Alliance Online - September 2006

Warren Buffett still has a chance to do it right

Buzz Schmidt

News of Warren Buffett’s $30.7 billion gift to the Bill and Melinda Gates Foundation reached me in Europe while I was attending a conference on non-profit accountability. The Gates Foundation would now comprise over 10 per cent of US foundation giving capacity, and Buffett had placed these assets into a vehicle with someone else’s name attached. The European press was awash with praise for this wealthy and selfless American and admonishments for charitably obdurate European billionaires. For one who has spent a lot of time in Europe over the past years, it was one of the few times when I heard praise for Americans. Why then am I perplexed by this event? Like Buffett’s transactions, it’s complicated. In a nutshell, it was an opportunity lost. But, unlike other gifts to private foundations, it was not an opportunity lost in perpetuity.

You see, Warren Buffett didn’t give the Gates Foundation $30.7 billion. Rather, he committed himself to passing 5 per cent of the value of a dedicated quantity of Berkshire Hathaway shares through Gates annually so long as Bill and/or Melinda Gates are involved. Unless something changes, this annual commitment is only for a limited time period, and the full story of Buffett’s philanthropy has yet to unfold.

Because he has committed himself to giving away 5 per cent of the value of the shares each year, the value of the shares that underwrite his Gates commitment will continue to climb so long as the annual growth of Berkshire’s share price exceeds 5 per cent – and they will remain in the control of Buffett or his estate upon the conclusion of the commitment. What Buffett has effectively done is to form a charitable lead trust, with an undetermined destination, not necessarily charitable, for a much greater residual value.

Consider this. If (1) the Gates involvement in their foundation, and along with it the Buffett commitment, concludes in 2036, (2) Berkshire repeats its past 10-year 11.4 per cent growth rate and (3) inflation climbs at an annual 3.4 per cent rate, the real value of the remainder shares in 2036 will be more than twice their current value. These prospective $60 billion plus remainder shares are not now committed to the Gates or anyone else. Paradoxically for charity, that is the best news of all. There is time for Buffett to pursue long-term strategies that are more creative, economic and effective than merely plopping assets into a private foundation. And a truly groundbreaking approach is the least we should expect from our greatest investor.

Even now, a germ of greatness

Indeed, Warren Buffett’s interim strategy contains a germ of greatness. Instead of placing the assets into a single entity, he has chosen to invest through five charitable vehicles, which will continue to receive annual funding so long as conditions are maintained. In placing the biggest multiyear bet on Gates, he is backing the current class of the field. The Gates provide a serious model for concerted, directed, results-seeking philanthropy.

The idea of investing one’s philanthropic capital through existing grantmakers is a very important one. There is an inherent absence of efficiency and accountability in private foundations, which is due to the convergence of endowment and grantmaking activity within a single decision-making unit. No shareholder-equivalent force demands accountability from this unit, and grantmaking staffs receive their annual allotments from endowments regardless of their performance. Buffett has decided to disaggregate this unit, keep control of the invested corpus, make third party, professional intermediaries responsible for grantmaking, and set a time limit on the arrangements.

Taking account of the social cost of capital

Unfortunately, unless he takes a hard look at the economics of philanthropy, Warren Buffett will likely at his death establish another huge perpetual private foundation endowment or further endow a set of already huge foundations. This would be very bad news. Apart from lacking efficiency and accountability, the standard foundation model deprives society of much of the intrinsic monetary value of foundation assets. Let me explain.

The US foundation investment mantra is to preserve, at a minimum, the inflation-adjusted purchasing power of its endowment in perpetuity after making the statutory minimum payout. In practice the payout minimum has become an effective maximum, and, despite annual 5 per cent distributions, foundation endowments have continued to grow at rates far exceeding inflation. Given the Gates Foundation’s record to date, it appears that it too has a ‘perpetual’ life expectancy and treats its legal minimum payout requirement as a maximum.

