CHAPTER 10
MANAGING YOUR ORGANIZATION'S LIABILITIES
- 10.1 MANAGING THE BALANCE SHEET
- 10.2 BALANCE SHEET MANAGEMENT: BENEFITS AND STEPS
- 10.3 PAYABLES
- 10.4 SHORT-TERM BORROWING
- 10.5 STRATEGIC FINANCING PLAN
- 10.6 STEPS TO SUCCESSFUL BORROWING
- 10.7 MATCHING FINANCIAL SOURCES TO STRATEGIC OBJECTIVES
- 10.8 PREPARING THE FINANCING PROPOSAL
- 10.9 MAKING THE PRESENTATION
- 10.10 OTHER FACTORS IN BORROWING/LENDING DECISIONS
- 10.11 MUNICIPAL AND TAXABLE BONDS
- 10.12 LEASING AND NONTRADITIONAL FINANCING SOURCES
- 10.13 DEVELOPING A DEBT AND HEDGING POLICY
- 10.14 LIABILITY MANAGEMENT IN PRACTICE
- 10.15 CONCLUSION
The nonprofit landscape is littered with failed organizations that presumed on their financial futures by taking on too much debt. Denver aquarium Ocean Journey overestimated its annual visitors and had to declare bankruptcy within two years of opening because it was unable to make payments on its $57 million of debt.1 The Allegheny Health, Education, and Research Foundation (AHERF) filed bankruptcy with $1.3 billion in debt and 65,000 creditors – primarily due to too-rapid expansion, unfulfilled merger operating result projections, and an overload of debt that it accumulated: Debt mushroomed from $67 million to $1.2 billion over a 12-year period. The nonprofit liquidity challenges and ensuing cash crisis we identified in Chapter 2 came to the fore: AHERF tried to grow via acquisition to become a statewide provider, had no ability to tap equity financing (as would a for-profit), and purchased hospitals with negligible operating cash flow.2 Numerous churches and other religious organizations borrowed too much in the 2000–2010 era, basing their capacity to repay on projected growth of adherents and giving levels, or anticipated asset sales, which never materialized. Largely due to debt-related obligations and a very weak economy with fewer donations of cash or appreciated securities, there were 497 bankruptcy filings made by 454 different religious organizations in the 2006–2011 period.3 Consequently, many banks no longer make church building loans.
Properly used, debt financing may provide an important piece of the expansion funding and financial flexibility that organizations require. Bonds or loans to fund land or building purchases or renovations are prime examples. Lines of credit provide short-term cash needs, when grant or contract funding is delayed, and they also constitute an important component of the target liquidity level in the form of unused borrowing capacity. The American Red Cross applied for and gained approval of a $1 billion line of credit from its banks, tapping a maximum amount of $340 million during one year. It borrowed and repaid various amounts under this line during the year due to the fact that cash outflows temporarily exceeded cash inflows or due to limited ability to mobilize those inflows to the locations where cash outflows are occurring. Many nonprofits find it prudent to have a seldom-used line of credit available from a bank, so that in the event that revenues drop or expenses spike unexpectedly they do not have to cut back on services and payroll.
This chapter provides guidance for an organization that chooses to borrow with short-term loans, long-term municipal bonds, or mortgage loans. The starting point is a consideration of the balance sheet, as your organization establishes its capital structure. We also profile the lender's view on a borrower's creditworthiness. Furthermore, we mention sources of funds that your organization may tap other than through arranged borrowing. Recall from the Lilly study that two out of three of the organizations surveyed never do short-term borrowing, and only one in eight organizations is a perennial short-term borrower.4 Yet all organizations benefit from a knowledge of borrowing alternatives and the borrowing process: Many of these same faith-based organizations have mortgage loans. Finally, in this chapter we discuss different liability, or borrowed fund, accounts, and program-related investments (PRIs).
10.1 MANAGING THE BALANCE SHEET
Your financing decisions, including whether to and how much to borrow, require a context. That context is the target capital structure, or how much of various financing sources your organization shall employ to finance its assets. You should have your philosophy and strategy stated in a debt and hedging policy. That requires another look at the balance sheet, or statement of financial position (SFP).
Every dollar of assets on the balance sheet must be financed with either a dollar of debt (borrowed money) or equity (net assets). As we note in Chapter 9, you should use your balance sheet template to forecast assets, which represent a funding need, out to at least three to five years in the future. Then as you project your statement of activity (SA), you will determine your additional equity capital: To the degree your revenues exceed expenses, you will earn a surplus (change in net assets) that will provide “equity capital” to self-fund your assets. Some of these surpluses you may have set aside as strategic reserves or plant and equipment reserves to use for new programs or expansion and the asset investments that these entail. As a nonprofit may not issue stock, you are limited to this net revenue source of equity capital, whether designated as reserves or not. Any other asset growth will have to be financed by liabilities, or debt. Correspondingly, the upside to using debt is that your organization may grow more rapidly, providing more services, if it chooses to use debt financing.
The main downside to using debt financing is the additional risk to your organization's stability. Financial risk is the possibility that your organization will not be able to meet its fixed, financing-related obligations. We saw examples of this in our chapter-opening examples. One cannot “lay off” interest or principal payments as one lays off workers or cuts back on other discretionary expenses. Arranged borrowing, whether a bank credit line or bonds issued to investors, represents a contractual agreement that must be taken very seriously. Your organization and its stakeholders stand to lose if you are not prudent in your use of debt. Borrowing to cover structural deficits, when ongoing revenues and support are inadequate to cover ongoing expenses, or without planned known repayment sources, constitutes an imprudent use of debt.
10.2 BALANCE SHEET MANAGEMENT: BENEFITS AND STEPS
(a) WHAT CONSTITUTES A WELL-MANAGED BALANCE SHEET? According to Wareham and Majka, a well-managed balance sheet:
- Supports the organization's strategic plan within an appropriate credit context
- Provides the most flexibility, given market expectations and legal considerations
- Reflects the optimal capital framework, given the organization's needs, capabilities, and risk profile
- Provides the lowest overall cost for the risk of the asset and liability portfolios
- Allows for future financing needs5
Balance sheet management requires a six-step approach to qualify as proficient financial management. These steps are:
- Analyze your cash levels and debt capacity – no surprise here. We have emphasized that achieving and maintaining your target liquidity level is your number-one financial objective.
- Assess your capital needs.
- Match capital needs with capital sources.
- Consider alternative capital sources.
- Mitigate risks.
- Monitor the balance sheet on an ongoing basis.6
Let's look at each of these steps briefly.
Step 1, analyzing your cash levels and debt capacity, involves determining days' cash on hand from all unrestricted sources (unrestricted cash plus unrestricted short-term investments plus unrestricted long-term investments, divided by [(total expenses − depreciation expense)/365], the current ratio, the ability to cover debt service (both interest payments and principal repayments), and days' sales outstanding (if your organization has any credit sales). You may wish to refer to Chapter 7 (including the appendixes) for a review on the relevant measures. Debt capacity may be assessed as the ratio of your operating cash flow to the maximum annual debt service (the highest level of payments that your financing source could charge on your financing), the ratio of debt to total capital (arranged debt plus all net assets), or the balance sheet ratio of cash to debt. Days' cash on hand and the ability to cover debt service stand out as the primary indicators that predict the organization's borrowing ability. For example, a lending bank may require that your church have as much as 50% in unrestricted and undesignated cash as a percent of all borrowing obligations.
Step 2, assessing capital needs, includes internal analysis, external analysis, and your capital budget. Your long-range financial plan (see Chapter 9) should have already provided you with a financial snapshot of future years' needs, so we will not elaborate here. The key is to maintain strategic priorities in your financial plans.
Step 3, matching capital needs with capital sources, includes consideration of multiple factors, which are listed in Exhibit 10.1. Primary attention should be given to cost of capital and to covenants. The mainstream approach to cost of capital must be modified to fit nonprofits, as the cost of equity capital is not easily estimated.
Source: Financing the Future Report. Copyright © Healthcare Financial Management Association. Used by permission.
Exhibit 10.1 Checklist of Criteria for Evaluating Appropriate Capital Sources
In Chapter 9 we showed how to calculate net present value (NPV) and return on invested capital (ROIC). The discount rate for NPV, and the comparison rate (sometimes called the benchmark, or hurdle rate) for ROIC, is the weighted average cost of capital. Put more simply, on capital projects that generate revenues or reduce costs, we make the go/no-go decision based on comparing the financial return with the financing costs of the funding required for the investment. To calculate the cost of capital, we take the proportion of financing from a given source and multiply it by its cost, then sum these products. Let's say that your organization has no “permanent” short-term debt (it uses its credit line only occasionally for emergency needs), has issued bonds yielding 6 percent, and has its long-term cash reserves invested at 5 percent. We look at your organization's condensed balance sheet and see:
| Assets | Liabilities and Net Assets |
| | | | |
| | | | |
| | | | |
| | | | |
| Bonds $200,000 | |
| Net Assets $400,000 | |
| Total = $750,000 | Total Liabilities & Net Assets $750,000 |
The formula for calculating the weighted average cost of capital (WACC) is:
Be careful to include in “Total Capital” only your arranged permanent debt financing, including any permanent short-term and medium-term funding (e.g., a seven-year term loan). Here your organization has $600,000 of total capital ($200,000 in bonds plus $400,000 in net assets, or equity). For the cost of net assets, ideally you should be capturing the riskiness of your assets. Since asset risk is very difficult to estimate for most nonprofits, we recommend using a proxy measure called the “opportunity cost of investment.” Technically, this is the rate of return you could earn on long-term investments of similar risk to your assets. Based on the variability of operating cash flows experienced by most nonprofits, we know that the business risk of nonprofits is high, and the required return on net assets (equity) should be correspondingly high.
Since the exact amount of risk of your assets is hard to pin down, you might simply use the long-term investment return you could earn if you invested those funds in a well-diversified stock mutual fund or in your endowment fund (if you have one). Note that this is not the same as the rate of return you are earning on your long-term strategic reserves, which should be invested in relatively conservative investments such as governmental obligations. For most organizations, using long-term stock returns would imply an opportunity cost of investment of around 9 or 10 percent.7 We will use 10 percent for your organization's achievable long-term investment return. Someone may object: “But our equity represents surpluses earned on operations over the years, much of which was based on fundraising, and we expensed all the costs of that fundraising in the past.” Nevertheless, those funds could be deployed in an alternate use to those to which they are being invested (on the asset side of your balance sheet at present), and so using them to fund your assets means that you are giving up the investment return that could be earned on those funds.
Substituting your numbers in the formula, we compute your cost of capital (WACC):
Expressing the cost percentages in decimal form:
In general, your goal is to minimize the weighted average cost of capital. The chief constraint here is to maintain an assured pipeline of financing, which on occasion means you may include one or more long-term sources of funds that cause you to pay more than you would for the minimum-cost mix of long-term capital. One more time, we are made aware that the principal financial objective is not to maximize stockholder value or minimize expenses (including interest expense) in order to maximize profits, but rather to achieve and maintain a target liquidity level. Some healthcare or educational organizations, which could adopt a for-profit status, may view their objectives with an eye toward profitability – and value cost minimization more highly.
