April 13, 2016
April 13, 2016
For many nonprofit organizations, revenues can be sporadic. Some components of revenue, such as earned income and gifts from longtime patrons, can be reliable while others, such as gifts from community members and corporations, can be cyclical. For organizations fortunate to have built up an endowment, the expected returns of the investment portfolio can provide an additional stream of cash flows to support organizational expenses. However, endowment withdrawals are often projected to be linear in nature when in practice, may increase dramatically when an organization falls on tough times. Failure to anticipate cash flow correlations can leave nonprofit institutions in a pinch, and ultimately degrade financial wellness.
For example, a hypothetical organization named Project Art that receives most of its revenue from individual donors is able to successfully grow operations in a strong economy by expanding its donor base while also elevating average annual gifts from existing donors. Meanwhile, positive economic conditions provide Project Art’s endowment with outsized portfolio returns relative to projections, modelled based on historical averages. The board of directors concludes that in light of the robust individual giving, the Organization can spend all of the portfolio returns, rather than bank all or a portion of the increment over and above projections, further expanding Project Art’s invaluable services to the local community. Some years later, the economy is in recession and prices for stocks, real estate, and other risk assets have dropped significantly, causing Project Art’s donors to tighten their proverbial belts. With revenues down, the board is now in the precarious position of either laying-off staff and reducing services or aggressively taping portfolio assets at the worst possible time (low prices).
The broader observation from this hypothetical nonprofit institution is that for many organizations, endowment withdrawals increase when other sources of revenue fall but do not necessarily decrease when other sources of revenue are strong, which, in effect, erodes the financial strength and sustainability of an organization over time. In my experience, this occurs because: a) board directors and management are understandably focused on the organizational mission and the expansion of mission-driven services; and b) endowment allocation decisions are made around risk and return objectives under the false presumption of withdrawal discipline that may simply not be feasible in certain economic conditions.
Approaches to help mitigate this dynamic may include:
1) reducing an endowment’s overall allocation to risk, lowering downward volatility in a bad market;
2) maintaining a low risk investment portfolio apart from endowment assets to accommodate emergency spending;
3) establishing an endowment withdrawal cap that implicitly banks savings when portfolio returns are high;
4) mandating a series of expense reductions should revenues decline by certain thresholds; or
5) some combination of the above.
Ultimately, there’s no rule of thumb. Each and every nonprofit institution is unique and achieving financial wellness requires analysis, ongoing vigilance, and focus on long-term sustainability over mission-driven impact in the short-run. It is incumbent upon management and board directors, alongside their financial advisors and consultants, to chart the course, find financial cadence, and help keep our invaluable network of nonprofit institutions alive and thriving.