Nonprofits Weigh the Costs of Paying Debts With Endowment Assets

Some charities are considering an idea that would have seemed radical only a few years ago—whether to pull funds out of their endowments to pay off debts.

The very consideration of the idea is a testament to the lasting scars of the financial crisis, which led to a sudden drop in endowment values at the same time that other sources of charity revenue were also falling.

Wes French, an investment adviser in Atlanta who serves on the investment committees of several local charities, including the Atlanta History Center, Agnes Scott College, and the Foundation of Wesley Woods, says the question has come up both at boards on which he serves and at other charities for which he manages money.

“Investment portfolios have done very well as the markets have righted,” Mr. French says. “Is now the time to carve off some of the endowment and go ahead and pay that debt off?”

Mr. French says board members generally splinter into groups on the topic, based on their appetite for risk.

Those who favor leaving money in the endowment point out that stocks tend to earn a higher return than the cost of debt over the long term.

And borrowing rates have rarely been better. Some charities with adjustable-rate debt are currently borrowing money at just over 2 percent a year; the Massachusetts Institute of Technology recently issued century bonds—debt that is not due for 100 years—at a rate of 5.6 percent.

A bullish board member might point to an endowment’s long-term record—say, an average return of 9 percent a year—and argue that the charity is making money on the cheap debt.

“You’ll go around the room, and someone will say, ‘Why would we give up that 7-percent spread that we have locked in?’” Mr. French says. “But it’s not locked in. You could just as easily have a year with 20-percent losses.”

More-cautious board members argue that using unrestricted funds from the endowment to eliminate the debt might help a charity’s operating cash flow. The payments to service the debt would go away.

A Disciplined Approach

The investment committee of the Houston Ballet recently debated moving more of the endowment into cash that could potentially be used to pay off the $4-million it borrowed to finish its $46-million Center for Dance. Cheryl Zane, the ballet’s finance director, described the debt as a “huge undertaking” since the charity has never borrowed before.

The organization ultimately decided it would try to raise money to pay off the debt. And Ms. Zane believes the wager should pay off even if the debt stays around for a while, since the charity is currently borrowing at a floating interest rate of roughly 2 percent. “We should be able to earn more in the endowment than what we’re paying on the loan,” she says.

Mr. French advocates a middle-of-the-road approach for nonprofits considering using endowment for paying debt. At one charity on whose investment committee he serves (he declined to name it), the organization has developed a plan to pay off its debt within 10 years.

The group is increasing the annual share it taps from its endowment from 4.5 percent to 6 percent, and in any year in which part of the endowment money is not needed for operating costs, those funds will be used to retire a portion of the debt. “We’re not making a big bet either way, but we’re putting a discipline in place to pay off the debt,” Mr. French says.

Developing a strategy for eliminating debt is more important than the specific approach, he says: “If interest rates go up and stock prices go down, you’ll be sorry that you didn’t have a plan in place.”