Another issue to be careful about is the imposition of covenants when borrowing from a financial institution or when issuing bonds. These normally restrict your organization in some fashion, and may have tough remedies in the event you are not in compliance with one or more of the covenants. A key point to be aware of: In some cases covenants can be negotiated out of loan contracts or bond indentures. Maintenance covenants indicate the financial ratio values or other financial requirements your organization must maintain as long as the debt is outstanding. For example, your organization may need to maintain a certain level of days' cash on hand (creditworthy hospitals typically have eight months or more of unrestricted cash on hand) and have a debt service coverage ratio of at least 1.1 times to be viewed as very creditworthy. Incurrence covenants indicate what events would be viewed as negatively impacting existing debtholders, and therefore your organization is pledged not to initiate. Examples are issuance of additional debt, merging with another organization, or selling specific assets.
Step 4, considering alternative capital sources, addresses the fact that borrowing may not be your first or best funding source. Consider operating cash flows, fundraising, program-related investments (covered later in the chapter) and leasing as alternatives to bank loans or bond issues. The capital investment size, life expectancy (you may be better off leasing equipment that will become obsolete quickly), time-sensitivity, relation to your mission, and expected return all have a bearing on how you might best finance the investment. The effects of the capital source selected on both your cash position (or target liquidity level) and your debt burden are important. A real estate investment trust may buy one or more of your buildings and then lease space back to your organization, enabling your organization to monetize some of its fixed assets and build cash and liquidity. We will return to the topic of alternatives to borrowing in a later section of this chapter.
Step 5, mitigating risks, might include the use of interest rate swaps and other financial derivatives, as interest rate spikes threaten your organization's surplus and cash position. Newly issued bonds may include interest rate swaps, and if you have existing debt, you may use a swap or perhaps an option to enter a swap (“swaption”) as well. We return to this topic in Chapter 14.
Finally, step 6 indicates that setting debt levels and the mix of short-term versus long-term debt are not one-time decisions: You must monitor the balance sheet on an ongoing basis. Here you review changes in asset amounts, current liabilities, long-term liabilities, and net assets. Calculation and review of key financial ratios are essential, along with a look at how these changed year over year. “Get behind the numbers” by interpreting the reasons for those changes. Consider opportunities that may arise, including:
- Have interest rates dropped enough to warrant a look at possibly refinancing? If your organization can reduce its interest rate by 1.75 percent (from 6% to 4.25%) on a $10 million loan balance, the annual savings of $175,000 immediately offsets any prepayment penalty and closing costs that might be incurred and then results in annual savings of significant amounts as you pay the loan down ($157,500 when loan balance is $9 million, $140,000 when loan balance is $8 million, etc.). The River of Life Church in Kent, Washington, saved $30,000 a year in annual debt service and gained a 25-year mortgage in the process (churches often must take five-year commercial loans, and if not able to pay the bullet payment due at the end of five years, find alternate financing).8
- Should we change the mix of variable-rate and fixed-rate debt, possibly through a transaction in the swap market?
- Should we obtain a realized cash gain by reversing a swap?
- Have our financials changed enough to discuss a possible rating upgrade with credit rating agencies (Moody's Investors Services, Inc., S&P Global Ratings, Fitch Ratings, Inc., DBRS Inc., A.M. Best Rating Services, Inc., Kroll Bond Rating Agency, Inc. (KBRA), and Morningstar Credit Ratings, LLC)?9
- Can we match up asset life spans to liability life spans?10
(b) DETERMINING YOUR ORGANIZATION'S DEBT CAPACITY. One of the key considerations in your capital structure decision-making is your organization's debt capacity. One way to assess this is to “back into” that capacity via calculation of relevant financial ratios. Wareham and Majka, of Kaufman, Hall and Associates, suggest a weighted approach to doing this for healthcare organizations that makes sense for many commercial or partly commercial organizations, as noted in Exhibit 10.2.11 For donative nonprofits, scale the “indicated capacity” numbers down, because lenders and investors will be reluctant to finance to these levels in cases where the revenues of the organization come from dues, contributions, endowment income, or grants, as opposed to product or service sales. Typical nonprofit revenues and support sources do not make good sources of collateral, or security, on loans or bonds. Applying this methodology, the example organization has a debt capacity of $57.0 million, as shown on the bottom right of the exhibit. If a zoo is using only $40 million of that in its existing debt, it has $17 million (=$57 million − $40 million) in financial flexibility, or unused debt capacity.
Exhibit 10.2 Calculating Your Debt Capacity
As a final note on balance sheet management, not all of your organization's risks and vulnerabilities are captured on the balance sheet. Potential liabilities arise from many sources. Consequently, we will address risk management in Chapter 14.
We now turn to the specific forms of debt financing that your organization may procure. A liability that gets little attention but that can provide an organization much-needed and interest-free financing is discussed first – accounts payable.
10.3 PAYABLES
Think of the accounts payable function as a source of interest-free financing from suppliers. True, the cost of this credit extension is built into the price of the supplies you are buying. Correspondingly, the seller expects you to take advantage of the credit period offered. Common terms are “net 30,” meaning the full amount of the invoice is due and payable 30 days after the date of the invoice. For many businesses, accounts payable are the single largest source of financing used. However, our Lilly study revealed that a minority of nonprofits still think it is commendable if they “pay the invoice the day it hits our desk.” Such a policy is simply an unwise use of scarce cash resources. Pay on time, but not early.
It is unethical to “stretch payables” to wring more financing out of one's suppliers. Stretching payables may be the most common unethical practice in corporate America. It is unethical both because one has agreed to pay invoices at the stated terms when beginning to buy from the supplier, and because the buyer is in effect borrowing more from its suppliers without their knowledge or approval. Each dollar of extra interest income put in one person's pocket is taken out of another's pocket – the supplier's. If you foresee problems paying invoices on time, contact your supplier, explain the situation, and ask the supplier for additional time – making sure to communicate your willingness to pay and your proposal for how and when you will pay.
Some credit terms are stated like this: “2/10, net 30.” This means a 2 percent cash discount is being offered if the bill is paid within 10 days of the invoice date, or the full amount of the invoice may be paid in 30 days. Should you take the cash discount, paying $98 per $100 invoice amount in 10 days? Almost invariably, the answer is “yes.” You are giving up a 37 percent rate of return by foregoing the cash discount. This is demonstrated in the following formula:
This formula is used to estimate the cost of a foregone discount (the rate of return you could have had if the cash discount was taken) with 2/10, net 30 terms:12
Surprisingly, many of the nonprofits surveyed in the Lilly study indicated they either chose to or had to forgo cash discounts some or most of the time. Such a policy is unwise – you would be better off using some of your short-term credit line, if necessary, to have the funds to take the discount. The preference for borrowing to take the discount applies as long as the annual interest rate of the credit line is less than the cost of the foregone discount – 37.24 percent in our example. We underscore the wisdom of applying for a credit line with your financial institution, if you do not already have one. If you have been operating for two or more years, have annual revenues of $200,000 or better, and ran a surplus in your most recent year, you are a strong candidate for credit line approval.
10.4 SHORT-TERM BORROWING
A nonprofit might borrow money for eight reasons:
- Borrowing is much faster than grants or fundraising for bringing money into the organization, with funds made available within days or a few weeks.
- Borrowing can stabilize the organization's cash flow and compensate for temporary revenue shortfalls. For example, borrowed funds can be used to meet payroll when in a temporary cash crunch.
- Borrowing can prevent costly delays in starting new projects. This “bridge financing” is an important role for borrowing. Government agencies at the state and local level issue bond anticipation notes for this purpose.
- Borrowing can increase earned income by speeding up the start of a revenue-generating project. Getting income-producing ventures off the ground may necessitate start-up financing or financing to fund the expansion of the new venture.
- Borrowing can help consolidate bills. The idea here is to enable the organization to take cash discounts or maintain good supplier relationships (by enabling your organization to pay on time).
- Borrowing can initiate or build on long-term relationships with financial institutions. Individuals know the value of an established credit history, and the same holds true for a nonprofit organization.
- Borrowing can help improve the organization's financial management. Financial institutions require financial reports with a fair amount of detail and the calculation of key financial ratios. Organizations that previously managed without key financial data will be pressed to improve their financial and accountability structures.
- Borrowing can help the organization achieve independence. By replacing restrictive donations or grants/contracts, the organization may be freed to pursue the mission it is called to accomplish. The flip side is that your organization may be limited via restrictive loan covenants placed on you by the financial institution. Limiting the borrowing and keeping the loan payments current will enable your organization to avoid becoming the “servant to the lender.”13
Some nonprofits shun debt, with the justification being that they do not pay interest to solicit donations or grants. However, there is a cost to raising funds through donations and grants. Let's say that $100 is raised for every $10 spent. That amounts to a 10 percent interest rate if $10 is taken as “interest” and $100 as principal. The main difference, of course, is that the donation funding stream must be renewed every year, while the borrowed funds are there until “maturity” – which is when the organization must make the principal repayment on the borrowed funds. (You may opt to pay early on principal or pay down revolving credit line draws in order to save on interest expense.) Our point is that there is a cost of funds, regardless of how you acquire them.
Planning for short-term borrowing must take place within the context of the organization's overall strategic planning process (see Chapter 3) and long-range financial plan (see Chapter 9). Otherwise, borrowings may cost more than they should or funds will be borrowed on the wrong terms, or both. We shall develop the specifics of short-term borrowing in Section 10.10.
10.5 STRATEGIC FINANCING PLAN
Financial managers have two different ways with which to plan and manage an organization's debt and capital structure: (1) the at-whatever-price theory, and (2) the strategic planning theory. The at-whatever-price theory is related to the traditional supply-and-demand concept and is based on the belief that any financial manager can raise enough capital to do business if there is sufficient pressure placed on the potential lender.
Under the at-whatever-price theory, capital is like any other commodity: The greater the need, the higher the cost. Unfortunately, this theory suggests that the most advantageous time for an organization to borrow money is when it does not need to borrow money, and the most advantageous time being when borrowing is least expensive. In some cases, such “market timing” financing can be attractive. It can be less expensive and less restrictive than financing under more pressing circumstances, for instance, when the organization has an acquisition target in mind, has committed to a major construction project, or needs to purchase a major piece of equipment. Bankers are then aware of the urgency of the need to obtain money and may be inclined to dictate stiffer terms.
The more advantageous financial approach is to make capital and debt management crucial parts of the organization's strategic planning process. In fact, capital and debt management should be accorded as important a place in strategic planning as revenue projections, business model changes, cost containment programs, community marketing programs, and expansion plans. If capital and debt management is part of an organization's strategic planning process, its long-range goals and objectives can be considered under all types of financing options.
