Can a state agency manage an entrepreneurial entity?

For a period of five years I chaired the board of directors for a non-profit entity that was a subsidiary of a state agency. About a year ago, the parent board (of the state agency) chose to "reconstitute" the non-profit board and all of the non-interested directors were dismissed.

During the first seven years that the entity was in existence (2 years before and my five years ) the organization did some pretty good things. But in the subsequent year it has stalled. That is partially a result of changes in policy at the federal level and partially because the entrepreneurial spirit of the place has been almost entirely drained. Here is the record for the first seven years - this entity grew from about $1.7 billion in activity to $7 billion. At the same time the start up capital grew from $20 million to more than $160 million - that was in spite of paying out more than $500 million in benefits to students. During the period the major indicator of success (in this case defaults in student loans) was improved (or reduced) by a third. Finally, even with all the growth, the entity reduced its operating costs by 11%. By any account that is a phenomenal set of statistics.

When non-profit was created after two failed attempts to run the function as a state agency. Since the non-profit was created, if anything, the competitive conditions and challenges have grown. So there is a real question about how to best manage this function. There are several alterantives - exclusively as a state agency, in the current model, selling off the non-profit and having the buyer submit a residual back to the state, or moving all the functions including the current ones to a non-profit where some additional state oversight might be still in place. Clearly, based on my experience with the board, something in the structure needs to change.

The conflict between the state and agency and the non-profit was continuous. That was caused in part by a clash in cultures. The state agency wanted to operate like a state agency and the entrepreneurial entity needed to operate much differently. But the state culture did not serve the entity well. Remember, this non-profit operates in a very competitive environment - there are lots of competitors and most have a wider range of revenue centers than the one in California. Four examples might illustrate the problem. Several years ago, the board, as a part of a long range planning process, began discussions with a for profit entity. We made a proposal to acquire the entity for a present value price of about $250 million. The state control entities began picking the deal apart. Ultimately, they denied the ability to make the buy. A few months later the company went on to do an IPO that amounted to more than $1 billion. That left a substantial amount of additional resources off the table and at the same time continued the business in its one area. After that experience the company's board along with the state agency worked hard on a business diversification strategy. The issue was vetted as carefully as something like this could be. Yet, in the end the agency's board rejected the proposal - even though several of the leadership in the agency had supported the proposal. Another example, and what precipitated the eventual change in the board, a competing entity wanted to join with the company on some joint projects and a possible merger. The state would have realized a huge sum. But again the state organization could not figure out how to do the due diligence to figure out whether the right sum was being offered. In all of these cases the state could not figure out how to deal with a quick changing situation.

What was most frustrating about the process from my perspective was a complete lack of ability to follow through in a timely fashion. The final straw was a six-eight month process to look at ways to diversify the business activities of the company. Again the process thoroughly vetted a variety of models. But again, the board of the agency ultimately was unable to act in a timely fashion.

Admittedly, there were some personalities involved here that clashed. There were also some fundamental conflicts based on the statutory construction that created the non-profit. But there were also some interesting personalities - some very dedicated to the purposes of the entity and the broader purposes of the state agency and some very dedicated to the narrow political agendas of their own invention.

When the board was dismissed, a lot of grumpiness emerged. Amazingly, I was not in that crowd. I was pleased to relinquish the role - although I think I added some value while I was there. Some key legislators joined in the discussion. Two important ones supported the dismissed board and one other took the side of the executive in the state agency. Ultimately, legislator in support of the state agency director asked the Bureau of State Audits to do an audit of the non-profit. The BSA released its report this week with three main conclusions. The BSA audit is in addition to a whole host of other audits done on the entity by internal and independent auditors and by all sorts of other entities. The point is the BSA audit was not the first. The BSA audit was very narrowly drawn. It did not audit the business position of the entity nor did it look carefully at the the broader issues that might be examined in a normal audit. It did look at how the entity spent its money and it ultimately made some comment on the organizational structure of the entities. So my impression of the audit is that it was technically correct on the issues but failed to recognize the unique structure of the non-profit or the conditions under which it operates. The three conclusions were not surprising.

