Types of Hedge Fund Investors

consistent with a set of objectives. The money donated to the foundation is
treated as a charitable donation for income tax purposes. Subject to some
exceptions, the investment return of the foundation is exempt from federal
income taxation.
Foundations are often established to maintain voting control of a
closely held company. A foundation may play a role in corporate gover-
nance. The foundation may also control management succession, particu-
larly when a family, together with the foundation, controls a voting block
of stock in a publicly traded company.
According to federal tax law, at least 5 percent of the foundation must
be distributed each year to retain the tax-free status of the foundation. Al-
though the investment returns of a foundation are not taxed, a foundation
would be taxed on the returns of a business if it operates a business. The
returns on such a business are unrelated taxable income. Unfortunately, in-
come from highly leveraged hedge funds may be classified as unrelated tax-
able income if the fund borrows money and distributes significant interest
expenses to the foundation. See Chapter 10.
Foundations may invest in offshore hedge funds organized as corpora-
tions. As described in Chapter 5, hedge funds domiciled in low- or no-tax
areas are usually organized as corporations. These offshore corporate
funds are not flow-through tax entities, so a foundation would not be allo-
cated interest expense from a hedge fund.
Why Foundations Invest in Hedge Funds
Foundations invest in hedge funds for many of the same reasons that other
types of investors incorporate hedge funds into their portfolios. A founda-
tion that earns high returns can increase the funding of projects consistent
with its objectives. Because of the 5 percent distribution requirement, a
foundation needs to earn a substantial real return to preserve the size of the
foundation relative to inflation.
A foundation may also invest in hedge funds to get the benefit of lower
risk, either by incorporating hedge funds with low volatility of returns or
by investing in hedge funds with low correlation to other assets in the
foundation portfolio. All investors like to lower the risk in their portfolios
if this is possible with little reduction in expected return. Foundations may
be particularly sensitive to the effects of a short-term loss in a portfolio be-
cause the combination of the loss and the commitments the foundation has
made to make distributions may shrink the size of the foundation and limit
its ability to achieve its objectives in future years.
Types of Hedge Fund Investors
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