Endowments of Non-Profit Organizations

(Excerpt from the Reader for Advanced Nonprofit Organizations, published by PDCS in 2000)

In Central and Eastern Europe, endowments began to be discussed as an instrument contributing towards the permanent financial stability of the third sector in the second half of the 1990s. An endowment is an organisation's capital and other assets, which are invested in a targeted way; for example, into the financial or capital markets. Its structure may change. Endowments are successful mainly in countries where these markets are highly developed, and are regulated by solid rules. An endowment is an instrument that is appropriate for an organisation with long-term stability, a strategic financial plan, a high level of support from its members and donors, and a long-term commitment to its mission. In developed countries, these are usually large grant-making foundations. The long-term sustainability of the third sector in Central and Eastern Europe is based upon the notion that the endowments of a number of successful foundations will secure the financing of other non-profit organisations. However, it must be observed that the idea of setting aside a relatively large amount of finances in order to invest them in accordance with the 'money makes more money' principle traditionally leads to distrust on the part of the public, for whom investment is merely "speculation," which does not create any "real values".

Endowments require the fulfilment of a number of conditions:

the organisation has been operating, or plans to operate, for many decades;
the organisation has finances at its disposal that are not immediately essential for, or tied up to, operation and programme activities;
the legal and social environment enables the organisation to invest these funds legally, and
the organisation is capable of coping with the risks associated with this financial instrument over the long term.

The steady growth of the capital and financial markets in Central and Eastern Europe over recent years has necessitated significant legislative amendments, which has also had consequences for non-profit organisations. The concept of endowments in the form in which it is recognised in developed democracies has only asserted itself in a few countries in this region. Some organisations therefore prefer to create a reserve fund as a financial instrument. An endowment is an instrument that has an effect not only upon the financial administration of the organisation, but also upon its relations with members and donors. The returns obtained from this instrument must serve to fulfil the mission; otherwise, there is a danger of losing the trust of both small and large donors, or casting doubts about the integrity of the organisation's intentions. Funds making up the endowment come from contributors, to whom the non-profit organisation has a responsibility for minimising the inherent risks of the endowment (such as loss on investment, currency devaluation, fraud, banks going bankrupt, etc.), and, needless to say, for fulfilling its mission. An endowment requires steady investment in order that it fulfil its purpose as a financial instrument, and the value of the endowment must be many times higher than the organisation's annual budget. The need for a flawless mechanism to administrate it is therefore obvious, especially if we take into account the failure of similar instruments in the commercial sphere (such as the collapse of some investment funds).

Who is able to build up and use an endowment correctly in a non-profit organisation? How is it possible to maintain stability in a changing legislative and economic environment? How may an endowment be planned in a way that allows for possible changes in the composition of the board of directors, the main donors, and the management over the next three, ten, or thirty years? These are questions that must be answered.

Having successfully defined the statutes and strategy of the endowment, the chosen administrator should examine the effectiveness of the investment strategy. It is absolutely vital that the administrator be familiar with the various types of risk that are characteristic of the capital market in a market economy, such as the risk of inflation, devaluation, abrupt changes in the exchange rate, and the risk of fraud. Every entity using the financial instruments of the market faces a certain level of risk, and either endeavours to manage these risks alone, or engages the assistance of professionals. The overall level of success in securing returns on endowments also depends upon the administrative and financial costs associated with individual investment activities. Furthermore, the individual legal responsibility of people involved in administering the endowment must be clearly defined in advance. These administrators monitor the observance of conditions relating to the endowment's investment (or expenditure), the usage of returns, the methods of resolving extraordinary situations, and also issue reports on their activities.

Having obtained the optimum level of endowment capital (often at least 20 times the level of the expected annual yield), it may be advantageous for a number of organisations to merge their endowments into one single fund. Although such an approach requires agreements to be reached, it may also increase returns, significantly reduce costs for the administration of the fund, and diminish investment risks. One example of this is the approach of a group of Czech foundations, which opted for a joint investment of finances received from the Foundation Investment Fund of the Czech Republic (see the box below).

An example of cooperation between foundations in the Czech Republic involving the investment of endowments

In the first half of the 1990s, the Czech government established the Foundation Investment Fund of the Czech Republic (FIF), with the aim of creating a permanent and relatively stable source of financing for the non-profit sector in the Czech Republic. One of its aims was to contribute to the creation of endowments for non-governmental, non-profit organisations. In 1999 the government and parliament approved a proposal for the distribution of CZK 500 million ($15 million) of FIF funds amongst 39 Czech foundations. In 2000, the distribution of a further CZK 1,200 million ($36 million) was approved, of which at least 85% had to be used for the creation of endowments. In that year, a group of the most courageous foundations, which accepted the idea of joint investment, got together in the Czech Republic. The organisational and financial basis was provided by the Czech Donors' Forum. 20 banks and investment companies expressed interest in the tender for administering the endowments, while allowing the foundations to influence and control the investments and the risks involved. ®B Trust, the owner of ®ivnostenská banka, won the tender, mainly due to its understanding of the foundation sector - the foundations were not expecting the highest returns on their capital, but rather investment security, reliability, and cooperation.

It is understandable that banks demonstrate a much greater interest in administering endowments when these sums involve many tens of millions of dollars. For example, in Slovakia, a number of organisations are building their own endowments independently, with no state support. Fees charged by banks for the administration of a number of separate endowments are naturally higher, while services are less well tailored to the specific needs and expectations of individual non-profit organisations.

