4. How Should Nonprofits Invest? Key Investment Considerations for Non-profit Organizations
Every nonprofit is different and thus their investment objectives will differ. However, there are a few characteristics inherent to nonprofits that make them unique compared to an individual or taxable investor, which can alter how the non-profit investment portfolio is managed. A few considerations for how nonprofits should invest are discussed ahead.
Time Horizon: The investing time horizon is typically defined in a nonprofit’s IPS. A nonprofit’s time horizon may vary greatly from a traditional individual investor. While many individual investors are investing to save and fund for a specific, time-constrained goal such as retirement, nonprofits generally display a much longer time horizon and aspire to invest in perpetuity with no tangible end point. This dramatically changes a nonprofit’s investment approach.
Investing in perpetuity may sound abstract, but a long-term investment horizon produces a few valuable benefits. First, investing with a long-term perspective allows nonprofits the ability to take on more risk to achieve enhanced returns, as it makes them better able to weather short-term volatility or temporary market impairments. Additionally, with a long-term investment horizon, nonprofits are presented with a broader array of investment options and the opportunity to invest a portion of the portfolio in more illiquid, alternative investment strategies that typically offer higher return potential than traditional investment products.
Portfolio Cash Flows: While a nonprofit may aspire to invest in perpetuity, the portfolio’s time horizon may be shifted by the organization’s cash flows. For many nonprofits, the investment portfolio is the primary source of capital for their spending policy or large expenses (e.g., funding a scholarship, constructing a new building, etc.). On the other hand, a nonprofit’s investment portfolio can be aided by the inflow of fundraising efforts and charitable gifts. It is imperative for the nonprofit to project future cash flows both into and out of the portfolio, as these cash flows will have a material impact on the investing time horizon and consequently the risk level and asset allocation of the portfolio. For example, a nonprofit with adequate current year cash flows may invest the portfolio more aggressively for larger long-term returns.
Non-profit Tax-Exempt Status: Perhaps the most impactful investment characteristic of a non-profit organization is its tax-exempt status. Given their status as a 501(c)(3) entity, nonprofits are provided an income tax exemption that applies to their investment portfolio. As a result, nonprofits invest as a tax-exempt entity without the burdens of realizing capital gains or ordinary income.
Not only does this tax-exempt status provide a significant tax savings and thus increase the overall return potential, but it also allows for more flexibility in the portfolio. The nonprofit can freely make changes to the portfolio’s asset allocation or underlying investments without the inhibition of tax implications (being required to pay capital gains tax if a certain investment is sold). It also eases the decision of investments to sell when raising cash for liquidity needs/withdrawals from the portfolio.
Additionally, the status of nonprofits as a tax-exempt investor removes the barrier for nonprofits to consider investing in tax-inefficient investments. Tax-inefficient investments can include high-income strategies or funds that generate significant short-term capital gains, which for individuals are taxed at ordinary income rates that are above the tax rate for long-term capital gains. Relative to an individual or taxable entity, the barrier to investing in tax-inefficient investments is non-existent for nonprofits, as this will not create any elevated tax liability. While a taxable investor must consider what the after-tax return of the investment opportunity is, a nonprofit should focus on the strategies with the most efficient gross return potential for a specified level of risk.
While investing as a tax-exempt entity provides significant benefits for nonprofits, it does mitigate the attractiveness of tax-advantaged investments, particularly municipal bonds. To encourage investment in states and local municipalities, the interest income paid by municipal bond issuers is exempt from federal income tax (as well as exempt from state income tax for those who are residents of the state in which they are issued). Thus, many taxable investors, specifically those in high income tax brackets, allocate to municipal bonds to alleviate their overall tax burden. However, to counteract their tax-exempt status, municipal bonds have historically offered a discounted yield to comparable taxable bonds. Since nonprofits are tax-exempt entities, they do not receive any incremental benefits of a municipal bond’s tax-exempt income. Thus, nonprofits should avoid investing in municipal bonds in almost all circumstances, as more attractive yields can be found elsewhere in the fixed income asset class with similar risk characteristics.
