After years of planning and managing a well-crafted fundraising campaign, a nonprofit lands a game-changing, million-dollar gift. Or maybe the organization has accumulated funds over time that now has become a large cash balance many times greater than the nonprofit’s annual budget. When these nonprofits call us for assistance with their fund management, the cash often has been sitting at the nonprofit’s bank, perhaps in a checking or savings account, for months and sometimes years. Why? Because nonprofit leadership is typically stuck on the following:
How should our nonprofit invest these valuable funds so that our program and operational goals are supported effectively?
There is no one investment strategy for nonprofits. Which is a good thing! Determining the most appropriate investment strategy for a nonprofit’s funds requires analysis and scrutiny before any investment transaction is executed.
Fairlight recommends nonprofits follow a four-step process that includes:
- Determining Funding Goals
- Establishing When Funding is Required or Time Horizon
- Understanding Basic Investment Strategies
- Match Funding Goals and Time Horizon to Investment Strategies
Step One: Determine Funding Goals
If the funds are part of a restricted gift, the goal should be specified in the donor agreement. If the funds are unrestricted, the use of those funds would be determined by nonprofit leadership with potential approval at the board level. Fund goals typically fall into four different categories.
Emergencies and Large Unexpected Expenses
While we always wish for the nonprofit to operate without failure, we know that’s impossible. For example, a large grant that was counted on for years is suddenly terminated. A key staff person leaves and the search for a replacement requires unanticipated recruiting costs. Without sufficient funds to address these challenges, it could spiral into further pain for the organization.
A pot of cash set aside that is easily accessible can give an organization peace of mind should unexpected expenses create a major dent into the organization’s budget. If a nonprofit has yet to set aside reserves for emergencies, this must be achieved before any other investments are considered. Ideally emergency reserves are governed by a policy that specifies eligible expenses and the approval process to withdraw funds. For more information on how much to set aside in emergency reserves, refer to our article How Much in Reserves Should a Nonprofit Have?
Income Smoothing
A nonprofit may need occasional cash to manage fluctuations in the timing of donations or grants to effectively pay for fixed monthly expenses, such as rent and salaries. This income smoothing may be needed regularly or be used periodically to help the organization operate without long periods of scarcity. Funds used for income smoothing should also be governed by a policy that stipulates the approval process.
Major Purchases
A growing and thriving nonprofit at some point will require equipment upgrades, new facilities or any other one-time, costly expense. This often needs pre-planning months or years in advance, as does the saving or fundraising for this purchase. The funds allocated for the major purchase should be set aside in an account that will not be touched for other purposes.
Growth and Perpetual Program Support
Funds set aside for a specific, long-term goal, like the expansion of a program or for perpetual support, also need to be ring-fenced safely to ensure their protection for a longer time horizon. This often requires a more comprehensive investment strategy, deploying a range of investments. Growth and perpetual program support are usually the goals of true endowments.
Step Two: Establish When Funding is Required or Time Horizon
Time horizon is the time interval from when nonprofit funds are invested to when the funds are used for their intended purpose. While definitions of short-, medium- and long-term time horizons vary slightly between professionals, we think of nonprofit funds used within two years to be short-term, medium-term between 2 years and 7 years, and long-term for a period of over 7 years. Long-term could also define funds used in perpetuity.
The importance of time horizon in nonprofit investing is that it determines whether your primary goal after the period is to
- a) receive your initial investment back in full or
- b) grow your investment.
If funds are anticipated to be used after a short time frame, nonprofits most likely expect the money it invested not to change much in value, if at all. Longer-term investments are expected to grow but are often more volatile—they experience significant price changes—and need time to achieve positive returns.
Step Three: Understand Basic Investment Strategies
The world of investing is complex and opaque. The investment industry has created so many types that even someone with a reasonable understanding of markets can’t keep on top of everything available to investors. However, investments can be placed into three important strategies and it’s key to understand the benefits and risks of each.