However, non-profit organisations in Central and Eastern Europe, where there is a shortage of long-term capital, may mistakenly regard the basic function of an endowment as 'a financial safeguard against hard times ahead'. In reality, the usage of returns from endowments is very strictly defined, and these returns cannot be used to supplement the organisation's budget in the event that fundraising efforts prove unsuccessful. Funds saved by an organisation to be used in an emergency do not represent an endowment, but rather a reserve fund. As most non-profit organisations do not build stability upon the strength of their assets, but upon their programmes and the support of their constituents, it is only to be expected that many more reserve funds have been established in Central and Eastern Europe than endowments. The following table presents their differing characteristics, and may assist organisations in deciding which of the cited financial instruments is most appropriate for them.

**Basic characteristics of endowments and reserve funds**
	Endowment	Reserve fund
Establishment	Preceded by strategic planning and the approval of administrative rules by the board of directors	Requires no special regulations from the board of directors; however, rules of usage or decision-making mechanisms concerning spending are necessary
Purpose	The long-term stability of the organisation	More flexible usage (until its exhaustion) - when necessary, or in financial emergencies
Termination	Defined by the statute	Until exhausted
Duration	Generally unlimited	Limited by time, with the possibility of complete exhaustion - termination
Usage	Only in cases, and to a limit, set out in the statute; subject to approval by the administrator	When necessary and as the management of the non-profit organisation see fit
Increase	Only in cases, and to a limit, set out in the statute; subject to approval by the administrator	When necessary and as the management of the non-profit organisation see fit
Administrative demands	The involvement of a large number of people is unusual: only the management and board members are involved	Greater activity, without the need to involve the board of directors or an expert
Optimum size	At least 20 times the sum expected to be utilised from annual returns	Varies; according to the current situation and requirements
Benefits	The long-term establishment of the organisation and the strengthening of its stability; enables the financing of activities that are unappealing to donors	Brings flexibility to the financial management of the organisation
Possible disadvantages	Reduces fundraising motivation and subsequent communication with supporters and donors	The danger of losses if funds are inappropriately managed

Examples illustrating poor understanding of the strategy of building and administering endowments:

Fundraising: "If we fail to meet our budget, we will use part of our endowment, or the returns on it, to make up the deficit". Insufficient preparation: "So that this three-year grant that we have just been awarded can start making money for us now, we will use it to establish an endowment - after all, we have been considering it for a long time." Insufficient risk assessment: "This particular investment fund has been making 25% annual returns over the past three years, and is now offering 30% a year. If we were to buy a share of the fund, we could start building our endowment capital." A poor understanding of endowment administration: "A reliable friend, who works in a bank, has increased his savings by 90% over the past two years by investing in the USA. We should ask him to administer our endowment capital."

Examples illustrating a good understanding of the strategy of building and administering endowments:

Using the endowment as an instrument: "Over the last year, we have managed to obtain funds for re-granting twice; however, we were compelled to pay the administrative costs ourselves. Because community development through re-granting is the mission of our non-profit organisation, we should use part of the annual returns on our endowment to fund a coordinator for our mini-grant programme." Endowment planning: "Two of the main contributors to our non-profit organisation, which is involved in environmental education, support our development strategy for the next ten years, which anticipates a growing number of paying members, two fundraising activities per year, and the establishment of an endowment. We will begin to use the returns on this endowment in five years' time to award financial prizes to secondary schools in our district with the best grades in environmental education." Endowment administration: "In September, one of the five members of the commission administrating our endowment will begin working at the Frankfurt branch of his or her bank. If, in accordance with the statute, the other members of the commission approve our proposed candidate, who is the marketing director of company X, as a replacement, then this person could improve investment strategy leading to better returns." Risk assessment: "Life insurance companies with a fifty-year tradition do not invest their clients' money into funds with a guaranteed return of 25%, but into less profitable government bonds. The member of our board of directors who insisted that 50% of the endowment should be invested into risk-free, although less profitable, state bonds, was probably right. We shall see how this strategy will be assessed by the endowment's administrator this year."

Exercise: Possible scenarios and questions connected with endowments

In order to understand what issues you may face in relation to endowments, try to discuss with your colleagues a number of questions that you will need to answer when considering the creation and administration of your endowment capital:

Should we use $400 raised at a charitable concert to increase our endowment? Are we capable of explaining this to reporters from local newspapers who ask us how the funds were used?
After a demanding year of discussions, you receive $8,000 from a friendly business to establish an endowment. Subsequently, a long-standing donor foundation informs you that, as a part of its strategy for strengthening financial stability, other organisations have received priority in the last grant round. Are you prepared to explain publicly the possibilities and limits of the endowment, in order that there is no misunderstanding on the part of your supporters and donors?
After six months of unsuccessful fundraising activities, you are forced to limit expenditure on administration and individual programmes. There is a danger that the publication of the textbook that you have prepared will be delayed. You have approached five sponsors, but you still need $1,200. The textbook is to serve as a basis for one of your long-term programmes. This year's returns on your endowment have, as in previous years, been distributed in the form of mini-grants, and the statute does not allow you to utilise part of the endowment itself; however, there is a theoretical possibility that the administrator will make an exception in this case, or that you will be able to force through a change in the statutes. Should you do this? Is it worth it?
Some of the members of your board of directors, which is composed of well-know personalities of your country's third sector, also make up the commission that administers your endowment capital. At their meeting in February, they entrusted your financial director with the task of drafting a proposal as to how this capital should be invested. He or she recommended an investment into one-year deposit certificates from a certain bank, which went bankrupt six months later. The law does not cover this type of deposit, which means that you have lost your entire endowment, and have had to pay the costs of a lawyer in an attempt to recover at least part of your investment. Friends of yours from the business sector, who know almost nothing about the organisation's programmes, told you that it was obvious as early as March that the bank was heading for failure. Should you try to establish an endowment again? If so, who should be involved in its administration?