Additionally, it is critical that tax-exempt entities avoid investments that may be subject to Unrelated Business Taxable Income (UBTI). UBTI is defined as net income derived from any unrelated trade or business that is regularly carried on by any tax-exempt organization or tax-advantaged account.[i] UBTI is typically generated from two main sources of income: 1) any pass-through income from an unrelated business (e.g., direct investment in limited partnerships), and 2) debt financed income (e.g., debt-financed real estate investments). If a tax-exempt entity recognizes more than $1,000 of UBTI in a given tax year, the organization is subject to income tax on that income and will be required to file a Form 990-T. Additionally, a nonprofit may lose its tax-exempt status if it is determined that the organization is deriving an excessive amount of income from unrelated businesses. The most common investments that generate UBTI are alternative investments exhibiting a pass-through limited partnership structure, such as master limited partnerships (MLPs), private equity, private real estate funds and hedge funds.
Investing Alongside the Mission and Values of the Organization
Nonprofits provide immense assistance and welfare to society, guided by their stated mission and a defined set of values. Given the evolution of the investing landscape over the last decade, it is now possible to invest capital in accordance with those values and align the investment portfolio with the mission of the organization.
The emergence of Sustainable, Responsible and Impact investment strategies, commonly referred to as SRI investing, can provide nonprofits the opportunity to achieve their financial goals while continuing to “do good” through their investment approach as well. SRI investing is a broad investing discipline and is inclusive of a wide array of investment approaches that balance both the social impact of the investment and the financial return potential. Below are the most commonly employed SRI investment strategies.
- Value-Alignment: The value-alignment approach attempts to remove some of the negative or socially destructive companies from an investment portfolio. The process is exclusionary in that it starts with an investment universe and attempts to screen out the negative options. Many investors express an aversion to investing in “sin stocks,” which are typically defined as companies involved in activities widely considered to be unethical or immoral such as tobacco, alcohol, gambling and weapons manufacturing. Meanwhile, other investors insist on excluding specific countries from their asset allocations that are notorious for human rights violations or companies that have done environmental harm. The overarching investment goal is to maximize investment return, while meeting socially responsible restrictions. The simplified, exclusionary nature of value alignment makes it the most popular and widely available investment strategy within SRI investing. For many nonprofits, it provides the easiest and most efficient way to remove the worst social offenders that may contradict the mission and value of the nonprofit. Value-alignment strategies are offered across almost all asset classes and some strategies allow for customization to exclude specific industries or types of companies from the portfolio.
- Environment, Social & Governance (ESG) Investing: ESG investing moves a step beyond value-alignment. ESG investing can be thought of as a value-alignment strategy with a more proactive approach to finding companies that positively align with the core philosophies of environmental, social and governance criteria. The environmental standard is self-evident. It covers a company’s environmental impact and focuses on issues such as carbon footprint, pollution, the use of renewable energy or sustainable workplace practices. Social issues are more closely tied to a company’s employee base and community, focusing on issues such as workforce diversity, fair wages, labor conditions and community involvement. Governance issues are tied to the treatment of shareholders, the independence and diversity of the board, transparency in accounting, and political influence. When these core values are combined in the investment process, the ESG approach aims to target investment in companies that operate under positive environmental, social, and governance standards and avoid those that score poorly.
- Thematic Investing: The thematic approach to SRI investing allows investors to focus on a specific theme or industry. Thematic investment strategies are concentrated in highly impactful industries or themes and allow for a specific investment focus where an investor may be most interested. For a nonprofit, this can mean targeting investment strategies that acutely line with the organization’s mission or values. A common SRI theme is faith-based, but they can also range to themes such as gender diversity and companies with women in leadership. Alternatively, these strategies can be focused within influential industries, such as renewable energy or water resources, which produce a tangible social or environmental impact. For many thematic or focused investment strategies, the financial return is balanced with the influence an investor can have on social impact.
- Impact Investing: Impact investing provides financial capital to address social or environmental issues, with the primary purpose to create a direct and measurable social or environmental impact. The investment’s financial return is a secondary consideration. The concept of impact investing originated with microfinance loans, which are small loans made to low-income individuals who may not have access to capital through traditional means. Microloans allow these individuals to pursue a small business venture and generate sustainable income. However, impact investing has expanded well beyond microfinance loans and now ranges from investments to establish affordable housing or the development of sustainable food products to venture capital firms focused on minority-owned and operated start-ups. Given their priorities, impact investments are often more esoteric and unique in nature, but also tend to be more illiquid investments and not offered in the public market.