An operating nonprofit entity (as opposed to an endowment or foundation), is a nonprofit that has a source of revenue from the pursuit of its mission. Examples of such operating nonprofits include educational, healthcare, media and environmental services as well as many others. Like any similar for-profit business, a successful operating nonprofit is one that over time generates revenues in excess of its expenses, which result in retained earnings that can be re-invested back into the mission. When invested, these retained earnings can grow over time providing a greater contribution than simply leaving the funds in a money market account until needed.
Prudent questions for the nonprofit’s leadership are:
• What is the best way to benefit from these retained earnings in contributing to its mission?
• Are these earnings a reserve for future operating expenses?
• Are they for a future capital expenditure?
• Or, are they for a traditional “rainy day” fund?
The answers provide the opportunity for an operating nonprofit to consider investing funds to an endowment or foundation to provide a greater investment return over the long-term, increasing cash flow, and a buildup of retained earnings in the future.
As with any investment portfolio, the most important component is time. The longer funds are invested in this manner increases the opportunity for higher returns and managing associated risks.
Retained earnings targeted for current operations have a short investment horizon and should be invested in cash or cash-like instruments for preservation of principle with a yield component. Earnings targeted for a future capital project, say five years, could be invested in a more balanced portfolio combining preservation of capital with conservative growth. Retained earnings for operating a nonprofit long-term can be invested in a college or university endowment.
The benefit of adopting the endowment model for investing long-term reserve balance sheet retained earnings is, like an endowment, the portfolio can provide an income stream today while preserving the reserve’s purchasing power for the future. Like an endowment, this investment portfolio can provide between three percent to five percent of the reserve’s balance annually for operations or a special project while growing at the rate of the annual draw plus inflation.
The key is what’s the purpose of the reserves on the balance sheet and how best they can contribute to the business and its overall mission. For reserve funds long-term in nature and invested in the endowment model, benefits include:
1. An annual funding source for operations or other uses.
2. A disciplined approach to preserving and growing reserves long-term.
3. An asset that can build over time for a major project, acquisition or capital expenditures.
4. An asset that can be leveraged for the benefit of the nonprofit.
Like all investment portfolios, there are risks, but over time can be mitigated. Risks include:
1. Market risk of investment loss.
2. Balance sheet risk of a decline in retained earnings during a market decline.
3. Income statement risk of realized losses during a market decline adversely impacting the cash flow. In the endowment model, the use of mutual funds and ETF’s significantly help the management and timing of losses.
These risks, utilizing the endowment model with a diversified investment portfolio, are designed to be managed and capture long-term return.
DiMeo Schneider works closely with our operating nonprofit clients to determine the strategy for reserve capital on their balance sheets. They include:
• Identifying the appropriate investment time horizon depending upon the objectives for the cash reserves
• The investment objective
• Drawing rate and risk measures and to determine the best overall investment structure to implement (i.e. cash pool, asset preservation portfolio or endowment model portfolio)
DiMeo Schneider uses Frontier Engineer™ proprietary asset allocation tool to model the range of outcomes (strong markets, weak markets, recession, etc.) to forecast potential impacts to our clients’ balance sheets, income statements and cash draws. The tool assists clients to determine their risk tolerance and the impact on financials; especially those clients who may have debt covenants or other financial reporting requirements that could be impacted by changes in the value of the reserve portfolio long-term. We believe the process is effective for our operating nonprofit clients to measure the risk and benefits.
From modeling, the goals and objectives for the balance sheet reserve capital can be determined. Additionally, the tools employed by colleges and universities are used here as well. They include:
1. Develop an Investment Policy Statement (IPS).
2. Determine asset classes to invest; including global equity, global fixed income and alternative.
3. Establish appropriate asset allocation for investment objectives and risk tolerance established in the IPS.
4. Implement the investment portfolio using passive and active investment management strategies.
5. Ongoing performance measurement and tracking to goals and objectives.
6. Periodic adjustments to stay on track to meet goals and objectives.
7. Annual review of the goals, objectives and IPS.
Operating nonprofits with reserve capital on their balance sheets are able to utilize these funds through effective investing.
The time horizon is key for the use of reserve funds. Funds with a long-time horizon can be invested in a college or university endowment to provide a source of annual spending and preserve the reserves over the long-term.
DiMeo Schneider has more than 23 years of experience successfully guiding operating nonprofits. For more information, please contact any of the professionals at DiMeo Schneider & Associates, L.L.C.
