The inefficient nonprofit marketplace

A friend who’s doing a lot of work to improve giving practices and flows of capital in the nonprofit marketplace asked me the other day: “do you think capital is allocated efficiently in the nonprofit sector?”

“Of course,” is what I was supposed to say, but instead I asked, “Compared to what?”

Here’s another version of these questions, played back with a little more detail:

Question 1: Is there a significant gap between the way capital optimally would be allocated in the nonprofit sector and how it is allocated (where optimal = the best, most high impact ideas / organizations get the most funding; the worst get the least)?”

Answer: Yes.

But before we stop there and dive headlong into the steps we can take to “optimize” how capital is allocated – with better rating systems and more transparency and standards – I’d like us to ask and answer this question too:

Question 2: Is the nonprofit sector any worse than any other sector in how it allocates capital?

Answer:  I haven’t seen any data that helps me answer this question.  So for now, I have to say I don’t know.

Or, more simply:

Might we be a mess? Sure.
Are we any more of a mess than anyone else? Dunno.

For example, let’s compare the nonprofit sector to the mutual fund industry (since both involve individuals and institutions allocating their capital in pretty significant ways).  Mutual fund clients have the clearest incentive to allocate their capital efficiently and to avoid paying for things (like high management fees or stock-picking managers that say they’re going to beat the market) that are proven to be inefficient.  Plus, tons of time and effort has gone in to creating standards and disclosure requirements to protect individual investors and provide them with clear, easy-to-understand information.

And….?  And investors make all sorts of screwy decisions about what to do with their money, pouring billions of dollars into funds that cost 10, 20, 30 times the cheapest and most efficient option.  (And in further proof that we keep on getting halfway to the wall, just three weeks ago the mutual fund industry had another call to action about how disclosure and transparency need to be radically improved.)  In the meantime, high fees persist, people put money into underperforming funds, and investors ignore reams of data that says it’s impossible to beat market returns in the long term, especially with high-fee mutual fund managers.  On average, we buy high and sell low most of the time.

So what about another, simpler point of reference, like, say, just about any consumer product on the market?  Because while mutual fund fees may be obtuse and hard to understand (so arguably a great point of reference for the nonprofit sector), people also routinely spend, say $250 for 1.7 ounce facial moisturizer when its non-comodogenic cousin costs $10.99 for a 20 ounce container (about a 300:1 price difference).

$150/ounce or $0.50/ounce?

The point is not that the nonprofit marketplace doesn’t need better disclosure, more transparency, more accountability – it does. But we need a mental model of what we hope our sector will look like when we’re successful if we’re ever going to get there.  And “better than where we are now” isn’t much of a rallying cry.

Is the model publicly traded companies (with GAAP and ratings agencies…which failed us spectacularly in the latest economic meltdown)?  Is it the mutual fund business?  Consumer credit?   The point is obvious: lots of markets more “advanced” than ours fall short the same ways we do.

Since it’s so hard to find examples of markets that are “working” in the sense that capital is allocated in the “right” way, I would advocate starting by understanding how we’re the same (we’re interacting with consumers who, with limited time and attention, are allocating capital) and how we’re different (nonprofits tend to die slower deaths than their for-profit brethren), and then be clear about what these differences and similarities  mean and, from that, describe the gap we hope to close from where we are to where we hope to be.

In the meantime it feels like there’s a lot of railing about what’s wrong (“it’s not all about overhead ratios!” “Donors just respond to stories and sad pictures instead of digging in and understanding who is most effective!”), and a lot of effort to improve on what we have (by the nonprofits “rating” agencies and work to improve online giving marketplaces) which is all probably productive, but if we don’t know where we’re ultimately trying to go I have trouble seeing how we’re going to get there.

So my closing question is, “What does a highly functioning nonprofit marketplace look like, one filled with real actors who act like real human beings when deciding how to allocate their capital?”  And from that statement, let’s figure out what it will take to get there.

