A Need for Renewed Focus on Improving Capitalization in the Arts

After the Great Recession, much attention was focused on the need to recapitalize arts organizations. Foundations funded research to improve collective understanding of appropriate capitalization levels and identify the barriers to responsible capitalization.  The punchline: undercapitalization was not due to lack of financial fluency among arts organizations. They knew what they needed.  Instead, arts organizations found it difficult to ask for the kinds of capital they needed most, cash reserves.  After all, if an organization is well run, why should it need for reserves? Contributors prefer to fund big projects such as facilities that may actually contribute to capitalization challenges rather than relieve them.

All the scrutiny surrounding capitalization levels yielded little improvement. Over the next decade, the working capital levels of arts organizations declined below the levels where they had exited the Great Recession. According to SMU DataArts, in 2019, the average arts organization had only about a month and a half of cash on hand. Had governments not undertaken massive bailouts, the pandemic could easily have wiped out a third of arts organizations or more.

As organizations reemerge from the pandemic, their cash positions are worse than ever. Nearly half of arts leaders surveyed by ABA expect a deficit budget next year. That’s unfortunate because the operating environment is even more treacherous than it was coming out of the Great Recession. Audiences have been slow to return, and many long-time donors are turning their attention to social justice and safety net causes. At the same time, inflation is driving up costs and staff are turning over at record numbers. 

To survive and thrive, arts organizations absolutely must have more capital, and it must be the right kind of capital, to navigate the risky path ahead.

ABA has just written a capital primer to educate board members, funders and other stakeholders about arts capitalization needs. (ABA Members, click here to access this report) In part, the report provides a taxonomy of capitalization types and in part a distillation of expert advice for appropriate capitalization levels.

At the basic level, capital allows organizations to operate existing programs, preserve long-term assets, and mitigate the risks associated with change. For these purposes, the following types of capital are needed:

• Working Capital: smooths out cash flow bumps arising from predictable business cycles

• Operating Reserve: protects against operational disruption due to unexpected downturns

• Capital Replacement Reserve: funds long-term facilities-replacement plans (e.g., a new roof)

• Opportunity capital: Funds innovation necessary to fuel growth within the existing model

Most stakeholders are at least aware of the first three of these capital types, but fewer think about Opportunity Capital. It’s helpful to think of Opportunity Capital as the research and development (R&D) fund for the organization.  Most for-profit firms have R&D budgets in order to keep their products relevant and take advantage of growth opportunities. Few arts organizations set aside Opportunity Capital, yet it’s arguably more important for the arts, where one misstep with core programming can place an organization on precarious financial footing. More than ever, arts and culture organizations need to find ways to resonate with the next generation of attendees without turning off current core audiences.  Opportunity Capital will likely play an increasingly important role in mitigating the risk of that experimentation.  

Related to the capital dialogues currently underway is the question of the role endowments should play in arts organization capital health. Nearly everyone agrees that having a huge endowment already would be delightful, especially as a means to protect against the next major disruption.  The question is whether to invest the next increment of organizational resources in building the endowment right now, at a time when arts organizations badly need unrestricted cash in order to balance budgets and protect against disruptions.  Of course, each organization must decide based on unique circumstances, and no organization should turn down funds that will only be donated as restricted endowment, but a high bar exists right now for devoting discretionary resources to endowment-building.

One thing that nonprofit capitalization experts agree on is that endowments should not act as a substitute for a sound business model. Just before the pandemic, in an editorial in the Baltimore Sun, the chair of the Baltimore Symphony Orchestra’s Endowment Trust wrote, “we are not and cannot be the only answer to an unsustainable business model. Larger draws from the endowment would not fix the problem, they would just kick the can down the road.”

In the coming months and years, the question of business model sustainability is likely to open a new frontier in capital spending—Change Capital.  More and more, organizations are going to find that their financial health depends on more than simply bridging the gap between their current state and their former business model. For many, long-term revenue trends compounded by pandemic-driven behavioral changes, will mean that current business models are no longer sound. To remain viable, organizations will need to build the capability to develop fundamentally new products, tap new kinds of customers and even transform their missions to serve the community in completely different ways. To avoid existential risk during this period of significant transformation, organizations will have to get much better at defining and articulating the business model change they need to make and raising the Change Capital that will enable it.

The good news: organizations that are successful at investing Change Capital wisely are likely to find themselves in less need of the rainy-day funds they’ve been asking for repeatedly this century.  Organizations that don’t need to take such drastic measures have, at a minimum, got to get much better at making the case for raising the unrestricted funds that will protect against the next, inevitable, disruption. After two major upheavals this century, hoping for the best is not an option.