The basis for your strategic financing plan for financing are your organization's strategic plan, discussed in Chapter 3, and its long-range financial plan, which we discussed in Chapter 9. A strategic financing plan should be a specific statement of your organization's financing goals and in accord with your organization's debt policy. A financial manager must become a team member when it is time to establish a plan for the organization's capital and debt strategy. By assisting in this aspect of the strategic plan in advance, your financial manager can ensure that your organization obtains financing on the most favorable terms.
Most important, when setting a strategic financing plan, your organization must ensure that the plan dictates financing requirements; financing requirements should not determine the plan. The plan must include considerations of the organization's present assets and debt, internal funding sources, and management's expansion goals. Other pertinent factors to consider regarding the organization are:
- Mission or charter and bylaws
- Financial and operational goals
- Market and competitive analyses
- Business model
- The target liquidity level
- Debt policy (see Section 10.13)
- Strategies for achieving goals and objectives
No strategic financing plan can answer every question. There is always uncertainty about future business conditions, changes in the competitive environment, government regulations, information technology and other technological advances, and new service delivery techniques. A good plan, however, will include various scenarios, thus adding a degree of flexibility.
The nonprofit organization must develop a strategic financing plan and a debt policy to ensure its long-term financial health. The absence of identifiable shareholders does not relieve your financial manager from operating the organization as a business and strategically planning its financial health. A nonprofit organization exists to serve members of the public, who are its very real, although anonymous, shareholders. Failure to maintain financial health over the long term is the death knell of all organizations, public or private – as the Hull House overuse of debt reminded us in 2012.
(a) BORROWER'S STRATEGIC FINANCIAL OBJECTIVES. Answers to these questions will begin the process of identifying your institution's strategic financial objectives:
- How much risk is your management willing to take for various financing alternatives?
- How much interest can your institution afford?
- Does your institution intend to provide collateral to the lender, such as physical assets or your short-term investments or bonds or stock, which the lender could take possession of in the event the loan is not fully repaid?
- Can another party provide a guarantee to secure a loan?
- What type of covenants and restrictions is your management willing to allow?
- How much control does your management want to retain?
- What limitations in other agreements must your institution consider when pledging assets as collateral?
By answering these questions, you can help to clarify the organization's current financial status and to determine the direction in which your management team is moving or wants to move your organization. The answers also help specify financing sources and keep short-term strategy consistent with long-term capital management objectives. The answers also help shape your debt policy (see Section 10.13).
(b) BORROWING REQUIREMENTS. A strategic financing plan should evaluate short-term borrowing requirements. Lean periods never can be fully anticipated, so an institution always requires a contingency plan that may include short-term borrowing to tide it over until cash flow resumes. Before a plan can be developed, however, the financial manager must monitor and understand the elements of your organization's cash flow. Cash flow should be forecasted and monitored on monthly, weekly, and daily bases.14 When studying cash flow, these factors should be considered (refer back to Chapter 8):
- Seasonality of revenues
- Collection periods and timeliness of disbursements
- Regulatory changes and economic trends
- Contingency plans
Seasonality of revenues can have a tremendous impact on your organization's short-term borrowing requirements. By looking at historic seasonal revenue patterns, your financial team can obtain part of the picture needed to plan borrowing strategy. Additionally, you must monitor and measure the lag time between the provision of services and the collection of revenues (whether from donations, grants, or fees charged) as well as predict the amount likely to be collected. Your collection pace on receivables, when slowing, may dictate that the institution arrange a larger credit line to see it through the lean months. By analyzing your organization's cash flow, the financial manager can anticipate this situation and plan accordingly.
10.6 STEPS TO SUCCESSFUL BORROWING
Management will be ready to approach potential financing sources after determining strategic objectives and developing a forecast that indicates the amount of money needed, when it must be borrowed, and when it can be repaid. If the need is within the next 12–18 months, the cash forecast will be of paramount importance (see Chapter 8). If the need stretches out from 2 to 30 years, the projected financial statements will be required (see Chapter 9). Before any financial source is approached, however, financial managers must understand:
- Debt and what borrowing involves for the organization
- The loan approval process
- The various short-term borrowing alternatives
- The suitability of financing sources versus strategic objectives
- The preparation and presentation of a loan request
(a) UNDERSTANDING DEBT. Debt is a way of life for most consumers and business organizations. It is interesting to note that borrowing and investing are two sides of the same coin. “Capital” can be defined as the resources that an organization needs to attain a financial objective. There are two broad categories of capital: equity and debt. Equity is money belonging to the organization, and debt is money belonging to another person or organization. Borrowed funds carry the borrower's obligation to repay the debt, and lenders furnish money for the sole purpose of earning more money. Our references to the characteristics of equity, or net assets, are to provide a basis for comparison.
(i) Risk-Reward Trade-Offs. Debt capital, in the form of financing received from a lender, generally is priced in terms of an interest rate. A nonprofit founder or donor contributing capital requires an in-kind return, namely service provision in line with the organization's mission – but no interest is charged or other financial return expected.
An important element in the pricing of debt is the relationship between risk and reward: The greater the risk, the greater the reward. The lender or bond investor is willing to risk the possible loss of money in return for monetary rewards. The “junk,” or high-yield, bond market that developed during the 1980s illustrates the lender's perspective. An organization that wants to issue long-term bonds but that does not have an investment-grade rating (the top four creditworthiness rating categories, AAA, AA, A, and BBB in Standard and Poor's framework, are considered investment grade) must issue noninvestment-grade bonds and pay a higher return to attract the needed funds than would an investment-grade company. This same relationship holds true when tax-exempt bonds are issued by charities. When managing debt, a financial manager must assess the level of risk that the organization presents to a financing source, the resulting availability of financing, and the cost that the financing will carry. Return to the bond investor or lender represents cost to the borrower.
(ii) Leverage. Leverage is defined as the use of another person's or organization's financial resources. The more leverage (the greater the proportion of debt to equity, or net assets) that an organization has – the greater the risk to the organization and to the lender that the organization will be vulnerable to the impact of external factors. So think of equity, or net assets, as a cushion for the lender or bond investor. The effects of external factors, such as recessions, unemployment, and interest rates, are magnified by leverage, sometimes positively and sometimes negatively.
The amount of leverage that a nonprofit organization can take on without risking future loss of control to the organization's lenders varies. For example, in the nursing home and home healthcare industries, markets must be served; lenders can be instrumental in forcing changes where existing management demonstrates lack of ability. Where the market already is well served, lenders are usually inclined to limit their losses by simply closing down an inefficient or ineffective business. Financial managers can get a good idea of where they stand in the eyes of a lender familiar with the nonprofit industry by studying the financial statements of other nonprofit organizations in similar service arenas. Doing this will also assist financial managers in determining the financial alternatives available. Illustrating, it is much easier to be approved for a short-term loan or credit line if the nonprofit offers collateral such as inventories or receivables in the form of government contract payments (although this might be arguable in some states where government fiscal irresponsibility has severely slowed payments), tuition payments, or grant proceeds. Absent these normal forms of short-term loan collateral, some nonprofits borrow using a personal guarantee from a manager or board member or using the building as collateral. Nonbank sources of loans, including loans from board members, may fill in the gap when bank sources are unavailable.
(b) LOAN APPROVAL PROCESS. It is essential that financial managers understand what lenders and bankers consider important in making decisions to provide financing. The decision to lend capital may be partly emotional based on the personalities of the lender and the borrowing organization's officers. Before your financial manager attempts to make a presentation to a lender, he or she should have some idea of the type of personality who will be sitting across the table. Although the stereotype of the banker-lender is not a totally accurate gauge, it does point out some common traits that lenders share. Lenders tend to be conservative, cautious, and pessimistic. They will look at what is wrong with a borrowing proposal and appear to exclude what is right. If a bank makes $100 million of uncollateralized short-term loans at an average interest rate of 5% per year, and only one in 20 (5%) of the borrowers default and do not make payments in the current year, the bank has effectively earned nothing on its loan portfolio for that year.
(i) Basic Preparation for a Loan Presentation. In order to be successful in obtaining financing, a financial manager must distinguish the institution's presentation from all others that lenders evaluate. The financial manager should also try to discern what the lender already emotionally believes about the deal and attempt to reinforce a positive belief and reverse a negative one. To be effective, a financial manager should be aware that lenders, too, think in stereotypes about nonprofit organizations that seek financing. They perceive nonprofit officers who make financial presentations as generally unprepared, hopelessly optimistic, and out of touch with economic reality. When presenting a loan proposal, therefore, the successful financial manager should demonstrate better preparation, greater knowledge about the organization and its financial prospects, and better capability of repayment than any other customer who approaches the lender.
The financial manager can assess the level of preparedness to make a loan proposal by addressing these questions:
- Why would a nonprofit organization borrow money?
- What does a lender want to know immediately?
- How does a lender evaluate a loan proposal?
- How does a borrower generate funds to repay a loan?
- Under what reasonable circumstances would a lender agree to refinance a loan?
None of these questions is particularly easy, but the right answers may very well predict the success of a loan proposal.
(ii) Reasons for Borrowing. The reasons why a person or organization does something are important. Knowing the reasons and, more important, explaining them quickly are crucial when a financial manager must persuade a lender that the nonprofit organization deserves a loan. The three essential reasons for borrowing are to:
- Buy an asset
- Pay an expense
- Make an acquisition
Knowing those reasons, however, is not sufficient. Financial managers also must know how different lenders view these reasons. For instance, leasing firms financing equipment purchases have no interest in funding other investments. Banks are more interested in providing short-term working capital financing for seasonal needs and modest longer-term financing for equipment and construction.
(iii) Immediate Concerns of Lenders. The immediate concerns of a lender are important because they generally dictate the terms and conditions of the loan. These concerns include:
- How much money do you need to borrow?
- How long do you need to keep the money?
- What do you need the money for?
- How do you plan to repay both the principal and the interest?
- What contingency plans do you have in case your intended source of repayment does not work?
The most important of these questions, of course, are the last two, your repayment method and your contingency plan. Above all, your management team must be able to show a lender how the loan will be paid back, in scenarios of both expected conditions and unexpectedly negative circumstances.
(iv) Evaluating the Application. All lending decisions are based on the same classic set of factors known as the “5 Cs of credit”:
- Character of management. This measures the willingness to pay.
- Capital available to the organization. This typically is measured as the amount of net assets on the balance sheet.
- Capacity to earn operating cash flow to repay the loan.
- Conditions of the market. This includes the economy, the borrower's industry, and the local client/customer/donor marketplace.
- Collateral that the borrower has available to pledge. For short-term loans, this is typically accounts receivable or inventories, but for many nonprofits, the only receivables that might be acceptable would be those related to grants or contracts.
Of these factors, the two more critical are the character of your management, which may account for as much as 80 percent of a lender's evaluation, and your organization's cash flow. If one of the other factors is inadequate, a borrower can usually obtain the loan, although the source of financing, the approach to obtaining it, and its interest rate may be altered. The borrower will not be able to raise external capital, however, if there are deficiencies in either the character of management or the organization's cash flow.