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12 Responses to The inefficient nonprofit marketplace

  1. You raise a great point. The idea that traditional economics always results in efficient, optimized allocation of assets has been widely discredited. This is part of what has given rise to the interest in behavioral finance.

    But, that being said, traditional markets at least have feedback loops where the people allocating the assets get direct feedback (because they buy and use a product or they make an investment and get the investment returns). While this loop may not result in perfectly optimal allocation, largely because of the systematically irrational way that humans behave, it at least helps.

    The giving market place lacks this mechanism since donors do not experience the “product” of the nonprofit which they support. So I find it likely that without a much more coherent effort to create a substitute for this link, giving are markets almost certainly less optimally allocating resources than traditional markets.

  2. This is a great post, Sasha and right on.

    One area, however, where nonprofit capital is for sure allocated less efficiently is the seed investment space. For the large amount of conversation about seed stage money (nonprofit and for profit) for social ventures, people mostly start social change organizations off the backs of contests and the occasional Echoing Green.

  3. Sasha says:

    Sean, thanks for your comment. Quick thoughts in response, none fully formed: first, we agree that clear feedback loops don’t necessarily prompt “rational” or “optimal” capital allocation. And we’re asserting that the feedback loop in the nonprofit marketplace is less well-developed than in investing markets. That all sounds right, and prompts one to ask:

    (1) How feasible is it, really, with the diversity of nonprofit actors, to imagine that we’re going to create a good, strong feedback loop (look for example at the – mostly failed I would argue – attempts to discern which companies are “good” and “not good”)

    (2) If the above is really possible, what magnitude of change in behaviors and, more importantly, flows of capital, do we expect to see?

    Reflecting on point (1) above, from my experience in the CSR space I’d posit that the ratings – if well developed – will if anything have more of an effect on the actors (the nonprofits) than on the flows of capital. Which could be a good outcome too though less direct.

    And regarding point (2), the question I’d ask is: if the goal is to optimize capital flows, what’s the best way to go about THAT?

    No doubt better information will be better…can’t argue with that. I still would love us all to articulate more clearly exactly what we expect to come of it.

  4. Sasha says:

    Nathaniel, you’re absolutely right. It’s not even “less efficiently,” it’s just not there!!

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  6. Hello, Sasha. I want to offer a comment on your post because this is such an important topic and I believe your analysis is wide of the mark. First, some perspective.

    Nonprofits devote an inordinate amount of time, effort and money to fundraising, all of which is secondary to their mission-related work. This unproductive activity is necessitated by the inability of the nonprofit capital market (NPCM) to allocate donations to the most productive recipients. Fundraisers strive heroically to maintain and increase the flow of funding, but given the fact that individual giving has reached record levels and that the recession is far from over, the prospects for increased fundraising become more and more difficult all the time.

    An alternative approach that can significantly increase the capacity of the nonprofit sector to produce greater social impact is to shift some portion of existing donations from less effective to more effective nonprofits. For the same amount of philanthropy provided today, the social sector could produce much greater benefit for people in need. How much more? We can’t say. Which nonprofits are more effective than others? We’re trying to figure that out. How can we encourage donors to think about effectiveness when they give? Another difficult question.

    But the fact that so many difficult questions arise does not undermine the basic fact that improving the allocation of nonprofit capital — rather than focusing solely on increasing its quantity – is one of the most important challenges we face in our efforts to advance social progress.

    Your answer to the question, “Is the nonprofit sector any worse than any other sector in how it allocates capital?” is that you don’t know because there isn’t any data available. I respectfully disagree and submit that the nonprofit sector is unquestionably far worse than almost any other sector I can think of in the way it allocates capital. Because there is so much room for improvement and because the potential benefits of any substantial improvement would be so great (even if we can’t make meaningful quantitative estimates), I think it’s important to consider your question carefully.

