Academic journal article The McKinsey Quarterly

For Nonprofits, Time Is Money

Academic journal article The McKinsey Quarterly

For Nonprofits, Time Is Money

Article excerpt

Society pays a price when foundations and nonprofit organizations stockpile their assets. Donors should ask not just how, but how soon, their gifts will be used.

In spite of the current economic slowdown, the US nonprofit sector remains financially strong. Foundations and endowed nonprofit organizations have accumulated almost $1 trillion in investment assets, $450 billion of it belonging to foundations and more than $500 billion to endowed nonprofit organizations. (1) The portfolios of the largest of these institutions top $4 billion (Exhibit 1, on the next spread). Even allowing for a short-term slowdown in charitable giving-a slowdown that many nonprofit leaders expect-an additional $1.7 trillion to $2.7 trillion is projected to flow into the sector over the next 20 years. (2)

How this enormous wealth should be managed and how fast it should be spent are the subject of debate. To shed light on these questions, we employed a standard financial concept known as the "time value of money." The results of our analysis suggest that the current approach to building and distributing this wealth isn't serving the best interests of society.

Foundations and endowed nonprofit organizations have traditionally been cautious in distributing their bounty. In 1999, foundations took in more than $90 billion in new contributions and investment returns but distributed under $25 billion. (3) Indeed, foundations (4) and endowed organizations (5) have typically distributed about 5 percent of their assets each year--less than their annual investment returns alone. Undoubtedly, the go-slow approach allows foundations to refine their skill at evaluating potential grant recipients, and for operating nonprofit organizations, increasing the endowment has much to be said for it. Large nest eggs free organizations from time-consuming fund-raising, thereby enabling them to focus on their missions, while wise investment strategies increase the resources available for future use.

But in some cases, building the endowment appears to have become an end in itself. A large endowment helps attract top talent and increases the prestige of the institution. Donors perpetuate this syndrome by showering their gifts on well-endowed institutions. The question of how much is enough often appears to be overlooked.

Today's low distribution rates amount to an implicit decision to hold back funds in the expectation that worthier causes will appear in the future. But many current social needs are already overwhelming. Numerous foundations and endowed nonprofit institutions ought to spend their wealth sooner rather than later, and donors should favor organizations that put their gifts to work straightaway. Viewing these issues from the perspective of the time value of money shows why.

Sooner is better than later

Given the choice of receiving $100 now or in a year's time, most people would take the money now. By doing so, they acknowledge the time value of money. Indeed, the concept explains many of the financial relationships we see every day. Banks, for example, must pay interest that is higher than the inflation rate in order to persuade depositors to postpone their consumption. When asked to choose between receiving a donation now or in 12 months' time, the managers of nonprofit organizations whom we interviewed indicated that to accept a delay, they would need an implied interest rate as high as 50 percent because they could use those additional resources today to address pressing social needs.

When managers in the for-profit world are considering whether to make an investment, they first calculate the present value of its future returns by discounting those returns at a certain rate to reflect the time value of money. Only an investment whose future returns have a present value that exceeds its initial cost makes sense. Companies typically use their weighted-average cost of capital (the blended cost of their debt and equity funds) as the discount rate. …

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