Nonprofits Behaving Badly

In an increasIngly competitive and highly regulated environment, banks must behave as responsible corporate citizens. With regulators, the media, and clients focused on how banks conduct business, it is imperative that institutions demonstrate the ability to work with the stakeholders in their communities. 

Almost all banks invest significant time and money to publicly demonstrate their commitment to community, whether through highly publicized grants, sponsorships, or organized volunteering by bank personnel. 

However, the most fundamental commitment a bank can make to its community is to lend to organizations that serve a greater purpose than just making a profit.

By lending to religious institutions, schools, trade associations, and civic organizations, banks receive both the visibility and inherent marketing advantages of being a preferred vendor to a large and captive customer base. Additionally, nonprofit loans are lucrative, often fulfill several goals in the bank’s mission statement, and serve various community reinvestment initiatives.

Of course, as with all credit products, lending officers must properly underwrite and structure deals to limit the bank’s downside risk. This is especially true with nonprofits, given that banks have limited options for working out or resolving a nonprofit loan. The same factors that made the loan so attractive to the bank in the first place—high visibility with an ingrained and active customer base—also limit the bank’s ability to resolve the loan in the most economically beneficial way.

Given the high profile of such deals and the significant reputation risk at stake, resolution strategies such as litigation and note sales are immediately off the table except in cases of fraud or insolvency. Usually, the bank must see the deal through term, often making concessions that it otherwise wouldn’t.

With that in mind, the bank must take extra care during origination, due diligence, and monitoring. Once the money has been lent, or even been committed to be lent (through a commitment letter or matching funds agreement), the bank is tied to the organization until the loan is fully paid.

As with all niche lending, nonprofits involve nuances and differences that must be considered. Beyond normal credit analysis of the client’s operating budgets, giving units, or specific project fund-raising, red flags can be raised during underwriting. While these red f lags are not proof of a nonprofit’s inability to perform under their loan documents, they do represent latent risks and deviation from typical nonprofit governance and performance.

When nonprofits demonstrate atypical performance and adopt high-risk behaviors, their conduct can be compared to that of “bad boy” rock stars, prima donna celebrities, and pampered athletes. Diva leadership, extravagant expenditures, poor selection of business partners, large entourages and staff, and inability to manage money are all indicators of a poorly operating nonprofit.

By being mindful of these parallels, lenders can avoid enabling their borrowers into self-destruction and insolvency. It’s important for lenders to take note of these bad behaviors before nonprofits do damage to the bank’s balance sheet and, to borrow a term from the aforementioned rock world, become a “deadhead” asset.

The Cult of Personality

All nonprofits are established with a mission. Churches, schools, and charities are often founded by transformative individuals who have a clear strategic vision for the organization. Such leaders frequently inspire tremendous devotion from their congregation and administrative staff. While this loyalty is certainly an asset—especially as it pertains to religious organizations, since it results in more giving units and higher tithings—over—reliance on one individual carries risks that must be identified and mitigated by the lender.

First, the transformative leader who establishes a nonprofit often has an outsized influence on the organization’s direction and performance. When a popular pastor who established a church and grew the congregation eventually retires, the result could be a precipitous decline in membership. Banks that have lent to churches when they were at peak attendance can easily find themselves overleveraged once popular pastors leave and take the cash f low with them.

As when lending to a small business dependent on a key person, the prudent lender would be wise to ensure an organization has a defined succession plan in the event of a pastor’s exit. Failure to recognize that loan repayment is tied to a particular pastor can result in sudden default. Bankers should be sure they are lending based on the underlying economic demographics of the institution and not solely on a pastor’s ability to generate attendance.

Second, some transformative leaders act as if the nonprofit exists to serve their purposes and not necessarily the stated aims of the organization. These self-dealing individuals treat the nonprofit as a closely held business and use its resources to meet their own personal needs and wants. For instance, they may reward themselves with large salaries, purchase homes and cars for personal use, and engage in nepotism by hiring family and friends to administrative positions.