    You arrive at your answer by citing examples from the mutual fund and consumer products industries of unjustified price disparities, unwise and uninformed consumer choices, and other “screwy decisions” that contradict the case for more efficient capital allocation in other markets. Although your examples are valid, they don’t, in my opinion, justify your conclusion. All of the examples you point out represent exceptions to the rule that investors and consumers generally try to maximize the financial return on their mutual fund investments and buy the best products at the lowest cost. I don’t know whether the exceptions represent 1% or 20% of the total spending in those markets, but I do know it isn’t anywhere near 50%.

    And the reason I know that is because, as Sean points out, feedback loops would inform competitors that there are business opportunities to take customers away from mutual funds and consumer product makers that were overcharging and underperforming. The exceptions will never be eliminated entirely, but the for-profit capital market has a dynamic mechanism that is designed to help people get value for their money, and that mechanism works more often than not to increase investments that produce higher returns and increase sales of better products.

    The nonprofit sector has no such mechanism. As Hope Neighbors’ research confirms, most donations are based on affinity relationships that are not going to change very much. But there are tens of billions of dollars in charitable donations made every year that are mobile. That money is “allocated” in response to fundraising appeals and other outreach efforts by nonprofits. In contrast to the for-profit capital market in which far less than 50% of spending is based on “screwy decisions,” the NPCM provides donors with no information whatsoever upon which they could make intelligent decisions so that, as you rightly put it, “the best, most high impact ideas / organizations get the most funding; the worst get the least.”

    We all know the reason this is so: donors don’t consider information about nonprofit effectiveness because nonprofits don’t publish meaningful information about their results, and nonprofits don’t publish meaningful information about their results because donors don’t consider that information. Until the NPCM creates a mechanism to help donors find and fund well-run nonprofits that are accomplishing well-designed goals and outcomes, philanthropy will remain essentially indiscriminate.

    That is, while we know that “screwy” investment and consumer buying decisions are the exception rather than the rule (even though we don’t know exactly how large the exception is), we can’t say the same thing about charitable donations. The NPCM provides no mechanism to guide donations to more effective nonprofits and away from less effective ones. For all we know, the NPCM (or at least those tens of billions of dollars that are in play) could be 100% sub-optimal. If donations find their way to more effective nonprofits, it would result more from luck and other random factors than the intelligent allocation of capital.

    I’m encouraged by two trends. First, there are much wider differences among nonprofits today in terms of how well they’re managed and how much they accomplish than there has ever been. Even though it’s nearly impossible for average donors to distinguish between high-performing and low-performing nonprofits, there are very compelling incentives for them to do so. The potential for donors to increase social impact by making more informed choices has never been greater.

    Second, a lot of really smart and innovative folks are coming up with a raft of really promising ideas for creating an NPCM that will make that information readily available to donors, and provide strong incentives for nonprofits to focus on improving their results and publishing that information as a much more cost-effective alternative to traditional fundraising. I predict that, within five years, we’ll look back and say, “Remember when we used to make donations without any idea of what the charities actually accomplished?”

    Thanks for the opportunity to comment on this vitally important issue.

  7. Mike Bowerman says:

    Great post and comments! I would amend your definition of efficient capital allocation from “the best ideas get the most money, and the worst get the least” to “the best ideas get the most money, the worst get the least with the very worst getting none and closing.”

    Bankruptcy and creative destruction are vital to improving capital allocation, and they are weak forces in the non-profit and government sectors but real forces in the business sector. Having equivalent forces culling inefficiency in non-profits would help the sector in the long term.

    The inefficiencies you point out from the business world are accurate, but the most interesting thing about the traditional capital markets is that despite such flaws and imperfections they are allocating capital in a generally more efficient direction — which is why the global economy grows on average, and we see constant innovation like iPhones and iPads, hybrid cars, Google docs and cloud computing, etc. Even when the financial markets “fail” with a 30% collapse, lights stay on, food is delivered, planes fly, surgery is performed. It’s a flawed system which can be improved and needs repair, but amazingly resilient.

