How Should Nonprofits Invest?

By Conrad de Aenlle

Nonprofit organizations have no shareholders to keep happy, but they still need to generate income. Whatever their mission—fostering scientific research, helping the disadvantaged, advancing a moral cause, assisting students—nonprofits must invest the donations they attract in ways that generate sufficient returns to cover operating expenses and meet philanthropic goals, while beating inflation and preserving capital.

Charities, and especially university endowments, lately have turned to sophisticated methods of portfolio diversification to meet this investment challenge, expanding beyond stocks and bonds into vehicles like hedge funds, private equity, venture capital, real estate, and even timberland.

Nonprofits are investing with “increasing complexity and sophistication,” says John Griswold YC ’67, executive director of the Commonfund Institute, the research arm of Commonfund, a nonprofit organization that designs portfolios for other nonprofits. “They have embraced [a model of] broad diversification…heavily biased toward equities, whether public or private, and heavily biased toward illiquid securities.”

The use of alternative asset classes in philanthropy was pioneered in the Ivy League, notably at Harvard and Yale in the 1970s, and has since become nearly ubiquitous at universities. In the fiscal year that ended in June 2014, just over half of the money in 835 university endowments was allocated to alternative assets, according to a report by Commonfund and the National Association of College and University Business Officers.

Cultural institutions have also warmed to alternatives, although not to the same degree as universities, Commonfund’s research shows. Religious nonprofits invest more traditionally, while hospitals, due to their reliance on bond issuance, hold much of their own portfolios in bonds and cash to bolster their credit ratings.

With the aftermath of the financial crisis still playing out, risk control is a significant consideration. In a video discussion with Yale Insights, Sandra Urie ’85, chairman and chief executive officer of Cambridge Associates, an investment consulting firm, highlighted the emphasis that nonprofits are placing on breaking down risk into its various components, including exposure to movements in currencies and interest rates and the amount of borrowing employed to beef up returns.

“You can’t eliminate risk, but you can understand where you’re taking risk and you can make a decision on whether or not you want to be exposed to that particular risk at that given point in time,” Urie said. “It’s really important not just to focus on return but to look at risk-adjusted returns.”

Urie also sees a growing commitment to governance in the nonprofit firms she works with.

“Our clients…increasingly are coming to us for what you would characterize as a governance study [involving] how they make decisions—what’s the process for decision making at the fiduciary/trustee level, at the investment committee level?” Urie said.

A 2008 Internal Revenue Service memo on governance of charitable institutions suggested that a nonprofit should have “an active and engaged board [comprising] individuals who not only are knowledgeable and engaged, but selected with the organization’s needs in mind.” There also should be written policies on investment practices and ethical matters such as document retention and treatment of whistleblowers, it said.

Although the guidelines are merely suggestions, nonprofits are taking them to heart.

“The adoption of good-governance practices is certainly on the rise,” the Urban Institute, a Washington think tank, concluded in a 2014 study. “We see increases in the percentage of organizations adopting many of the…practices recommended by the IRS,” including the use of audit committees, a compensation review and approval process for executives, and policies on conflicts of interest.

Implementing rigorous governance standards helps an organization do the right thing, and not just in ways related to ethics, Urie pointed out.

“If you have a good process, it tends to lead to good outcomes,” she said. “If you don’t have good governance, then you probably aren’t going to make good decisions.”