John Franklin is a recent widower with some experience in investing for his own account. Following his wife’s recent death and settlement of the estate, Mr. Franklin owns a controlling interest in a successful privately held manufacturing company in which Mrs. Franklin was formerly active, a recently completed warehouse property, the family residence, and his personal holdings of stocks and bonds. He has decided to retain the warehouse property as a diversifying investment but intends to sell the private company interest, giving half of the proceeds to a medical research foundation in memory of his deceased wife. Actual transfer of this gift is expected to take place about three months from now. You have been engaged to assist him with the valuations, planning, and portfolio building required to structure his investment program appropriately.

Mr. Franklin has introduced you to the finance committee of the medical research foundation that is to receive his $45 million cash gift three months hence (and will eventually receive the assets of his estate). This gift will greatly increase the size of the foundation’s endowment

(from $10 million to $55 million) as well as enable it to make larger grants to researchers. The foundation’s grant-making (spending) policy has been to pay out virtually all of its annual net investment income. As its investment approach has been very conservative, the endowment portfolio now consists almost entirely of fixed-income assets. The finance committee understands that these actions are causing the real value of foundation assets and the real value of future grants to decline due to the effects of inflation. Until now, the finance committee has believed that it had no alternative to these actions, given the large immediate cash needs of the research programs being funded and the small size of the foundation’s capital base. The foundation’s annual grants must at least equal 5% of its assets’ market value to maintain its U.S. tax-exempt status, a requirement that is expected to continue indefinitely. No additional gifts or fund-raising activities are expected over the foreseeable future.

Given the change in circumstances that Mr. Franklin’s gift will make, the finance committee wishes to develop new grant-making and investment policies. Annual spending must at least meet the level of 5% of market value that is required to maintain the foundation’s tax-exempt status, but the committee is unsure about how much higher than 5% it can or should be. The committee wants to pay out as much as possible because of the critical nature of the research being funded;

however, it understands that preserving the real value of the foundation’s assets is equally important in order to preserve its future grant-making capabilities. You have been asked to assist the committee in developing appropriate policies.

a. Identify and briefly discuss the three key elements that should determine the foundation’s grant-making (spending) policy.

b. Formulate and justify an investment policy statement for the foundation, taking into account the increased size of its assets arising from Mr. Franklin’s gift. Your policy statement must encompass all relevant objectives, constraints, and the key elements identified in your answer to part (a).

c. Recommend and justify a long-term asset allocation that is consistent with the investment policy statement you created in part (b). Explain how your allocation’s expected return meets the requirements of a feasible grant-making (spending) policy for the foundation. (Hint: Your allocation must sum to 100% and should use the economic/market data presented in Table 28H and your knowledge of historical asset-class characteristics.) L02