Retooling Your Financial Reserves

Catholic Charities USA Annual Gathering October 1, 2012

Ben Aase and Bruce Braunewell CliftonLarsonAllen LLP

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©2012 CliftonLarsonAllen LLP

Learning Objectives
At the end of this session, you will be able to:  Speak with confidence about the importance of financial reserves to the long-term viability of your organization.  Prepare, communicate, and update a data-driven reserves policy that will build confidence with your organization’s key stakeholders.  Understand how this policy integrates with your financial planning and reporting processes.  Create an interactive process to develop and adjust reserve targets that will engage your staff and board.
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Why Nonprofits Need Reserves
 To bridge cash flow needs  To maintain financial solvency  To weather economic cycles  To fund expected opportunities  To fund unexpected opportunities  To protect yourselves against unpredictable political behavior  To purchase and maintain productive assets  To drive capacity for new debt to fund major capital needs
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Who Cares About Our Reserves?
Organizational leaders Board members Creditors Regulators Rating agencies Contributors Service recipients A lot more people than you’d think when you don’t have them…
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What We’re Seeing and Hearing

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Context

Reserves (by themselves) ≠ Capital Reserves are (just) one important part of an organization’s overall capital structure.

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Capitalization: One Definition
The accumulation and application of resources—operating and working capital, operating reserve, risk capital, endowment and building reserve—to support achievement of an organization’s mission over time.

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Excerpted from http://www.kresge.org/content/files/Webinar%20PPT%201-25-11.pptx ©2012 CliftonLarsonAllen LLP

Understanding Risks of Undercapitalization
The theory being that without adequate capitalization – or the appropriate capital mix – your mission is at risk.

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Excerpted from http://www.kresge.org/content/files/Webinar%20PPT%201-25-11.pptx ©2012 CliftonLarsonAllen LLP

July 2009 Urban Institute Study
AGE DOESN’T MATTER “Sixty-five percent of young organizations—defined as no more than five years old—had operating reserves that would cover less than three months of operating expenses, and nearly onethird of these young organizations have no operating reserves. Older organizations tend to be somewhat stronger, but even among those that are more than 30 years old, nearly 50 percent had low operating reserves.” MISSION DOESN’T MATTER “More than half of all organizations across all missions, except for environment and animals, had operating reserves of less than three months.” SIZE DOESN’T MATTER “More than half of organizations in every range of expenses reported operating reserves of less than three months.”

REVENUE BASE MAY MATTER “Two categories had significantly more organizations with less than the suggested minimum reserves—those with revenue primarily from government grants or program services.”

HOW DID THESE ORGANIZATIONS FARE THE LAST RECESSION?

Those that filed an IRS Form 990 in 2000 but did not file in 2006 because of organizational closure or contraction reported reserves ONE-THIRD THE LEVEL of those organizations that survived.
9 Available at http://www.urban.org/uploadedpdf/411913_dc_nonprofit_reserves.pdf ©2012 CliftonLarsonAllen LLP

Nonprofit Operating Reserves Initiative
Ad hoc group of nonprofit finance professionals. Center on Nonprofits and Philanthropy at the Urban Institute serves as secretariat. Objectives:
 Define an “Operating Reserve Ratio”  Use the ratio to focus attention on the importance of nonprofit financial stability

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Available at http://www.nccs2.org/wiki/images/3/3c/OperatingReservesWhitePaper2009.pdf ©2012 CliftonLarsonAllen LLP

Nonprofit Operating Reserves Initiative
White paper recommendations:
 Set a minimum operating reserves ratio.  Tailor your policy to your organization’s needs and funding structures.  Recommendation = no less than three months of operating expenses.  Define how the operating reserves will be invested as part of your organization’s overall investment policy.  Decide how often to measure and report.  Discuss how your operating reserves will be replenished if you need to dip into your reserves or they fall below the minimum threshold.

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Available at http://www.nccs2.org/wiki/images/3/3c/OperatingReservesWhitePaper2009.pdf ©2012 CliftonLarsonAllen LLP

Why You Need Them Today More Than Ever
In conclusion, both intuition AND evidence suggest that… Many nonprofit organizations have inadequate reserves and have suffered over the past several years because of it… …and while many organizations are understandably focused on a relatively short time horizon… …there is an emerging interest in addressing the question of financial reserves more prudently… …to help you emerge from this current economic crisis well positioned to withstand the next challenge that arises.

