How Private Foundation Sophistication Affects Capital Campaign Grant Decisions

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How Private Foundation Sophistication Affects Capital Campaign Grant Decisions

ABSTRACT:

 We examine how charity financial information related to efficiency and financial vulnerability is used by private foundations in determining how much they grant to charities during capital campaigns. In general, private foundations are likely to be better able to evaluate charity financial information because they are sophisticated donors. They have the incentive to incur search costs, the ability to judge financial information, and are focused on grant-making. We find no evidence that efficiency measures are used by private foundations in determining capital campaign grant amounts, regardless of foundation sophistication. We interpret this result as being consistent with private foundations focusing on factors related to program accomplish- ments rather than on reported efficiency. We find evidence that private foundations pay larger grant amounts to less financially vulnerable charities. This effect is concentrated when grants are paid by more sophisticated private foundations (i.e., those that employ a professional staff ).

Data Availability: Data are available from the public sources cited in the text.

Keywords: private foundations; public charities; efficiency; program ratio; financial vulnerability; donations; capital campaigns.

 

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INTRODUCTION

harities play a large role in our economy by receiving donations that are used to provide critical services to those in need. In 2017, public charities received an estimated $410.2 billion in total donations (Giving USA 2019). Donors are primarily interested in whether

charities are effective in providing their program services (Parsons 2003) and, ideally, donors


 

This paper has benefited from helpful comments by Christine Petrovits, Perry Solheim, session participants at the 2014 American Accounting Association Western Region Meeting and 2014 Annual Meeting, and the work by Tim Yoder on an earlier stage of the paper. Professor McAllister would like to thank the College of Business at the University of Colorado Colorado Springs for summer research funding.

Editor’s note: Accepted by Vaughan S. Radcliffe.

 

Submitted: July 2018

Accepted: September 2019 Published Online: September 2019

 

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would evaluate effectiveness by comparing program accomplishments to dollars spent. However, due to their complexity and qualitative nature, program accomplishments are difficult to quantify. Most donors lack adequate time, expertise, and detailed information to make a thorough evaluation.

Private foundations differ from other donors in that their core business is evaluating charities and distributing grants. Private foundations are ‘‘all assets and no liabilities’’ (Schramm 2006), meaning they have extensive resources to employ toward grant-making activities. Because private foundations’ activities are focused on grant-making, they have both the incentive to incur search costs and the ability to judge financial information. Many private foundations also formally request charities to apply for grants, which provides access to private charity financial and nonfinancial information that individual donors are unable to obtain. In general, private foundations are sophisticated donors. In 2015, over 79,000 independent U.S. private foundations existed, and combined, they held $704.0 billion of total assets and paid grants totaling $44.1 billion (Foundation Center 2019).

Our study is the first to our knowledge to examine how charity financial information is used by private foundations in making charitable grants. We focus on grants for capital campaigns because they involve fundraising efforts by charities to secure significant amounts of financial capital for specific, long-term purposes. Capital campaigns provide a context where private foundations are likely to provide leadership grants to charities. Leadership grants often launch a capital campaign, and therefore are important as a credible signal of grantee charity quality (Andreoni 2006). As a result, private foundations are likely to expend significant resources to gather, evaluate, and communicate information about grantee charities seeking capital campaign funding.

Because most donors are less sophisticated than private foundations, the majority are likely to rely on readily available charity efficiency measures such as the program ratio. Prior research (Weisbrod and Dominguez 1986; Posnett and Sandler 1989; Tinkelman 1999; Okten and Weisbrod 2000) provides consistent evidence of an association between total donations and efficiency measures. However, donors’ reliance on the program ratio has been criticized as being incomplete and inaccurate (e.g., Tinkelman and Donabedian 2007). Administrative and fundraising costs are necessary for charities to achieve their mission. Program ratios disregard organizational strategy and are dependent on charity-specific factors (Baber, Roberts, and Visvanathan 2001; Tinkelman 2006). Failure to adequately plan, evaluate, and coordinate program activities is likely to lead to program costs that are inefficient, even counter-productive, at achieving charity missions. Further, prior research (Tinkelman 1998; Khumawala, Parsons, and Gordon 2005; Jones and Roberts 2006; Krishnan, M. Yetman, and R. Yetman 2006; M. Yetman and R. Yetman 2013) has established that charities often attempt to manipulate their program ratios. Donors’ excessive reliance on the program ratio has the potential to lead to inefficient allocation of charitable capital, such as cutting productive administrative and fundraising costs, as well as other dysfunctional behavior (Kitching, Roberts, and Smith 2012).

