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University Endowments: The Gathering Storm

11.7.08

In reporting investment returns on the endowment through last June 30, Harvard Management Company's (HMC) leadership—writing in early September (see here)—cautioned that "We are quite cognizant of the near-term risk of subpar investment returns from many of the asset classes in which we and other investors participate. We are closely monitoring the deterioration in certain underlying debt and equity markets and the potential impact of these declines on the ultimate realizable value of investments in our private equity portfolio and on certain of the investments held by our hedge fund managers.” The investment environment, they warned, would be affected by the continuing "process of financial market de-leveraging. This process will likely create periods of disruption and market volatility.”

And how. Although neither the University nor HMC has commented further on the change in value of endowment investments, other institutions have begun to report large losses in recent weeks. All of the news has been grim—much of it accompanied by announcements of immediate cutbacks in spending, or strong suggestions that such belt-tightening is in prospect.

Here we take a look at Harvard's reliance on endowment income to fund academic operations; the news from other academic institutions; and the composition of the endowment—in an attempt to provide context for any forthcoming University announcements. Harvard Magazine will of course immediately report any breaking news on this website.

What is Harvard's position? The sustained strong growth in Harvard's endowment, to an aggregate value of $36.9 billion as of last June 30, has underpinned much of the University's academic and programmatic growth for the past two decades, while effecting a transformation of institutional finances. During the fiscal year ended last June 30, distributions from the endowment in support of operations totaled just over $1.2 billion, nearly 34.5 percent of the University's revenue of almost $3.5 billion; separate capital distributions from the endowment totaled another $400 million or so.

Endowment distributions are much the largest source of operating revenue today, far outstripping tuition and fee revenues (20 percent), sponsored support for research (19 percent), and other flows of funds.

A decade ago, endowment distributions accounted for just 23 percent of operating revenues. Historical data (they were last published for fiscal year 2006; see the exhibits at pages 63-68 of that year's report, here) show that some schools were much more dependent on the endowment, which accounted for 46 percent of revenues for the Faculty of Arts and Sciences (FAS), 66 percent for Harvard Divinity School, and 73 percent for the Radcliffe Institute.

It is reasonable to estimate that reliance on endowment to fund operations has increased since, at least in some cases: the Corporation has authorized significant boosts in endowment distributions for the past few years (to pay for expanding the faculty ranks, augmenting financial aid, and other priorities); federal support for research (primarily in the sciences) has been flat; and the business and law schools have been conducting significant capital campaigns during this period, augmenting their endowment resources. Indeed, in reporting to FAS last May, Dean Michael Smith noted that endowment distributions accounted for 50 percent of that faculty's revenue in fiscal year 2007—a four-percentage-point gain in one year (see the financial exhibits at pages 30-31 of his report, and the following financial statements, here).

Speaking at the first FAS meeting of this fall's term, on October 21, President Drew Faust took the unusual step of placing her business ahead of the dean's, to make a statement on the financial situation. While emphasizing Harvard's overall strengths—including its long history of enduring genuine national and international political and economic crises—Faust said, "We are not immune" to circumstances. The endowment had been "hit," it was prudent to assume an "impact on giving" in the months and years to come, the outlook for sponsored-research support remains clouded, and costs are increasing in such core areas as financial aid. Administrators and deans were modeling various scenarios, she said, to best insure that the University's teaching and research priorities are protected, but those involved were "very far from understanding" the full impact and likely duration of the external economic and financial problems.

For his part, Smith observed in his fall letter to the faculty, distributed on October 9, that the financial turmoil intersected with rising costs for food, fuel, and construction, and that "These challenges arise at a time when the FAS is facing a structural deficit in unrestricted income created primarily by building projects and faculty growth. This deficit, if not addressed, will limit our ability to undertake new initiatives, will hamper campus renewal, and will stifle educational innovation." Smith had already announced last April a pause in expanding the faculty ranks during this academic year—a measure he took to digest past growth and to plan for the future, before the current financial crisis and economic downturn took hold. Speaking after Faust on October 21, he said FAS's staff was engaged in planning to get the faculty through "turbulent times."