Adapted from “Maintaining Nonprofit Operating Reserves,” The Nonprofit Operating Reserves Initiative Working Group, December 2008
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Common Questions
       How can we build some? How do we defend them? How much is enough? Too much? How do I build a culture that values them? What sources can fund reserves? What should our policy include? How can I respond to clawbacks?

HOW ARE RESERVES IMPACTING YOU?
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CASE STUDY: NATIONAL COUNCIL ON FINANCIAL RESERVES

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NCFR’s Reserves

Does this trend look familiar?

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Old Target
November 2003: NCFR Board of Directors approved recommendation from NCFR Finance Committee Resolved that the following motion shall be approved: To establish a reserve goal of at least 50% of operating expenses and that NCFR work to achieve this goal within 10 years.

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Why 50%?

Because it felt good. Responsible. And it’s what their peer organizations were doing.

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Ask Yourself…

Q: Best practice or popular practice? A: Popular practice

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The Danger of Conventional Wisdom
Benchmarking may provide a good starting point… …but beware of conventional wisdom.

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SO WHAT IS ONE TO DO?

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1 Approach / 2 Phases / 6 Steps
Review of Current Policy and Practice Data Collection (via Survey) Facilitated Stakeholder Sessions Quantitative

Phase 1: Identify risks to major programs / business lines

Iterative Feedback Loop

Modeling Draft Policy Recommendations

Phase 2: Quantify identified risks and build appropriate policy
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Finance Committee and Board Approval

STEP 1: REVIEW OF CURRENT POLICY AND PRACTICE

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Review of Current Policy and Practice
 Current reserve policy and historical context  Business and financial reporting structure  Historical reserve targets vs. actual performance and use  Program summaries  Related risk (e.g. SWOT) or strategic planning documents for each program, operating unit, or entity-wide  External environmental scan  Investment allocation risk analytics

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STEP 2: DATA COLLECTION

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Data Collection (via Survey)
 Suggest surveying internal departmental directors
− Direct service delivery at the departmental or site level − Business and finance − Information technology − Physical plant

 Questions revolved around…
− Identifying specific business risks − The likelihood and timing of their occurrence − Their anticipated financial impact − Their categorical nature − Alternative mitigation strategies
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Sample Survey Questions

 True or False: NCFR’s current reserves policy works well.  What are the most critical cost drivers in your department?  Keeping both your cost drivers and income sources in mind, what potential high impact risks could result in your department’s need to access NCFR reserve dollars?
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Sample Survey Questions (cont’d)
For each of these identified risks…

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TIME OUT FOR A SURVEY

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STEP 3: FACILITATED STAKEHOLDER SESSIONS

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Facilitated Stakeholder Sessions
Goals:  Test departments’ response to seeing the survey data in aggregate  Fill any data gaps or clarify items that required interpretation  Move to consensus, most likely scenario for each identified risk  Test the materiality of smaller risks identified  Explore rationale in assigning likelihood, timing, and financial impact  Test risks identified by other respondents to ensure they are:
− Appropriately excluded − Void of any overlaps and disputes

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Sample Session Agenda
 Introduction and Perspectives of Participants  Review Committee Charge  Ground Rules
− Risks vs. Opportunities − Insurable vs. Uninsurable Risks − Budgeted New Initiatives vs. Reserve Contingencies

 Review of Survey
− − − − − Agree on nature, likelihood, impact timing, and dollar exposure Review proposed financial model conventions Consider overlap with other operating units or departments Identify additional reserve requirements Agree on adjustments to survey results

 Open Discussion and Wrap-Up
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On to Phase 2
Review of Current Policy and Practice Data Collection (via Survey) Facilitated Stakeholder Sessions Quantitative

Phase 1: Identify risks to major programs / business lines

Iterative Feedback Loop

Modeling Draft Policy Recommendations

Phase 2: Quantify identified risks and build appropriate policy
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Finance Committee and Board Approval

STEP 4: QUANTITATIVE MODELING

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Quantitative Modeling
Objective: To develop a data-driven financial reserve model that quantifies the risks identified in surveys and stakeholder sessions against NCFR’s current reserve levels, and that provides NCFR with a reasonably comprehensive yet practical tool to carry forward.

