Much has been written of high market returns over the past few years, and the COVID-19 pandemic will certainly lead to higher volatility going forward. What hasn’t been written is that these data points have created a precarious situation for endowments and the organizations they support: Spend rates are up or at unsustainable levels, often beyond realistic expectations for real returns.
If real returns for most portfolios are unlikely to meet these increased spending goals, what should endowments do to adjust to this new market reality?
The resolution is not simply an exercise in math, in providing guidance for expected returns from a given portfolio, then backing out a realistic spend rate. Such an approach may avoid disaster, but it does not resolve a common issue connected to spend rates and to portfolio construction: a communication disconnect between the investment and operational sides of an organization.
This is not to say that the investment committee and operational management are necessarily at odds, but that they are often both working toward the best interests of their organization—using differing definitions for “best interests.” Operational management is fulfilling the daily work of an organization now and planning for the immediate future. This requires growth and thus increased expenditures, which stresses all sources of funding and may lead to a request for more endowment dollars. Meanwhile, the investment committee is ensuring perpetuity, funding part of the organization’s mission today, but not at the expense of its future. Those viewpoints are always going to be at least somewhat at odds.
To further complicate the situation, we are all human. Increasing spend rates have many complex justifications, but in the end, increased endowment spending is a direct result of human decisions made with human expectations: Returns have been strong for years; we can afford to spend more.
Optimism is a part of human nature, as is the desire for independence, which leads to the second reason for increasing spend rates: a desire to minimize reliance on increasingly uncertain sources of public funding given the fiscal pressures that states and local governments are facing during the pandemic.
That second reason is a valid desire. The market pressures that create lower expected returns long term can also depress public funding and philanthropy, putting even greater pressure on the endowment. How should a nonprofit’s investment committee manage this perfect storm?
Start with getting both sides together.
Investment consultants should do this at the start of a client relationship; in-house teams would be wise to put such a meeting on their next agenda. Have both sides bring short- and long-term goals and be prepared to talk about how they define the best interests of the organization. The goal is as great an understanding as possible about all aspects of the business that affect funding requirements: risks, needs, long-range plans, regulatory, donor community’s appetite to give, and non-financial market pressures; everything.
Have a candid conversation.
Identify consistencies and inconsistencies. Don’t stop there: Discuss how those goals and plans affect budgetary needs and all sources of income, not just the endowment. There are four primary sources of non-endowment funding for most nonprofits: philanthropic donors, public funding and grants, operational revenue for entities like colleges and hospitals, and current and future debt financing. A well-designed portfolio shouldn’t operate in a vacuum, as though it were unaffected by the business end of the organization.
It is part of an interrelated funding system that includes both operational and investment levers. The manipulation of those levers can affect how much pressure is put on an endowment, regardless of whether the manipulation takes place on the investment or operations side of the house. Too often, portfolio decisions and spend rates are set without a full understanding of the business pressures that the organization faces operationally. Businesses experience operational volatility; it’s an accepted part of the for-profit world and is no doubt a main concern of the operational management team at a nonprofit.
Market volatility is something that investment committees talk about often; almost daily in an uncertain financial market. But operational volatility is often absent in investment discussions. It should not be absent. A regular open communication session helps ensure that changing operational needs are part of investment decisions.
Revisit this collaborative planning session regularly.
It doesn’t need to happen annually; probably somewhere between one and five years is right for most nonprofits. Let your nonprofit’s unique situation determine the timing. Higher volatility than expected—for either markets or operations—may indicate that it’s time.
This approach may seem outside the scope of investment consultants to some. After all, we are not management consultants, paid to improve business operations. But this approach is critical to helping nonprofits make smart decisions. Our bias, always, is to ensure that investment committees and organizations make decisions grounded in reality, not grounded in hope. Excess optimism and excess pessimism both are not good for long-term investing, but reality is.
