Before the bust of 2008, nonprofit endowments enjoyed halcyon days. Large university endowments became the talk of Wall Street, routinely reporting annual returns of 20 percent or more. Many other nonprofits followed the leaders, devoting more and more of their endowment portfolios to riskier investments in hedge funds, private equity, and other alternative strategies.
Today, the golden days have gone gray. Endowed charities—ranging from museums and orchestras to social service providers and policy organizations—have lost billions in endowment wealth since 2007, despite some recovery in the securities markets in 2009. The sharp deflation of the endowment balloon offers an opportunity for those in the nonprofit sector to re-examine how these funds—vital to so many institutions—should be established and managed, in order to fulfill both the needs of nonprofits and their obligations to donors.
The Carl B. & Florence E. King Foundation, which I have led since 2005, started awarding grants to build charitable endowments in the 1970s. In the decades that followed, 62 organizations across the country received more than $6.2 million in such grants, ranging in size from $1,000 to $1 million. The endowments supported a range of purposes, including university chairs and professorships, scholarships, and facilities maintenance.
There is no record of why Mr. and Mrs. King started making endowment grants, but there are many legitimate reasons for donors to do so. Endowments help to protect against the ups and downs of annual fundraising, enabling nonprofits to devote more of their time to service delivery. From the donor’s perspective, creating an endowment is a vote of confidence in a nonprofit’s mission, management, and longevity. It also enables the donor to preserve the family name and legacy far into the future.
In 2004, after a change in board leadership, the King Foundation changed its grant guidelines to preclude further endowment giving. In the foundation’s organizing documents, the Kings had given the board a free hand in setting the foundation’s course and giving priorities. The new board concluded that the foundation could have a bigger impact on causes of concern through grants for current programs, and it did not want to add to the administrative burden of endowment monitoring by creating new endowed funds—particularly because the foundation had no executive staff at the time.
Soon after I joined the King Foundation in 2005, I began reviewing all past endowment grants to determine the current status of the endowments. How had the funds grown over time? Were the funds still being used as intended? What had been accomplished? These were good questions. The answers? Not so good.
We found that a few of our endowments, especially at large universities, had done well both in investment growth and reporting to us. But the majority of endowment grantees rarely communicated with the foundation after the grants were made—and vice versa. This mutual silence contributed to misunderstandings about the proper management of the endowments.
Indeed, many endowment funds had been invested so conservatively that asset growth was minimal—as little as 4 percent over 30 years in one case. Some organizations had no record that the foundation had ever made an endowment gift to them. In other cases, the initial gift documentation was so unclear that we learned apparent endowment gifts had, in fact, been designated for immediate expenditure.
Some of the endowments we reviewed had made no distributions—ever—or had ceased distributions many years earlier when the program originally supported by the endowment ended. Some endowments showed distribution drift, using the funds for purposes distant from the original intent of the gift.
Several organizations that we reviewed had borrowed significantly from their endowments. In one case, the grantee prevaricated for more than a year before revealing that it had spent the endowment. Other organizations had closed their doors, presumably after spending their endowments on operations as their fortunes declined.
Overall, it was a very disappointing picture. The problems we uncovered resulted both from our actions and our grantees’. Nearly all the grantees under review corrected problems after we brought them to light, but in three cases, we demanded and received the return of the gift principal.
Given the magnitude of endowment holdings—based on recent surveys and estimates, somewhere in the high hundreds of billions of dollars—the scope of the problem could be enormous. If even a fraction of nonprofit endowments have the kinds of problems that we encountered, then donors may benefit from learning about our experiences.
There are several factors for both donors and nonprofits to consider before giving or accepting an endowment gift:
Readiness. Is the grantee capable of investing and monitoring an endowment fund? A small endowment grant to an organization that does not yet have investment guidelines, an investment policy, or a formal endowment program is probably not a great idea—particularly if the grant comes at the donor’s initiative rather than the grantee’s. What can a $25,000 endowment, standing alone, really accomplish?
Documentation. Clear grant records are obviously necessary, but too often we found that our records were anything but clear. Sometimes a one-page letter from the foundation was the only indication of the gift’s purposes, and even then, it was articulated in terse language like “for scholarship endowment.” Gift documentation is particularly important considering the frequency of staff turnover at most nonprofits. In the case of one “lost” endowment gift from King, the controller who reportedly knew about the endowment fund had left the organization, taking institutional knowledge of the gift with her.