Other schools' disclosures: declining endowment values… The University of Virginia Investment Management Company's September report describes a 9 to 11 percent decline in asset value—some $600 million—through September 30, and as much as a 20 percent further decline in October, admittedly with challenges in calculating the value of illiquid, private investments. The University of Texas System combined endowments lost $1.6 billion in value during September alone, according to the student newspaper, the Daily Texan.

…and spending reductions. President Anthony Marx reported to his campus community on October 28 that Amherst College's endowment had declined by "roughly a quarter of its value" from the end of June. He announced deferral of a major capital expenditure, and said, further, "In the weeks ahead, I will be asking all departments—academic and administrative—to review their expenditures and to propose ways to enhance the efficient use of our resources. Though we are not considering a hiring freeze, the College will review with greater stringency all requests for replacement or additional positions. Undertaking this task with diligence and purpose is essential, and it may forestall more difficult and painful choices later on."

Reporting to his faculty on October 27, Dartmouth president James Wright said, "This past year, although we still had top-quartile performance, was not as good as we had hoped: We were marginally positive in the fiscal year ending June 30, and in the quarter following that we have been down several points. The immediate impact here is that under our endowment distribution formula, we have less revenue than we projected this year and are likely to have still less next year—and this despite the fact that we do have a comparatively aggressive endowment spending formula. We will discuss this situation with the Board of Trustees at its upcoming November meeting, and following that we will initiate measures to reduce expenses. " Commenting on the pending conclusion of that institution's capital campaign, he said further, "In the near term many of our generous donors will not be able to provide financial support as much as they wish to do. This will result in the delay of some of capital projects previously announced and in the planning stages. Consistent with our past policies we will not authorize projects that do not have a full funding plan established. In these economic conditions, putting these funding plans in place will simply be more challenging. We will review with the Board controlling additional debt except for advantageous refinancing of current obligations and for projects underway or for those required for basic renovation and for safety and code issues. Over the next several months we will need to reduce significantly the growth in expenses.…At the outset I wish to make clear my priority is to protect our financial aid program and our competitive faculty compensation objective. We will need to reduce payroll projections, but I hope that the need for reduction in force will be accomplished through attrition."

In late October, Cornell president David Skorton suspended hiring of non-faculty staff through next March 31; suspended the start of any new construction projects for at least 90 days; and began a 45-day institution-wide financial review. That institution anticipates reductions in the support it receives from New York State.

On November 4, Brown President Ruth Simmons informed her community of a freeze on all administrative and staff hiring, review of all faculty searches under way, review of all capital projects, and a committee "to develop recommendations for the FY10 budget that consider more modest tuition and fee increases, salary pools for faculty and staff, and inflationary adjustments in the context of the more unfavorable economic forecast. At this time, we anticipate little or no growth in revenue to fund requests for increases in operating budgets."

Among Harvard's closest peer institutions, Yale has suggested that it has built sufficient reserves and has budgeted so as to withstand a financial slowdown, but would rein in "investments" in new projects and programs—and directed managers to avoid "unnecessary spending" and to "exercise caution" in proposing budgets for the next year.

Stanford bluntly said that investment income, one of its principal revenue sources, "is going to be significantly reduced for the coming budget year." Provost John Etchemendy said that the university's $800-million "general funds budget"—for faculty and staff salaries, administrative operations, and non-research expenses—would need to be reduced $45 million in the fiscal year 2009-2010, with further reductions of equal magnitude in the following year. While resisting "across-the-board" layoffs or salary freezes, he anticipated that "some jobs will be lost" and salary adjustments "will certainly be smaller than in recent years." Every unit, academic and administrative, has been asked to prepare budget reductions of 3, 5, and 7 percent, as the basis for allocating expense cuts. Because Stanford's endowment spending policy operates so as to "buffer the effect of sharp volatility" in investment returns, Etchemendy said, it would effectively postpone budget reductions—but would inevitably spread them out over "several years." Finally, in a statement that could well echo eastward to Allston (where Harvard has begun extensive new academic development), he said, "Will all the projects in the capital plan be built at the speed we had originally hoped? No." The aim is to curtail both construction outlays and the accompanying debt service. Stanford deans have been told, he said, "that we do not intend to add any new projects to the capital plan at this time."

