BPA 331 University of Phoenix Financial Management of an Endowment Case Study You and your Learning Team members are the financial managers of a midsize no

BPA 331 University of Phoenix Financial Management of an Endowment Case Study You and your Learning Team members are the financial managers of a midsize nonprofit that has just received a substantial endowment from a longtime supporter. The board members are excited because years of effort have gone into seeking this endowment, and they are expecting that the endowment will mean increased financial stability for the nonprofit in the future.

The board members have been distressed by money shortages in recent years caused by donor fatigue and the economic downturn. However, they do not know how an endowment should be managed. A few members have knowledge of accounting and auditing, but no one on the board is an investment expert. The nonprofit has no experience in endowment investment, given that this is the first endowment the nonprofit has received.

As the financial managers of the nonprofit, you have been asked to take on the responsibility of establishing and managing the endowment, which is a situation not uncommon in small and midsize nonprofits. You are all very pleased with the infusion of capital as an endowment, but you are taking on the role of managing the endowment with some trepidation because you know how unprepared the nonprofit is for this new financial management task.

Your team wants to perform well with the endowment for the mission of the nonprofit, but you do not want to take the blame if the endowment does not achieve excellence, despite your best efforts, because of uncontrollable events like swings in the stock market and economic fluctuations.

What should you take into consideration and what steps should you undertake if you intend to take on responsibility for the endowment in addition to your other duties?
With the new infusion of capital, why is it important for your nonprofit to develop and maintain an internal control system?
Why are independent financial reviews necessary for this nonprofit?
With new infusions of capital, how does the Sarbanes-Oxley Act assist you in being a more responsible financial manager?

Include references and citations to support your responses.

