Five Best-Practice Investing Tips for Nonprofits

Barbara Bruser, CFA, Portfolio Manager, First Republic Investment Management

August 22, 2016

Nonprofit groups have a special responsibility when it comes to investing. That’s because, unlike private client assets, every dollar managed by a nonprofit was raised from a donor with a passion for the organization’s mission. That kind of capital comes with a special obligation.

In addition to the fiduciary responsibility, nonprofits are also facing increased regulatory scrutiny. The Uniform Prudential Management of Institutional Funds Act (UPMIFA) and Sarbanes-Oxley Act have both placed increased responsibilities on nonprofit organizations. UPMIFA, for instance, requires nonprofit boards to classify their endowment funds, consider several specific factors when investing those funds, and establish a prudent spending policy. Sarbanes-Oxley, whose primary focus is for-profit corporations, requires that nonprofits have defined whistle-blower provisions, document-retention policies and policies regarding government investigations. Nonprofits and charities are at risk if they do not properly meet the requirements of these regulations.

Nonprofit organizations need to invest under the assumption that the organization will be in existence in perpetuity–or at least for a very long time–and thus, need to plan over a long horizon. What’s more, they may face capital needs over a shorter period of time, or attract donors who place specific limitations on the use of contributed funds. The need for future financing or financial flexibility may place additional restrictions on the investment of endowment assets. Given this range of complexities, the unique investing requirements of nonprofit organizations need to be handled by investment managers with dedicated experience in this area.

Following are five important tips for nonprofits to consider when investing assets.

1. Size matters

An endowment with $1 million to $2 million does, of course, have a very different set of options to consider than one with $1 billion. Whereas larger endowments may be able to hire a consultant who researches and hires investment advisors in multiple asset classes for the organization, smaller endowments may be considering a broker or an independent investment advisor.  

Asset allocation and risk appetite will also differ depending on the size of the portfolio. Larger endowments can usually take advantage of a wider array of asset classes than smaller endowments. What’s more, larger endowments can often afford to take on more risk and have more funds in illiquid investments than smaller endowments. For example, a large endowment might invest just 10 percent in fixed income, compared to smaller endowments that might invest 30 or 40 percent in bonds.  Alternative investments, such as hedge funds and private equity, make up an increasing percentage of the portfolios of larger endowments. According to the most recent NACUBO (National Association of College and University Business Officers) study of endowment funds, larger endowments have about three times more exposure to hedge funds than smaller endowments. Private equity, venture capital and real estate or infrastructure are also popular assets, making up as much as half of alternative investments made by large endowments. The fact that these types of investments are often unavailable to smaller endowments is not the only challenge that endowments of this size face; lack of liquidity can create additional problems to be addressed. Even very large endowments can be hit with liquidity challenges. In fact, during the 2008/2009 economic downturn, some large endowments were forced to sell private investments at a significant discount in the secondary market.   

2. Keep investment management at an arm’s length  

Though some nonprofits, especially smaller ones, may be tempted to oversee investments internally, this is generally not advisable. Because the management of endowment assets requires objective oversight, the potential to create both a conflict of interest for anyone with the fiduciary duty of a trustee and a liability for the organization as a whole is always present. The safest and more preferable route is to hire a third party investment manager to manage the funds.

Finding a reputable, qualified investment manager should be done methodically and carefully. Boards should assemble a list of at least three reputable, qualified managers who have dedicated experience working with nonprofits and understand how to invest for this type of organization.

3. Do your due diligence

Thorough due diligence in the search for an investment advisor is vital. The financial press is replete with reports of Ponzi schemes and fraudulent activities that have been used to part investors from their money. Reputable investment managers need to have well-defined procedures and processes and be able to explain how and why they make investment decisions. Additionally, they must have strong compliance and operational support.

It is also a good idea to vet the professionals who will be managing your investments.  Public filings will detail their credentials and experience and should be reviewed and verified.   

4. Create an investment policy and review regularly

Nonprofit organizations generally want to grow their portfolios over the long term with dual goals of supporting both current and future operations. Operations that require $1 million of spending today might require $2 million of spending in 10 or 15 years just to stay even. The role of the endowment portfolio in meeting those needs should be well defined by the organization and communicated to the investment manager. A well-crafted investment policy with a clear statement of investment objectives, asset allocation ranges, risk tolerance and portfolio measurement and reporting is an important first step in working with your investment manager. The investment policy serves as a roadmap for meeting the organization’s investment and financial objectives. It should be reviewed annually to ensure that it continues to meet the organization’s needs. 

The investment policy might also include the anticipated level of distributions from the endowment portfolio. The majority of nonprofits set a target distribution that is a percentage of a moving average value of the endowment. According to the most recent NACUBO study, the average distribution is 4.7 percent, with very little variability based on size of endowment. Under the UPMIFA rules, a distribution in excess of seven percent is deemed imprudent.   

5. Determine the best course of action for working with your investment manager

Perhaps one of the most important steps successful nonprofits should consider taking is to decide how to work with their investment manager. How often should the portfolio be reviewed? How often should the investment manager be reviewed? While organizations differ for various reasons, it is advisable to meet with the investment manager at least annually to complete a thorough portfolio review. It is also advisable to review the investment manager’s performance every three to five years to ensure that he or she is still meeting the needs of the organization.

For any nonprofit, preserving and growing the organization’s portfolio is a critical step. With the right investment manager and plan, a nonprofit can focus on supporting its mission for many years to come. 

The information in this article is presented as is.

©First Republic Bank 2016