underwater endowments

Watch webinar on Endowment follies!

Check out this 50 minute webinar presentation that is a follow-up to my previous blog post.

Endowment follies abound!

Throughout my 20+ year career in law and planned giving, I see various patterns that emerge that are sometimes frightening and clearly give us (nonprofit fundraisers) reason for concern.

One such area of frightening incompetence (as it turns out) is simple endowment management.

That includes the investment of “endowment” monies.  Sure, it is very troubling when institutional leadership violate every rule in the book regarding investment of endowment funds: over investing in hedge funds, allowing investment committee members to manage part of the pool, lack of independent oversight, etc… Yes, very troubling but not why I am writing this post.

My issue today is something even more basic: bookkeeping and record keeping and just following the law!

How hard are these tasks? Finance folks must be able to handle them?

Well, I have found in most cases the answer is that apparently bookkeeping and record keeping are not so easy – at least for those tasked with doing it!

Yesterday, I glanced at some endowment fund totals for a client going through an extensive entity merger that required filings with the attorney general, clarifications about which funds can have their restrictions released, etc… Actually, a very complex process in New York, by the way.

What did I see yesterday that has me all in a tilly?  I saw one endowment fund’s initial principal was around $500,000 and its appreciation was over $1.5 million.  Hmmmm.  A permanent endowment? Yes, probably close to 30 years old. Their supposed spending rate? 5% or more.  Hmmmm. Yes, this endowment pool was invested very aggressively (your draw would drop if you knew what percentage of this particular endowment had been in hedge funds going into 2008).  Ok, maybe it just grew tons, lost 50% of its value in 2008 and the winnings were still $1.5 million on their $500,000 principal?

I am not going to bother with the math.  There is something wrong with this picture.  If the organization actually withdrew any spending rate, it would be nearly impossible for the fund to more than triple in value, especially after they got killed in 2008 (and didn’t recover because hedge funds are probably not the best option for investment recovery).

My guess?  Maybe they withdrew the spending rate from other funds and didn’t subtract the distributions from the particular fund’s ledger page? Maybe they didn’t spend anything?

What else did I see? Some funds without any documents at all.  Numerous funds whose restrictions should have been released 20 years ago. A complete and utter disregard for the state’s legal requirements regarding managing those endowments (this is NY and NY has the most complex endowment management law).

In yesterday’s meeting, I am estimating that the initial entity that brought in the endowments – and which has been suffering due to its endowment market losses – blew its chance at sorely needed budget relief to the tune of $100 million or more!  What I mean is that if finance/legal staff at that institution had been doing their jobs well, they could have seen that much or more cash flow into their operating expenses that were severely needed through proper endowment spending and freeing up of old/outdated funds.  Instead, they borrowed more money, sold more property and finally were forced into the merger situation that I’m peripherally advising on.

Of course, yesterday’s revelation was no surprise to me.  I have seen endowment managers who use laws that were out of date by 20 years or more. And, I have seen cases where magically an endowment fund kicks off the exact same dollar amount each year and they tell them the funds are there and invested. In fact, I can not recall seeing an endowment program managed properly – from bookkeeping, records, the law, etc.. – EVER.

This blog got a huge boost when New York finally passed its version of UPMIFA – in fact, that was the single largest day of viewers for several years.  So, I put together a great presentation on NYPMIFA and assumed plenty of NY nonprofits would need my help (as it was and is so clearly needed).  Well, I did not sell one NYPMIFA audit.  People tuned in, asked questions, and then went about their way of ignoring the law and screwing up their endowments further.

So, why did the above nonprofit have to actually clean up a mess?  They were going through a complex merger that involved moving of endowment funds from one entity to another.  And, lo and behold, they now have a major law firm helping them address the issues because there are so many.

What’s my point?  Maybe it is the nature of those tasked with simple bookkeeping and record keeping and following endowment law?  Maybe they are just stubborn and/or lazy or just uninformed?  Maybe it is human nature to wait until you are forced to address something?  New York, for instance, could put together a SWAT team of auditors and easily bring down over 90% of NY’s nonprofits for utterly spitting in the face of their law. Very, very few NY nonprofits follow NY endowment law but until the NY attorney general’s office decides to actively enforce NY state law, nonprofits will continually do themselves the major disservice of totally botching their endowments.

I guess my frustration is that virtually none of these nonprofits sought help in this area. Thousands checked out this blog, picked up all of the advice I flooded them with. But, none – zilch – actually took the step to even discuss fixing their problems.  At least not with me!  And, my guess is that very few actually implemented what they were supposed to.

Of course, by the time you are forced to address your endowment issues, you’ll likely be forced to hire one of those white shoe law firms who will easily charge 100 times more them me. Or, in this case, one entity will be left lamenting why they didn’t address their problems earlier – it could have actually help salvage their situation. Instead, a new entity is cleaning up (both literally and figuratively!).