Result: A compilation of total financial risk that can be analyzed by various characteristics – reserve type, time horizon, likelihood, etc.
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Reserve Model Schematic

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STEP 5: DRAFT POLICY RECOMMENDATIONS

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Recommended Reserve Categories
Membership/Assessment A reduction in members, membership dues, and/or assessment allocations due to economic downturn. Conference and Meeting Activities Poor performance on conference and meeting activities from economic downturn, open access, political disruption, or disruptive technology. Publishing Activities Poor performance on publishing activities due to a host of environmental, competitive, and functional factors. Market Volatility Decreased investment returns caused by market volatility.
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Recommended Reserve Categories (cont’d)
Capital Investment Repair, replacement, or expansion of major physical and technological infrastructure. Employment Funds Uninsurable litigation risks. Major Initiatives Entity-wide strategic undertakings not yet executed. Other Baseline Reserve Needs Unclassified ongoing business risks.
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Data Summary
Projected requirement of $10 million at full risk valuation. Recommended reserve categories are as follows.
Capital Investment Publishing Activities Market Volatility Employment Funds Major Initiatives Conference and Meeting Activities Membership/Assessment Other Baseline Reserve Needs Total
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$

2,300,000 2,300,000 1,700,000 1,000,000 400,000 400,000 400,000 1,500,000

23% 23% 17% 10% 4% 4% 4% 15%

$

10,000,000 100%

Not All Risks Will Occur Simultaneously
A reserve level of approximately $7.1M would capture all risks assigned either a medium or high likelihood and a time horizon of 5 years or less. …accounts for 71% of all identified risks at full their valuation. …represents 52% of forecasted fiscal year 2012 operating expenses. …offers a subjectively reasonable bottom range.

LIKELIHOOD

TIME HORIZON

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Recommendation
Based on current risks and forecasted fiscal year 2012 operating expenses of $13.7 million, NCFR should maintain reserve levels between $7.1 million and $10 million.
Reserve Level % of Forecasted FY12 Expenses % of Current Risks at Full Value Amount Over / (Under) Current Reserve Level

Ceiling

$10 Million

73%

100%

$1 Million Over – $1.9 Million Under

Current

$9 Million

66%

90%

Baseline
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$7.1 Million

52%
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71%

Other Considerations
 The nature of these risks will continue changing  Our recommendation is not a static range  NCFR will need to update the data model for significant budget growth or reduction and changing risk profile based on activities  Possible methodologies for further refinement
− Subjective Scenario Modeling: Interactive, more variability − Regression Analysis  Expected Value: Simplistic, would likely undervalue reserve needs  Normal (Gaussian) Distribution − 1 Standard Deviation = 68% of fully valued risks − 2 Standard Deviations = 95% of fully valued risks  Monte Carlo Analysis: Computational algorithms, random sampling
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STEP 6: FINANCE COMMITTEE AND BOARD APPROVAL

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Committee and Board Approval
 Proposal: Change the NCFR Reserves Policy  From the present…
− The minimum recommended goal is to have NCFR reserves at least equal to one half of the total budgeted yearly expenditures.

 To a policy based on a data-driven approach…
− Total Reserves Risks / Exposure of the NCFR

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Proposal
 The Total Reserves Risks (TRR) shall be the sum of all reasonable potential draws on the NCFR reserves.
− NCFR will use a bottom-up method to determine TRR.

 The NCFR FinCom will annually determine TRR update process.
− FinCom will conduct reviews at least once every three years.

 The lower and upper reserve targets shall be determined by the NCFR FinCom as follows:
− Lower: $7.1 million (Today = 71% of current TRR) − Upper: $10 million (Today = 100% of current TRR)

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Proposal (cont’d)
 NCFR FinCom will annually set target points as dollar amounts.
− FinCom will review and recommend to BoD annually or upon major changes for approval. Treasurer can call for a review as needed.