Yet as these endowments continue to grow, the world’s unmet needs grow at a greater rate. Foundation policy assumes that society realizes the full value of these assets whether they are deployed charitably today or in a hundred years – that there is no opportunity cost of warehousing philanthropic funds in endowments indefinitely. When Buffett and other savvy investors value a security, they discount a company’s future projected cash flows by that firm’s cost of capital. They know that each dollar in hand today has greater value and utility than that same dollar will have at a future date.

So too should social investors recognize that there is greater utility in solving problems today than waiting to respond to the same or other problems in the future. There is a real cost to this waiting, a very real social cost of capital. This cost is partially a function of the value of improving the quality of individual lives today rather than years from now. It also reflects the rapidly growing costs to society of leaving specific problems unattended, for example infectious diseases, global warming and urban youth unemployment.

Ironically, the private foundation model disrupts the movement of wealth directly to operating charities today. Because gifts to foundations receive essentially the same tax advantages as direct gifts to operating charities, they compete directly with real-time philanthropy. Does it really make sense for American polity to push the realization of charitable value indefinitely into the future? If so, then why allow charitable tax deductions if we don’t believe we need to expend funds charitably today? Perhaps we as a nation feel we must warehouse philanthropic funds today to meet future charitable needs. If so, we must truly believe that the economy of the future will, for the first time in history, be unable to regenerate its philanthropic capacity? Warren Buffett would certainly refute that belief.

What about those remainder shares?

And what of the assets that underwrite the annual commitment to Gates and will comprise those ultimate remainder shares? In his letter to the Gates, Buffett makes the case for retaining ‘charitable’ assets in Berkshire Hathaway stock, writing: ‘I regard Berkshire as an ideal asset to underpin the long-term well-being of a foundation.’ In taking this attitude, he is far from unique. The endowments of US foundations are typically invested in the same securities in which they were invested before becoming foundation assets. In fact, relatively little has actually changed for the world as a result of these magnanimous ‘charitable actions’. In all, if Buffett stepped back and looked broadly and analytically at the economic reality of the foundation model, he would find a private investment company that gives its excess cash annually to charity.

Warren Buffett could still preempt the perverse economies of philanthropy. With his unique hand of wealth, brilliance and reputation, he should not leave all the bidding to his famous bridge partner and pass on this incredible opportunity. He has committed his interim philanthropy capacity to Gates and his own family’s foundations. But for the long term, he should pursue a more ingenious strategy, one more consistent with his longstanding investment principles. For example, he could:

recognize the ‘social cost of capital’ in his own philanthropy and set a tremendous example for others. He could follow the example of Atlantic Philanthropies where, by paying out $6 billion over 15 years, our most publicity-eschewing philanthropist generates far more societal value than any endowed foundation;
diversify grantmaking risk using several intermediary social ‘investors’. To this end, he could devise a competition among grantmakers and distribute his billions rapidly through a score of the best grantmakers in those areas that are most critical for the health of the world;
place uncommitted endowment funds in mission-related investment vehicles. One way to mitigate the social cost of capital is to deploy retained investment funds in profit-seeking investments that further the mission of the foundation;
invest in the development of new, disciplined philanthropic market systems to support more effective and properly resourced charitable activity. Just as in the corporate realm, the social capital market needs consistent reporting practices, market signals, and accountability from the providers, intermediaries and users of capital resources. Buffett is just the person to engage with this challenge.

Now near the end of his career, Warren Buffett is saying that he did all of it mainly for society. This is a bold notion, but there is so much more he can and must do if society is to gain full value from his talents, resources and charitable inclinations. If the world’s leading investor applies his mind to it, he can force the emergence of a far more resourceful, accountable, results-driven, philanthropic capital marketplace – one that respects the full social costs and opportunities implicit in the great resources controlled by foundations and used by charities.

In embarking on such a course, the world’s new leading philanthropist could set the ultimate charitable example. However, if the experience of other large foundations is any guide, he had better put these aggressive strategies in motion now, because they are highly unlikely to happen once the lawyers and accountants take control.

Buzz Schmidt is founder of GuideStar charities reporting systems in the US and UK. He leads Civil Society Systems, which builds GuideStars worldwide. Email bschmidt@civilsocietysystems.org

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