Foundation Allocation: Spending, Illiquidity, and a 7.5% Target
A $250 million foundation has a 4.5% spending policy, a 2.8% inflation assumption, and 0.60% all-in investment cost. Its current allocation is 45% global equity, 35% core bonds, 10% private equity, 5% real estate, and 5% cash. The board wants to add 10% to private equity and 5% to private credit, funding from core bonds, to reach a 7.5% expected return. The foundation must distribute $11.25 million next year and has $22 million of uncalled private-equity commitments over the next three years. Bonds yield 4.6% with duration 6.0; equities have an expected return of 8.0% and volatility of 16%; private equity is modeled at 10.5% but with a 0.85 beta to equities and reported volatility of 22%. The investment committee asks whether the proposed shift is prudent and how to structure liquidity.
1. Calculate the required return and assess whether 7.5% is sufficient.
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On a simple additive basis, the required nominal return is 4.5% spending plus 2.8% inflation plus 0.60% costs, or 7.9%. On a compounding basis it is (1.045 × 1.028 × 1.006) − 1, or about 8.1%. If the 7.5% expected return is gross of costs, the net figure is about 6.9%, a shortfall of roughly 1.0–1.2 percentage points a year; on $250 million that is $2.5–3.0 million annually. If 7.5% is already net of costs, the shortfall is still about 0.4–0.6 percentage points, or $1.0–1.5 million. The board cannot treat 7.5% as sufficient merely because it is close. It must either lower the spending rate, accept erosion of real principal, or take more risk. The third option is not free: the proposed private-market shift raises illiquidity and smooths reported volatility, so the required return should be compared with a risk-adjusted, not reported, portfolio return.
2. Evaluate the liquidity position under the proposed allocation and recommend a liquidity structure.
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Cash is 5% of $250 million, or $12.5 million. Next year’s distribution alone is $11.25 million, leaving only $1.25 million before any capital calls. The foundation also has $22 million of uncalled private-equity commitments over three years. Moving 15% from bonds to private equity and private credit reduces core bonds from $87.5 million to $50 million but does not create a dedicated liquidity sleeve. A prudent structure would hold at least one year of distributions plus a substantial portion of near-term calls in Treasuries or money-market funds, perhaps $30–35 million, and secure a backstop credit facility. Private credit should not be treated as liquid; it may have gates or quarterly redemption limits. The committee should adopt a pacing model that limits annual commitments to a percentage of assets and tests a stress case in which public markets fall 20% and private distributions slow. Without that, the foundation may be forced to sell illiquid assets or cut spending at the worst time.
3. The private equity expected return uses a 0.85 beta and reported volatility of 22%. Explain why this may understate portfolio risk and how you would adjust the policy portfolio.
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Private-equity returns are appraisal-based, so reported volatility is smoothed and beta is stale. The 0.85 beta may understate the portfolio’s true equity sensitivity because private assets are marked infrequently and correlations rise in stress. Using 22% volatility and 0.85 beta in mean-variance optimization will therefore over-allocate to private equity. A better policy portfolio uses unsmoothed or lagged returns, a beta closer to 1.0–1.2 for the equity-like portion, and a stress correlation assumption. Apply a liquidity haircut and test a 2008-style scenario with a 35–40% private-equity drawdown, frozen credit markets, and no distributions for several quarters. Cap illiquid assets at a level the foundation can tolerate without forced selling, commonly 25–30% for an endowment with this spending rate, and revisit the 7.5% target against the risk budget rather than the expected return alone.