tax reporting forms and added costs.
Given these complexities, foundations should approach private equity investments with a proactive and strategic mindset. Before committing to an investment, it is critical to assess the potential for UBIT liabilities by carefully analyzing the fund’s structure, operations, and use of debt. This analysis should weigh the benefits of the investment against the risk of additional taxes and administrative burdens to determine whether the investment aligns with the foundation’s long-term financial goals.
Addressing Liquidity Concerns and Annual Distribution Requirements
A critical consideration for any private foundation investing in private equity is the impact of illiquidity on its ability to meet the annual minimum distribution requirement. Foundations are generally required to distribute at least 5% of their net investment assets each year for charitable purposes, a mandate that can be challenging when significant funds are locked into private equity.
Private equity investments typically involve long-term commitments, with capital often tied up for five years or more. Unlike public equities or bonds, private equity funds provide limited opportunities for early redemptions, leaving foundations reliant on distributions or capital gains generated by the fund. Foundations must therefore plan carefully to ensure they have sufficient liquidity to meet their annual payout obligations.
To mitigate liquidity risks, foundations should maintain a mix of liquid assets, such as publicly traded stocks, bonds, mutual funds, ETFs, and cash reserves, alongside their private equity investments. They can also forecast cash flow needs and align their private equity allocations with the timing of anticipated distributions.
Is Private Equity the Right Choice for Your Foundation?
Deciding whether to invest in private equity requires a foundation to evaluate its risk appetite, operational capacity, and access to professional expertise. While private equity can deliver outsized returns and serve as a valuable diversification tool, it demands a higher level of oversight, financial sophistication, and tolerance for illiquidity compared to traditional investments. Furthermore, it is important to understand that private equity funds have a wide dispersion of returns—while one fund may produce exceptional results, another could underperform significantly, eroding the expected benefits of the investment. This variability underscores the need for foundations to approach private equity with realistic expectations and a clear understanding of the potential risks.
Large foundations with substantial resources and access to experienced investment managers are often well-positioned to capitalize on private equity opportunities. They can absorb the additional compliance costs and administrative complexities while leveraging private equity as part of a diversified portfolio. Smaller foundations, however, may find the challenges outweigh the benefits, particularly if they lack in-house expertise or the capacity to manage the additional complexity and liquidity concerns.
Final Thoughts
Private foundations can invest in private equity funds, but doing so requires a deliberate and well-informed approach. Foundations should remain mindful of regulatory requirements, particularly those related to excess business holdings, jeopardizing investments, and UBIT, while addressing practical challenges like illiquidity and annual distribution obligations.
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