    Similarly with the mutual fund example — the average market return is going to be the rate of growth in the economy as a whole. So we would expect mutual funds and other investors to average the exact same rate — not more or less. 50% of mutual funds will be below average, and 50% above average. That includes grossly incompetent money managers, and the Warren Buffets of the world. On average, they are getting things right more often than getting them wrong — that is where the growth is coming from.

    I’m not aware of analogous evidence of improvement or efficiency from the non-profit sector.

    The critical point made in this post and elsewhere though, that better tools are needed, I wholeheartedly agree with. I think it requires: 1. more sophisticated evaluation strategies, 2. more educated funders who allocate a percentage of all their grants to evaluation and stop considering “overhead” to be undesirable, 3. educating NP management in these same systems.

    The idea of a “Chief Impact Officer” or “Chief Evaluation Officer” should become the norm and parallel specialists should exist in funding agencies.

  8. Sasha says:

    Hi Steve, thank you for such a detailed, thoughtful comment. I won’t try to reply in full, but do want to share some thoughts:

    1. You state “Nonprofits devote an inordinate amount of time, effort and money to fundraising, all of which is secondary to their mission-related work.” I think you’ll see as you dig deeper into this blog that I disagree with this statement – when done right I believe that fundraising is absolutely integral to mission and I believe that the mindset that it’s obviously ‘secondary’ to mission-related work is part of the problem.

    2. “We all know the reason this is so: donors don’t consider information about nonprofit effectiveness because nonprofits don’t publish meaningful information about their results, and nonprofits don’t publish meaningful information about their results because donors don’t consider that information.” Hmm, my head is spinning with this circle but I think this is the crux of the issue. My main point in this post is that if we observe consumer behavior across the spectrum – multiple products, multiple sectors – we see that in the majority of cases the availability of the type of “meaningful information” about performance isn’t driving the majority of purchase / capital allocation decisions. Does that mean we shouldn’t take steps to provide this information in the nonprofit sector? No, I don’t think it does. But I think we should be realistic AND more articulate about the expected impact once said information is made available.

    3. By and large I think I’m fundamentally less sanguine than you that we’ll succeed in creating information about nonprofit performance that will serve as anything but a gating factor / negative screen. My perspective here is highly informed by the time I spent working in the Corporate Social Responsibility space just at the time when the first raft of standards were being created. So I feel like I’ve seen this movie before, and a decade in we have BOTH progress in the kind of information that is available about corporate behavior AND minimal shift in terms of the impact providing this information has had on corporate behavior writ large.

    I do hope I’m wrong and you’re right, and that five years from now we’ll look back at today with awe over how far we’ve come. In the meantime I think we would be much more likely to get there if we put additional effort into looking into the paths that have been walked in other sectors – CSR, financial products, etc. – to see what we have to learn. Otherwise, we have no advantage, as a sector, from being a late mover…we’re just late.

  9. Brigid says:

    I believe when you say “nonprofits” here what you really mean is “nonprofits solving social problems.” Hunger, poverty, access to education, etc – the types of issues where you want resources efficiently allocated to the org that will achieve the most impact. I.e. the competitive marketplace where the best problem-solver wins (at least theoretically).

    However, some nonprofits should not operate in this competitive “winner-solves-all” environment. The arts, for example. Here, having more organizations with more forms of expression reaching out to more people is better. Taking one artistic idea and scaling it would be counter to point of the arts. You want lots and lots of localized ideas meeting localized communities. Funding that encourages more ideas is better (funding that encourages competition destroys the point: http://artsbeat.blogs.nytimes.com/2010/07/16/arts-groups-are-all-a-twitter-over-grant-money/)

  10. Sasha says:

    Brigid, great point. I think the inherent value of diversity of ideas and forms of expression in the arts is probably qualitatively different. By definition great art doesn’t “scale” (whatever that even means).

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