(v) How Lenders Are Repaid. There are four ways to repay lenders:
- Use net revenues and cash flow.
- Borrow more money.
- Find another lender.
- Sell existing assets.
Borrowing more to repay a loan is often acceptable, but it can be an expensive proposition. Selling assets also can be acceptable, especially as part of a contingency plan, but the best way to repay a loan is to generate cash flow. Consequently, a financial manager is wise to keep borrowing plans confined to the capacity of the organization to generate sufficient cash flow to repay the loan within a reasonable period. Lenders much prefer this method of repayment, even when they tell you they insist on having collateral to back up their loans. They would much rather not have to think about seizing and selling that collateral, especially given the public relations problems that action can cause the lender when foreclosing on a charitable institution. Furthermore, the collateral – such as a church building – may be a “limited use” asset that has questionable market value due to there being few potential buyers.
(vi) Refinancing. Barring a decision to restructure a borrower's total debt, perhaps to save on interest expense due to declining interest rates, a borrower seeks to refinance loans for either of two reasons: The original plan did not work, or the borrower did not use the money for the intended purpose. No lender is sympathetic to a borrower who did not use the money for the purpose stated in the loan proposal. Most lenders, however, understand that not all business plans work as intended. The fact is that most business plans do not work as originally intended, but they do work after they have been modified. Lenders understand that planning is a dynamic process and that flexibility is part of it. Therefore, business plans that did not work as expected are generally considered valid reasons for lending more capital.
(c) ALTERNATIVE SOURCES OF SHORT-TERM FUNDS. Before a nonprofit organization commits itself to borrowing money, it should look within. Often there are internal sources of funding that are not immediately apparent. Indeed, one of the objectives of making debt and capital management part of the institution's strategic plan is to identify such internal sources of funds before management seeks funding from outside. Five primary internal financing sources, along with methods to use them, are listed next.
- Aggressive working capital management (see Chapter 11):
- Improve collection practices.
- Extend terms of payables (within terms or with explicit supplier approval).15
- Reduce idle cash (but only modify target liquidity level after careful analysis).
- Sell unneeded or nonproductive assets.
- Existing operations:
- Increase service fees (subject to competitive conditions).
- Charge for services previously provided free.
- Increase marketing effort for donations and grants (this takes time).
- Reduce operating costs.
- Sell fixed assets unrelated to core mission.16
- Sell and lease back (“monetize”) fixed assets related to core mission.
- Short-term investments:
- Liquidate securities (see Chapter 12; if balances were part of target liquidity level, quickly replenish those after funding need has been met).
- Overfunded pension plans:
- Seek to recapture assets in the plans for the institution's use.
- Change in business structure or business model:
- Consider new means of service delivery or greater use of volunteers. Search for those with lower fixed, annual costs.
- Increase investments in technology to achieve cost savings.
- Seek strategic alliance partnerships and joint ventures with other service providers (see Chapter 9).
These internal alternatives will not meet the needs of all organizations. The financial manager is then faced with a long list of creative financing alternatives. Consider, for instance, these financing possibilities for a nursing home or home healthcare agency. It could:
- Obtain a bank loan, either secured by assets (or in a truly desperate situation, we have seen board of directors' personal guarantees as security) or unsecured.
- Sell accounts receivable without recourse. (The nonprofit does not have to stand behind sold accounts that prove to be uncollectible.)
- Sell accounts receivable with recourse.
- Securitize accounts receivable for offering in public or private markets.
The differences among these short-term financing alternatives lie in the source rather than the particular use of the funds, and they are based on the criteria that a lender considers when making a loan decision. There are three basic criteria:
- How much debt capital must be raised?
- How long a term does the borrower need to repay the loan?
- What return will the lender receive for the loan?
10.7 MATCHING FINANCIAL SOURCES TO STRATEGIC OBJECTIVES
It is difficult to match the best capital source to the strategic objectives of a nonprofit organization; few financial alternatives provide perfect matches. When attempting to match financial sources to strategic objectives, however, financial managers should:
- List the strategic objectives in the order of their apparent levels of priority.
- Summarize in writing the alternative choices.
- Seek advice from consultants or others who are involved in matching strategic planning and financial sources.
- Consider the decision carefully and preferably without pressure of time.
The first two items listed force your management team to focus on the organization's critical issues, because they involve ranking objectives. By reducing these issues to a one-page summary, you can identify the major financing alternatives. Doing this requires that the major advantages and disadvantages of each alternative be considered. It can be helpful to develop a scoring system to rate financial alternatives, although such a system is only as good as the idea behind it.
The time criterion is also particularly important. Making a final decision a day or a week after completing the list of alternatives is generally a good idea. This provides your financial manager time to reflect on the institution's strategic objectives and whether the alternative choices meet them. All alternatives should be thoroughly evaluated before a decision is made. Yet delay in the name of perfection can be counterproductive. A financial manager can delay a deal so long that interest rates rise before a choice is made. Financial markets also lose interest when they believe that management is only shopping around and is not serious about a deal. It is good to generate competition among financing sources, but not to the point that the borrower is paralyzed and unable to meet its objectives in the most effective manner.
10.8 PREPARING THE FINANCING PROPOSAL
After the financial manager has determined what type of financial source is best to meet the institution's particular short-term capital needs, it is time to obtain the financing. The basic tool for this task is the financing proposal package. The financial manager uses this document to present the institution's “story” as well as to anticipate and answer all questions posed by the lender. Of utmost importance in telling that story are the five criteria essential to all lenders, beginning with the character of organization management (see Section 10.6, “Steps to Successful Borrowing”).
(a) TERM SHEET. One of the most important parts of the proposal is called the “term sheet.” In this part of the plan, the financial manager must answer the five basic questions a lender will ask: how much, how long, what for, repayment plan, and contingent repayment plan.
(b) PLAN OVERVIEW. A financing proposal must contain a brief overview of the plan. Bankers and other lenders tend to make decisions quickly. Review committees, for instance, generally rely on a subordinate's summary and recommendation when evaluating loan requests. A review committee may spend only two or three minutes looking at what took weeks, even months, for a financial manager to assemble. As a result, when a business plan is turned into a proposal, it must include an “executive summary.” This should be the most sparkling part of the package.
The overview must describe the essential nature of the organization's service offerings, list its major services, and characterize its management people. The overview focuses on facts, but the facts should be presented in such a way that a potential investor – that is, after all, what a lender is – gets a positive emotional feeling about the institution.
(c) PRESENTATION CONTENTS. The overview can be supplemented with marketing brochures, testimonials, and perhaps even a video presentation to enhance the written word. A full set of financial statements for three years is essential. The financial statements will be used to evaluate the risk of the proposed loan and determine the terms and conditions of any financing deal. The statements should be supplemented with explanations wherever appropriate. For example, the statements of some nonprofits contain quirks that may confuse a lender unless they are explained. When dealing with a lender who is basically unfamiliar with the healthcare field, for example, some explanation of reimbursement methods and the handling of unreimbursed charges is desirable so the lender can understand the inevitable write-offs of receivables. This explanation should extend to both the balance sheet and the statement of activities.
Nonprofit business plans also need to cover the basics of an organization's operations: Delivery of service, marketing, and accounting/finance. The plan should show how the desired financing will enhance these areas. However, the projections should be realistic. Lenders often believe that a borrower is hopelessly optimistic, and aggressive revenue projections will make them even more skeptical. In fact, it is always better for management's position if actual operating results turn out to be higher than anticipated by the projections, rather than using forecast figures that are too rosy. If management really does believe that revenues will grow by 200 percent over five years, however, then substantiating information should be included in the plan along with documentation showing why the projections are realistic. Detail is crucial in a business plan. Any error in calculations, for instance, can threaten a plan's credibility; it gives the impression of sloppy management.
10.9 MAKING THE PRESENTATION
Even more important than a detailed business plan is the ability to communicate it with confidence and forcefulness to potential lenders. Your financial manager and board treasurer may not think of themselves as salespersons, but that is exactly what they are when they represent the institution that requires financing. They must sell the entire organization, its operations and service delivery processes, plans, and creditworthiness. Having the would-be borrower ask questions during the presentation is an excellent technique as it focuses the presentation on the needs of the audience, the potential lender. A pointed presentation is important, because it shows that the organization has thought out its financing needs. This distinguishes it from other organizations competing for the same scarce financing dollars.
(a) IMPORTANCE OF QUESTIONS. Questions can be the most effective tool for your financial manager in preparing and making the presentation. They provide valuable information and allow the financial manager to focus the presentation. Close scrutiny is avoided until the financial manager has all the necessary information to test assumptions regarding the audience, confirm suspicions, and figure out what the lender considers important, before making the actual request for financing. Consequently, the financial manager is better able to handle objections. It is surprising how good questions will keep the mood relaxed and the conversation flowing.
Financial managers should not feel inadequate when they ask about the lending and loan approval process. Each lender does things a little differently. A financial manager should also ask for a copy of the financial analysis the lender performed on the institution. The analysis can provide valuable information the next time financing must be sought. Asking questions about the process will also show that the borrower is more sophisticated and thus a better credit risk.
(b) ANSWERING OBJECTIONS. No matter how controlled and tightly organized the presentation may be, objections will arise and the financial manager will have to answer the lender's questions. Further questions by the borrower can be excellent answers to lender questions. For instance, if the lender's major objection focuses on collateral, the financial manager might ask, “Isn't it the case in bankruptcy that legal fees cause liabilities to increase while the value of collateral generally decreases?” The financial manager might further ask, “Doesn't the organization's real value lie in its ability to generate cash flow rather than its present holdings of assets?” (It does.) And “In a bad loan situation, does the amount of collateral really make much of a difference?” Almost any objection can be handled by turning it around with a simple question. By understanding the motive of the lender in making an objection, the financial manager can gauge what response will be most appropriate.
The importance of questions does not end with the presentation and objections. Questions are even more important when a loan has been turned down; they may even be able to salvage a rejection or make it easier to obtain financing from the same source the next time around. Potential questions should be designed to discover why the proposal was declined, where such financing could be obtained, what would make this financing more attractive, and how the lender who turned down the proposal would respond to inquiries from other lenders. As with the other questions, this information can provide feedback that will help in the next presentation.
(c) PERSONALIZING THE PRESENTATION. Finally, anything that will personalize the presentation will usually work to a borrower's benefit. It is also helpful for the financial manager to invite a representative of the potential lender to tour the nonprofit institution's facilities before the presentation. This will get the lender more emotionally involved with the institution and more concerned about its future success. It also provides a more personal and relaxed atmosphere to make initial contact with a lender. The key to obtaining a loan is to connect emotionally with the lender, to persuade the lender that the institution's success is the lender's success as well.