Underwater Endowments Training In New York

I have to admit that I am a bit of a cynic when it comes to educational programs. Usually, the speakers are going over things I know already and frankly, I am part of the ADD generation with about a 3 second attention span.

So, when I got ready to attend the NYC bar’s 3hr presentation on Underwater Endowments (held last week), I packed plenty of snacks and extra reading material.

I’ve written on the topic, organized several presentations on it. What else can I learn except: when is New York going to pass UPMIFA!?!

I was wrong. I am going to use this opportunity to list some very important facts that I picked up (please go to previous posts on UPMIFA for background). All of these points are specific to New York (especially since New York still maintains the old UMIFA) but I still recommend that non-New Yorkers look over these tidbits because they are definitely food for thought.

1. When does an organization have an affirmative duty to literally restore an underwater endowment to its historic gift value (ie..put real money into the endowment account)?

I used to think this was an accounting canard. Wrong I was – at least partially. In New York, the AG says that if a permanent endowment goes below its historic gift value due to application of the org’s spending-rate policy, then it does have an affirmative duty to replenish the endowment! On the flip side, if you can attribute the drop to market depreciation, you don’t have an affirmative duty.

Wait a second. This doesn’t make sense. You apply your spending rate, there is nothing wrong with that when you are not underwater. Then the market tanks and the fund goes negative. When is it the fault of the spending rate and not the market? A question I should have asked. It seems that the AG takes the position that if the market appreciation generally lagged behind the spending rate, the board should have adjusted the spending rate down to prevent the fund from going underwater. In other words, it’s pretty murky in New York when to blame the spending rate vs. the market decline.

Advice for all boards (in UMIFA or UPMIFA states): watch the funds, know the original funding amounts of each fund, be aware of long term goals of each fund, spend less to extend life of fund of each fund when need be.

2. Have you ever had auditors or accountants claiming that you have bring back the permanent endowments to their historical gift value on your financials (aside from the NY AG’s approach mentioned about but from an accounting point of view)? To me, this was part of the accountant’s canard mentioned above. It turns out that there is some truth to this (and this may or may not apply to apply to UPMIFA states, too).

The accounting principals require that on your books, any underwater permanent endowments must make up the deficit from other assets on your books (ie..unrestricted assets).

Practically, this does not mean transferring funds from unrestricted accounts to the permanent endowment accounts. It means that the books have to allocate unrestricted assets towards the negative balances, all on paper though.

So if its only on paper, what’s the big deal? The big deal is that underwater endowments drag down your bottom line net assets which might violate debt covenants (agreements with lenders to ensure that the organization maintains a certain level of assets).

Two solutions to this problem are: 1. try to make sure debt covenants are drafted to exclude the negative impact of underwater endowments; and 2. your financials should show negative underwater balances as separate and explained items.

3. I know New York is peculiar but the current proposed form of UPMIFA is a real doozy. There was some excitement that NY might include a presumption that greater than 7% spending rates are presumed to be imprudent. Not such a big deal to me but charities should rather do without it (still, my advice is to take the new law regardless of this provision).

The doozy though (for the proposed NY version) is a 90 day check the box provision. What’s this??? UPMIFA, if passed as currently proposed in NY, would require all charities with living permanent endowment donors to send a letter to those donors giving the donors 90 days to decide whether the donor wants his or her fund to follow UPMIFA or to stay with the old UMIFA law. Actually, the wording is really screwy and assuming the law requires charities to use the law’s language in the letter, it will give donors the impression that their choice is between the charity spending their entire fund (new law) vs. maintaining their fund (old law). Yikes for New York charities.

4. Incorporating in Delaware (or wherever) may actually help avoid NY’s insane laws regarding endowments. When I heard this, I made them repeat it. According to the big shot attorneys on the panel at the bar conference, for these purposes only, the state of incorporation would control. This is a good question for your general counsel but some New York charities may already be off the hook in this area if they were incorporated in other states.

5. NY’s proposed law, and included in other state versions, has an escape clause for older, smaller endowments. The uniform version of UPMIFA included a provision for less than $25,000 and older than 20 years permanent funds. It permits charities upon notice to their AG (90 days to protest) to release or modify restrictions if the purposes are unlawful, impracticable, impossible or wasteful. NY’s version increased this old endowment escape clause to $250,000! I know NJ included a $250,000 version of this clause, too! NY’s proposed version requires notice to living donors – not sure if this applies to other state versions.

I would say that if this law gets passed in NY, and certainly the 42 other state that have passed a form of UPMIFA, it would be time to clean up all of those old, out dated endowments.

For non-New Yorkers, check your UPMIFA (if you have it).