After Madoff

Bernard Madoff called it the “split-strike conversion strategy” – a tactic he promised investors would out-perform the stock market while minimizing investment risk. It’s too bad the riskiest thing nonprofits could have done was to trust the 70-year-old false financer with their money.

Madoff’s split-strike conversion held true to its name. It split endowments of well-known charitable organizations into pieces and his scheme struck across the country. Seemingly robust endowments converted to figments of the imagination, including the formerly Palm Beach, Fla.- headquartered Picower Foundation. The organization, once listed as the 71st largest in the United States by the Council on Foundations in Washington, D.C., had to close because Madoff managed the endowment.

Madoff pleaded guilty to 11 felony charges and faces as many as 150 years in prison when sentenced in the United States District Court for the Southern District of New York. In a prepared statement, when pleading guilty, Madoff said he was grateful for the “opportunity to publicly speak about my crimes, for which I am so deeply sorry and ashamed.”

Madoff can’t be as sorry as those who relied on the services of the nonprofits and foundations he decimated, or as ashamed as those put in charge of monitoring those organizations’ investment and endowment policies.

“I think the Madoff scandal and more recent Stanford scandal are both wake-up calls about the danger of complacency and compelling reminders that many risks can be avoided,” said Melanie Lockwood Herman, executive director of the Nonprofit Risk Management Center in Leesburg, Va. Allen Stanford, chairman and founder of Stanford Financial Group in Houston, Texas, was charged with fraud earlier this year, as were other executives of the firm. It had been a sponsor of a golf tournament benefiting St. Jude Children’s Research Hospital in Memphis, Tenn.

“While no single nonprofit was in position to alter the course of our nation’s economy, many organizations that made unwise investments could have fared better had their leaders stepped up and asked tough questions.”

Lockwood Herman explained that each organization should foster a “culture of candor” where nonprofits boards and committees can ask hard-hitting questions and challenge decisions.

“I often tell nonprofit CEOs that if you get through an entire board meeting without a single board member asking a difficult question — a question that you could not answer right off the bat — then the board isn’t doing its job and you haven’t empowered the board to do its job,” said Lockwood Herman.

The ripple effects of the Madoff Ponzi scheme, now estimated at $65 billion, will likely reverberate across the sector for years to come. Lockwood Herman believes that nonprofits should challenge stakeholder complacency. Tough questions could have identified risks and potential problems, like the Madoff scam.

In his courtroom statement, Madoff explained that the fraud began during the early 1990s. And since hindsight is 20/20, there are glaring signs that something wasn’t right, for example, a three-person auditing firm handling billions instead of the “big four” auditing firms – KPMG, Ernst & Young, PricewaterhouseCoopers or Deloitte, she said.

“A good reputation is not due diligence. Determining that a prospective advisor has a good reputation is not the same as due diligence. With respect to recent scandals, we can now see that all sorts of questions should have been raised,” said Lockwood Herman.

All organizations can learn from the scandal, according to Lockwood Herman. “You can’t in one fell swoop protect your organization against losses, whether they are financial losses, allegations of misconduct or injuries suffered by clients,” she said. “There’s nothing that you can do to build a fortress around the organization so it’s fully protected from harm and loss. While you can’t fortify an organization overnight, you can commit to improving the organization each and every day. One key step in doing that is making the commitment to candor and encouraging stakeholders to speak openly about their concerns,” she said.

Lockwood Herman recommended that nonprofit leadership create a list of questions they would not like to answer if asked by the media or organization stakeholders and find the answers now. If the leadership doesn’t like the answers it finds, it might be time to reassess and change practices nonprofits wouldn’t want to come to light.

“In this day and age of incredible scrutiny of nonprofit organizations, every leadership team needs to be aware that questions can be asked and as leaders you should be prepared to explain what you’ve done and why.”

It doesn’t take a scandal to bring down investments. Endowments around the country are getting kicked in the assets. Most people just have to look at their own investments to see that investments are down across the board. The investment adage to diversify allocations to protect investments could not fortify against the collapse of the world’s financial market.

All the old rules are kind of out the window” when it comes to investing and asset allocations, according to John Walda, president of the National Association of College and University Business Officers (NACUBO) in Washington, D.C.

“In the past, if you were invested in U.S. equities and you had a big portfolio of international equities, if one went down the other might go up. If you invested in a traditional allocation of certain percent in equities and the rest in fixed income, if one went down the other went up,” said Walda. “Well, those rules don’t work anymore because everything went down.”

