LAST week, in this column we began discussing foundations and other non-profit organizations and their finance challenges. This week, we continue with the mathematics of forever, its applications in finance and other things non-profit finance managers should pay attention to.
Forever
There are two areas in finance that involve the concept of forever. One is in endowments or trust funds where the essential question is how much money is needed in order to generate an annual funding stream over an indefinite horizon. The other we will tackle some other day.
In finance, an infinite stream of annual payouts is called a perpetuity – essentially a perpetual annuity. Last week, we showed that, in fact, a perpetual stream of funds can be paid out of a fund through the mechanism of a guaranteed annual interest rate.
The key requirement to developing the perpetual stream of payments is the annual interest rate that can be earned. The next few paragraphs are based on the reading I made for our managing the arts program.
Endowments!
Yes, Virginia, you too can have an unending stream of cash
The current value of an infinite stream of cash flow equal to CF is calculated by dividing CF by i, where i is the interest rate.
Technically, this unending stream is called a perpetuity (from the words perpetual and annuity) and the present value of the stream, called P would then be the formula below:
P = CF/i
For example, if you wanted to generate an infinite stream of 5 million at the end of each year and you believe you can earn at least 5% net on your money each year, you will need to ask someone to give you an endowment of:
5 million divided by = 100 million
Remember, an endowment is one of those donations whose corpus (the original amount) you cannot touch, but whose income you can use.
Let’s test that:
We start with year 1. At the end of the year, our 100 million has earned 5% or 5 million. That’s our first cash stream and our 100 million is still intact. It will generate another 5 million by the end of the second year. And so on ad infinitum! This is even better than Santa……
This is one of the most basic rules of endowment management:
Never spend your principal.
You need your principal intact so that it will continue to generate income each year ad infinitum.
Don’t Forget Inflation!
However, in real life, we actually do want that income stream to increase to account for inflation.
The formula for that, called an increasing perpetuity, is
IP = CF divided by ( i – g )
Where g is the rate of growth we wish for in the cash stream. We would normally set the growth rate at inflation.
This means that if we want, for example, 2% growth, a beginning cash flow of 3 million and we believe we can earn 5% indefinitely, we would need:
3 million divided by (5%-2%) = 3 million divided by 3% = 100 million
How should we manage this?
In the first year, our money would earn 5%, that is, 5 million. We use the 3 million we originally wanted and use the remaining 2 million (2% inflation!!) to increase our endowment.
This means that our restricted cash, the original endowment of 100 million plus 2 million of appropriation for inflation, is now 102 million. This will earn another 5% or 5.1 million. At a 2% inflation, you would now need 3.06 million. The remaining 2.04 is used to increase our investments.
You will notice that what we are doing is simply taking 2% (inflation rate) of the investment and putting it back into the endowment. This allows us to grow investment income each year at the expected rate of inflation. This is a VERY good thing.
And, this is the second basic commandment of endowment management.
Grow your endowment.
At bare minimum, grow your endowment with inflation. This means that the amount of what you would think of as restricted funds, the funds you must consider part of the corpus and not available for spending is grown each year with inflation.
At this point, we must point out a very important thing. This formula only works if i is greater than g, that is, if the investment rate of return is higher than inflation rate.
Now, what happens if you earn more than the 5% you expect? Do you set aside the 2% for endowment growth and then spend whatever is left? NO!
Here is another of the commandment s of endowment management.
NEVER spend all of your investment income.
What I would normally recommend is that you create a fluctuation fund. This is a fund that you add to every time your investment earnings are over 5%. This gives you a pocket to tap when investment earnings are below expectations.
Now, what about non-endowment donations such as grants? There is a golden rule concerning soliciting grants.
Longer is better than shorter
Grants tend to be one time. Some of them are really one shot while others generate a stream of cash for 5 years or more. Clearly, longer term grants are preferable to shorter-term ones. In fact, if you can get a large, stable organization to guarantee a perpetual grant – such as funding for ten scholars a year, that is almost as good as an endowment.
Of course, endowments, properly managed, guarantee a forever that your organization is actually in charge of. When Foundation treasurers go to heaven, they will have unlimited endowments with no need to search for grants.
Prince Charming belongs to Snow White, Philip belongs to Aurora (that’s Sleeping Beauty to you!) – Now, who did Cinderella marry???
In non-fairy tale terminology, Match your fund sources to uses!
For capital expenditures which will require a continuing stream of expenses for upkeep (a new gallery, a new dance company, etc), go for the endowment. This is also a time when donors are willing to give more – especially if there are naming rights available.
Donors normally do not like to spend on operating expenses, so capital fund-raising for such things as a new school building or museum hall or hospital wing require a matching generous endowment whose income will support operating expenses and inflation.
This also means that you must always try to keep continuing operating expenses within investment income of the endowment. Investment income should be enough to fund continuing operating expenses. Grant income should be used for grant activity.
Simply put, permanent sources of income should fund permanent expenses and temporary sources of income should be used to fund temporary expenses.
NEVER create a permanent stream of expense simply because you currently have a fairly long temporary source of funds. This means, for example, that grant money should never be used to hire permanent employees.
Finally, a quick word about investment management.
Don’t gamble away food money
Most of your endowments are required to fund operating expenses. They should be placed long and safe.
If you are particularly lucky, you might have a little extra to take some risk with in order to see if you can get higher returns. That is ok but remember to first secure what you need to support operations.
So there it is, foundation finance 101. Nothing exciting. Better safe than sorry.
Readers can email Maya at integrations_manila@yahoo.com. Or visit her site at http://integrations.tumblr.com. For academic publications, Maya uses her full name, Maria Elena Baltazar Herrera.