10.10 OTHER FACTORS IN BORROWING/LENDING DECISIONS
Borrowing and lending decisions would be easy if the loan criteria just listed were as straightforward as they sound. A financial manager would then choose the alternative that raises the most capital at the least cost over the longest term. Unfortunately, however, one alternative generally raises the most funds, while another has the longest term, and yet a third costs the least. The lender's decisions also would be more mechanical if each element to be considered were based merely on its own merits. Intangible factors, however, often complicate borrowing and lending decisions. These factors include a number of questions involved in loan evaluation:
- Is the transaction flexible enough to be structured to meet the organization's financial needs?
- Does the borrower have confidence that the lender will be able to complete the transaction?
- Can the deal be documented and negotiated within the borrower's time frame?
- How complex is the legal documentation?
- Can the borrower afford the front-end fees associated with the transaction?
- Will the borrower be able to cancel the deal if circumstances dictate, and how much will it cost to do so?
- What requirements does the lender have for credit support?
(a) BORROWING FROM THE BANK. Nonprofits borrow short term for seasonal working capital, to cover abrupt changes in payment patterns or unexpected expenses, and when net revenue is not adequate to support continued operations. Banks traditionally have provided most of the short-term and medium-term loans for nonprofits.
About half of short-term bank loans are unsecured (usually in the form of a line of credit), and the others are secured (where collateral is required to ensure an adequate secondary source of repayment; these may be single-payment loans for lines of credit). Like small businesses, nonprofits have found bank lending officers more favorable when a long-standing relationship is in place, as the bank's comfort level with the character of the borrower and likely sources of repayment will be higher.
The following survey of bank credit and credit-related services notes the major domestic and international services offered, and concludes by talking about some lending trends.
(i) Domestic Short-Term Bank Loans. Bank lending alternatives are best described in terms of their maturities, or how long they allow borrowers to use the money. The shortest-term lending generally takes the form of a line of credit, which allows the organization to borrow up to a prearranged dollar amount during the one-year term. The maximum amount may be capped as some percent of your accounts receivables or of your grant commitments. Credit lines may be established on an uncommitted or committed basis, and they sometimes have the added feature of overdraft protection. They are typical “revolving,” allowing your organization to borrow, pay down, borrow some more, and pay down as it chooses during the year. Examples of when credit lines are especially valuable include eras when states or other funders are slow to pay their obligations. In 2015, numerous banks saw increased applications and/or drawdowns of credit lines by nonprofits when states such as Pennsylvania had budgetary impasses. Almost 60% of 280 nonprofits in Pennsylvania tapped existing credit lines and 42% of nonprofits said they were unable to get an additional credit line (United Way of Pennsylvania).17 The YWCA tapped a $1.1 million credit line to get the organization through the next three months, along with freezing hiring other than emergency hires.
An uncommitted line of credit is technically not binding on the bank, although it is almost always honored.18 Uncommitted lines are usually renewable annually if both parties are agreeable. These informal arrangements are appealing to organizations that only rarely need to draw down the credit line, maintain a consistently strong financial position, and like the fact that uncommitted credit lines do not normally require a fee to be paid on unused balances. The only charges are interest on amounts borrowed. Banks like the flexibility offered by such arrangements, which free them from providing funds in the event of deterioration by the borrower or due to capital restrictions being imposed on the bank by federal regulators. Some banks will charge a nominal fee for making the funds available. Example: A 15-year old human services nonprofit in the Midwest has $2 million in assets and almost that much in revenues. It obtained a $100,000 credit line with a bank, with collateral being all assets of the organization and an interest rate of “Prime plus 0.75%.”19 It has not drawn on the amount at this point, but keeps the line available as part of its target liquidity (ALT). It is charged $150 per year for the line (plus interest, on a daily basis, if it draws down any amount of the line).
A committed line of credit is a formal, written agreement contractually binding the bank to provide the funds when requested. Committed lines usually involve commitment fees of up to 1 percent of unused balances. Whether uncommitted or committed, an overdraft credit line has the added feature of being automatically drawn down whenever the organization writes a check for which it does not have sufficient funds. The treasurer is thereby delegating to the bank the need to carefully monitor disbursement account balances and to fund it when necessary. We caution that both uncommitted and committed lines are less than completely reliable as funding sources, as banks can determine not to fund under a line due to a “material adverse change” in your organization's financial health.
A noteworthy trend regarding credit lines is the rapid growth of the standby letter of credit, which guarantees that the bank will make funds available if the organization cannot or does not wish to meet a major financial obligation, such as a very large purchase.
The second type of bank financing is intermediate term. The two major forms of intermediate-term bank financing are revolving credit agreements and term loans. A revolving credit agreement, or “revolver,” allows the borrower to continually borrow and repay amounts up to an agreed-upon limit. The agreement is annually renewable at a variable interest rate during an interim period of anywhere from one to five years. At the end of the interim period, the agreement generally is converted to a term loan for a period of years. The key advantage to the borrower is assured credit availability for the life of the agreement, regardless of overall economic conditions and credit availability. Like on a committed credit line, the bank will charge a commitment fee on unused amounts of revolvers, along with interest on drawn-down amounts. Revolving credit agreements are usually unsecured.
A term loan is simply a loan made with an initial maturity of more than one year. Maturities for bank-originated term loans range from over 1 year to 10 years. Like revolving credit agreements, they involve an extensive written loan agreement and an in-depth “due diligence” analysis of the organization's management and financial position. Term loans are generally repaid in equal monthly or quarterly payments and may be fixed or variable rate. Nonprofit organizations use term loans to replace other loans or to finance ongoing investments in working capital, equipment, and machinery. The main advantage is that they provide a stable source of funds.
Some secured bank loans are a form of asset-based lending. Like any collateralized lending, such lending has a claim on an asset or group of assets, ordinarily receivables or inventory that could be easily sold if the borrower defaults on the loan. The difference is that while most conventional lending relies on the cash flows from the overall business for repayment, asset-based loans are offered based on anticipated cash flows arising from the sale or conversion of a specific asset or group of assets, such as inventories. These loans are especially attractive to small, growing organizations that may only qualify for this form of borrowing and whose management is willing to pay the higher interest rate necessary to compensate the bank for continuous monitoring of the asset serving as collateral.
One final borrowing-related service that many banks offer is a swap. In its simplest form, an organization engaging in a swap exchanges a fixed interest rate obligation for one that has a variable, or floating, interest rate. Nonprofit organizations that qualify for a lower variable rate spread (the amount of extra interest the organization must pay over and above the bank's cost of funds is lower on variable rate loans than on fixed rate loans, or perhaps the bank does not wish to make a fixed rate loan) might enter into a variable to fixed rate swap to eliminate the risk of rising interest rates and the resulting higher monthly payments. Banks usually serve as the opposite side on the swap, called the counterparty, but they may later find another counterparty that wants to make the opposite exchange.
(ii) International Short-Term Bank Loans. The nonprofit organization operating in multiple countries must consider a more complex set of bank lending services because operating abroad introduces the treasurer to different economic and banking regulations, the uncertainty about how exchange rates will change in the future, and new customs and cultures. US-headquartered banks provide a valuable service simply by introducing the treasurer to foreign banking officers and to the different payment systems that will be encountered. In addition, three major lending services are offered internationally:
- Documentary credit
- Asset-based lending
- Traditional forms of bank lending
Banks doing business abroad, whether US or foreign banks, offer various forms of documentary credit, including sight and time drafts, bankers' acceptances, and letters of credit. The sight draft is a formal, written agreement whereby an importer (drawee) contracts to pay a certain amount on demand (“at sight”) to the exporter. The bank is not extending credit but simply helping in the payment process by receiving the draft and presenting it to the drawee. A time draft does involve a credit element, because the payment obligation agreed to by the drawee is designated as due at a specified future date. A bankers' acceptance is a time draft drawn on the buyer, whose bank agrees to pay (accepts) the amount if the buyer does not. In essence, the bank's creditworthiness is exchanged for the buyer's, and there is an active secondary market where these acceptances are traded. The bank charges the buyer a fee for this service. Related to this, a short-term acceptance facility allows the selling firm to initiate drafts (bills of exchange) against the buyer's bank instead of against the buyer, which can be discounted at the bank.20 This facilitates foreign trade, but in the United States and United Kingdom it also is used to finance working capital needed to conduct domestic trade. A commercial letter of credit is a guarantee of payment by an importer, made by its bank, which becomes binding when the shipping and other documents related to the goods sold are presented to the bank. Exporters appreciate the bank guarantees involved in acceptances and letters of credit due to the lack of information about foreign customers, as well as the shifting of the complexities and costs that might be involved in collecting on unpaid accounts. Note that most letters of credit used in international business are unconditional, differing from the standby letters of credit we discussed earlier.
Banks increasingly are getting involved in international asset-based lending. As with domestic asset-based lending, lending is done mainly by banks and commercial finance companies, with the collateral and source of the cash flows counted on for debt service usually being inventories or accounts receivable. Asset-based lending has been utilized in the United States for some time, and with the growing unification of European economies, most observers anticipate asset-based lending to expand rapidly in Europe. Banks based in the United States hope to capture a large share of the European secured lending volume.
There also are several traditional forms of bank lending abroad. Nonprofit organizations are offered overdraft services that are renegotiable each year, may be secured, and are generally based on some percent above the bank's base rate. For example, a strong organization might be charged 1 percent above the base rate, which is often the London Interbank Offered Rate, or LIBOR. Whether the bank uses LIBOR or not, the base rate is reflective of that bank's cost of funds. Organizations are prohibited by law from overdrafting demand deposit accounts in the United States, although banks have permitted intraday (“daylight”) overdrafting (debits to a checking account when it is known that offsetting credits will come later that day).
Another standard lending service seen abroad is an advised line, which is very similar to a credit line in the United States. This involves unsecured lending of up to one year in maturity, available on short notice to the borrower. The rate is somewhat less than would be the case for overdraft services, but is still calculated from the base rate.
The foreign parallel to the term loan is called a committed facility. The bank charges a fee to compensate it for agreeing to lend upon request for a period of five to seven years. Loan terms and conditions, including whether the funds made available will be in the home currency or some other currency, and the formula for calculating the interest rate, are described in a written agreement.
Our discussion of international bank services up to this point fits the major industrial economies of the world but not developing countries. Recent survey evidence suggests that most undeveloped countries do not yet have connections to the major global cable and payment settlement mechanisms, making it almost impossible for nonprofit organizations operating in those countries to tap international financial lending sources for domestic borrowing.
(b) TRENDS IN SHORT-TERM LENDING. More and more banks are going after smaller businesses and nonprofit organizations as part of their client base. For example, Wells Fargo offers small businesses a credit card that acts as a committed line of credit.21 As a general rule, your chances of getting a short-term loan are higher if you approach a smaller bank in your local market.
Banks' reliance on asset-based lending, term loans, and revolving credit agreements (especially to smaller businesses) has grown largely because of the lack of competition from the commercial paper and loan participation markets. The extent of nonbank penetration into lending is illustrated by the fact that total debt held outside the banking industry is at least equal to that held by banks. Finally, globalization is occurring in lending services.
