Income from investments can be an important part of a nonprofit organization’s revenue portfolio, though it is the unusual organization that depends on such revenue for the bulk of its economic sustenance. While many nonprofits last off the large endowments that would support them with a steady stream of income unencumbered by obligations to satisfy consumers or fulfill particular contractual obligations or donor preferences, neither returns on endowments nor income derived from other investments are a panacea for a nonprofit’s economic welfare or effectiveness. While theory of nonprofit investment income is, as yet, not well developed, a few strands of theory can help us to understand the appropriate role of investment income in supporting nonprofit activities and operations.
First, it is well to recognize that nonprofits may have funds of various kinds, not just endowments whose principal is normally unavailable for spending. Such funds range from liquid accounts to cover day-to-day operations to accounts limited to special purposes as designated by donors and contractors, to endowments which may or may not be restricted in terms of what particular assets can be held and what purposes returns may be expended upon. In all these cases, investment income is produced for the nonprofit to expend in some way, and as Marion Fremont-Smith points out in her chapter in NCNE’s new book “Effective Economic Decision-making by Nonprofit Organizations,” nonprofits have the obligation of investing and expending such funds in the manner of a "prudent" decision-maker. Aside from meeting the restrictions associated with particular types of funds, this means choosing investment portfolios that reflect the organization’s stated tolerance for risk and promotion of its particular social mission. In financial terms, this suggests such practices as accounting for "total return" on investments, i.e., dividends as well as capital gains as well as by justifying portfolios in order to properly manage risk.
In economic terms, prudent nonprofit investing also means taking account of "opportunity costs." In particular, there are two, (not mutually exclusive) ways for a nonprofit to maximize social returns on its investments. One is to produce maximum financial returns (within limits caused by restrictions and risk tolerance) and use the money for mission related programming, and the other is to invest directly in programs (e.g., via program related investments.) A prudent decision maker would not want to invest in a purely financial instrument if investing directly in program capacity could ultimately produce greater social returns. And indeed, some investments may yield both kinds of returns in desirable proportion for example, investing in a small business in which the organization's clients learn employable skills may produce both mission related and financial returns. Indeed this idea underlies much of what many people have come to call “social enterprise." Thus, a fuzzy line, requiring careful judgements and calculations, exists between the investment and the expenditure functions (and hence the use of potential investment income) of a nonprofit organization with significant funds to invest. The two functions should thus not be completely segregated from one another but considered simultaneously.
Assuming, however, that a nonprofit has its funds appropriately invested, and that these funds produce a stream of revenues, what can theory tell us about the appropriate use of those revenues? And how does this theory connects with the theoretical constructs that support the use of contributed funds, government support and earned income, as discussed in previous columns?
Basically, I think there are two main thrusts to a theory of investment revenue. First, the public goods and externalities theory previously discussed is also relevant to the use of investment income. In particular, investment income can be a source of subsidy for services that create collective benefits not accounted for by the market, i.e., by the willingness to pay of organizational clients or consumers. If, as in one of our previous examples, inoculations for disease entail substantial collective benefits, then the price of those inoculations can be subsidized to ensure that most everyone receives them. In this way, investment income or subsidies from the government.
Second, in addition to such program-specific uses of investment income there is, however, another important use of investment income having to do with a nonprofit organization’s stability and economic welfare. To understand this use of investment revenue, one must call upon theory at the nexus of economics and organization studies. This theory, pioneered by economist Richard Cyert and the organizational theorist James March in a book called A Behavioural Theory of the Firm, written in 1963, postulates the presence of slack in most organizations. Organizational slack represents both a level of inefficiency (the employment of more resources that are technically necessary to produce the organization's current output) and a margin of extra resources on which an organization can draw in difficult times. Thus, organizational slack can be either useful insurance or unnecessary waste, depending on its level and the circumstances under which it exists.
Albert O. Hirschman analyzed the functionality of organizational slack in his classic book Exit, Voice and Loyalty published in 1970. Hirschman basically argued that too little slack would leave an organization vulnerable and subject to failure if it came under severe pressure, for example by loss of a significant portion of its share or membership. On the other hand, too much organizational slack could make an organization insensitive to outside pressures, leading it to ignore problems and losses of outside support until it was too late.
The connection to nonprofit investment income is clear. The build up of funds can be facilitated by reinvesting investment returns rather than spending them, or by employing more staff or other resources than are absolutely needed to address current mission obligations. These policies can usefully build up organizational slack in prosperous times, resources which can then be cut back or made available for exigencies in more difficult circumstances. But, as Hirschman argues, there is also a limit to this policy. As we know, some nonprofits have suffered dysfunctional, even terminal, levels of slack, because they have lost the ability to remain sensitive to an external market or political signals. Boys Town is a famous case, as is the New York Historical Society as studied by Kevin Guthrie, where inflated endowments undermine serious focus on mission or on putting the financial house in order. (As an aside, it is interesting that the works of Howard Tuckman and Cyril Chang, and more recently of Janet Greenlee, Elizabeth Keating and others on nonprofit financial health, seemingly because of the connection to achieve a functional level of organizational slack.)
In addition to subsidy of collective benefits and slack to support stability, there is at least one other theoretically justified use of nonprofit income as well, that of funding innovation. Nonprofits often have limited access to capital because they cannot directly sell stock and can be limited in their ability to borrow. Philanthropy and government programs are often important sources of nonprofit capital, but frequently limited ones as well. Retained earnings and returns from investments can therefore be important sources of venture capital for nonprofit organizations because these sources may be more easily controlled and accessible. This use of investment income is, in turn, connected with the notion of organizational slack. An organization with too much slack will be unmotivated to innovate in order to accommodate change, while one with too little slack will not have the inner resources to do so.
In all, theory appears to argue for a dual use of investment income – for certain operating purposes and for certain reserve purposes. Operating purposes not only include the meeting of obligations associated with restricted funds but also the subsidizing of mission related services so as to account for collective benefits. Reserve purposes including building up organizational slack to a functional level that helps ensure organizational stability and allows setting aside funds for venture capital that can be used for ongoing innovations and improvements in organizational capacity.