Economic Reflections

Responding to Crisis

by | Oct 12, 2020 | Economic Reflections

Many institutional investment advisors, including Syntrinsic, anticipate lower capital market returns over the next decade due to the long-term economic ramifications of the pandemic. With these lower return expectations, many nonprofit organizations are wrestling with the existential question of, “How do we fund our mission and last into perpetuity?” This question is not new. Since the Great Financial Crisis, steadily lower global growth and interest rates had been weighing on many nonprofit organizations. The COVID-19 crisis resurfaced this question and added another layer by dramatically increasing needs for funding in health care, education, elder care, food security, housing security, the arts, economic development, and many other sectors. Thus, for many, the question has shifted to, “How do we fund our mission NOW and into perpetuity?”

For many decades, the rule of thumb for many nonprofits has been to distribute 5.0% of their endowment annually in support of mission. This calculation has been largely driven by the Internal Revenue Service (IRS) ruling that private non-operating foundations must distribute 5.0% of the value of their net investment assets annually in the form of grants or eligible expenses.1 Meanwhile, many university endowments and other endowed public charities had grown accustomed to distribution rates around 5.0% as well, though often based on a three- or five-year rolling average asset base, which tends to lower the actual current distribution rate. A study by Dahiya and Yermack found that the mean and median distribution rate for large endowments (not just private foundations) was in the neighborhood of 4.5%.2

Most nonprofit institutions strive to have their endowments maintain their purchasing power in perpetuity, which means that in addition to the need to earn the distribution rate, the endowment must also keep pace with inflation. Keeping pace with inflation would provide future generations with the same purchasing power as the current generation even with annual distributions. According to the 10-Year Breakeven Inflation Rate, US inflation expectations are 1.7%.3 Thus, an organization that wanted to distribute 4.5% would need to earn investment returns of about 6.2% (1.7%+ 4.5%), net of investment expenses, in order to maintain purchasing power over time. Syntrinsic’s Forecast for global equities over the next 10 years is 6.1%, well in line with the forecasts of many of our peers. Even if a nonprofit took the uncommon step of investing its endowment in a 100% equity portfolio, that organization still would have a challenging time earning enough to both fund the mission and last into perpetuity.

The capital markets are universal, as is this challenge, so nonprofit organizations are addressing this situation in various ways.

Increasing Investment Risk

Prior to COVID, expectations for capital market returns had been steadily declining due to slowing growth, low inflation, and low-interest rates globally. The COVID-19 crisis caused a dramatic decline in economic activity, further weighing on growth, inflation, and interest rates4. This led to several financial institutions lowering long-term return forecasts from the beginning of the year. Further exacerbating the situation, government bonds are yielding close to negative real yields, correlation benefits are declining, and the opportunity cost of holding these bonds has increased thereby pushing investors into riskier asset classes. As a result, some nonprofit investment committees have been increasing their allocations to riskier assets in order to meet return objectives, adding and/or increasing exposure to public market equities, private equity, private debt, private real estate, and aggressive hedge fund strategies.

For qualified investors, the quintessential asset allocation of 60% equities + 40% fixed income has dramatically changed over the last couple of decades, in part because forecasts anticipate returns in the range of 4-5% with such an allocation. That 60/40 mindset has been replaced with more nuanced and complicated portfolio allocations that include higher allocations to public and private equities, extremely low or no fixed income, hedge funds, and private credit. While private equity and private credit fundamentals are dependent on public markets returns, limited partners in private investments typically earn a premium in exchange for the inherent risks, including liquidity. For non-qualified investors that are limited in the use of private investments, equity allocations in many cases have bumped up to 75-90% while allocations to liquid alternative investments appear to be increasing as well.

Increasing the allocation to riskier assets can improve the likelihood of meeting investment objectives; however, doing so also heightens volatility, the intensity of drawdowns, and the risks associated with illiquidity. None of these risks are inherently problematic unless an investment committee proves unable to withstand market movements and sells during downturns, thus destroying capital. While institutional investors tend to resist market timing efforts more successfully than individual investors, it is important to ensure such fortitude is confirmed in policy and culture before materially increasing portfolio risk.

For all organizations, the decision to increase investment risk lies with the investment committee’s risk tolerance and the trade-off between the risk in the portfolio and the opportunity cost of not meeting the organization’s long-term objectives.

Increasing Leverage

Earlier in 2020, in this extremely low-interest-rate environment, four high-profile nonprofit organizations publicly announced that they would issue debt to increase the annual amount they distribute.5 While relatively unheard of in the nonprofit industry, this form of arbitrage has long been common amongst corporate and private investors to take advantage of extremely low-interest rates. On the most basic level, using leverage to arbitrage returns is similar to taking out a home mortgage at 3.0% and receiving a tax deduction on the mortgage interest instead of paying cash in hopes of earning more than 3.0% in the investment markets.

This debt issuance provided these organizations with immediate liquidity to fund grantmaking during a time (June 2020) when the price of their invested assets was more than likely below fair market value. This issuance eliminated the need to sell at market lows and destroy capital to increase grantmaking. The debt issuance by these organizations—particularly the Ford Foundation—has provided a case study for not only nonprofit organizations, but also other private and institutional impact investors as the bond issuance6 is expected to have a “social bond” designation and be the first of its kind. Social bonds as defined by Sustainalytics are use-of-proceeds-bonds that raise funds for new and existing projects with positive social outcomes.