Purposes. Is there an explicit mutual understanding between the donor and the grantee about how endowment distributions will be used? Take the example of a “research endowment” for a medical school. What does the donor consider a research-related expenditure? Does it extend to the costs of operating a research lab? To the costs of entertaining a faculty member being recruited to run the lab? What about a share of the institution’s overall fundraising costs (which happened with one of the King Foundation’s endowment gifts)?
Timing. Does the grantee have institutional policies or side agreements dictating when endowment distributions will begin? In one case, we learned that no endowment distributions had been made in the five years since our grant. When we inquired, the grantee only then informed us it had previously agreed with its founding donors that no distributions would be made until its endowment reached $750,000. In addition to side agreements with contributors, the recipient institution might also have a policy prohibiting distributions until a multi-year endowment pledge is fully satisfied. Either way, endowment donors need to know before making the gift.
Investment policies. A number of the endowments we tracked had not kept up with important changes in the state laws that govern endowments—namely, the Uniform Management of Institutional Funds Act (UMIFA), drawn up in 1972 and adopted by 47 states, and its successor, the Uniform Prudent Management of Institutional Funds Act (UPMIFA), which since its drafting in 2006 has been adopted by 44 states.
Prior to UMIFA, the traditional approach to endowment investing was to pursue income-producing assets like dividend-paying stocks and bonds. The institution could spend “income,” in the form of interest, dividends, rents, and royalties; but “principal”—including the original value of the gift and any additions to it—was to be preserved. UMIFA allowed charities to invest and spend from their endowments on a prudent basis that included both income and appreciation. A charity therefore could change its investment mix to include assets that were likely to appreciate, like growth stocks, and then distribute a portion of the market value of the endowment, including capital appreciation.
When we reviewed our giving, we found several instances in which endowment funds sat for decades in money market funds or certificates of deposit, long after UMIFA permitted growth investments. In the current economic climate, one can be forgiven for casting a wistful eye at CDs. But over the long term, ultra-conservative investments are wasteful.
For example, in 1977, the King Foundation made an endowment grant of $100,000 to support a youth home. The gift was used to establish a trust at a rural bank in the community where the home was located. The fund had grown to only $104,000 by 2007, when we inquired about it. The original bank had been sold to another, and the trust now was held by a different rural bank hundreds of miles away. The trust funds were socked away in CDs. They missed the most prolonged bull market in U.S. history. The King Foundation teamed up with the charitable beneficiary and persuaded the trustee bank to change the investment mix, but it was too late to make up for decades of lost opportunities.
Spending policies. How will the grantee determine the amount available for distribution? UPMIFA allows nonprofits to spend as much from an endowment as the institution deems “prudent.” An optional provision of the act provides that a spending rate per year of more than 7 percent of the fund’s fair market value creates a rebuttable presumption of imprudence—and with good reason, for a number of studies have demonstrated that a payout rate above 5 percent will likely deplete the value of the fund over time.
In our endowment review, we found several institutions that had authorized payouts as high as 8 percent at the discretion of the organization’s board. This type of spending policy is attractive to a nonprofit due to its flexibility. But it also tempts the nonprofit to distribute generously when investment returns are good, but hesitate—after it has become accustomed to healthy payouts—to reduce rates commensurately when returns turn negative, or to hold back some of its return in good times to protect the endowment against future downturns. Higher spending rates also can drive a nonprofit to riskier investments to achieve the necessary return.
The widespread adoption of UPMIFA may allow charities to spend from their endowments at very high levels. UPMIFA was revised in part because of the difficulties charities encountered in the bearish financial markets from 2000 to 2003. In that downturn, many endowments that had been created in the boom markets of the mid-to-late 1990s dropped below their historic dollar value (the amount of the original gift and any additions to it), causing charities to suspend distributions entirely or limit distributions to “natural income” like interest. UPMIFA was designed to give nonprofit leaders greater flexibility in managing their finances. Although the law still maintains an overarching standard of prudence, a charity could conceivably argue that distributing heavily from an endowment is a prudent course to keep itself afloat.
