The Role of Nonprofit Endowments

We consider the role of the endowment in nonprofit organizations. Nonprofit managers often describe the endowment, or fund balance, as serving a precautionary savings function. We provide a description of endowment size, for nonprofit organizations in a wide range of industries in the United States, and find that a large number of organizations have endowments that exceed levels that would normally be considered to be appropriate from a consumption smoothing prospective. We suggest that this may be the source of governance difficulties within the organization, analogous to the classic problem in corporate finance described by Jensen (1986). We describe a number of potential approaches to mitigating these governance concerns, and provide some preliminary evidence of the role of government regulation in reducing governance problems. _________________________________________ *Corresponding Author: Associate Professor, Graduate School of Business, Uris 614, Columbia University, New York, NY 10027, (212) 854-9157, Fax: (212) 316-9219, Email: rf250@columbia.edu Theories of nonprofit organizations have generally centered on the motivations of not-for-profit entrepreneurs. Regardless of the motivations of the nonprofit's founder, however, a key connecting idea among these theories is the assumption of the nondistribution constraint as the defining characteristic of the nonprofit form (Hansmann, 1996). In this paper, we take this definition of nonprofits as a point of departure, and discuss the implications for the financial structure and governance of nonprofit organizations, regardless of their underlying motivations. In a for-profit organization, shareholders act as the residual bearers of risk. Because nonprofits, by definition, have no residual claimants, there must be some other means of absorbing shocks that exist in a world of uncertain donations and uncertain needs for program expenditures. One possibility would be to simply allow for shocks to revenue streams to be passed on to program expenditures, thus effectively making the recipients of an organization's services bear the burden. However, a desire for “production smoothing” naturally leads to a search for an alternative buffer. Thus nonprofit organizations will hold precautionary savings in the form of endowment fund balances, to protect against adverse revenue shocks. In this paper, we take a preliminary step in empirically the role of the endowment in nonprofit organizations. We begin by describing, across industries, the endowment characteristics of nonprofit organizations. We further provide some preliminary regression results on endowment intensity that are suggestive of a precautionary saving motive for endowments. This need to maintain a fund balance to smooth the provision of 1 More precisely, most theories of nonprofits are based on one of two ideas: (1) a desire to provide a product at the low marginal cost of production, perhaps due to externalities created by the good (see, for example, Weisbrod, 1988); or (2) an interest in signaling the production of a high-quality good where quality is difficult to observe or verify (e.g., Hansmann, 1996; Glaeser and Shleifer, 2000). services potentially leads to problems of governance and managerial discretion. This observation is obviously related to familiar themes in corporate finance, which has often focused on the agency problems created by giving managers access to discretionary funds in for-profit organizations (e.g., Jensen, 1986). The problem is that, given the opportunity, for-profit managers will 'steal' from the firm, by consuming perquisites in one form or another. A similar question arises for donors to nonprofit organizations. On the one hand, there is a need for a fund balance to smooth consumption. On the other hand, managers may take advantage of these funds to pursue pet projects or even pay themselves higher salaries. Two possible solutions exist: donors may insist that funds be spent right away, thereby ensuring that their donations are put to good use at the expense of the production smoothing ability of the organization. Alternatively, donors may rely on monitoring technologies that guarantee that all funds, both present and future, are spent appropriately. We describe some of the modes of oversight and monitoring that might be used to curb malfeasance, and suggest some empirical implications of our framework for future work. The rest of the paper is structured as follows: In section I, we describe the process of endowment generation and donor behavior that we believe governs nonprofit organizations. Section II provides a discussion on potential measures of governance in nonprofits. In section III, we provide details on the IRS data that we use to examine organizations' endowments. Our results on patterns of endowments and precautionary savings are presented in section IV. In section V, we undertake a preliminary 2 Note that this more commonly takes the form of donations of products (e.g., medicine to aid organizations or books to a library) rather than cash donations that must be spent immediately. From a saving perspective, the effect is the same. investigation in the link between governance and endowment intensity; section VI concludes. I. Donations and Endowments in Nonprofit Organizations Consider first the problem faced by a not-for-profit entrepreneur who derives utility from providing a good, for which the equilibrium market price will not cover average cost. This entrepreneur must therefore raise donations from like-minded donors, who similarly obtain utility from the provision of this good. By assumption, consumers and donors of the nonprofit's output are not identical. Donors are therefore required to provide funds to the entrepreneur, with the assumption that he will use them to further the stated mission of the organization i.e., by producing the good that the organization was established to provide. Within this model, we introduce the following complication: Very often, an organization is faced with uncertain circumstances with regard to revenue and cost streams. This may be driven by uncertainty over future demand for the organization's services, future donations, or changes in input prices. For example, consider the circumstances of the Riverside Church Soup Kitchen, whose mission is to feed the homeless of upper Manhattan, following the stock market decline of 2000-2001. This simultaneously increased the demand for its services, while reducing the capacity of its donor base to provide funding. Assuming that this is a temporary shock, the organization may be forced to cut back services exactly when the need is greatest. An alternative is for the entrepreneur to hold funds in reserve, as precautionary savings, for situations 3 See preceding references, such as Hansmann (1996) and Glaeser and Shleifer (2000) for reasons that this might be the case. where the organization faces a shortfall. This is what is commonly referred to as an endowment, or fund balance. This may be used as a buffer in circumstances where that exists a gap between what donors provide and what is required for program services. Endowments are often described in these terms, as a fund to protect the organization from 'rainy days. ' However, as noted in the introduction, providing managers with this precautionary savings device may allow him to 'steal' from the organization, by pursuing interests that diverge from those of the donors, or by consuming perquisites, or by potentially even taking inappropriate financial compensation. Having recognized this danger, donors and society more broadly may wish to impose conditions that restrain nonprofit management from taking inappropriate actions. This may include government monitoring or by donors; we consider some of the mechanisms in use in the following section, in some greater detail. Furthermore, if donors know that they will be expropriated by providing an endowment to the entrepreneur they may choose to limit the discretionary funds available to managers in the first place. Now, the preceding story is premised on two basic assumptions: (a) that it is easier for managers to pursue personal interests with endowment funds rather than streams of revenue, and (b) that donors have some incentive to provide managers with an endowment, rather than simply providing funding on an annual basis. We now provide some evidence in support of these assumptions. A. Expropriation of the Endowment Application of our argument to endowment expropriation follows closely agency models, which emphasizes that providing managers with discretionary funds may lead to governance problems. In such a setting Jensen (1986) argues, for example, that organizations should hold high levels of debt, so all cash inflows must be used to service this debt and stave off bankruptcy, which will cause the manager to lose his job. Analogously, in a nonprofit firm, if the organization has very little cushion in the form of an endowment, all cash inflows will be required to meet the organization's basic mission requirements, leaving relatively little scope for expropriation. Furthermore, to the extent that the organization faces binding constraints, and donations are made for particular purposes, expropriation may be difficult. The popular press is littered with examples that illustrate this distinction between endowment and revenue expropriation. For example, in a particularly high-profile case in 2000, three former officials of Alleghany Health Education were arrested and charged with diverting $52 million in charitable endowments, for "inappropriate and personal uses. ” The case of the Bishop Estate, a charitable trust created in 1884 by one of the last members of Hawaii's royal family, that provides a particularly compelling illustration of these ideas. The Bishop Estate held an endowment, worth $10 billion in 1997, which in the words of the Honolulu Star, “apparently proved to be too much of a t