Tuesday, September 3, 2013

The Curious Case of Andre Agassi and the Cash Flow Hedge

With the US Open now in full swing, what better way to celebrate than discuss one of tennis' most well-known philanthropists, Andre Agassi.  Andre Agassi's Foundation for Education is a well-known charity effort aimed at transforming education, which includes its own charter school.

Despite its popularity, the foundation has also faced criticism.  Most notably, it has been scrutinized for its high fundraising expenses and low program expenses.  The low program expenses played a part in its receiving only one star by Charity Navigator.  Thanks to strong program expense growth, however, it now receives four stars for its financials.  Two pictures using data from the organization's audited financials demonstrate this change in financial fortunes:

Agassi Foundation Program Expenses
Agassi Foundation Program Expense Ratio
As it turns out, both the problems and the improvements in the foundation speak less to fundamental changes in the foundation than than they reflect a simple feature of accounting for cash flow hedges. To explain this requires a digression or two on cash flow hedges...

Cash Flow Hedge for Variable Interest Debt
Like many organizations, the Agassi Foundation issued debt to finance the building of its school.  Starting in 2009, this entailed a bond of $35 million, issued in conjunction with the city of Las Vegas.  The debt entails interest payments that vary with the prevailing market interest rate.  Such debt can be an effective form of financing long-term projects; however, many charities place a high value on predictable cash outflows, and variable interest debt cannot offer that since the interest payments will vary with (unpredictable) interest rates.

Fortunately, there is a solution – an organization can hedge against such risk of cash flow fluctuations by entering into an interest rate swap agreement.  Such an agreement effectively entails the organization paying a fixed payment to one party who then provides, in exchange, the variable interest payment the organization owes.  The swap is a financial instrument but has the feature of turning variable interest debt into fixed interest debt and, as such, helps smooth cash outflows related to debt service.  This is precisely the road taken by the Agassi Foundation.

Accounting for Interest Rate Swaps by Nonprofits
Here is where things get interesting. Accounting standards require financial instruments to be adjusted to fair value.  If interest rates go up, investors demand more interest but the debt issued by the organization also pays more interest, so the "value" of the debt is essentially constant.  The swap, however, sees fluctuations.  As interest rates go up, the organization's fixed payment gets exchanged for a higher variable payment in return, so the value of the swap increases and the organization sees a gain.  The opposite happens when interest rates go down.  As a result, an organization seeking to smooth cash flows invariably creates volatility in accounting values.  This issue is complicated further for nonprofits, because those value changes flow through the statement of activities, creating volatility in expenses and expense ratios. In the case of the Agassi Foundation, the changes are all treated as program expenses (or negative program expenses in the case of gains), meaning changes in interest rates will create volatility in program expenses due to their hedging activities not their underlying programs.

Revisiting the Agassi Financials
With an understanding of how cash flow hedges can create volatility in a nonprofit's financials, we now revisit the financial picture of the Agassi Foundation.  In 2009, interest rates increased, meaning the organization showed a negative expense relating to its interest rate swaps.  In 2010 and 2011, with falling interest rates, the organization showed a positive expense relating to its interest rate swaps.  As it turns out, these amounts were substantial (in 2011, the $4 million loss was over 30% of the organization's expenses).  If one were to re-calculate the financial statements by excluding the changes in the value of the interest rate swaps, an entirely different picture emerges:

Agassi Program Expenses after Removing Interest Rate Swaps
Agassi Program Expense Ratio after Removing Interest Rate Swaps

Does this mean that the Agassi Foundation's performance has worsened over the last few years?  No, not at all.  What it does mean is that the cursory look at its financials that led people to believe it was once poorly run but has since recovered does not tell the whole story.  Often, the whole story is much more nuanced.

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