 The state of the actual reserves will be tracked and reported in Treasurer’s monthly financial reporting package.
− Actual reserves are defined as the reserves market value minus forecasted reserves spending plus forecasted operations surplus

 If reserves fall below the lower reserves target…
– NCFR Treasurer will notify President and FinCom and hold a FinCom discussion within two weeks. – FinCom will any suggested actions to BoD.
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Risk is…well, risky…what to watch out for
 Segregate current risks from hypothetical ones.
− Conversely, changes in strategic direction warrant reassessment.

 Know which risks should be mitigated through insurance and/or litigation rather than reserves.  Separate reasonable, ongoing risks to your organization from singular catastrophic events that could jeopardize entity-wide solvency.  Beware of duplicative risks.  Address the nuances of precedent relationships between risks when analyzing for aggregate financial impact.
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Thank you. And come see us at booth #3!
For further information, please contact:
Ben Aase Principal, Nonprofit
220 South Sixth Street, Suite 300 Minneapolis, Minnesota 55402 612-397-3069 ben.aase@cliftonlarsonallen.com

Bruce Braunewell Partner, Nonprofit
610 West Germantown Pike, Suite 400 Plymouth Meeting, PA 19462 267-419-1137 bruce.braunewell@cliftonlarsonallen.com

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Retooling Your Financial Reserves
by Ben Aase It’s an age-old question that many leaders are revisiting during these difficult economic times: “How much money should my organization have in reserves?” There are plenty of arbitrary rules of thumb—for example, holding a minimum of three months’ cash or setting aside 25 percent of your projected annual operating budget. Unfortunately, these “best practices” are not supported by thoughtful reasoning, nor do they reflect the business realities facing your unique organization.
Look to your industry

Being aware of financial trends in your industry can be a good way to start thinking about reserves. For example, governmental entities across the country are facing delayed payments due to projected federal and state budget deficits. As states delay or hold back payments to reduce their fiscal year appropriations, individual entities that rely on those revenue streams need to position themselves to shoulder these aid shifts. Governmental entities should also consider statutory requirements and the limitations that can be placed on financial reserves. And they should know what types of activities the funds can be reserved for, the appropriate mechanism for designating reserves, and any dollar amount limits. Most industries’ membership associations or trade publications also offer standards or benchmarks as guidance.
The “bottom up” method

If you want to move to an objectively informed reserve policy, a more nuanced approach is to use a “bottom up” method. This technique dissects your organization’s business model and identifies the risks to your revenue and expense drivers (and assets and liabilities where appropriate). It then assigns dollar amounts and probabilities to those risks. The result gives an organization a range of acceptable reserve levels based on real scenarios that your organization could face, given your line of business and competitive environment. In practical and general terms, this type of analysis addresses risks and associated reserve needs that are likely to fall under the following groupings: • General operating: for ongoing operational expenses during interim periods of economic disruption (less than 12 months) • Capital investment or improvement: for the repair, replacement, or expansion of major technological infrastructure and facility needs • Business model: for operations over a three-year period during which your organization must make a significant change in its business model • Uninsurable legal: for uninsurable costs associated with litigation • Market volatility: for unanticipated investment losses caused by market volatility • Initiative or opportunity: for business initiatives that require significant development or start-up costs
Putting the idea into practice

To illustrate the idea, take the instance of a large international association with a $350 million operating budget. It used the “bottom up” method to move away from its previous “best practice” reserves policy requiring 50 (continued on page 16)
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(continued from page 15) percent of the operating budget. And while the “bottom up” method did not provide right or wrong “answers” per se, it did provide an objective and data-driven framework and process. In the end, the organization’s trustees felt confident that their reserves policy was supported by a disciplined and reasoned approach that was predictable and consistent. Too often, reserve policies are treated as a one-time exercise, reflective of your organization at a snapshot in time but then left to sit idle. Your organization’s reserve policy should not be static. It should grow with your organization. In today’s tight credit markets, you can’t afford to come up short on reserve funds when they are needed. And while organizations with reserves are often applauded for their conscientious behavior, a short-sighted and insufficient reserves policy can actually turn an organization’s rainy day fund into a risk. So ask yourself: what are our key risk areas at this stage, in this economy, in our field? And then evaluate your reserves. Ben Aase is a nonprofit and government consultant with LarsonAllen. Contact Ben at baase@larsonallen.com or 612-397-3069.

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