Investments in endowments didn’t just go down — the numbers seemed to freefall. A joint study from the Commonfund Institute and NACUBO estimated average total return for college and university endowments was -24.1 percent for the first half of Fiscal Year 2009, which ran from July 1, 2008 through December 31, 2008.

The online survey was completed between this past January and February by 235 of the 629 institutions that participated in the 2009 Commonfund Benchmarks Study of Educational Endowments.

Walda also explained that some investments that are only valued on a quarterly or annual basis might not be tallied in some endowment losses just yet.

“I think it’s reasonable to assume that when the time comes for those values to be established, they will have taken a significant downward turn,” said Walda. “That adds to the problem.”

“We don’t know what’s going to happen here on out, of course, but it would take an extraordinary rally to bring us back to even a moderate decline,” said John Griswald, executive director of the Commonfund Institute in Wilton, Conn.

“This has been a brutal period for nonprofits because it has come on quickly and it has been devastating, particularly to those who were very dependent on their endowments. But on the other hand, thank goodness they had their endowments and thank goodness they are bigger than they used to be,” he said.

Griswald explained that endowments have two crucial purposes. “One is to provide a steady income to the operating budget each year to support programs. And another purpose, of course, is a rainy day fund,” he said. “And right, now it’s pouring.”

The current economy has created a financial monsoon that nonprofits are trying to battle while investment losses are slicing endowments in sizable chunks and hitting donated stocks. Nonprofits are reacting in different ways to try and keep afloat. Some are making staff cuts and freezing salaries and new hires. Others are adjusting spending rates and double-checking budgets.

The Community Foundation for Greater Atlanta planned for a $4.1 million budget for 2009 Fiscal Year. The organization just came off its second best year with new gifts reaching $120 million and committing $90 million in grants, according to Alicia Philip, the foundation’s president.

Then the market tanked and the organization had to make some tough decisions. The budget that was devised in August was sliced nearly $500,000 by November, eliminating retirement payments and some other budget items.

The organization continued to watch the market drop. From February 2008 to February 2009, the organization’s $800 million in assets dipped 26.3 percent.

“We have very solid, very diversified high-quality investments. And our investment committee is sticking with it. But everything went down,” said Philip. “In an investment portfolio, there is nothing you can go to.”

The foundation had to cut where it could for an additional $200,000 in savings this past February. Two employees were laid off, which accounts for 6 percent of the staff, and the organization stopped paying parking and transportation subsidies. Employees who never had to pay for health benefits now have to contribute 20 percent. And, Philip’s pay was cut by 5 percent. “No one wants to let people go – no one. It’s the most painful thing I’ve done in 32 years,” said Philip. “But we need a strong community foundation.”

Philips said the investment community for The Community Foundation for Greater Atlanta has met twice since the financial fallout and recommitted to the investment allocation each time. “They looked at all the risk analysis they’ve talked about it They thought long and hard and looked at all the potential risk we had and said, ‘No, we are staying the course,’” she said.

Griwald warned nonprofits that while endowment losses seem scarily high, organizations should caution against investing too much in low-yield, safe assets. “That is almost a guaranteed losing position because in fact you need to spend from these endowments. You need to grow longer term. While it’s very important to raise gifts for endowments it will be even more so in the future to rebuild them,” he said. “You cannot depend on so-called ‘safe’ or very conservative investments, like treasury bills and bonds, to rebuild with. They just aren’t going to yield enough. They can be very vulnerable in a rising interest rate environment, which is very possible given the amount of government spending we’re going to see.”

Arguments regarding asset allocation and investments can be made in any organization, but the real issues are at a nonprofit’s core, according Lockwood Herman. “One approach is to begin by looking at the technical decisions that were made [about investments]. I’d suggest that leaders step back and first examine cultural issues in their organizations,” she said.

Griswald worried that pressure on investment managers and business officers might force them to address short-term concerns, like liquidity, and could deteriorate endowments over the long term. “The longer-term concern is what should our portfolio look like and what should the risk profile of that portfolio look like for the longer term. That will put us in a better position to not only take advantage of opportunities but to guard against future short-term shocks,” he said.

Griswald said most organizations are not adjusting asset allocations much, if at all. Most organizations are just trying to ride the economy out. Griswald explained there is a certain duality to the investment market: nonprofits are facing harsh endowment losses, but the current market creates a great chance to buy undervalued equities.

“This is a period when some of the leading thinkers in the investment business say this is one of the most extraordinary periods of opportunity that they have seen because almost everything has been beaten down,” said Griswald.

“The evaluations are very low, there are clearly undervalued assets out there, good companies with good earnings prospects that will turn around at some point here,” he said. “So, staying the course is the advice we give because, in fact, you don’t want to sell low and depressed prices.”