Overreliance on Endowments

The COVID-19 pandemic and subsequent economic fallout tested the financial strength of organizations across the country, pushing many to step outside their comfort zone to ensure survival. For some organizations, fundraising exceeded expectations while others explored new service offerings, but some nonprofits had all funding measures grind to a halt. Many large nonprofits have an endowment that plays a critical role in building many organizations’ revenue passively, but this valuable tool can lead nonprofits down a dangerous road. An endowment is a great source of added revenue, but when an organization relies on it heavily alongside other revenues vulnerable to the same market pressures as an endowment, they are at serious risk of financial disaster if financial markets crash. 

Constructing a financial bedrock for the organization, an endowment offers regular returns without serious investments of time or personnel. Universities and large nonprofits take advantage by withdrawing a percentage of the returns on their invested endowments to serve as a source of revenue for the organization. This plan becomes a risk to their stability when they heavily rely on this withdrawal as a key part of their revenue. This risk compounds when other revenue sources are subject to the same market effects as the endowment. Increasingly relying on endowment sourced revenue only increases the risk of disaster. A private university that receives a majority of its revenue from tuition and endowment interest risks the complete failure of its funding mechanisms in the event of a recession like the 2008 financial crash. In 2008, endowments’ market values plummeted, and enrollment dipped while more students required financial aid to attend university. Universities’ main revenue sources were all negatively affected by the same crisis, jeopardizing the whole funding structure. Furthermore, if allowed in the donor agreement, universities in need of cash and reacting to precipitous drops in market values could sell off their positions to acquire capital but do considerable damage to the principal endowment sum.  

An endowment is just like any investment, it offers opportunities for growth and passive revenue, but that benefit comes with the risk of the principal invested. Overrelying on this potentially unsteady revenue source can lead an organization to disaster. Similarly, it would be risky for an individual to solely plan on receiving their monthly living expenses from stock market returns. Without savings available to provide several months of expenses, nonprofits can be crushed by a sudden market downturn. Endowments may look like savings, but they can quickly depreciate or disappear altogether. Although rare, invested funds can disappear or be severely damaged before organizations can even react. Prior to the 2008 financial crisis, it was estimated that 10-24% of alternative investments (hedge funds and private equity funds) were held by endowments. In 2008, Bear Stearns saw two hedge funds valued around $1.5 billion lose over 90% of their value. In the early 2000s leading up to his 2009 guilty plea, Bernie Madoff operated his wealth management company as a Ponzi scheme, walking off with $18 billion in investors’ money. These are just two instances in which investments in these organizations’ funds instantly and unexpectedly lost incredible value. In the blink of an eye, a previously secure revenue source dried up. 

All of this is not to say that endowments are inherently bad, but it highlights that they are unstable revenue sources. Any revenue source that is subject to the whims of market forces and heavily relied on places the organization at risk of disaster when those forces turn unfavorable. For these reasons, nonprofits must be careful to not become overly reliant on an endowment during a bullish market only to take many steps backward when the market dips. This Thursday’s blog post will examine several instances in which market drops, fraud, and investor failures decimated the value of investment funds and considerably damaged endowments. 

Need help organizing your nonprofit to maximize efficiency and effectiveness? Reach out to info@nmblstrategies.com to learn how we put our nonprofit executive experience and expertise to work for our clients.