2022 has brought a multiyear run of strong equity market performance to a screeching halt. After annualizing at 26% for the three years ending Dec. 31, 2021, the S&P 500 entered a bear market this year. Compounding the damage, fixed-income returns have been upended by spiking interest rates and soaring inflation.
Against this backdrop, investment committees are wrestling with the prospect of a lower-returning, more volatile long-term outlook for public markets. What are foundations and nonprofits to do? For many, the answer is to continue diversifying into private-market alternatives.
That shift may already be underway. According to recent research, private foundations’ exposure to marketable alternatives and private assets increased from 45% to 50% between 2020 and 2021; community foundations saw a 2% jump over the same period.1
Inflation Threatens Spending
One reason foundations may be increasingly turning to alternative investments is to make up the shortfall between spending targets and lower expected returns for their portfolios. Consider that over the last decade, a nonprofit could spend 5.6% of a typical 60/40 stock and bond portfolio annually and still maintain its purchasing power, or inflation-adjusted value. However, over the next 10 years, inflation is expected to rise to 3.1% from 2.1%. That erodes spending power to less than half—a mere 2.3% (Display).
Make Illiquidity Your Friend
While alternatives can be part of the solution, their illiquidity gives some fiduciaries pause, especially as markets retreat. We think those concerns are misplaced. In fact, their less liquid nature offers benefits that many investors tend to overlook—namely, an illiquidity premium, lack of daily market volatility, and attractive entry opportunities. As market turbulence increases, as it has of late, these three attributes become even more compelling.
To understand why let’s explore the rationale for the long lockups associated with some alternative investments. Take private equity, which can be illiquid beyond a decade. That said, while some funds may exist for longer than 10 years, most closed-end structures return original capital in full by the 10-year mark. Having a longer time horizon is in keeping with their investment mandate: Venture capital funds the growth of fledgling businesses while private equity managers provide operational expertise for mature business to scale their revenue and profits. In other words, private equity investors warrant a premium, or higher return, because of their willingness to have their investment dollars tied up for lengthy periods. That premium is far from guaranteed—some vintage years of PE underperform public markets—but historically, investors who have demonstrated a long-term commitment to the asset class have generally benefited from higher absolute returns with lower volatility than traditional stocks and bonds. At the same time, the long-term nature of private equity and other private market strategies shields investors from the daily swings that occur in public markets. This stems primarily from:
- Less price transparency: Many illiquid alternative investments are valued or marked-to-market only at specific points in time—usually quarterly. Their exact return is only known when the investment is sold.
- Less chance of forced selling: Because investors cannot buy or sell illiquid alternatives easily, they aren't as prone to indiscriminate market sell-offs. while private market investments may be experiencing similar stresses as public ones, their investors are typically only concerned with their exit price.
Many funds also enjoy multiyear terms over which to deploy the capital investors have committed. When markets get rocky or overly expensive, private funds can press pause, and wait for more optimal conditions—often called a “dry powder effect.” While it’s hard for alternative funds to buy the dips (because deals take a long time to analyze and close) a prolonged downturn may offer a window to buy when other investors remain fearful. Seizing this attractive entry point often results in a better starting point from which to build returns.
Four Keys to Success
Nonprofits have unique considerations when determining whether alternative investments suit their investment needs. Below we explore four factors for investment committees to bear in mind.
- Fee Structure: Alternatives often come with different fee structures than traditional assets so understanding how fees are assessed and the expected net-of-fee return is crucial. Nonprofits can try to lower fees in several ways. In some cases, direct access to an investment strategy—rather than through a third party—may help.
- Liquidity: Many alternatives lock up capital for multiple years while others cannot be readily sold on the market, so a full understanding of the organization's liquidity needs and operating reserves is vital. What's more, alternatives come with a variety of schedules for funding into the strategy, lock-up periods, redemption windows, and time frames. It is important to map capital committed, called—and ultimately distributed out—of various investments to available liquid funds.
- Reporting and Valuation: Many alternatives do not mark to market regularly, so there is a natural lag in performance reporting. Thus, communication between the finance staff and the audit team is imperative to confirm the valuation of less transparent investments. Lack of foresight and preparation can substantially delay the completion of audited financial statements for key funders and other stakeholders.
- Taxes and UBTI: Certain alternative investments introduce the potential for incurring unrelated business taxable income (UBTI) along with delays in filing the IRS Form 990 due to the timing of the Schedule K-1s. But not all alternative investments generate UBTI, and in some cases, an investment may be sufficiently attractive to justify paying tax on the limited UBTI received. Sometimes, UBTI can be avoided by investing through a partnership that doesn't use leverage, a structure that can block UBTI (such as a Business Development Corporation (BDC) or a mutual fund), or an offshore entity.
A Game Plan for the Future
The integration of alternative investments like private equity can provide substantial benefits to nonprofits, particularly if the environment gets tougher. But private equity isn’t the only option. Other strategies like real estate and private credit may also offer advantages from a liquidity and vintage diversification perspective. Just keep in mind that alternatives are not without risks. Consulting with investment, tax, and audit advisors—and using analytical tools that can properly project the unique risk and return characteristics—are crucial for success. Alternatives can be a winning strategy for many organizations, but education, communication, and transparency are key.
- Greg Young, CFA
- Senior Investment Strategist—Foundation & Institutional Advisory
1 The Council on Foundations and Commonfund recently released their 2021 Study of Investment of Endowments for Private and Community Foundations, which surveyed 231 private and community foundations representing approximately $120B in assets.