Increasing leverage, however, bears substantial risks. In most arbitrage situations, the investor is borrowing at a fixed interest rate that must be paid in the hopes of earning more in highly uncertain investment markets. There have been plenty of nonprofit institutional investors hurt by failed arbitrage efforts, such as pension obligation bonds and auction-rate securities. While a tool, leveraged arbitrage is one to be considered with great care.

Reevaluating Perpetuity

Perpetuity essentially means forever. Most reading this commentary were not alive when the first private family foundation was established in 1907, the Russell Sage Foundation. In 1911 and 1913, the Carnegie and Rockefeller Foundations were established. While the organizations’ leadership teams have changed, 100 years later these institutions are still integral to the fabric of the philanthropic community. That said, many organizations are wrestling with how to balance current societal needs with potential future needs. We reported earlier this summer in Perseverance, Partnerships and Innovation in the time of COVID that over 40% of our nonprofit clients have increased distributions to support their grantees during this crisis. Commonfund7 recently released a study that 35% of private foundations and 28% of community foundations they surveyed have increased distributions as a result of the COVID-19 crisis. So, clearly many are opting to prioritize distributing funds NOW over reserving them for the future.

Increasing distributions to grantees during this time is a topic that continues to be hotly debated within the sector. Emergency Charity Stimulus asked investors to sign onto a letter8 addressed to Speaker Pelosi, Chairman Neal, Ranking Member Brady, Minority Leader Schumer, Chairman Grassley, and Ranking Member Wyden to urge them to consider legislation that would mandate private foundations and donor-advised funds to distribute at least 10% of their assets each year for the next three years. The Council on Foundations expressed a different perspective in their Policy Brief.9 The Council on Foundations surmises that, “Doubling the payout requirement for private foundations and creating a new mandate for donor-advised funds would unnecessarily limit philanthropy’s ability to respond to future crises.”

For many funders, the decision is somewhere in the middle, as organizations recognize that perpetuity is a long time away and increasing the payout for a few years may or may not have a significant effect on the ability of future generations to react to crises. Those future effects largely depend on the size of the organization’s distribution increase and the returns of the investment markets during those years. While evaluating investment projections, reacting to the moment, and catalyzing movements are important, every organization must stay true to its unique strategic plan and long-term goals, as well as the expectations of its donors. An organization’s strategic plan is one of the most important tools it can use as a guide to answer the question of, “How do we fund our mission NOW and into perpetuity—or not?”

Aligning Investments with Mission

Like many of the strategies above, aligning investments with mission is not a new concept. Nonprofit organizations have been employing negative screening – excluding companies that do not align with their values – for decades. However, over the last two decades, nonprofit organizations have begun to not only screen out certain investments but also target investments that benefit from the integration of environmental, social and governance (ESG) factors. Many are beginning to ascribe to the notion that this way of investing can further the impact of the organization, reduce portfolio risk, create positive systems change, and help offset the greater difficulty of earning portfolio returns in the 6-7% per year range via traditional investment markets.

Outside of the public markets, some nonprofit organizations have started to increase their use of program-related investing – loans, guarantees, and equity investments to mission-aligned nonprofit and even for-profit companies. Program-related investments (PRIs) as defined by the IRS in 1969 allow private foundations to make investments instead of grants to organizations as long as the purpose is to accomplish mission and not to produce income.10 Some private foundations have been using this tool for decades, but the concept has been gaining traction with more private foundations and other types of nonprofit organizations (as evidenced by client activity). For those struggling with how to navigate lower returns while not increasing or decreasing distributions, this tool provides for a potential return of grant capital. Grant capital that historically has not been directly recycled back into the community can be reused in the form of additional grants or investments. There always will be a place for traditional grants, and program-related investments generally will not fund or finance an organization’s entire mission; still, PRIs can be another tool in the toolbox along with grantmaking to fund mission.

Bottom Line

While the pandemic is undeniably challenging the nonprofit sector by squeezing investment returns and placing ever greater demand on financial resources, that pressure is compelling greater creativity and resourcefulness as well. Each nonprofit organization must evaluate whether it makes sense to increase portfolio risk, leverage assets, re-evaluate timeline and distribution rate, or align investments with mission. There is no one answer for every organization. But times like these require most nonprofit organizations to ask hard questions and create an intentional strategy for the years ahead. Much good can come from adversity and this crisis. Let us try to make it so.

  1. Internal Revenue Code, Section 4942
  2. September 2020, Investment Returns and Distribution Policies of Non-Profit Endowment Funds, Sandeep Dahiya and David Yermack
  3. October 9, 2020 Federal Reserve Bank of St. Louis, 10-Year Breakeven Inflation Rate
  4. July 20, 2020 Syntrinsic Mid-Year Capital Markets Forecast Update
  5. July 2020, The Chronicle of Philanthropy, Who Benefits When Foundations Float Bonds to Do More Grant Making
  6. June 10, 2020, Bloomberg – Ford Foundation Plans Record $1 Billion Borrowing for Grants
  7. 2019 Council on Foundations – Commonfund Study of Investment of Endowments for Private and Community Foundations.
  8. Emergency Charity Stimulus, We Support an Emergency Charity Stimulus Bill to Mandate Increased Payouts for Private Foundations and Donor-Advised Funds
  9. Council on Foundations Policy Brief: Foundation Payout and the COVID-19 Crisis
  10. IRS, Charities and Nonprofits, Private Foundations, Program Related Investments