Building consistency and consensus among a volunteer-led, ever-changing Board can be quite a challenge. There are individual Board member risk tolerances and bias, and market fluctuations that no one wants to be “responsible for”. Board members often argue about fiduciary duty – is it their fiduciary duty to protect the organization from risk, or their fiduciary duty to grow the organization with prudent risk? Similarly, there is often lack of reasoning or benchmarking for risk capacity and amounts allocated to short term vs long term needs. The Board may be silent, or there may be one or two Board members that try to steer the conversation. So how in the world can we build a meaningful, prudent Reserve program that is measurable and consistent?
Step 1: Stop talking about risk tolerance, start talking about liquidity.
If you try to start a conversation about investments with risk tolerance, it will end quickly with zero consensus. Instead, lead with the association’s liquidity needs. You should identify any history of taking money from reserves to fund an annual operating shortfall, and any foreseen or planned liquidity needs outside of the annual budget (capital projects, investments in infrastructure, new offerings, etc.) over the short or medium term.
2 Years Prior: Accessed $70K from reserves to prepay a hotel bill for upcoming conference; shortfall occurred due to timing differences in annual budgeted conference revenue
Next Year: Plan to launch new online learning and certification system; $95K initial investment
Step 2: Use operational data to stress test and forecast revenue.
www.mcdonnell-capital.com 708.925.9507 Page 1 The very best associations use data to make decisions – period. Cash flow forecasting does not have to be overly complex. Identify and stress test your revenue centers (by definition, a revenue center is any item that generates more than 15% of annual operating revenue). Stress test revenue centers by looking at actual prior year performance and asking common questions such as “what if our membership dues fell by 20% due to industry consolidation?” Model and simulate years of underperforming revenue against years of high expenses to determine worst case scenarios in annual operating shortfalls. Example: One Year of Potential Operating Deficit: $90K
Step 3: Assign time horizons to those collective liquidity needs
These liquidity needs become the foundation for financial planning. Once you assign time horizons to them, the Board can better conceptualize overall reserve strategy and compartmentalize how it manages risk.
0-1 Years: Worst Case Scenario: One Year of Potential Operating Deficit: $90K
0-1 Years: Operations Backstop for Funding Liabilities (Timing Difference): Potential $70K Need
1-2 Years: Worst Case Scenario: Another Year of Potential Operating Deficit: $90K
1-2 Years: Launch New Learning System: $95K Need
2-3 Years: Worst Case Scenario: Another Year of Potential Operating Deficit: $90K
3-5 Years: None
5+ Years: None
Step 4: Put it all together using the “bucket” approach
Liquidity driven investing is an academic institutional asset management framework that relies on liquidity and time horizon as the driving factors behind resulting investment objectives and risk. Using a “bucket” approach helps answer the commonly asked questions such as “how much of our reserves should be kept liquid” and “how much risk should we be taking,” among others. In the example, $435K should be kept in short term reserves with conservative risk, allowing any additional funds to be allocated to long term investments. Because it is driven by the association’s own data and liquidity needs, it becomes easier to build Board consensus. Also, communication is stronger between the adviser and Board, and the actions of the reserve account tend to be more deliberate and purposeful.