Format your presentation consistent with APA guidelines. INVESTMENT STRATEGIES
Even a modest increase in return on investment can, over many years, make an enormous difference in the financial health of an
organization. To obtain such benefits an organization must integrate investment policies into all aspects of organizational and
financial life.
—Robert P. Fry, Jr.1
CHAPTER 13 LEARNING OBJECTIVES
Understanding investment policies and guidelines
Understanding short-term investment strategy and investment vehicles
Understanding long-term investment strategy and investment vehicles
OPERATING NONPROFITS AND charitable foundations have working capital and longer-term funds. For instance, short-term surplus
cash from unsynchronized cash inflows and outflows may swell cash position on a nonprofit’s balance sheet. Long-term
endowments and pension funds accumulated over the years can be substantial financial resources for established organizations.
These funds can generate income for nonprofits through well-developed financial investment strategies. The success or failure of
these investment strategies can have significant consequences for some nonprofits, such as colleges and universities, in carrying out
their mission programs.
In this chapter we discuss investment principle and guidelines in the nonprofit context, emphasizing the key role of the board as the
fiduciary in developing a policy statement and overseeing its implementation. We then address short-term and long-term
investment separately, recognizing the different priorities in investment objectives and the different strategies needed to achieve
these objectives.
INVESTMENT POLICIES AND GUIDELINES
A well-developed investment policy and guidelines arguably are the prerequisites of a successful investment program. The key
elements for investment policy and guidelines include management structure; investment objectives; asset allocation and
rebalancing guidelines; permissible instruments; consultant, custodian, and manager selection and evaluation; reporting
requirements; and policy review. Given the limitation of space for this discussion, we will address the most essential elements from
the financial manager’s perspective. For nonprofit investment programs, the roles and responsibilities of the nonprofit board are of
special significance. We therefore start this section by discussing the fiduciary responsibility of the nonprofit board.
Role and Responsibilities of the Board
The board of directors of a nonprofit organization has the fiduciary responsibility to steward the organization’s financial resources
and to ensure that funds are used to further the organization’s mission and goals. In addition, the board must ensure that donors’
intentions and designations are honored. Federal and state laws institutionalize the board as the fiduciary for tax-exempt
organizations. A fiduciary, by definition, is an individual or organization holding assets for another party. The board of directors has
the fiduciary duty for all the assets of a nonprofit, including investing funds in trust for the benefit of the nonprofit’s constituencies,
so that the organization can deliver its mission on a sound financial basis.
A board, in discharging its fiduciary responsibilities, establishes policies and guidelines, selects key officers and managers, oversees
policy implementation, evaluates results against benchmarks, and initiates changes as needed. It is common for a board to set up an
investment committee to assist in policy development while delegating the operation of the investment program to the
management of the nonprofit internal staff or external investment advisers/managers. Large organizations often hire external
consultants and fund managers to operate their programs under the supervision of their investment committees or designated
internal financial managers, supported by the consultants. Selecting appropriate and proficient external professionals is critically
important for the success of investment programs, and time and resources are needed for a carefully run recruiting process. As
demonstrated by recently exposed investment frauds such as the notorious Bernard Madoff Ponzi scheme that came to light in
2008, nonprofits need to be very careful in selecting individual advisers and investment funds, especially when these are not
associated with reputable firms.
Investment Policy Statement
The investment policy statement is a major tool for regulating the investment behavior of the parties involved. It is the key
document that the board creates to discharge its fiduciary responsibility in nonprofit investment. An investment policy statement
outlines the objectives and strategies of a nonprofit’s investments; provides an organizational structure, including delineation of
responsibilities and discretions; establishes accepted risk level and the subsequent strategic asset allocation guidelines regarding
allowed and prohibited investment vehicles; specifies the criteria and process for selecting investment consultants, managers, and
custodians, if needed; outlines methods and benchmarks to be used in monitoring and evaluating investment performance; and
stipulates procedures for corrective actions, or other adjustments, if needed. The policy statement also includes a schedule for
policy review, which is often conducted annually.
The specific content and format of investment policy statements vary among nonprofit organizations, but commonly these
statements cover general policies and specific guidelines. More often than not, an investment policy statement begins with
information on the nonprofit and the environment in which it operates. The statement then stipulates a spending policy and an
investment policy (objectives and strategies) based on the mission of the nonprofit and applicable laws of the federal and state
governments. The statement then specifies asset allocation guidelines (to be discussed in detail later in this chapter) and establishes
parameters within which investments are allowed and/or prohibited. These specifications are often followed in the investment
policy statement by guidelines for management selection if external fund managers are involved. Reporting and evaluation
procedures are specified, with selected benchmarks, depending on the specific portfolio. The typical statement often closes by
outlining the policy review process, which keeps the investment program up to date.
An example of an investment policy for short-term investments for nonprofit education foundations is presented in Appendix C.
More complete and complex examples are available from investment firms and from textbooks that focus specifically on investment