Liquidity and Capital Preservation
Liquidity is the ease at which an asset can be converted to cash without the value of the investment losing value, which is crucial to capital preservation. Capital preservation is the foundation of conservative investing by prioritizing the safety of the original investment over growing the funds. Capital preservation is appealing to nonprofits that anticipate the payment of a specific outlay or expense. That being said, capital preservation often involves investing in liquid investments because they can be quickly converted into cash to pay for a nonprofit’s needed goods and services. Savings accounts, money market accounts, and short-term Treasury securities are examples of very liquid investments. The downside of capital preservation and liquid investments is that if held for long periods they do not keep up with inflation. In other words, the funds maintain their dollar value while the cost of goods and services will continue to rise.
Income Generation
An income-generating investment strategy focuses on maintaining a steady stream of payments. This strategy is ideal for nonprofits that have a need regular cash flow for ongoing expenses. Many investment assets generate income, but the investment income is mostly associated with savings accounts, CDs, money market funds, bonds, dividend-paying stocks and some real estate investments. It’s important to understand that the higher the rate of income an investment generates, the more likely the underlying value of the investment will change.
Growth/Capital Appreciation
Capital appreciation is a rise in the price of an investment over time. It is also the difference between the purchase price of an investment and the selling price of that same investment. Investments typically designed for capital appreciation are stocks, real estate, commodities and alternative investments.
Step Four: Match Nonprofit Strategic Goals with the Appropriate Investment Objective and Time Horizon
Once a nonprofit has determined its primary strategic goal associated with its large cash balance and understands the various investment objectives available to it, nonprofit leadership including the board should match the strategic goal to the investment objective and time horizon, preferably with help from an investment or financial professional. However, it’s still helpful to understand the fundamentals. Below are a few specific examples:
Community Health Center
A community health center with a budget of $6 million built up a $2 million cash surplus in their bank checking account. The nonprofit’s Director of Finance maintained this buffer in the case of emergencies since the organization was dependent on few revenue sources. However, the funds were pooled among the nonprofit’s operating funds and there were no specific rules that governed these funds. Leadership established an emergency reserves liquidity policy that governed general cash-on-hand and projected program expenses for the next 24 months. It was determined that only FDIC insured accounts, money market funds, CDs and treasury bills and treasury funds of under 1 year in maturity were permissible for these funds.
Funding Goal: Emergency Reserves
Time Horizon: 24 Months (short-term)
Investment Strategy: Liquidity
Senior Services Nonprofit
A human services nonprofit providing food and social services to immigrant seniors sold real estate property for a profit of $1 million. The organization already maintained four months of emergency reserves in a money market account to safeguard their $1 million budget. The organization wanted to use the $1 million profit toward a board-designated fund that provided occasional income smoothing and growth. The nonprofit also had a 5-year plan to build a more robust fundraising platform to fill the occasional budget gaps. The board approved an investment strategy that included a large allocation to higher income-generating investments like bonds and some exposure to growth-oriented investments like stocks.
Funding Goal: Income Smoothing
Time Horizon: 5 Years
Investment Strategy: Income Generation/Moderate Growth
Youth Services Nonprofit
A youth services nonprofit providing after school and educational services to low-income kids received a $10 million gift to fund a permanent endowment. The donor stipulated that the gift would be restricted to providing grants to first-generation, college-bound students indefinitely. The donor agreement was silent on the value or number of grants the endowment needed to support annually. Because the nonprofit had other sources of funding to support the endowment mission and ample funds to support the mission, the nonprofit board approved an aggressive growth investment strategy that allowed the organization to support more grants over a longer period of time.
Funding Goal: Perpetual Program Support
Time Horizon: Long-term
Investment Strategy: Aggressive Growth/Capital Appreciation
Choosing the right investment objective for a large unrestricted philanthropic gift or cash balance does take some deliberation, planning, and continuous management from nonprofit leaders and the board. But when the work is accomplished, your robust nonprofit investing decision-making process can help your organization emerge stronger and more resilient, providing more impact to the communities you serve.
Endowments can create a legacy and stable financial future for your nonprofit. But an endowment or board-designated fund does not guarantee a nonprofit’s perpetual financial resilience. The following series of content will assist your nonprofit to achieve a level of financial resilience that ensures the organization not only survives in today’s dynamic economic landscape but thrives.
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