Standby Letters of Credit: The Underdog of Charitable Financing

Thursday, June 25, 2009

By John Hoover
Senior Vice President and Chief Financial Officer
The Andrea and Charles Bronfman Philanthropies

At ACBP, our President has a top ten list that quotes Tom Peters. One item is, “Try easier, not harder.” As a foundation that invests in the next generation and is not afraid to take risks, we (with our partners) take innovative ideas and create programs; then develop programs into vibrant charities. One of those is Birthright Israel International, an organization that sends young adults to Israel for a 10-day educational experience. Its annual revenue surpassed $100 million in recent years, yet it is only now celebrating its 10-year anniversary.

As with any entrepreneurial endeavor, there are growing pains and a tendency to make things harder, not easier. Working capital is one of those items where being short can quickly make many things harder.

Birthright grew quickly. It maintained a balanced budget. However, it did not have time to build a reserve since demand outstripped supply. As program obligations (and expenses) reached 6 to 12 months into the future, working capital could only support a couple of months’ worth of expenses. Any hiccup to the system would have created unnecessary costs and eroded quality. This was an organizational risk that required an immediate financial solution. As a result, the Birthright Israel Board and several funders came together to provide collateral by providing standby letters of credit that supported lines of credit at Birthright Israel.

In this context, a standby letter of credit is a document that states that a bank’s client (in this case a Donor) will guarantee payment should another party (in this case Birthright Israel) fail to repay a loan issued by another bank on behalf of the charity. The Donor becomes the payer of last resort, and assets held in the Donor’s name become collateral. While the Donor can invest the assets in a variety of ways, any distribution or mark-to-market depreciation that causes their value to fall below the collateral limits would prompt the bank to issue a margin call to the Donor, which would require additional collateral. The cost to the Donor for establishing and maintaining a standby letter of credit typically ranges from 50 basis points to as high as 100 basis points (this does not include the cost to the charity that takes out the loans). Interest rates for the grantee can range from prime to as high as prime plus 2½ percent.

From a grantmaking standpoint, there are advantages. For foundations, unrelated business income tax (UBIT) would not apply as it would with a traditional loan, since the foundation did not obtain proceeds from a loan. In the event of default, payment could be considered a charitable donation (think of it as pre-funding of future years’ contributions): individuals would get a charitable deductible while foundations would receive credit for a qualified charitable distribution.

Clearly, the downside is that collateral such as cash and marketable securities must be posted and kept at the bank; fees must be paid; and, more importantly, there is a risk of loss. A good rule of thumb is to post no more collateral than you are willing to fund through future years’ contributions to that grantee—just as a grandmother who goes to Atlantic City for a day at the slots should bet no more than she can comfortably afford. For the grantee, the risk is alienating donors. Donors and grantees become business partners and should treat each other accordingly. If communication is not maintained and plans are not thought through clearly, the risk of financial and donor loss increases.

There are many options for providing or obtaining working capital. Charities can go it alone, or they can partner with their donors. A standby letter of credit treats philanthropy as a business transaction rather than a purely charitable one. It is an elegant solution that aligns the interests of the charity and the donor where society is the ultimate beneficiary. It is not an appropriate solution for all situations, but it is an option that should be put on the table.

John Hoover serves as Senior Vice President and Chief Financial Officer of The Andrea and Charles Bronfman Philanthropies. Prior to joining ACBP, Mr. Hoover was the Vice President of Finance and Administration for the Jewish Communal Fund, one of the nation’s largest public foundations. He has been an advisor to several Jewish service agencies, businesses, and family offices, as well as serving the government of New York City in the Bureau of Management Audit. Mr. Hoover has a Master’s in Business Administration and a Bachelor of Science in Accounting and Economics.

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