Working with a Donor's Investment Manager
“If I create a fund at the community foundation, can my investment manager still manage the funds?” You may have already come across a donor that asked this question. Such a donor is essentially requesting that the fund they create be invested outside of the foundation’s investment pool(s). While there are cases where the answer must be “no” (e.g., donor wants the investment firm she owns to manage the assets), there are also cases where the answer should be “no.” A strong policy will guide the community foundation in those cases where the answer may be “yes.”
Background
There is no legal precedent for community foundations permitting such arrangements. In at least one private letter ruling, the IRS has permitted a community foundation to establish multiple investment pools and allow a donor to choose among those pools. However, no similar rulings have been issued that permit a donor to recommend an investment manager. While the absence of such guidance, does not mean an arrangement is prohibited, it is a cause for caution. In particular, permitting a donor to recommend an investment manager needs to be clearly structured in a manner which does not permit the donor to control the investments of contributed funds.
Beyond IRS concerns about donor control, community foundations should also take their obligations under relevant prudent investor standards into account. For the majority of community foundations that are now subject to the Uniform Prudent Management of Institutional Funds Act (UPMIFA), consideration must be given to the explicit duty to minimize investment costs found in Section 3(c) of UPMIFA. An investment manager recommended by the donor who charges more than managers of pooled assets or an increase in investment costs of pooled investments because the community foundation is permitting donor recommend investment managers are both concerns to take into account under UPMIFA. In addition, whether the community foundation is subject to UPMIFA, its predecessor, the Uniform Management of Institutional Funds Act (UMIFA), or the Uniform Prudent Investor Act (UPIA), the community foundation and its investment committee needs to consider how many managers the investment committee can adequately supervise.
Creating a Policy
In light of the considerations above, some community foundations may choose to prohibit the practice of allowing donors to recommend investment managers. If, however, the community foundation chooses to permit the practice, a policy is critical. The key elements to any such policy that permits donors to recommend investment managers are:
1. Review of investment manager. Prior to accepting an investment manager recommended by a donor, the board or investment committee needs to review that investment manager’s performance, fees, and credentials just as it would for any other investment adviser. This due diligence process should provide enough information to determine if the investment manager meets the foundation's requirements. The Council's Recommended Best Practices in Managing Foundation Investments and Investment Management Practice Tips and Resources contain guidance and resources on such processes.
If the community foundation decides to engage the recommended investment manager, the community foundation board or investment committee needs to periodically assessment performance of the manager against its established benchmarks.
2.Establish Direct Relationship with Community Foundation. While the donor may have recommended the investment manager, the agreement with the manager must be between the community foundation and the manager. The community foundation would make any investment decisions. In other words, the donor has no continuing role in the relationship and should have no ability to instruct the manager or obtain information directly from the manager with regard to the funds contributed to the community foundation. Similarly, the community foundation board or investment committee must retainthe right to terminate the relationship with the manager.
3. Restrictions on Investment Manager. The donor, donor advisors to donor advised funds and parties related to donors or donor advisors should not be permitted to serve as investment managers. The term “related parties” generally includes family members and entities where donor or donor advisors hold 35-percent control over the voting power or profit interest.
In the case of a donor advised fund, donors, donor advisors and related parties are strictly prohibited from receiving compensation or benefits from the donor advised fund. This would preclude most arrangements between the community foundation andthose individuals or entities. However, even if such an investment manager were willing to forgo fees for the services, you may find that what may appear to be a pro bono relationship on its face may confer a benefit to the investment manager (e.g., underlying soft dollar or other relationships between the investment manager and third parties, or volume discounts).
Even if there is no financial benefit to the investment manager or the fund is not a donor advised fund, the continuing role of the donor, donor advisor or related party as investment manager couldbe viewed as impermissible continuing donor control over the fund and should be avoided. The importance of not allowing the donor to direct or control the investments or investment manager is underscored by the case The Fund for Anonymous Gifts v. the IRS, 79 AFTR2d Par. 97874 (D.D.C. 1997). In that case, the U.S. District Court for the District of Columbia considered the difference between allowing donors to choose among investment pools and allowing them to control investment decisions. The court reasoned that the provision of the charity’s governing instruments which permitted donors to direct investments after their contribution to the charity was too much donor control. The opinion contrasted the situation where the charity controlled the pools and the donor was only are permitted to allocate the contribution among investment pools established by the charity. Note that The Fund for Anonymous Gifts was later granted status as a charity after it amended its governing instruments to eliminate donor control over gifts (83 AFTR2d Par. 99654 (D.C. Cir. 1999)).
Finally, in the event the donor is not an investment professional and asks to provide direction on the investment of his/her gifts, a community foundation should also consider that allowing the donor to provide direction about investment of assets that are no longer owned by the donor may put the donor in violation of securities laws.
For all of these reasons, a policy should prohibit the donor, donor advisors to donor advised funds and parties related to donors or donor advisors from serving as investment managers of the nonpooled assets of the particular fund.
4.Fund Minimum. From a practical angle, consider what size the fund would need to be for the community foundation to consider vetting and potentially hiring an investment manager recommended by the donor. Remember, since these funds would be managed outside your pool, every donor’s recommendation that you consider will mean an additional manager to vet and, if hired, monitor, meet with and periodically review. For this reason, and in light of the prudent investor standards under state laws discussed above, take into account the capacity of staff, investment committee and board to prudently manage, evaluate and monitor additional investment managers when considering the policy and fund minimums.
Working with an investment manager recommended by a donor may have its benefits. It exposes the community foundation to a new manager and eliminates one more hesitation a donor may have about making a significant contribution. However, such arrangements need to be handled carefully because, ultimately, the community foundation has fiduciary duties with respect to all its assets regardless of who is managing them.
