Chris Cuffe explores the nuances of developing effective investment strategies for foundations.

The objective of all investing is to achieve a required return, within an acceptable risk tolerance level, to meet a required goal. This involves a four-stage process:

1. Setting an appropriate investment objective to meet a required goal within a required time frame; 2. Determining an investment strategy most likely to achieve the investment objective; 3. Determining an appropriate asset allocation to fulfil the investment strategy; and 4. Selecting individual securities within the confines of the investment strategy and within an appropriate risk management framework. While the principles for investing for foundations, including private ancillary funds (PAFs), are the same as those for other investment structures, the specific circumstances of PAFs lead to different investment strategies. These differences arise from their longer timeframe; a different tax environment; specific investment rules in the PAF guidelines (including the cash flow requirements to meet the required five per cent grants per annum); and funds being invested for public benefit or social return, rather than for private or individual gain.

The time frame for foundations, including PAFs, is usually long and can be in perpetuity. This has a number of important implications, particularly as the risks are quite different. For foundations, long-term capital growth is crucial to counter the dilution effect of inflation.

For this reason, a key feature of investment strategies for PAFs is their greater orientation towards growth assets in asset allocation. As we know from the past 100 years or more, equity and property markets have outperformed fixed interest and cash, here and internationally.

PAFs are required to make minimum distributions of five per cent of their capital base each year, so inherent equity volatility will flow through to the minimum distribution level. While the long time investment horizon for PAFs usually allows such volatility to work through, foundation investors should not be investing in highly volatile or speculative stocks which may have more of a “crash or crash through” profile about them. Although volatility in capital values may not be, of itself, a concern for PAFs, avoiding the possibility of permanent capital loss absolutely should be. So PAF investors need to ensure their stock selection focuses on sustainable businesses that canendure and recover from periods of economic and market volatility. For example, investing in well-managed mature smaller companies may be perfectly fine, but investing in a “fingers crossed” start-up is not!

Foundations and PAFs are usually income tax exempt, but their investment focus must still be on after-tax returns. The ability of foundations to claim back franking credits on dividends from Australian companies means that companies generating fully-franked dividends represent very attractive investments for them. Participation in off-market buybacks involving large franked distributions is also likely to be attractive for the same reason.

International shares don’t carry franking credits (and can occasionally have withholding tax, which cannot be offset) making them relatively less attractive for foundations. However, the diversification principle that is explicit in both PAF guidelines and trustee law can still be addressed by incorporating exposure to international economies as part of the stock selection criteria.

State trust law requires that the trustees of all foundations, including PAFs, have regard to several matters, including the benefits of diversification and the need to consider mission, risks, costs and tax when investing trust funds.

The PAF Guidelines (2009) also set further specific restrictions preventing: investing in collectibles; borrowing (although there are some short-term exemptions); running a business; and non-arms-length commercial transactions with related parties.

All of these need to be incorporated in the (written) investment strategy and considered as part of the annual investment review. Failure to do so places the directors of the trustee company in potential breach of the guidelines, with the possible consequences of financial penalties (to be paid personally and not by the PAF).

The trustees of all PAFs are required to exercise “the care, diligence and skill that a prudent person would exercise in managing financial affairs of others”. While this is often interpreted, correctly, to mean taking a “conservative” approach, this approach must be viewed relative to the risks facing the PAF, which are different from other investments.

For example, I would regard investing in cash for a perpetual PAF (with cash usually defined as bank bills, term deposits et cetera) as a highly risky long-term investment strategy, given that this will usually be insufficient to cover the required five per cent grant-making distribution plus an allowance for infla- tion and for the administration costs of running the PAF.

As with all investing there is no single “right” portfolio preparation for PAFs. This article provides a general discussion of the issues rather than advice, and trustees should take specific advice relevant to their PAF’s particular circumstances.

Chris Cuffe is a member of the Advisory Council for Social Ventures Australia’s Private Ancillary Fund Service.

Join the discussion