We examine how private foundations use program ratios to evaluate whether charities are using donations received efficiently toward program-related activities. Private foundations as more sophisticated donors are likely to place less emphasis on the program ratio relative to individual donors for at least three reasons. First, they formally request charities to apply for grants and have better opportunities to informally request information during the grant process, both of which provide access to private charity financial and nonfinancial information that individual donors are unable to obtain. Second, private foundations have greater expertise and experience to see through any manipulation of the reported program ratio. Most importantly, foundations have greater expertise and resources to evaluate program results. In contrast to prior research, we


 

expect that grants from a more sophisticated donor group, private foundations, will be less sensitive to program ratios.

We also examine how private foundations evaluate whether charities are financially vulnerable. Financial vulnerability is typically assessed using financial measures such as debt ratio, revenue concentration, profit margin, and working capital (Tuckman and Chang 1991; Greenlee and Trussel 2000; Trussel 2002; Trussel and Greenlee 2004; Hodge and Piccolo 2011; Gordon, Fischer, Greenlee, and Keating 2013; Searing 2018). Parsons and Trussel (2009) find that financial stability (the converse of financial vulnerability) is positively associated with total donations. However, their study does not examine the relationship between financial vulnerability and donations by donor type. All donors are likely to care about financial vulnerability. However, because financial vulnerability is more difficult to assess, not all donors are likely to have the ability to evaluate it. Private foundations as a larger, more sophisticated donor type are at an advantage of assessing financial vulnerability. Again, they have greater access to private financial and nonfinancial information through the grant application process to help evaluate financial vulnerability. They also have more resources to employ professional grant-making personnel with the sophistication to be able to judge financial vulnerability. Furthermore, private foundations are likely to be motivated to evaluate whether charities are vulnerable financially because of the long- term focus of capital campaigns. We expect private foundations to respond negatively to charities that are financially vulnerable.

Finally, sophistication is likely to vary across private foundations. We propose that the extent to which private foundations are sophisticated will impact how they respond to program ratios and financial vulnerability. Some private foundations are created with the intent to operate as stand- alone entities in the formal business of professional grant-making. These are ‘‘active’’ grant makers because they employ professional managers and staff (Sansing and Yetman 2006) to evaluate the likelihood and magnitude to achieve significant social impact through their grant-making (Fleishman 2009). We classify these as ‘‘more sophisticated’’ private foundations. Alternatively, some private foundations are established as extensions of the founder as an individual donor. They donate to express support toward a worthy cause, but do not expect to make a lasting social impact through their grants (Fleishman 2009). As a result, they have little need to employ professional managers or grant-making staff to evaluate potential grantee charities. Sansing and Yetman (2006) identify these as ‘‘passive’’ private foundations. We classify these as ‘‘less sophisticated’’ private foundations.

Our final sample consists of 2,872 capital campaign grants made by 530 private foundations to 1,700 charities. Because of data unavailability, we exclude charities that did not receive a private foundation grant.1 Therefore, our sample consists of charities after the use of efficiency and financial vulnerability measures by foundations to initially screen grant applicants. We find no evidence that efficiency measures are used by private foundations in determining capital campaign grant size to grant-eligible charities, regardless of foundation sophistication. We interpret this result as being consistent with private foundations focusing on factors other than reported efficiency (e.g., program accomplishments). In contrast, we find evidence that private foundations pay larger

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