10.11 MUNICIPAL AND TAXABLE BONDS
(a) MUNICIPAL BONDS. Nonprofits looking to borrow large amounts of money for 20 to 30 years find it advantageous to issue taxable or tax-exempt bonds. Taxable bonds, like bonds issued by businesses, have investors' interest income taxed as ordinary income for federal income tax purposes to those investors (unless the investors happen to be tax-exempt). However, the interest may be exempt from state and/or local income tax and the issuing governmental entity may also offer other incentives to the nonprofit borrower.22 Some nonprofit issuers are not eligible to issue tax-exempt bonds, so must issue taxable bonds. When tax-exempt, the interest paid to investors is exempt from federal income taxation and may also be tax-exempt for state or local income tax purposes if the investor lives in the issuer's state. Most municipals, or munis, as they are called, are tax-exempt. Because of the tax-exempt feature, the yields on munis are lower than those on comparably rated (equally risky) taxable securities. Much of the issuance goes to pay for building refurbishment or new construction to keep the institution competitive from a physical facilities standpoint. Many college issuers would rather leave investment funds in their endowments, gaining interest and building larger principal amounts, instead of spending these monies on buildings. Because of their lower interest rates, nonprofits normally have a governmental entity sell these “tax-exempt” bonds (which are also issued by governmental entities for their own funding purposes). These so-called “501c3” or “conduit bonds” are rarely backed by a governmental entity with respect to the interest payments and principal repayments but rather rely on the cash flows (revenues) of the underlying issuer for payment of interest and principal. The issuer may have “credit enhancement” through a bank-issued letter of credit, assuring timely payment of interest and/or principal if the issuer's revenues fall short. A city, state, or city- or state-related instrumentality/agency (the “conduit issuer”) issue or sell securities on behalf of nonprofit borrowers such as nonprofit colleges or healthcare organizations. (This is not always required, but before it issues the bond the nonprofit may request and receive an inducement resolution and agreement from the Issuer, indicating that the issuer agrees to sell bonds for the project that will be funded.23) As the underlying “conduit” borrower, your organization is funding a building or project and typically agrees to repay the governmental issuer, which in turn pays the interest and principal to the bonds' investors. Those payments are sourced from and predicated on the proceeds from earned revenue that you, as the conduit borrower, pay to the governmental entity solely from the “revenue” provided by your organization as the borrower.24 As an example, Samford University in Birmingham, AL, issued $46.64 million of “educational facilities revenue bonds” (tax-exempt municipal bonds) through the Educational Building Authority of the City of Homewood (AL). Life University, in Marietta, GA, issued both tax-exempt bonds ($89 million) and taxable bonds ($10.3 million) through the Development Authority of the City of Marietta (Georgia) University Facilities Revenue and Refunding Bonds program.
Fitch Ratings has studied defaults of municipal bonds and found that management practices were more important for predicting credit performance than had been thought in the past. The three most important management practices identified that led to stronger credit and lower defaults were:
- Superior disclosure
- Maintaining rainy day funds or operating reserves
- Implementing debt affordability reviews and policies25
We once again strongly reemphasize for your consideration the establishment of target liquidity, the second item, and of a debt policy, the third item. Also, we caution reliance on “new and improved” funding methods. Auction-rate securities, all the rage in 2008, disappeared from the scene when several auctions (in which investors tried to sell their securities) failed.26 More conventional is to tap the debt markets through the issuance of municipal bonds, our next topic.
(i) Selection of an Underwriting Firm. Because of the limited choice available, a nonprofit organization must be particularly careful in its selection of a capable and experienced underwriting firm. The nonprofit financial manager must first determine that the underwriting firm plans to continue in the municipal bond business for at least a sufficient period of time to market the bond issue. A firm that knows its bond operations will be terminating soon is simply interested in getting the issue sold as quickly as possible without the attention necessary to present it in the market in a proper and competitive fashion, and make a market (buy and sell the bonds) in the bond issue until it becomes seasoned.
If the bond issue is a floating rate, put-option bond (investors can cash out by “putting” the bond back to the issuer) and the investor has the right to redeem it for the return of principal on a one-day or one-week notice, what is known as a “remarketing agent” is required. This agent provides the vital function of accepting bonds tendered, or put, by investors and immediately finding other investors to purchase the bonds. A continuing underwriting responsibility exists to accommodate both investors and the borrower, whose interest it is to see that the issue continually remains in the hands of investors. The remarketing responsibility is usually assumed quickly and efficiently by other institutions.
Although most issues, once sold, do not trade actively in the secondary market, it is important to the nonprofit organization that its bonds receive reasonable secondary market activity, particularly if it expects to sell bond issues in the future. The institution does not want to lose potential investors because they had purchased its previous bonds and had been unable to sell them due to a weak or, worse yet, “no-bid” situation.
After a municipal bond issue has been sold, securities dealers frequently buy the bonds from investors who sell them before maturity to sell them to investors who are looking for secondary (or already-issued) bonds. It is important to maintain a relatively stable market price for the bond issue after its initial sale to the public. Therefore, the underwriting firm or group of firms that brought the issue to the public market should continue to participate actively in buying and selling the bonds in the secondary or resale market.
(ii) Preparation of Bond Documents. After selecting a bond underwriter and other professionals necessary to complete the financing task, including bond counsel, the actual indenture or disclosure statement is one of several documents that must be prepared. Of particular importance is the segment of the borrowing indenture that lists the instruments considered acceptable for investment of the bond issue proceeds prior to their disbursement or ultimate use. In the case of rated nursing home and educational facility debt, the credit rating agencies, such as Moody's Investors Service, Standard & Poor's (S&P), and Fitch Ratings, have their own rating criteria that include specific information about the instruments in which bond proceeds may be invested. However, very often the bond counsel for the underwriters uses a file form for the compilation of indenture clauses, including one listing acceptable investments. This file is often outdated and inappropriate for the listing of acceptable investment instruments.
It is very important for the nonprofit financial manager to submit to the underwriter a list of investments that the nonprofit institution considers safe and appropriate. The list should be broad enough in scope to meet the bond's indenture requirements. Typical instruments that can be listed are US Treasury securities, government agency securities, certificates of deposit and banker's acceptances issued by major creditworthy banks, commercial paper, and other corporate obligations rated in one of the top rating categories by the nationally recognized credit rating agencies. If others involved in the borrowing process disagree with this list, they should make it known, so that the list can be negotiated to one that is acceptable to all parties. However, the financial manager, after researching the appropriate investments to be included, should initiate a list of acceptable investments and not wait until the indenture is essentially complete before submitting it to the underwriter.
Another area of concern with respect to the process of investing bond proceeds is the specific approach of actually implementing these investments within the approved list of instruments included in the indenture. In considering the question of investing the proceeds from a bond issue pending their final disbursement, it is important to recognize the arbitrage provisions of the tax code. Briefly stated, these provisions will not allow the borrowing institution to benefit from any profit received on the investment of funds from a bond issue. Specifically, if the interest earned on the funds from a bond issue exceeds the cost of the interest on the money borrowed by the bond issue, that excess must be returned to the federal government. You will want to get competent legal counsel to help on this issue, as it is not our intent to offer legal advice on this very technical topic. At the time of this writing, Legal Information Institute (Cornell University) and the IRS provide the following information regarding tax code arbitrage provisions:27
Under [26 CFR 1.] section 148(a), the direct or indirect investment of the gross proceeds of an issue in higher yielding investments causes the bonds of the issue to be arbitrage bonds. The investment of proceeds in higher yielding investments, however, during a temporary period … as part of a reasonably required reserve or replacement fund … or as part of a minor portion … does not cause the bonds of the issue to be arbitrage bonds.
The rules for calculating the rebate interest amount are complex, as shown in Exhibit 10.3 below:28
1Regulations Section 1.148-3(b).
2Regulations Section 1.148-3(d)(1)(iv) and Regulations Section 1.148-3(d)(4). These regulations provide a computation credit of $1,400 for bond years ending in 2007, with annual adjustments for inflation thereafter, for bonds sold on or after October 17, 2016. An issuer may also apply these regulations to bonds sold before October 17, 2016, with the increased computation credit applying to bond years ending on or after July 18, 2016. A similar credit is available for bond years ending on or after September 26, 2007, under proposed regulations issued in 2007. REG-106143-07, 72 FR 54606, 54611, 2007-43 IRB 861, 887.
Source: IRS, Complying with Arbitrage Requirements: A Guide for Issuers of Tax-Exempt Bonds, n.d., IRS: 16. From Publication 5271 (4-2017) Catalog Number 69338P Department of the Treasury Internal Revenue Service www.irs.gov. Available at https://www.irs.gov/pub/irs-pdf/p5271.pdf. Used by permission.
Exhibit 10.3 Calculating Your Municipal Bond Rebate Interest Amount
Certain arbitrage rebate restrictions are waived if the amount of the bond issue proceeds is substantially spent down within two years for construction project bond issues (state and local governments and qualified 501(c)(3) organizations). Again, the intent of the provisions is to discourage entities from borrowing at a low interest cost through the sale of municipal bonds and investing the proceeds at a higher return, if the primary goal is to capture a profit from the privilege of being able to use municipal bonds as a borrowing vehicle.29
Most municipal bond issues are subject to these arbitrage provisions of the tax code. Put simply, arbitrage refers to borrowing at a relatively low interest rate and then investing the proceeds in a higher-rate investment security. It is obvious that an issuing organization will not benefit from any interest earned that is in excess of interest cost unless interest rates fall sharply during the five-year period during which the yield is averaged. This situation certainly will not provide an incentive to earn maximum interest on the proceeds of the bond issue until such time as the funds are finally disbursed. Therefore, it is important that under no circumstances should aggressive investment techniques be used or higher risks taken simply to earn additional interest income. It takes a substantial amount of additional interest income to equal principal lost through unwise investment of bond proceeds.
These limitations on earned interest are referred to as “permitted yield.” Although they provide no incentive to earn yield in excess of interest cost, there are other situations that must be considered. The borrowing organization may find itself in a low-interest-rate environment and need to be a competitive investor simply to earn the level of return to equal the cost of money borrowed. In this situation, it is extremely important that you take investment yields seriously to minimize the interest cost incurred on municipal bond borrowing.
Whatever interest conditions prevail at the time the municipal bond issue is brought to market, it is important to be a prudent and efficient investor. There are many alternatives available for the investment of proceeds from the bond issue. In examining these alternatives, your management team should be aware of your organization's needs, not only with respect to arbitrage provisions but also as to internal management capabilities, proper compliance with indenture investment limitations, and sound overall financial practices.