Client history #1 – a too optimistic spend rate
The value of this approach becomes apparent quickly for many clients, even when their situations seem to be strong. One community hospital engaged us just after the Affordable Care Act (ACA) took effect. They had a high spending goal for their portfolio at 5.5%, well above the national average of 4.4%, but attainable based on the previous three years’ returns. Going forward, however, 5.5% would be difficult for a hospital endowment—to achieve the long-term returns necessary to sustain it, they’d need to take on disproportionate risk for a hospital. Such risk may not have been unreasonable in the right circumstances, if, perhaps, other funding sources been solid.
But at that time, they—like all hospitals—were uncertain of how the ACA would affect reimbursements and revenues. Few hospital CFOs then held any confidence in revenue projections. Worse, the same market factors that weaken returns often cause donors to decrease giving. At the exact moment that they needed to throttle back endowment risk and spending, they were uncertain how or if they’d be able to meet future budgetary needs. It was a triple threat.
We had to have an uncomfortable conversation once we got both teams in the same room.
The hospital was still fiscally strong at that time, and was a valuable asset to its community. By bringing the finance team in and showing them the reality of the risk to the endowment—which was not on their radar because they were by necessity mired in day-to-day operations—we were able spur a review of overall budgeting, fundraising, and financing. We were the bearer of bad news—they couldn’t rely on higher endowment spending—but the result was a donor drive that used all the information we’d provided on future market returns and the long-term health of the endowment. That drive succeeded. It raised funds to bridge the gap and ensure that they could weather the expected and potential revenue changes. The negative became a positive.
Client history #2 – a too conservative approach
On the opposite end of the spectrum, another client faced an enviable nonprofit situation: Their operational revenue and donations were both excellent. They were a valued part of their community. Their spending rate was realistic.
Despite no apparent problems facing the endowment, we brought both teams together for a collaborative discussion. The investment committee still faced a dilemma: The operational side was conservative and had been building up cash reserves far beyond common standards for days cash on hand for health-care entities. They had about a year and a half of cash on hand, millions of dollars earning little interest or contributing to the long-term success of the organization. The investment committee was stunned.
We had to engage in a tough series of discussions about the point at which conservatism is no longer in the organization’s best interests but is actually detrimental to long-term independence. Those reserves were so strong that including them in the portfolio decisions allowed them to take more risks and provide more long-term returns and stability.
Had we not engaged those conversations, the portfolio would have been structured differently and the investment committee would still be unaware of significant cash reserves.
Communication is the key
While this holistic analysis is not a panacea, in our experience, there is tremendous value in connecting these two parties. In practice, the focus of each can be very different and in direct conflict with the other, leading to a divide in communication and collaboration. This is not a fault of either team; it is simply a result of the typical structure of nonprofits and their endowments. There is no one-size-fits-all investment strategy, but communication is a one-size-fits-all solution that can strengthen not just the investment portfolio, but the organization overall.
This eyes-wide-open approach leads to stronger decisions and a stronger organization over the long haul, able to manage both market and operational volatility. The focus of this communication and of portfolio structure should not be on predicting, but on preparing. A prepared endowment makes for a powerful future.
Mr. Chowdhury is the president and an investment consultant at Canterbury, serves on the Board of Directors, and is a shareholder of the firm. In his role as president, Mr. Chowdhury is responsible for firm strategy, consulting, investment research, and business development. He consults directly to institutions and private clients in the key areas of investment policy, asset allocation, and portfolio construction. Mr. Chowdhury is a member of the Global Equity and Hedge Fund Manager Research Committees. Prior to Canterbury, he was part of the advanced advisory services division of American Express in Minneapolis, Minnesota, and was also a contributor to the Human Genome Project while working in the Department of Pharmacology at the University of Minnesota. While there, he was lead author of a paper published in the Journal of Neuroscience Letters in 1995, Synaptotagmin I and 1B4 are identical: implications for Synaptotagmin distribution in the primate brain. He presently serves on the boards of the Child Abuse Prevention Center of Orange County and the Mission Hospital Foundation. Mr. Chowdhury received his Bachelor of Science degree in management and economics from the Carlson School of Management, University of Minnesota and is a CFA® charterholder.