To the extent there is a governing board, the self-serving leader sets the agenda, controls debate, and overrides votes if necessary. To mitigate this risk, banks should lend only to organizations that have formalized board and governance documents and also a healthy, diverse, and arm’s-length relationship between the board and founding leader. Only then will the best interests of the organization be ensured—rather than those of the founding leader. 

Investment in Nonproductive or Obsolete Assets

By definition, nonprofits are supposed to be motivated to accomplish the aims of their mission and not necessarily churn a recurring profit stream. To that end, many nonprofits and religious organizations invest in hard assets that help instill values and inspire their constituencies to accomplish their vision. This is especially true for religious groups that need an awe-inspiring facility to provide members the sanctuary to feel closer to their higher power.

Additionally, for civic organizations and schools, a beautiful facility can increase enrollment and maintain relevance for scarce resources such as donations and membership dues. However, like the celebrity who purchases a mansion and adds extravagant touches that ultimately decrease marketability, a nonprofit can develop a facility that serves a limited purpose far beyond the aims of the organization. While there is a natural functional obsolescence inherent with nonprofit facilities—they are not designed to generate revenue efficiently—it is the lender’s responsibility to ensure they do not over-advance on the collateral.

Functional obsolescence, or the loss of property value derived from superadequacy, inefficient design, or unattractive style, can manifest itself in various forms, some of which are not readily apparent to most bankers. For instance, when financing the construction of a nonprofit building that will be a headquarters or a school, the bank should be wary of high-end finishes that do not conform to industry standards or seem inappropriate for the intended use. Examples would be marble floors and granite countertops in middle-school restrooms. While some impressive finishes are to be expected in religious buildings, such as stained glass windows and marble altars, the buildouts of the various nonpublic areas should match the practical use of the space.

A lender should be aware of the functional obsolescence inherent in collateral, either by identifying items in the construction budget that equate to these items or by reducing the amount it is willing to lend against the estimated amount of the functional obsolescence provided in an appraisal.

This is especially important when lending against a special-use property such as a church or a school, where the lack of alternative uses limits the marketability of the asset in a liquidation. Banks can easily find themselves beyond their supportive equity cushion if they fund specialized or luxury finishes with debt, as those items do not generally translate into higher value in a distressed sale.

Moreover, nonprofits sometimes have difficulty disassociating between wants and needs in the capital budget. Set on projecting a robust operation to their constituency, some nonprofits purchase assets that provide little marginal return relative to the stated need. For example, a school may purchase extra buses that are not needed or replace existing buses well before the end of their useful life.

When purchased through specific fundraising efforts, these items pose little risk to the bank, assuming the board had no other need for the cash. However, when these nonessential items are leveraged, they become an extra burden on the organization and represent idle assets on the balance sheet. Overall, bankers can help clients identify which items in the capital budget add value to the organization and which are superfluous and wanted only for vanity’s sake.

Hidden Profit Motive

Many nonprofits are founded and governed by volunteers who generously donate their time and energies. Such individuals are the lifeblood of the nonprofit, and their efforts make the organization a pillar in their communities.

However, like a naïve rock band being taken advantage of by an unscrupulous record executive, there are companies—often with a for-profit motive—that attempt to leech off the host organization. These companies often assume the guise of helpers by offering to provide a service that is beyond the capabilities of the volunteer board.

For smaller organizations that do not competitively bid, that “help” could mean paying above-market rates for extraneous services that strain their budgets. Lenders would be wise to question budget line and celebrities, enormous resources can items that seem beyond the norm for similar services and have frank discussions regarding the bidding process required in the governing documents. The bank can engender a tremendous amount of goodwill by offering this advice to the board, especially when it results in savings to the organization.

The more insidious form of the hidden profit motive occurs when the founding principal or leader establishes a nonprofit and concurrently launches a forprofit management company to provide it with “essential services.” The management fees paid by the nonprofit, often without the board or other stakeholders understanding the relationship with the for-profit, can be steep and result in budgets that leave little room to accomplish the nonprofit’s mission.