Another issue related to endowment spending is borrowing from the endowment. Although donor-funded endowments are considered perpetually restricted funds, a financially troubled agency may have difficulty resisting the temptation of borrowing from the endowment to fund other needs. These “interfund” loans can be troublesome. Typically, an organization makes a loan to fund its operations when it’s on the ropes. But conditions are not always so desperate: one King grantee, a college, borrowed from its endowment funds to build golf cart paths on its campus. (Despite their professed best intentions, these organizations rarely repay these loans and replenish their endowments, at least in my experience from 15-plus years in the nonprofit sector.)
Can an endowment donor complain about interfund loans? Under general principles of charitable trust law, a charity is duty-bound to use restricted gifts, including endowments, as the donor specified. But typically, the ability to enforce that restriction lies exclusively with the state attorney general, representing the public’s interest in charity. The donor, whether an individual or a corporation, has not been regarded as having standing to challenge the charity’s use of funds absent an express right of reversion.
Regardless of the legality of borrowing from an endowment, a disgruntled donor can be a public relations nightmare for a charity. And the tide of the law may be turning, giving donors more of a voice. In recent years, courts have grown more sympathetic to donors or their heirs attempting to enforce the terms of restricted gifts. In a high-profile case begun in 2002, the heirs of Charles and Marie Robertson challenged Princeton University over its handling of a supporting foundation established with a 1961 donation from the Robertsons. The hotly contested litigation was settled in December 2008. Along the way, Princeton had challenged the standing of the donor’s family to sue—and lost the argument. The case also generated sympathy in many corners of the donor community, adding to longstanding concerns about preserving donor intent.
Contingencies. What if the purpose of the endowment is no longer valid? What if the charity wants to transfer the funds to a supporting foundation? The King Foundation had endowed several scholarships in degree programs that were no longer being offered at the sponsoring colleges, with the funds sitting dormant for up to two decades. But the schools had never notified the foundation or independently tried to reform the gifts. In fact, the schools were slow in responding to our invitations to suggest other uses for the funds. We only recently reached an agreement with one college to broaden the purpose of a scholarship endowment for a defunct program, after more than 18 months of effort. In another case, we could not come to terms with the college, so we sought and received return of the endowment principal.
It is not unusual in recent years for nonprofits to have a separate legal entity (such as the “State University Foundation”) to raise funds and manage endowment assets. If a grantee holds endowment funds and then sets up its own foundation, the pre-existing endowment funds will generally be transferred to the new entity. Where will control reside thereafter? Will the supporting foundation charge a fee, and if so, how much? (Administrative fees, which can be hefty, are common at university foundations.) How and when will distributions be made back to the “parent” nonprofit? How will the supporting foundation invest the endowment? One King grantee transferred funds to a supporting foundation whose board was heavily weighted with local bankers. By strange coincidence, the supporting foundation’s investment policy required that endowment funds be invested exclusively in local depository institutions.
My experience at the King Foundation has led me to several key insights for endowment giving. First, any significant endowment grant should be fully memorialized in a gift agreement, memorandum of understanding, or similar document. That document should address the key issues described in this article, especially spending rates and interfund borrowing. The problematic provisions of UPMIFA can be dealt with through an explicit agreement between the donor and recipient.
This agreement should include a requirement for reports from the grantee, specifying what these reports should include. The King Foundation now asks all past endowment grantees to provide a brief annual statement that details the fair market value of the endowment, the investment return for the prior fiscal year, the changes (if any) to asset allocation or spending policy, and the amounts and purposes of any distributions.
In order to protect donor intent, the agreement should give the grantor the right to sue to enforce the terms of the gift. If the grantor is a person, the agreement should specify whether the donor’s heirs can continue to protect the donor’s interests after his or her death. An explicit right of reversion may be added to give the donor standing, if required under state law. The agreement should also require explicit notice to, and permission from, the donor (and his or her successors) before the institution can make any transfer to a supporting foundation.
The King Foundation made endowment gifts and then assumed—as do many other donors—that the gifts would be handled properly and safely thereafter. While trust is essential to the nonprofit sector, we should have verified. As Mark Twain once said, “Supposing is good, but finding out is better.” An endowment gift creates a perpetual relationship between the grantor and grantee, and it deserves to be thoroughly considered, documented, and monitored—by both parties.
Michelle Monse is president of the Dallas-based Carl B. & Florence E. King Foundation.
