By Pete Kennedy, CPA – Director at Cover & Rossiter, P.A.
GetInvolved Nonprofit Guide Article published in the July 2014 News Journal


It’s summertime, and many of us dream of traveling overseas for a time to exotic locales where we can relax with few regulations, forget about worries and risks and come back greatly enriched.  Similarly, many nonprofit financial managers dream of going overseas with their endowment funds.  But like any journey, it pays to plan appropriately.

In the old days (15 years ago?), investment strategies were all pretty simple:  60/40 or 75/25 long equity/fixed income ratios where diversification meant getting into fixed-income mutual funds and mid- or small-cap stocks.  Most endowments were invested with a handful of local fund managers.  The paradigm shifted when word of the Harvard University endowment strategy emerged.   The claims of consistent 15% returns drew a great deal of attention and followers.  According to Harvard’s website, its endowment has averaged an annualized rate of 12.7% for the 20-year period ended June 30, 2013.  That is pretty impressive when you consider that includes the brutal years of the “Great Recession” in 2008 and 2009, as well as the DotCom Bust in 2000 and 2001.  Even though most endowments eclipsed 12.7% for their most recent fiscal year due to the overall market performance, I imagine endowment decision-makers would sign up for a 12.7% long-term average without hesitation.

A handful of considerations in overseas investing:

  • Choosing a Fund:  I hate to punt on this, but vetting a fund for legitimacy and suitability should be the job of investment professionals.  There are thousands of funds out there.  Reading through the materials that accompany the funds reminds me of Garrison Keillor’s claim of Lake Wobegon where “all of the children are above average.”
  • Regulatory Filings: On the Form 990, there is a relatively new Schedule F, but that is by no means the only filing requirement.  IRS Form 926 and FinCEN Form 114 (Foreign Bank Account Report or “FBAR”) are among other possibilities, depending on what the investment is and how large.
  • Unrelated Business Income Tax: There is a general rule that investment income and capital gains earned by a nonprofit’s investments are exempt from tax, in spite of the fact that they bear no relationship to a nonprofit’s exempt purpose.  An exception where such income would be taxable occurs when the investment is purchased with debt-financing.  Since many overseas funds are legally organized as limited partnerships, the amounts and characteristics of the financial activity are passed through to the fund holders.  If the fund uses leveraging or debt-financing, the income it generates may meet the definition of debt-financed income and be subject to Unrelated Business Income Tax (UBIT).  Some overseas funds set up parallel funds that invest in the same things but are structured not to generate UBIT.  This is because the fund is set up as a corporation vs. a partnership and taxed at the corporate level without passing anything through.  Returns are generally lower as a result of that and the additional administrative fees charged by the fund manager.
  • Delayed performance reporting: Most (but not all) overseas hedge and private equity funds are not very easy to value.  They often own either “real assets,” closely-held stock or other partnerships, which must first be valued then rolled up into a final reportable value, which takes time.  The reporting on these vehicles is often one to three months behind their publicly traded contemporaries.  This gives custodians, investment consultants, and auditors fits, since we must often wait for a significant piece of the puzzle prior to preparing reports or opining on financial statements.
  • Less regulated markets: There is a reason that these funds make potential investors sign absurdly large disclaimers and disclosures.  They are not without risk and only “sophisticated” investors who understand enough about investing to make educated decisions about those risks should be considering them.  Investing in vehicles that purposefully set up shop overseas to avoid the U.S. regulatory environment carries with it some inherent risks that should be considered as well.  Direct investors in Bernard Madoff’s funds will benefit from extraordinary collection efforts of the U.S Trustee, Irving Picard, and will likely receive $0.80 back on the dollar.  Investors through Madoff’s feeder funds – in most cases British Virgin Islands LP’s that invested the bulk of their funds with Madoff – will receive considerably less.  The highest court in the British Virgin Islands has disallowed clawbacks as a means of recovery, a tactic of retrieving funds from those who withdrew more than they originally invested – used with great success by Picard.
  • Liquidity Restrictions (lock-ups, gates and funding commitments): To prevent volatility and provide a guaranteed level of funding for a specified timeframe, many funds require an investor to commit to providing funding over time and restrict when the funds may be withdrawn.  These will be spelled out in detail in the fund agreements.  Deciding to go in a different direction may be like trying to turn around the Titanic.
  • Fees:  Experts suggest that net return (gross return less fees) is the key figure to consider when evaluating a fund.  There is certainly justification for that, but the fees charged by these funds can give one pause.  There is generally a flat-rate fee of between 1 and 2%.  Then there is a variable fee that will pay a percentage of the excess return – 20% is not uncommon – above a defined benchmark.  So if the fund’s benchmark returns 10% and the fund returns 20%, the fund manager is rewarded with a 2% variable rate fee on top of the fixed fee of say 1.5% for a total fee of 3.5%.  If the position is $10 million, the fund manager pockets $350,000 for the year, but your net return will be $1,650,000, so everyone walks away happy.  When looking for names to add to the annual fund list – the fund manager might be a good place to start. 

If you are considering investing in overseas investment vehicles, or need assistance with any other nonprofit topic, please contact Pete Kennedy, or any other member of our Nonprofit Practice team, at Cover & Rossiter at (302) 656-6632.



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