This type of non-arm’s-length situation is often seen in the charter school industry, where the school is a nonprofit but all the business functions (staffing, payroll, accounting, etc.) are conducted by a for-profit management company. (Full disclosure: This writer sits on the board of a nonprofit charter school that terminated its contract with the founding for-profit managing company.)

While this relationship is not inherently inappropriate, it can lend itself to large conflicts-of-interest issues—as well as abuse. Bankers need to understand the true nature of the relationship between a nonprofit and its essential service providers, especially when those contracts represent the largest portion of the budget. When significant conflicts of interest exist, they could portend other ethical challenges in the organization that the bank may wish to avoid.

Bloated Budgets

All nonprofits seek to provide the maximum benefit to the populations they serve. But although well intended, their goals could put enormous budgetary constraints on the nonprofit as the size of the staff grows beyond the organization’s resources. Like the large paid entourages that are a hallmark of athletes 24 be drained from an organization quickly when the hiring and spending decisions are not balanced against the organization’s needs and budget.

Management’s desire to add jobs and justify large budgets can even subvert the mission of the nonprofit, resulting in negative publicity that turns away donations. Recent news reports have exposed charitable organizations that use the majority of donations to support the management and fund-raising staff, resulting in only pennies on the dollar for the cause they claim to represent.

Once a nonprofit realizes the unsustainability of a large administrative apparatus, painful staffing cuts have to be undertaken, demoralizing the organization and potentially damaging its ability to bring in enough revenue to support fixed costs, including debt. Accordingly, it is important that loan officers fully review their clients’ operating budgets and financials to ensure that the level of administrative costs, especially payroll, is reasonable given the organization’s revenue and mission. If the organization is primarily a fund-raising one, the bank should recognize the truth of the business model and mitigate the risks appropriately.

Living on the Edge

Living paycheck to paycheck is not the exclusive domain of high-profile insolvent athletes. Nonprofits can be dependent on one or two revenue sources concentrated in a few lump-sum disbursements (for example, a government grant). Cash management and the ability to adhere strictly to budget plans are critical for the nonprofits that rely on only a few cash inflows per year. Obviously, the bank must keep a close eye on these borrowers, given the concentration risk and lack of readily available repayment sources.

Despite the apparent ability of these revenue sources to recur over time, it only takes the failure of one grant renewal application, a change in government policy, or the loss of a large donor for the nonprofit to find itself in the bank’s workout department. Accordingly, the bank should conduct stress tests of the nonprofit’s ability to lose a portion of its revenue and still be able to cover fixed costs.

In addition, even in situations where nonprofits have multiple and robust sources of revenue, they sometimes overspend on the effectuation of their mission and do not hold enough in reserve for capital improvements. For borrowers with real-estate term loans, the bank should insist that their collateral be reserved and that cash be set aside to cover major repairs.

For instance, a well-secured church with stable giving units and revenue— but no replacement reserves set aside— may be required to leverage the building further or run an emergency capital campaign to fund unexpected repairs. While it is best practice for a religious organization to either have a continual capital campaign or set aside a portion of its budget toward replacement reserves (as outlined in an appraisal or reserve study), the bank should require that reasonable reserves be held at the bank as part of the loan agreement.

Conclusion

Banks can act as responsible corporate citizens and increase their civic profile by lending to the invaluable nonprofit organizations in their communities. A responsible lender will not let nonprofit clients engage in unnecessarily risky behavior that threatens the repayment of the loan and the nonprofit’s prospects going forward.

Sometimes tough conversations need to happen. Quitting bad habits—such as operating beyond budgeted means or entering into unfavorable for-profit management contracts—is never easy. However, with the support, encouragement, and possible requirements of their lender, nonprofits can return to doing what they do best: serving the community.

 

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Jason Alpert, CRC, is a vice president at Wells Fargo Bank in Tampa, Florida, where he manages the Credit Management Group for the West and North Florida markets. He also sits on the boards of several nonprofits and teaches at the University of Tampa. He can be reached at jason.p.alpert@wellsfargo.com.