The Fox & The Hedge Hog: Risk Management in Philanthropic Finance
“The fox knows many things, but the hedgehog knows one big thing.”
– Archilochus, 7th century BC
In 1953, philosopher Sir Isaiah Berlin published an essay in which he described and sorted the world’s greatest thinkers into two categories: Hedgehogs and Foxes. Hedgehogs are those individuals “who relate everything to a single central vision, one system,” and Foxes are those who draw upon a wide array of experiences and ideas, oftentimes unrelated and disconnected, in the pursuit of understanding the human condition.
In the world of investing, risk is defined as the chance of a permanent and realized loss of capital. For nonprofits, risk can be characterized as the probability that the assets of the organization (programming revenue, donors’ financial gifts, interest from an endowment) will not match liabilities (staff compensation, delivery of services to disadvantaged community members, facility upkeep). This overarching conceptualization of risk for nonprofits falls under the Hedgehog’s column.
Within the independent nonprofit sector, funding streams historically have consisted of a balanced blend of numerous low-dollar and mid-range donors and a concentrated bundle of larger, six- and seven-figure donors.
Across the nation, the composition of donors contributing to charities is experiencing a dramatic change. Traditionally, the independent sector has modeled its development efforts to mirror the structure of a pyramid: Low-dollar donors ($25– $250) form the base of the pyramid; mid-range contributors ($500–10,000), who may give on a recurring basis, are the pyramid’s torso; and major donors and planned legacy gifts ($25,000–$1 million+) are at the top of the pyramid. Charities have relied upon a diverse stream of low-dollar and mid-range donors who supply, oftentimes at a monthly or annual cadence, a steady and reliable flow of dollars to fund the ongoing programmatic and operational needs of the organization. But the donor landscape has changed, and the source of funds has shifted away from broad-based low-dollar giving to an environment characterized by mega-gifts from a narrow pool of high-income earners. Chuck Collins, Helen Flannery, and Josh Hoxie of the Institute for Policy Studies have released a 35-page report, “Gilded Giving: Top-Heavy Philanthropy in an Age of Extreme Inequality,” on this trend in philanthropy that has been gaining momentum since the early 2000s. Here are some highlights:
- “From 2003 to 2013, itemized charitable contributions from people making $500,000 or more – roughly the top one percent of income earners in the United States – increased by 57 percent. And itemized contributions from people making $10 million or more increased by almost double that rate – 104 percent – over the same period.”
- “From 2003 to 2013, while itemized charitable deductions from donors making $100,000 or more increased by 40 percent, itemized charitable deductions from donors making less than $100,000 declined by 34 percent.”
Donor-advised funds (DAFs) have grown in popularity amongst high-income earners as a vehicle for warehousing and distributing funds to qualified nonprofits.
- “Among the nation’s 400 biggest charities, giving to donor-advised funds increased steadily from two percent of total giving in 1991 to 18 percent in 2015…. From just 2010 to 2014, the amount of assets held in donor-advised funds more than doubled, from $33.6 billion to $70.7 billion.”
- “For example, mid-size foundations, with assets from $10 million to $50 million, distributed 11.0 percent of their assets” while “The median pay-out rate of donor-advised funds for tax year 2012,” as reported in a study by Paul Arnsberger, a statistician at the Internal Revenue Service “… was just 7.2 percent.”
- In addition he found that “nearly 22 percent of the sponsoring organizations reported no grants made from their DAF accounts.”
At face value, this meteoric increase in dollars flowing to DAFs can be viewed as a positive trend; but unlike private foundations, who must meet an IRS-mandated payout policy of 5% of net asset value, DAFs (and public community foundations) are not bound by an annual payout requirement. So, although DAFs are awash in cash, a vast majority of those dollars are lying fallow, collecting interest and dividends and incurring administrative and investment management fees.
The twin trends of low payout ratios, coupled with the documented increase in infrequent but large gifts, underscore the need for nonprofits to sustainably diversify their revenue streams.
Depending on the financial position of the organization, an endowment may have been established from which funds can be drawn on a prearranged basis to support the ongoing operations of the organization. With legacy-level gifts supplying an ever-growing share of a charity’s income, development officers and board members must uphold a standard of care similar to the level of diligence one would apply in the management of one’s own personal assets. This is known as the “prudent man” rule.
- How will donor assets be invested to satisfy the perpetual mandate enumerated in the gift agreement?
- What process is in place to monitor the performance of the organization’s endowment? If the performance of the investment pool routinely fails to meet prescribed benchmarks, what action can be taken?
- How much is the organization paying in fees associated with the management, administration, and custody of the assets?
- Does the financial institution managing the endowment assets also retain custody of the assets?
- Does the endowment contain illiquid investments, funds-of-funds with multi-layered fee structures, securities denominated in foreign currencies, private equity, venture capital, or hedge funds with multi-year lock-out periods?
These are questions high-dollar donors may ask when considering a major gift.
We wish our clients happy holidays and a prosperous new year.
 Ibid. Pg. 3.
 Ibid. Pg. 3.
 Ibid. Pg. 17.
 Ibid. Pg. 17.
 Ibid. Pg. 17.