for nonprofits.
SHORT-TERM INVESTMENT STRATEGY
Nonprofits have liquidity and operating reserves. Liquidity reserves are financial resources set aside to smooth out operations and to
provide a cushion against cash-flow fluctuations. An operating reserve is a rainy-day fund—that is, a fund for unexpected events.
These funds need to be invested in safe and liquid investment vehicles to generate market returns. The proficient management of
liquid and operating reserves can make a significant contribution to a nonprofit’s finances, especially when excess cash is
substantial.
Issues in Short-Term Investment
To manage liquidity and operating reserves, the financial manager needs to know the amount and the duration of available cash that
the nonprofit has at present and is expected to have in the future. Thus a prerequisite of an effective short-term investment
management is a cash-flow forecasting system. As part of the annual budgeting process (discussed in Chapters 2 and 3), a financial
manager should develop a cash-flow forecasting system, estimating as accurately as possible and feasible the amount of cash
inflows, cash outflows, and the resulting cash balances over an extended time period. The cash-flow budget should give the financial
manager a good idea of when the nonprofit will have cash to invest and when it will need to liquidate (sell) investments to fund
operations and other cash needs. The manager should also be aware that an unexpected cash shortfall can occur and should make
sure that operating reserves or rainy-day funds are available at relatively short notice.
Investment Objectives: Safety, Liquidity, and Yield
Financial managers consider three objectives in managing investment programs: safety, liquidity, and yield (return). Safety refers to
the probability that the investors will get the principal back at the end of the investment period, liquidity represents the extent to
which the investment can be converted back into cash in a timely manner and without incurring loss to the principal, and yield refers
to the returns from the investment, net of expenses. Ideally, a nonprofit organization should seek to invest in a safe place, to have
access to the cash on short notice, and to earn high returns—all at the same time. Investment theory and experience, however, have
shown that risk, liquidity, and yield are not independent. Higher return is associated with higher risk and often with lower liquidity.
The three objectives of short-term investment need to be prioritized in the investment policy statement to provide clear guidance
for investment decisions.
As fiduciaries of public assets, nonprofits’ overriding objective for short-term investment is safety, meaning the protection of
principal. This is followed closely by liquidity, given the short-term nature of cash needs and the unpredictability of unexpected
events. Return, in relative terms, is not as important an objective as the other two and should be given lower weight in investment
decision making. Major losses can result if this rule is not followed closely, as the pursuit of higher returns is inevitably associated
with higher risk of losing principal in an efficient financial market. There is no free lunch, as economists often proclaim. Nonprofit
financial managers need to understand risk and the methods for managing risk if they are to manage investment programs
successfully.
Default and Market Risks
Risks can come from different sources. The two key risk sources are default risk and market risk. Default risk relates to the safety of
the security or to the company that issues the security. Investors may lose part or all of their invested principal and accumulated
interest if the financial soundness of the investment vehicle or the issuing company deteriorates materially or, in the worst
scenario, declares bankruptcy. Financial managers should thoroughly research the financial conditions, the expected future
performance of the securities, and the issuing companies carefully before investing.
A number of security rating agencies provide information on credit quality, and traditionally nonprofit organizations rely on the
judgments of such agencies in making investment decisions. Standard & Poor’s, Moody’s, and Fitch are the three major companies
that provide this service. The quality of credit is represented by a scheme of letters and numbers, depending on the rating agency.
For instance, the investment grades used by Standard & Poor’s are, in descending order of credit quality, AAA, AA, A, and BBB. Cgrade securities are speculative, and D-grade securities are in default. Financial managers of nonprofits are advised to make shortterm investments in investment-grade instruments only. In recent years, the questionable performance of the rating agencies,
epitomized by the indiscriminate high ratings given to collateralized debt obligations (CDO) composed of risky mortgage securities,
has shaken trust in the system. It is generally recommended now that nonprofits do their own credit investigations, if resources
allow, or stay with conventional investments that are within the knowledge range of their financial managers.
Market risk, or interest risk, relates to interest rate changes in the marketplace that go beyond an individual instrument or the
organization that issues the security. Future investors will request higher yield when market interest is rising or is expected to rise,
pushing down the value of existing security with fixed coupon payments or interest and causing the loss of principal if the existing
securities have to be sold before they mature to meet operating or emergency needs.
In this sense, high-quality securities with little default risk are not necessarily risk-free, especially in longer maturities. Even the
safest investment instruments possible—that is, U.S. Treasury securities—are not exempted from market risk because of interest
rate changes. The best way to increase safety is to match the maturity of the security to the forecast time for the use/needs of the
funds, whenever possible, to avoid the liquidation of the investment prematurely. Other strategies, such as laddering or interest
hedging, can be used to reduce market risk, although to a lesser degree or with a cost. Laddering is the structuring of security terms
so that a certain proportion of the investment matures every year over a few years. The mature investment is then reinvested,
laddering behind the last one to mature. For instance, an investment could be arranged in a five-year ladder, where the matured
investment is reinvested for another five-year term, if not needed for current use. This way the impact of interest change on security