The first was that somehow the Commission and the non-profit was not as careful as it should have been with expenses. They detail the costs of several meetings and their associated expenses. They cite some meetings and events that cost a total of slightly less than $700,000 over four years. The examples cited include a series of activities including an employee motivational event (held once a year) which cost something in the range of $100 per person - that included food and gifts and speakers fees. It was a high motivational event. Then there were some holiday party expenses. There the costs were in the range of $40 per person. Thus between the two events, employee motivation expenses amounted to $140 per employee. For a highly motivated organization that grew like the non-profit did - that seems like a small amount.

The costs of joint meetings and board meetings is also analyzed. Near the end of the tenure on the board there was a flareup about a meeting. The Executive Director of the state agency (who was a good deal of the problem - with no relevant business experience and a lot of political attitude) grumped about the place that the meeting was to be held. I asked the president of the company to look at the alternative that the Executive Director was suggesting. Our analysis suggested that the "cheaper" alternative would have actually cost about $2000 more. The logistics person for the non-profit was good at searching out nice locations that were relatively inexpensive. The land costs were always done American plan and one of the board members always paid for expenses that would not be covered under a state agency (like drinks at dinner). Sure, the costs of those meetings could have been less - but they were clearly in line with other non-profit entities and significantly less than for profit entity expenses in the same general line of business.

Finally, there is a discussion about the bonuses that were paid to the non-profit's executives and employees. A basic understanding of the authorizing statute was that employees should be incentivized. That was a primary reason for establishing the non-profit. One year the CEO of the organization was paid a $30,000 bonus in a year when the bottom line increase amounted to $60 million. That amounted to an incentive payment of about 14% of the CEOs salary - which in the world of for profits is more like a tip. The bonus structure in the non-profit was always a small percentage of total salaries. At the same time the board's compensation committee did a rigorous evaluation of both the perfomance of the executive team and the comparability of salaries in similar entities. What was interesting about the process from my perspective is that the comparative market scan and the rigorous employee analysis anticipated some of the standards established in the relatively new intermediate sanctions regulations of the Internal Revenue Service. The due dilligence by the board is not noted in the audit.

Ultimately the BSA audit got the numbers right but missed important issues about how to operate in a very competitive environment. An alternative review was done by the Legislative Analyst. This was not a formal audit but rather a policy analysis. As opposed to the BSA process which did a lot of counts of activities but missed the energy and dynamics of the organization - the LAO process looked at how to make the organization continue to offer continued benefits to the state and students. Their report suggested some alternatives that looked at how to make the organization work better - it suggested that the best way to solve the problems would be to eliminate one of the boards and move the entire entity into a non-profit. That idea makes a lot of sense.

I come back to the politics of the situation. For one who has operated in and around political activity over the last four decades - the politics here often outweighed the business purpose. Narrow agendas of board members and the executive director of the agency often took precedence over the broader long term goals of the entity. That is unfortunate. The key leaders of the non-profit (in the CEO, CFO and General Counsel) soon found other positions. An interim was installed who is probably the best kind of leader the non-profit could obtain at this time - a person with a lot of experience and knowledge about the area but without the entrepreneurial drive of the person who left.

So can a state agency manage an entreprenuerial entity? The experience from my five years and from the subsequent year since I left suggests that the culture of bureaucracies cannot be successful and probably should not try. That offers a couple of lessons. The non-profit only idea from the LAO has a lot of merit it might reduce the frictions established by the two entities and yet keep the public service nature of the two organizations in view (the non-profit had a strict public service mission but not a governmental one). Or the state could simply let the entity fade away over time - ignoring the manifold number of missed opportunities to benefit students. In either case the result is a troubling one.