Back in the pre-COVID days, when you boarded an airplane, did you look for the location of the emergency exits? Let us understand that the future is always uncertain; the uncertainty is just more obvious during some periods, as it is now. I reference the recent book by Dan Carlin, The End Is Always Near. Some crisis events come from within the financial system, as happened in the 2008 financial crisis. Others are exogenous, such as the 9/11 attack or the current pandemic. We might see the endogenous ones building, “bubbles,” but we are rarely able to anticipate the exogenous events. There will be future crisis events: “History doesn’t repeat, but it rhymes.”
Crisis events create shocks to the financial system that impact the value of endowment portfolios. How do we consider these risks as a foundation investing endowment money under UPMIFA with a perpetual time horizon? I am a proponent of the long-term modeling of a foundation’s business model based on investment return and cash flows of the organization. (And by long-term I mean at least 20 years; there are important trends that do not show up until more than 10 years out.) But the frequent practice of using the expected return on the portfolio for every year is of limited use. The expected return is associated with a 50 percent probability. A business model that merely breaks even on the expected return lives or dies on a coin toss. It is better to use a random return based on a lower than expected return (higher probability of achievement) and include a factor for crisis events. The probability of a crisis event happening in any one year is low, but for a long-term investor this probability is cumulative over time. The analysis cannot guarantee success, but it can increase its probability, elevate the organization’s strategic discussion, and highlight for an investment committee the benefits of defensive strategies against the costs of those strategies.
What are the costs of defense? Diversification, cash reserves, and options strategies detract from returns during multiyear rising investment markets, as we saw from 2010–2019. This intentional reduction of maximum return can be difficult to explain to constituents who have relatively short time horizons (or memories). And there may be an indirect cost: I often state that our biggest competitor is our donors. Why would a potential endowment donor contribute assets into our diversified, lower-risk portfolio when they may have earned more than 13 percent over the last 10 years (through December 31) in an S&P 500 ETF, or 17.5 percent in the QQQ? How much defensive cost can you incur without detracting from endowment contributions?
But now that the building is on fire, what does one do? If contingencies have been planned, now is the time to tweak and implement. If not, do not panic, do what you need to survive, and learn. It was easy for investment committees to become complacent during the years between the tech bubble and the financial crisis. Successful investing was relatively easy. In the aftermath of the financial crisis many institutions evaluated their decision-making process and determined that they did not have the ability to respond to crisis markets. As a result, we saw a significant swing to the Outsourced CIO (OCIO) model, giving to an outside partner the authority, within bounds, to manage and tactically shift the portfolio. Now those OCIO partners, and the redesigned decision-making processes, are tested. Over the next year or so as the data comes in, we will see the proof of this model and of these partners.
The investment risk in the portfolio is but one component of total enterprise risk, and for a foundation, risks are deeply shared with its university partner. Both share the risk of the university’s brand. There are shared risks related to organizational leadership and culture, the physical plant and security, and even in the success of alumni and their future contributions. Financially, the stronger and more resilient the university, the less of that financial risk flows to the foundation. Can the foundation lower spending rates, continue to fund the costs of alumni engagement and fundraising, and maintain fiduciary standards, or must the foundation increase spending for the health of its university partner? What impact is the crisis having on state funding, enrollment, and tuition? Money spent in a down market is very expensive money, but the partnership must survive. These times test the university-foundation relationship.
Even in quieter times it is difficult for foundation boards to discuss enterprise risk management, with topics divided among investment, finance, and philanthropy committees. And, has there been an honest, quantified, discussion concerning the strategic role of the foundation to the long-term success of the university and the integrated nature of the associated risks? During this crisis many institutions have formed a crisis committee to consider the immediate and apparent problems. Can these committees transition from tactical issues to discussions of longer-term strategic issues based on the experiences learned from the current crisis?
So how does a foundation develop an operating budget and financial plan for fiscal year 2021 right now in the middle of this COVID-19 crisis?
- Consider developing multiple budgets, or budgets with ranges around the key parameters, and expressly state the variables considered.
- Develop and discuss contingency plans around parameters more negative than used in your base case.
- Crises accelerate change. Transitions to online learning, online engagement and philanthropy, and online transactions have leapt forward. What is the impact on your systems and staffing?
- Reevaluate the long term. Investment firms are updating their capital market assumptions. Based on March 31 valuations, what is now the long-term expected return of the portfolio? What are the long-term changes for fundraising costs, alumni engagement, the physical plant, tuition?
Once the crisis passes, evaluate the organization’s governance structure and decision-making processes, and integrate the lessons learned into an enterprise risk management process. We are long-term institutions, and the end is always near.
Tom Heck is the chief investment officer at Ball State University Foundation in Muncie, Indiana.
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