By Deborah Kolsovsky and Sylvia Diez
Nonprofits’ budgets are increasingly strained due to the increasing needs of the communities and missions they serve. There are simply not enough resources to address every inequity, every need, and every cause, and thus, occasionally, nonprofit organizations need to borrow money to fulfill their missions.
One major reason for nonprofit borrowing is that the volatility and unpredictability of fundraising can cause the potential for an operating cash shortfall if investment income is not sufficient to meet budgetary requirements. Further complicating things, donations are increasingly coming with donor restrictions attached. Regardless of the cause, an endowment might borrow to make up the budgetary shortfall.
Another reason to borrow is to fund a large-scale, long-term capital project such as a new building, major renovation, or new equipment. The loan or debt, in most cases, would have to be paid for through a combination of donations, investment income and operating income, if applicable. The major issue with this type of borrowing is that, given the unpredictable nature of donations and investment income streams, nonprofits without substantial operating income sometimes have to pay a higher rate of interest than a comparable (with regard to leverage) for-profit entity would pay.
Borrowing Against an Endowment
One option is borrowing from a lender using collateral. The rate of interest on a loan is often determined by the perceived risk of the loan and the strength of the organization’s financials (both balance sheet and profit & loss). The perceived risk of the loan can be affected by whether the loan is secured or unsecured. An example of this would be an organization that pledges a portion of its endowment as collateral being able to borrow at a lower rate of interest than if it does not pledge its endowment. Also factoring into the perceived risk is the borrower’s financials: on the balance sheet side, this relates to restricted assets, unrestricted assets, and liabilities; on the profit & loss side, this refers to whether the organization runs a net income surplus (income greater than expenses) or net income deficit (expenses greater than income).
Borrowing using collateral generally takes two forms for nonprofits: by participating in a government guarantee program or by pledging the assets of the nonprofit or of the endowment as collateral. This essentially provides the organization the ability to borrow at a higher credit rating and lower rate of interest than they would have been able to without securing the loan. This lower cost of borrowing can help to increase the likelihood of the organization’s ability to repay the loan in full and on time.
Borrowing From an Endowment
A second option is borrowing from an organization’s endowment. In this option, there are two schools of thought with regard to setting the rate of interest on the loan: charging the same rate of interest as the return target for the endowment, or borrowing using a rate of interest on par with similar duration securities in the fixed income portion of the endowment’s portfolio.
The upside to this option is that the consequences of defaulting on the loan are internal. The endowment would still lose the remaining principal of the loan, but the potential for greater flexibility around repayment grace periods could help to prevent true default. There are also drawbacks to this method: in borrowing at the portfolio’s targeted return, the interest rate might be higher than what the borrower would pay from another lender; in borrowing at an index-determined rate of interest, the portfolio could be subject to a higher degree of duration risk.
Borrowing is always a difficult decision, and becomes even more complex when endowments enter into the equation. It is important to note that many nonprofits, especially those with restricted funds, will not easily be able to engage in either method; furthermore, the charter, investment policy statement, or other policies may also prevent borrowing in any form. Organizations should consult with their legal services provider before taking any action.
With that said, the endowment does have the ability to support the organization through serving as a lender or through collateralization. If it is not possible to secure a government guarantee for a bond issue, the collateralization of the loan with the endowment can help to lower the rate of interest on the loan and, unlike borrowing from the endowment, does not immediately take away from the fund liquidity. Alternatively, borrowing from the endowment allows more flexibility and less external consequences to paying back the loan. Ultimately, your organization’s leadership and board of directors are best positioned to determine the right choice for your organization.
Deborah Kolsovsky is the managing director for PNC Institutional Advisory Solutions.
Sylvia Diez is the managing director for PNC Institutional Asset Management.