Real Talk: Crunch time

Rapidly increasing interest rates and jittery lenders have conspired to create a classic credit crunch: the price of money has gone up and the supply has gone down. It’s called a “crunch” because it puts financial pressure on any organization reliant on outside capital. Start-ups and highly-leveraged businesses have a well-known susceptibility to getting “crunched” but we are also hearing from nonprofits – particularly larger ones with government contracts – that are feeling the pressure.

Imagine a $40 million nonprofit that is 90% funded by the government and 10% by philanthropy. For simplicity, let’s assume that philanthropy comes in six months before the associated expenses and government money comes in six months after. On these assumptions, the nonprofit needs working capital of about $15 million of which, let’s assume, they have traditionally borrowed $12 million.

Over the last year, the prime rate – the rate at which the very best customers can borrow – has risen from 3.25% to 8.25%. So the nonprofit in this example is now paying at least $600,000 more in interest. I say “at least” because the extra “spread” that many nonprofit borrowers pay above the prime rate has also increased as well. So, let's assume that the nonprofit pays $700,000 more in interest because of a combination of increased rates and slightly larger spreads; an increase that represents 2% of its revenue and more than 15% of its philanthropy.

For many businesses, higher interest costs can be managed. In fact, the Federal Reserve usually raises interest rates when businesses – taken as a whole – have it too good. Faced with higher borrowing costs, a business may be able to increase prices, decrease costs, or simply pay the extra interest out of profits.

For the nonprofit, things are trickier. It can’t raise prices since the government is unlikely to voluntarily agree to pay more and few contracts have built-in adjustments for interest rates. It can’t easily reduce expenses since most of its costs are for labor and staffing levels are already at a bare minimum. It can’t pay the interest out of profits since profit margins – particularly for larger human service organizations with government contracts – are already so low that even a small increase in interest costs can lead to unsustainable deficits. 

Facing this crunch, the nonprofit can do three things:

Reduce the need for outside capital by collecting faster

While it’s true that government is too often slow to pay, some nonprofits are still much better at collecting all of what they are owed than others because they are maniacal about getting the paperwork right the first time and submitting it as soon as possible. (It’s easy to blame all payment delays on the government even when they are only mostly to blame. Nonprofits that struggle with payments should consider getting an outside audit of their processes and might even consider outsourcing the function.)

Reconsider capital-intensive contracts

In a higher interest rate environment, late payment is a form of less payment. The 5% increase in interest costs means government contracts that pay six months late are now worth 2.5% less than they were a year ago. Nonprofits feeling squeezed should consider handing-back contracts that consume large amounts of working capital.

Actively manage cash

Most nonprofits have at least some cash sitting around and with short-term treasuries paying more than 5% they may be able to earn more interest by actively managing it as opposed to keeping it in the bank. 

All this assumes that the nonprofit can borrow as much as before provided it can pay the higher price. However, anecdotal evidence suggests that the amount nonprofits can borrow has also gone down which is hardly surprising given the recent turmoil in the sector, particularly among the smaller bankers that tend to be more active in lending to nonprofits. The inability to refinance or renew existing debt is often part of getting crunched.

What can the rest of us do to help nonprofits survive the crunch?

Government should recognize that higher interest rates make it even more imperative to reform procurement and get money moving faster since the burden imposed on nonprofits forced to wait has grown.

Higher interest rates create an even greater need for public-private lending funds to provide capital on reasonable terms to nonprofits getting squeezed. In particular, the city should provide more capital to grow the returnable grant fund managed by the Fund for the City of New York and other similar vehicles. (Full disclosure: SeaChange and the Adams Administration recently announced one such fund). 

Foundations and well-heeled individuals (including board members) should make loans to nonprofits either directly, by using an outside manager to support loans to grantees (as Trinity Church Wall Street and the Mellon Foundation have done), or through participation in outside funds. They should be more open to using guarantees and other mechanisms to encourage third-party lending.

Finally, funders should recognize that nonprofits facing higher interest costs may have no choice but to pay it from philanthropy. For many organizations, interest is an unavoidable cost of doing business and that cost has risen. While donors are unlikely to be excited by “Pay Our Interest” galas or interest-defraying grants, they must help give nonprofits at risk of being crunched the breathing room to figure out their longer-term strategy.