(iii) Municipal Bond Issuers and Purposes. Increasingly, private colleges and schools, nonprofit associations, and even some religious organizations are issuing taxable municipals or tax-exempt municipal bonds. Federal Reserve statistics document over $2 trillion in municipal bonds outstanding, issued by over 60,000 governmental and nonprofit entities. The percentage of nonprofits having tax-exempt bonds outstanding is fairly small – we will cite evidence of the issuance in the “Liability Management in Practice” section later in the chapter. One estimate of the amount of church bonds issued annually is $1 billion, as compared with total church financing of $20 billion to $40 billion annually.30
Let's illustrate how your organization can use tax-exempt bonds. In a three-year period, four private nonprofit organizations issued tax-exempt bonds in central Indiana. These were issued through a conduit issuer. Here are some features of those bonds:
- Pleasant Run Children's Home issued bonds “induced” by the city of Indianapolis – meaning that they were issued in the name of Indianapolis but were not a direct obligation of the city. These bonds were 7-day variable rate bonds, or “low floaters” as they are called, and paid between 3.75 percent and 4.25 percent during their first year in the market. The bonds were used to raise funds for facilities. The organization's foundation guaranteed payment on the bonds, and the issue was backed by a letter of credit from Fifth Third Bank of Central Indiana. For a fee of just over 1 percent of the amount of the issue, the bank stands ready to make interest payments or principal repayment if the issuer cannot.
- Archdiocese of Indianapolis issued $48 million in bonds to finance facilities and construction of private schools and cemeteries. The archdiocese did not need a letter of credit and took 18 months to close the deal from start to finish. This issue was the first of its kind in the United States.
- Lutheran Child & Family Services issued bonds to finance a treatment facility for children, also structured as a seven-day low floater, with a letter of credit backing the issue.
- Goodwill Industries issued bonds to pay for construction costs for new thrift stores, instead of getting a 10- or 15-year commercial mortgage on each new store that it opened. The $8.5 million issue refinanced existing mortgages and funded several new retail stores. Again, this issue was backed by a bank letter of credit.
To get these issues induced by the municipality, discussions and presentations were held with the mayor's office and appropriate city offices.
(b) TAXABLE BONDS. Many bonds issued by nonprofit organizations are not tax exempt in that the bond investor must pay income tax on the interest received. Church bonds, bonds issued to pay for private schools, and nursing home bonds illustrate the taxable bonds issued by nonprofits. The flexibility of the investment banker structuring the borrowing allows these to be used for bridge financing, working capital loans, or construction. Sometimes the state or city in which the nonprofit operates can lend its tax-exempt status to allow what would normally be a fully taxable bond to be issued as a tax-exempt bond, as noted earlier.
(i) How Can My Organization Use Taxable Bonds?. Let's illustrate the use of taxable bonds. BC Ziegler and Company (Milwaukee, WI) is an investment banker that assists many healthcare, retirement, educational, and religious organizations that may not be able to issue tax-exempt bonds.
Ziegler arranges the public sale and distribution of first mortgage bonds, which are secured by a mortgage on the property. These bonds are certificates of indebtedness issued by churches, private schools, and other nonprofit organizations to provide funds for acquisition of property, building expansion, and debt retirement.
For example, Ziegler served as underwriter for Truth Tabernacle of Bakersfield's $1.8 million issue of long-term bonds. Proceeds were used for two purposes: (1) refinancing the existing loan; and (2) funding two other small construction projects. The principal pay-down schedule, or amortization, on the bonds was matched up to the existing bank loan's then-current amortization schedule, and the interest rate on the bonds was comparable to the bank loan. The church's finance team was concerned about interest rate increases, and the bonds offered a long-term, fixed-rate. The bond issue was set up to be “fully amortized,” which means it would not have to be renewed nor would there be any balloon payments due prior to or at maturity. Finally, the bonds could be repaid by the church early with no prepayment penalty.31
Many of the organizations issuing bonds through Ziegler do so because financing from banks was not available or not available at acceptable terms (interest rate, down payment, or maturity). For churches, many of the bond investors are members or friends of the borrowing organization. The bond issue is normally structured so that some of the bonds mature each six months, with the final set maturing in 15 years (some extend to 30 years). The bonds are taxable, meaning that investors will have to pay tax at the ordinary income tax rate on interest received. Bonds are usually sold in a minimum amount of $5,000 and then in incremental amounts in $1,000 denominations, or in a minimum amount of $2,000 for IRAs. Most of the bonds are not rated by one of the credit rating agencies, because of their size: Most church-bond issue amounts range from $1 million to $5 million, with around $25 million being a maximum amount. Since 1980 Ziegler Investment Bank's “adjusted net default rate on religious lending projects remains at a sub-1% level, even after accounting for the tough environment in the post-2008 world.”32 Ziegler applies the following analytical criteria to evaluate a would-be issuer:
- The church's historic revenue base
- The church's prospects for growth
- Strength of the church/school management
- Number of members
- Value of the assets pledged to secure the proposed bonds
- Analysis of any school operations33
(ii) Can I Also Get Short-Term Financing Through Taxable Bonds? Although banks are the primary lenders for short-term funding needs, if a need is construction-related you might use an underwriting organization to help you raise the funds via a bond issue. Let's say you need some money up front to build part of a project. You might do a 36-month revenue bond if your long-term financial track record shows you are reliable in paying your bills on a timely basis. In evaluating your suitability for issuing such bonds, the investment banker will look at:
- Purpose – what you want the money for
- Timing – how soon you need the money
- Insufficiency of other sources – why you need bond financing
(c) WHAT QUALIFIES MY ORGANIZATION TO ISSUE BONDS? Investment bankers will look for these facts on mortgage bonds:
- Borrowing amount not to exceed 3.5 times annual gross revenues
- Projected cash flows showing enough excess cash inflow to make interest payments and principal repayment (or a realignment of cash uses to free up necessary cash flows)
- The total amount financed not to exceed 70 or 75 percent of the property's appraised value
Credit checks will also be performed on the borrower's chief administrators, and the investment banker will look for evidence that the organization will stand behind the bonds, even if the administrators depart.
Organizations that have defaulted on their bonds are characterized as lacking in understanding about what they are getting in to and/or resolve about debt repayment.
Interest payments cannot be “laid off” like employees when times get tough. Furthermore, the organization will lose the property if it does not make debt payments. Out of this understanding, and based on members' integrity, should come the resolve to stay current on debt repayment.
(d) WHAT IF MY ORGANIZATION IS NOT PERCEIVED AS CREDITWORTHY? When your organization does not have the creditworthiness to receive a high credit rating, what can you do to still issue a bond? Consider credit enhancement, including bond insurance, a bank letter of credit, or a third-party guarantee:
- Credit Enhancement: is the use of the credit of an entity other than the issuer to provide additional security in a bond. The term is usually used in the context of bond insurance, bank letters of credit state school guarantees and credit programs of federal and state governments and federal agencies but also may apply more broadly to the use of any form of guaranty, secondary source of payment or similar additional credit-improving instruments.
- Bond Insurance: is a guaranty by a bond insurer of the payment of principal and interest on municipal bonds as they become due should the issuer fail to make required payments. Bond insurance typically is acquired in conjunction with a new issue of municipal securities, although insurance also is available for outstanding bonds traded in the secondary market.
- Letter of Credit: a commitment, usually made by a commercial bank, to honor demands for payment of a debt upon compliance with conditions and/or the occurrence of certain events specified under the terms of the commitment. In municipal financings, bank letters of credit are sometimes used as additional sources of security with the bank issuing the letter of credit committing to pay on the bonds in the event the issuer is unable to do so.34
The majority of municipals are credit-enhanced, and most of that enhancement comes through bond insurance; about half of all new munis are insured. We see many nonprofits, however, using bank letters of credit to provide enhancement. Be open to many avenues for a guarantee. For example, a church may be able to get a guarantee from the state or national denominational headquarters.
10.12 LEASING AND NONTRADITIONAL FINANCING SOURCES
A broad definition of leasing is the use of equipment for money.
(a) THE LEASING PROCESS. The process you would follow to get equipment or vehicle lease financing from a lease finance company includes these seven steps:
- Fill out a lease application and mail or fax it to the lease financing company (lessor).
- Within 24 hours, the lessor will accept or deny the application.
- Lease documents are prepared (assuming your application was accepted).
- Documents are then properly executed by your organization (lessee), and equipment or vehicle is acquired.
- You return the documents, along with the equipment or vehicle invoice, to lessor.
- You are contacted by lessor via phone to provide verbal acceptance (which authenticates the mailed documents).
- Lessor pays vendor within 24 hours.
(b) LEASING VERSUS BORROWING. There are several advantages to using lease financing, several of which result from the fact that you are not buying the equipment or vehicles as you would under a loan arrangement:
- You may get longer-term and, therefore, lower-monthly-cost financing due to the two- to five-year lease terms (or seven years on certain equipment), possibly longer than what a bank would allow.
- You may get almost 100 percent financing, as opposed to 20 percent down or a compensating balance requirement when using bank financing.
- When squeezed for liquidity, you will appreciate having both your cash and your machines or vehicles for use, as opposed to outright purchase of the items.
- Capital project restrictions on outright purchases (whether using cash or bank borrowing), perhaps due to delays in getting a capital campaign off the ground, will not impede critical purchases that can be made with lease financing.
- It protects your organization against owning computers or other equipment that rapidly become obsolete.
- You may gain flexibility, both on the lease terms and on what your options are at the end of the lease: Renewal, purchase, or return of equipment.
These advantages come at a cost, as you well know if you have considered a personal lease on a car purchase. And, unless you are using the leased items in a for-profit subsidiary, you will not get the tax advantage that motivates some businesses to lease: Lease expense is tax-deductible, and if the lease period is shorter than the depreciation schedule that would apply to a purchase, the lease can lower your tax bill. However, a lease may fit your organization's need to finance copiers, computers, computer software, construction equipment, or an entire office. And as is true of so many other business transactions, you can now apply for an equipment lease right from your computer.35 Finally, more healthcare organizations are now selling some of their facilities, perhaps to a real estate investment trust, and then leasing them back. This “monetizes” the asset, reducing the balance sheet investment that the organization must make while enabling continued utilization of the facility.
(c) PROGRAM-RELATED INVESTMENTS (PRIS). One source of debt financing that you may not have considered is foundation-based program-related investments. Here is some basic information on PRIs from GrantSpace.36
Program-related investments (PRIs) are investments made by foundations to support charitable activities that involve the potential return of capital within an established time frame. PRIs include financing methods commonly associated with banks or other private investors, such as loans, loan guarantees, linked deposits, and even equity investments in charitable organizations or in commercial ventures for charitable purposes. Characteristics of PRIs and PRI-making include the following:
- Of the many thousands of grantmaking foundations in the United States, only a few hundred make PRIs. In addition, relatively few PRI funders maintain formal PRI programs or make PRIs on an annual basis (about one out of three).
- Foundations make PRIs to further some aspect of their charitable mission (e.g., in the areas in which they make grants). PRIs are often made to organizations with an established relationship with the grantmaker.
- Foundations commonly make PRIs as a supplement to their existing grant programs when the circumstances of the request suggest an alternative form of financing, when the borrower has the potential for generating income to repay a loan, and as a last resort when an organization – in most cases a charitable nonprofit but occasionally a commercial venture – has been unable to secure financing from traditional sources.