value is mitigated.
Hedging is another method of reducing market risk. Hedging often takes the form of taking an offsetting position in a related
security. For instance, the financial manager can purchase an interest swap or credit default swap (CDS) to protect against potential
loss caused by interest rate change. An in-depth discussion of the complexities of hedging is beyond the scope of this introductory
text. We recommend that interested readers seek out specialized texts to learn more about this topic.
Shorter investment terms can reduce market risk, as it is easier for nonprofits to wait for maturity when interest rate rises.
Consequently, the investment policies of nonprofit organizations often stipulate a maximum length of investment for their short-
term investment securities. The aggregated maximum length is often set at three years, supplemented by limitations on individual
investment instruments, often no more than ten years. Investment vehicles with floating interest rates may also be considered,
although the investors may lose some returns for the safety of the investment.
Given the safety and liquidity concerns for short-term investment, high-quality, short-maturity, fixed-income instruments seem to fit
the bill well. Fixed-income investment vehicles are those that obligate the borrower or the issuer to make payments on a fixed
schedule of a fixed amount. Contrasted with equities (which we will discuss in more detail later), fixed-income securities are less
affected by the performance of the issuers, as the income is guaranteed by the issuers. The debt holders take precedence in asset
claims even if the issuers are under restructuring or liquidation.
Key Short-Term Investment Vehicles
A number of different kinds of short-term investment securities are suitable for nonprofit organizations. The following is a brief
introduction to selected key investment vehicles, sorted according to the debt-issuing institutions: banks, government and
government agencies, and corporations.
BANK OFFERINGS. Banks offer a variety of interest bearing checking accounts, savings accounts, and money market accounts
wherein nonprofits traditionally park their working capital. The Federal Deposit Insurance Corporation (FDIC) insures these
investments up to a certain amount, and the money is available on demand. For those nonprofits that have low tolerance for
financial loss and limited cash and time to invest, these are safe vehicles to manage cash and cash flows. Little or no return can be
expected from checking, savings, and money market accounts in real terms, especially during times of economic recession, but the
banks selected can make some difference when large volumes of short-term cash are involved. Some banks give higher interest
rates with limited services, such as ING of Internet banking. Nonprofits may take advantage of such higher returns if the limited
services that are offered meet their banking needs.
Certificates of deposit (CDs) can be short-term investment vehicles that are safe (FDIC insured); however, they are less liquid than
some other options. When compared with checking and savings accounts, CDs offer marginally higher, fixed rates on funds
deposited for specified periods of time. If such an instrument is selected for a nonprofit, the financial manager should review the
organization’s cash-flow needs before deciding on the appropriate maturity term, because withdrawing funds from a CD before the
maturity date can incur substantial penalties, offsetting the gain in return. Many banks now offer negotiable CDs, which can be
traded in a secondary market and therefore have increased liquidity. One downside of a negotiable CD is the required size of
investment to take advantage of the secondary market. CDs are often traded in millions. Small nonprofits often do not have the
volume, and therefore this vehicle may not fit their circumstances.
U.S. TREASURY SECURITIES. U.S. Treasury securities are obligations of the U.S. government. These investment vehicles are backed by
the full faith and credit of the U.S. government for timely repayment of principal and interest. Treasury securities are issued in three
maturity ranges: Treasury bills, Treasury notes, and Treasury bonds. Treasury bills (T-bills) are offered in four-week, three-month,
and six-month terms; Treasury notes have maturities between one year and ten years; and Treasury bonds mature up to thirty
years. For short-term investment, Treasury bills and notes can be obtained directly from the Federal Reserve Bank or from security
dealers.
As far as default risk is concerned, treasuries are the safest securities, given the size of the U.S. economy and the financial strength
of the U.S. government. Treasuries also have a deep and broad secondary market for liquidity, and thousands of dealers across the
world are ready to trade Treasury securities. Consequently, treasuries have very low returns, especially at the short end of the
maturity spectrum. Treasuries are not exempt from market risk, and longer-term treasuries therefore tend to have higher interest
rates to compensate for the risks. Nonprofit financial managers should be cognizant of this market risk in investing in longer-term
treasuries. This is especially true currently, with interest rates at a historical low since the 2008 financial crisis. Interest rates will
eventually go up and the price of Treasury securities will go down, causing the potential loss of principal for security holders who
have to liquidate their securities before maturity. This is especially significant for those who have invested in the longer term.
BOX 13.1 REMEMBER:
Treasuries
Treasuries are considered risk-free investments, but they are not exempt from market risk. Investments in treasuries could lose
principal, especially in the current economic and financial environment, wherein the ten-year interest rate had fallen below 2
percent as of 2011. As the interest rate climbs back to its normal range in the future, the value of these securities will drop. If a
nonprofit invested in treasuries has to redeem securities before they mature, it could lose a substantial part of its investment. Thus
Treasury securities are not risk-free. The financial managers for nonprofits must be careful in interpreting financial terms.
OTHER GOVERNMENT AGENCY SECURITIES AND MUNICIPAL BONDS. Certain government agencies, such as Fannie Mae and
Freddie Mac, issue agency securities. Some of them are second only to treasuries in terms of safety and liquidity, with somewhat
higher yield. F…
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