Importance of Understanding Your Nonprofit's Risk Tolerance

A framework for determining if your endowment or foundation has a high, moderate or low ability to take risk.

An understanding of your endowment or foundation’s ability to take risk will help you determine the most appropriate strategic asset allocation. Setting the strategic asset allocation is the single most important  decision your Investment Committee will make — far more important than the managers you select or the securities they purchase.

In general, the optimal strategic asset allocation will depend on several factors.

So how do you determine if your endowment or foundation has a high, moderate or low ability to take risk? The following framework can help determine your organization’s risk tolerance.

Examining Risk Tolerance from an Enterprise Perspective

Your risk tolerance will depend on your organization’s ability to manage spending and the importance of the asset pool’s contribution to operations.  While numerous metrics exist to evaluate enterprise risk, we have found the areas below to provide a comprehensive, yet manageable, list for evaluation.

Spending flexibility: if your spending methodology, spending policy and operating environment do not afford you the ability to lower spending in down markets, you have a lower ability to take risk

Operational dependence: if your operational budget relies heavily on your endowment or foundation, you have a lower ability to take risk

Operational reserves: if you do not have excess operational reserves to help cushion a down market, you have a lower ability to take risk

Fixed vs. variable costs: if your cost structure is mostly fixed with few variable cost components, you have a lower ability to take risk

Liquidity: if you have limited operational cash on hand and / or a significant percentage of your portfolio invested in illiquid investments, you have a lower ability to take risk

Access to capital: if you do not have access to credit that you can rely on in down markets, you have a lower ability to take risk

Debt / liabilities: the higher your relative debt and debt service levels, the lower your ability to take risk

Risk Tolerance Assessment Illustrations 

Let’s look below at a sample illustration using two college endowments to help determine their ability to take risk. 

College Endowment A has a higher ability to take risk when compared to College Endowment B

Based on the metrics outlined above to evaluate enterprise risk, College Endowment A has a higher ability to take risk when compared to College Endowment B. Indeed, College Endowment A appears to have a more resilient revenue stream with a significantly lower tuition discount rate, modest annual revenue growth and a robust donor base. It is also less reliant on annual spending from the endowment and has greater spending flexibility thanks to its cash on hand and a stronger operating budget. Finally, College Endowment A has less financial leverage and a greater capacity to take on additional debt.

Next, we examine another sample illustration using two hospitals to help assess their ability to take risk in their foundations.

Hospital A has a higher ability to take risk when compared Hospital B

In this example, Hospital A has a higher ability to take risk when compared to Hospital B. Hospital A has better short-term liquidity, greater cash on hand and higher quality receivables. It also has a healthier operating structure, lower expenses and is less reliant on government program funding. Finally, Hospital A has less debt and a more favorable capital structure.

Conclusion

Assessing key metrics for your enterprise provides valuable insights on the level of risk your organization can take and informs decisions around the optimal strategic asset allocation. To help organizations evaluate their ability to take risk from an enterprise perspective, BNY Mellon has developed a series of peer group reports, which include an evaluation of the above metrics in isolation, as well as a comparison versus peers of similar type, asset size and/or geographical location. Please contact us or reach out to your relationship manager to learn more.

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