- While a large portion of PRI dollars support affordable housing and community development, they also have funded capital projects ranging from preserving historic buildings and repairing churches to providing emergency loans to social service agencies and protecting and preserving open space and wildlife habitats.
- For the recipient, the primary benefit of PRIs is access to capital at lower rates than may otherwise be available. For the funder, the principal benefit is that the repayment or return of equity can be recycled for another charitable purpose. PRIs are valued as a means of leveraging philanthropic dollars.
The next time you are considering borrowing funds, consider whether there might be a foundation with a mission consistent with your organization's mission, then approach the foundation to see if it has a program-related investment program.
10.13 DEVELOPING A DEBT AND HEDGING POLICY
Few nonprofits outside of the healthcare sector have debt policies. We strongly recommend that you craft and have your board review and adopt a debt policy. A best practice is to include your hedging policy as part of the debt policy, as interest rate risk is a key measure related to the amount of debt you take on. A debt and hedging policy should include some or all of these items, according to PricewaterhouseCoopers:37
- Short-term debt objectives and approaches
- Four-week and twelve-month rolling cash forecasts regularly completed and reviewed
- Liquidity availability at a suitable cost ensured
- Borrowed funds availability adequate for liquidity requirements assured
- Alternate sources of funding maintained in order to enhance financial flexibility
- Costs of short-term borrowing minimized while adequacy ensured
- Excess cash balances automatically used to pay down credit lines because of the lower interest yield on cash balances relative to the interest rate charged on the credit line
- Short-term debt instrument authorizations for some or all of the following:
- Commercial paper, bank credit line, revolving credit facility, bank loan syndication or participation, uncommitted credit line, reverse repurchase agreements, intercompany loans
- Long-term debt objectives and approach
- Consistent supply assured at reasonable cost and terms
- Present (discounted) value of the debt portfolio minimized
- Flexible financing of unanticipated future needs assured
- Reasonable debt covenants negotiated
- Insolvency and debt default risks minimized
- Maintaining a target debt-to-net assets ratio
- Long-term debt instrument authorizations (which and how much)
- Who is responsible for debt management (centralized or decentralized)
- Short- and long-term debt management strategies
- Use of foreign debt sources
- Importance of cash forecasts
- Maintaining a good credit rating with credit reporting and credit rating agencies
- Relatively more short-term borrowing when interest rate outlook is uncertain
- Match maturity of debt to lifespan of asset being financed
- Interest rate risk management
- Interest rate risk profile or appetite
- Creation of a risk committee
- Objectives and approach
- Fixed-to-floating rate balance
- Interest expense minimization
- Change in net asset threshold amount to be protected against
- Hedging of interest rate risk through swaps, and so on (see Chapter 14)
- Developing balance sheet flexibility
- Hedge program guidelines
- Active management of risk based on proximity (current quarter and fiscal year more important) and materiality (effect on change in net assets and on organization's growth rate)
- Feasibility and desirability of actively managing the exposures
- Responsibility for interest rate risk management
- Instruments authorized for interest rate hedging
- Interest rate risk management strategies to be followed
- Refinance risk
- Short-term exposures versus long-term exposures
- Overlap with debt management strategies
- Interest rate risk management operating controls
- Identify operational risks
- Protect against operational risks
- Who is authorized to execute strategies and trade
- What authority is delegated and to whom
- Segregation of duties
- Approved counterparties
- Dealing limits and how this is to be monitored
- Process to manage exceptions
- How performance will be measured and evaluated
- Use of benchmarks
- How will market risk be measured and analyzed
- Management reporting
- Accounting and disclosure
- Business continuity planning and plan for disaster recovering
Rules of thumb are sometimes used in implementing risk-management hedging strategies. For example, a number of larger healthcare systems include in their policies stipulation regarding when they will exit an interest hedge (as when interest rates fluctuate a certain amount).38 You will also want to disclose why your organization uses hedges, if it does, in the financial section of your stakeholder annual report. We will have more to say about hedging and derivatives in Chapter 14's discussion of risk management.
10.14 LIABILITY MANAGEMENT IN PRACTICE
In addition to the statistics we have included in this chapter from the Lilly study and other data, we note several studies that shed light on actual nonprofit use of debt. We will also provide evidence regarding the nonprofit use of credit lines.
The earliest study is taken from 1991 to 1994 Form 990 data, and conducted by Woods Bowman.39 Bowman uses large nonprofits, those with at least $10 million in assets, to study two competing corporate finance explanations for debt usage: the pecking order hypothesis and the static trade-off hypothesis. The pecking order hypothesis suggests that nonprofits finance assets first with net revenues, then asset conversion (including selling off short-term investments), then with additional debt. The static trade-off hypothesis proposes that the various costs of issuing debt, including transactions costs and higher likelihood of financial distress and bankruptcy, be considered by the financial manager in determining what source of financing to use. Bowman finds limited support for the static trade-off hypothesis. However, in his full-scale model, the effect of liquid asset holdings on the proportion of assets financed by debt is negative, which is at odds with the idea that lower bankruptcy and financial distress costs coincide with a relatively greater use of debt. We believe the pecking order explanation is more realistic for noncommercial nonprofits, in that we see a great degree of self-financing of large capital investments, and this requires a gradual buildup of cash and short- to medium-term investments that may not ever coincide with increased debt usage. Again, the target liquidity objective appears to best explain nonprofit financial behavior in our opinion.
More recently, Geoff Smith studied various forms of borrowing by nonprofits and found the following: organizations that had tangible assets (hence collateralizable assets), were growing more quickly, and larger ones tended to use relatively more debt financing. Younger organizations, more liquid organizations, and more profitable organizations tended to use relatively less debt. Regarding industry, religious organizations tended to borrow from internal sources, education-sector organizations (colleges, particularly) issued tax-exempt bonds, and human services organizations were more prone to borrow using mortgages and notes payable.40
Calabrese and Grizzle find some evidence that more highly leveraged nonprofits, those using the most debt relative to their peers, do see drops in donations from their donors.41 We might conjecture that this links to uncertainty about the future of the organization based on its more tenuous financial health, but more research should be done before firming up this conclusion.
Calabrese and Ely provide us with a number of useful statistics (Exhibit 10.4). They extracted data on over 24,000 nonprofits across various industries from Form 990 data. The average asset size of their sample is $123 million, which is partly a reflection of some very large organizations (we are unsure of the median amount of total assets). On average, the nonprofits were 30 years old. Of interest to us, as noted in Exhibit 10.4, the average nonprofit in the overall sample has 36% of all its financial borrowing from tax-exempt debt and 9% of total liabilities (including accounts payable and accrued expenses) from tax-exempt debt. We also see that almost 35% of total assets is in the form of fixed assets for this sample of nonprofits – and we should expect that these are the organizations that would be most prone to issue tax-exempt bonds or take out mortgages.42
Source: Thad D. Calabrese and Todd L. Ely, “Borrowing for the Public Good: The Growing Importance of Tax-Exempt Bonds for Public Charities,” Nonprofit and Voluntary Sector Quarterly 45, no. 3(2016): 469. Used by permission (STM Permissions Guidelines).
Exhibit 10.4 Nonprofit Financial Ratio Statistics
Second, as we see in their next table (Exhibit 10.5), hospitals (by far) and colleges/universities have issued the bulk of all tax-exempt bonds ($257/$336 billion, or 76.5% of outstandings). Human services organizations (25.57%) and “Other” nonprofits (15.76%) had the smallest percentages of their financial liabilities constituted of tax-exempt bonds. Notice, however, the relative growth in tax-exempt percentages over the years 2001–2009.
Source: Thad D. Calabrese and Todd L. Ely, “Borrowing for the Public Good: The Growing Importance of Tax-Exempt Bonds for Public Charities,” Nonprofit and Voluntary Sector Quarterly 45, no. 3(2016): 470. Used by permission (STM Permissions Guidelines).
Exhibit 10.5 Tax-Exempt Borrowing by Industry
Yan, Denison, and Butler studied revenue structure (a key aspect of your business model; see Chapter 3) and its relationship to debt issuance by arts, culture, and humanities nonprofits. Their study found:
- More revenue diversification is associated with a higher likelihood of issuing some debt
- More revenue diversification is not necessarily associated with higher debt ratios (long-term financial debt divided by total assets)
- When having a higher percentage of government grants in their revenue mix, arts organizations more likely to have some debt and also to have higher debt ratios43
We have little evidence to date on social-impact bonds, an interesting niche in the nonprofit bond market. Social-impact bonds, while a small sector of the nonprofit bond marketplace, are an interesting concept that you may wish to pursue. Foundations or other large donors provide money to a social service nonprofit, which in turn puts it to work in one or more of its programs. The funders (investors) then get back their money, plus a bonus, if the nonprofit achieves pre-specified performance goals. Otherwise, the funders (investors) do not get their money back. Early results from social-impact bonds are mixed. At the time of this writing, 11 states had enacted enabling legislation.44
Finally, you may wonder about the interplay between two of the key elements of your target liquidity, cash holdings (cash and short-term investments in some organizations) and credit line usage. We have data from a survey of 301 charities in the state of New Jersey. In Exhibit 10.6, we see the results. We would recommend that almost all nonprofits obtain a credit line, versus the 38 percent that we see in the New Jersey experience. We are also concerned by the fact that one-third of nonprofits do not have a cash reserve (unrestricted funds set aside as a cushion against future unexpected cash flow shortages, expenses, or losses) and that an additional 23 percent (34% of the 67% having reserves) have less than three months of operating funds in reserve.
Source: Center for Nonprofits (NJ), “New Jersey Nonprofits 2017 Trends and Outlook,” April 2017. Available at: www.njnonprofits.org. Accessed 7/12/2017. Used by Permission.
Exhibit 10.6 Cash Reserves and Credit Lines in Practice
10.15 CONCLUSION
Borrowers come in all shapes and sizes, and the astute lender must seek a way to differentiate between good loans and potentially unsuccessful loans. The financial manager must assist the lender in discerning the differences between the good loan represented by the financial manager's organization and all others.
The process begins with the preparation of a strategic financing plan that is part of the institution's overall strategic business plan. Then the financial manager must garner all the relevant facts and information that the lender will require, anticipate the lender's questions, and assemble a presentation to the lender. The presentation is a combination of written information and oral discussion, often including an onsite tour of the nonprofit's facilities. To be successful in the borrowing process, the financial manager must ensure that the selected lender matches the intended use of the funds and the duration of the loan. Banks, leasing companies, and insurance companies all have different objectives. The financial manager must recognize these differences and position itself toward the lender's interests.
Proficient financial managers with significant funding needs investigate bond financing as well as bank or insurance lease financing companies. They will also ensure that the organization pays its bills on time and makes interest payments and principal repayments as required. Because the worst time to contact a lender is when you finally really need them, they plan liquidity and capital project needs well in advance. Their degree of financial risk aversion, limitations on relative amounts or types of debt, allowable occasions for taking on debt, and stance toward liquidating debt are mapped out in a board-approved debt policy.