A Taxing Question
Ask A CIO #43
How are university endowments changing (or not) their investment strategies to deal with potential tax increases on endowment income?
For anyone who hasn’t been reading obsessively about the coming tax changes, Congress is on the precipice of passing a large tax and spending bill, aka the “One Big Beautiful Bill Act.” Among many other proposals, the bill includes a new tiered university endowment excise tax. Certain university endowments are currently subject to a 1.4% tax. The bill proposes raising rates up to 21% for those institutions with the largest endowment assets on a per student basis.1 Should the bill pass in its current state, there will of course be many repercussions beyond just the need to reevaluate endowment investment strategies.
Before we dive in, let me make some obvious caveats – colleges and universities are not a monolith, and neither are their endowments. Aside from the size factor, there’s also wide variations in asset allocations and rates of contribution to institutional operating budgets. So extend me some grace here, as I’ll almost certainly overlook a lot of nuances in our discussion below.
Ok, back to your question. As you’ll no doubt be unsurprised to hear, the upcoming tax changes have been an active topic of conversation for university endowment (and private foundation) investment offices for months now. And these changes are coming at a time when some of these same soon-to-be impacted endowments are already grappling with other portfolio challenges, namely the slow pace of distributions from their private investments.
For anyone who hasn’t been reading obsessively about the state of private equity markets, distributions from private equity managers to their investors have been meaningfully below historical averages for three years and counting.2 I won’t get into the weeds on why here, since the question this week isn’t about private equity, but there are consequences to these lower distribution rates.
Most notably, institutional investors with mature private equity programs – like, say, those university endowments with some of the largest assets per student – often rely on distributions to fund ongoing commitments (capital calls) into those same private equity managers.3 Without expected distributions, institutions have to pull capital from elsewhere in the portfolio to fund ongoing private market investments.
So to recap, these university endowments are facing two distinct, but intertwined challenges. One is market and portfolio construction driven, and the other is policy driven. But both challenges require the same solution – raise liquidity.
And that’s exactly what the likely-to-be-hardest-hit universities have done so far. Multiple universities have moved quickly to issue bonds, with proceeds providing operating flexibility (and providing a release valve of sorts on endowment pressure).4 Some have also sought to raise liquidity through private equity secondary portfolio sales.5 6
That said, raising liquidity is likely just the first phase in how university endowments (and private foundations, which will also be subject to higher excise taxes) might manage through the potential tax increases. I suspect the second phase will involve taking a hard look at those investments where institutions are sitting on sizable unrealized gains. Some of these investments may be longstanding, multi-decade public equity holdings. If the difference between selling today versus selling in a year is keeping 98.6% or 79% of proceeds, it’s probably worth a conversation.
From there, I imagine there are entire swaths of the portfolio – particularly on the hedge fund side – that will be completely re-underwritten. Having invested in and/or evaluated a large cross section of hedge fund strategies, I’ll go out on a limb and say that there are a number of funds living in endowment and foundation portfolios that only make sense in a tax-exempt context.
And on a go forward basis, university endowments will need to take tax consequences into consideration when making new investments. Certain strategies that might once have offered the benefit of consistent and non-correlated but lower return streams may no longer make the cut. Ultimately, I’m sure there are learnings and strategies from institutional family offices, which have always been taxable, that will make their way into university endowment portfolios.
Whatever happens next, it will take time for university endowments to shift their positions. These are large, complex portfolios, with investments subject to various lock-ups and redemption schedules in just about every asset class, not just privates.
I’ll end on a personal note – it’s odd to be contemplating these questions around how endowments and foundations might account for taxes in investing. I spent over 17 years managing capital for these types of institutions. These investment offices prepare for all sorts of market conditions and scenarios. But to become taxable institutions? I don’t think anyone had that on their bingo cards.
Thanks for joining this week! As always, reach out with questions: askacio@ivyinvest.co.
See you in two weeks,
Wendy
Private equity payouts fell 50% short in 2024, Financial Times, December 24, 2024
A mature private equity program is often synonymously described as a self-funding private equity program. When that program stops being self-funding, especially for an extended period of time, institutions are hit in two ways – the asset allocation gets out of whack, and more urgently, significant liquidity needs can arise.
A second chance for endowments, Secondaries Investor, May 1, 2025
I would expect that while the universities will use some liquidity from these private equity secondary sales to support upcoming operating needs, a meaningful portion of this liquidity is likely to be redeployed back into the private equity portfolio – secondaries as a portfolio management tool. And given the high-profile transactions announced to date, I would also expect to see more secondary transactions over the coming months from other universities following suit.