(This summary of announcements has focused on private colleges and universities, some of which practice investment diversification strategies like those used by HMC, albeit on a smaller scale appropriate to the size of their endowments.)

Harvard's endowment. The University's endowment, like that of Yale and several other institutions, is highly diversified, reflecting strategies intended both to protect performance against weakness in any one class of assets and to take advantage of the superior returns available to long-term investors in illiquid investment categories (such as real estate, private equity, hedge funds, and certain kinds of commodities). During the past quarter-century, HMC has, accordingly, moved from holdings based almost entirely on domestic stocks and bonds toward a multiclass "policy portfolio." Its construction is displayed graphically on the HMC website (click on the "investment philosophy" tab); the endowment section of the University's annual financial reports displays the actual distribution of assets and performance.

For the current fiscal year, the policy portfolio's model asset allocation (as of HMC's report on September 12) aimed at 11 percent allocations each to domestic and foreign equities (down a percentage point each from fiscal year 2008); 11 percent and 13 percent allocations, respectively, to emerging-market equities and private equity (up one and two percentage points, respectively); 18 percent and 2 percent allocations, respectively, to absolute return (hedge funds) and high-yield bonds (the latter up one percentage point); a 26 percent allocation to real assets (8 percent for liquid commodities, and 9 percent each for timber/agricultural land and for real estate)—unchanged from the prior year; and a reduced commitment to other fixed-income categories, totaling an 11 percent allocation to domestic, foreign, and inflation-indexed bonds (compared to 15 percent in the prior year). Cash, an offsetting number, was also to be reduced.

In recent months, as financial markets have been decimated by loan losses, bank and investment bank failures, the near-collapse of the credit markets and the ensuing massive government rescue plans around the world, investors have focused on holding cash or buying only the safest, short-term Treasury bills. About the only safe haven in the markets has been in the highest-quality, U.S. government bond sector. But in keeping with the long-term objectives outlined by the policy portfolio, diversified endowments like Harvard's now underweight such assets in their portfolios: as of last June 30, the total fixed-income holdings in the University's $43-billion General Investment Account (the endowment plus other assets) were just over $7 billion, further subdivided into domestic, foreign, inflation-indexed, and high-yield bond holdings. Each of those fixed-income subcategories was outweighed by pools of funds invested in domestic stocks (which have dropped sharply in value), foreign stocks (which have also dropped, and are worth less as the dollar rises), emerging-market stocks (which have been among the most severely hit asset classes), and private equity (where credit conditions and recessions pose special risks, and where asset valuations are especially difficult to ascertain). Liquid commodities, such as oil and gas—outstanding performers during fiscal year 2007—have been trounced (as oil declined from $147 per barrel to less than half that level, for instance). Land and real estate have probably been less affected, but are certainly under pressure. And the performance of the large absolute return (hedge fund) investments cannot be estimated without knowing something about the positions and strategies of each manager—information that HMC does not disclose, for competitive reasons. It is certainly possible that some hedge funds, such as the bond-oriented Convexity Capital Management (formed by former HMC personnel), have had their intended effect of offsetting the market's decline; but many others appear to have seen asset values reduced, and some have been forced to sell investments in unfavorable markets to return funds to their investor clients.

In the fall of 2007, when HMC's then-president Mohamed El-Erian reviewed results for the prior fiscal year, he warned that traditional diversification strategies were losing their potency. The maturing of hedge funds and private equity reduced expected future returns. The globalization of trade and finance made economies act more alike, lessening the protective effect (against inflation or recession) of geographic diversification. But he pointed to a gradual evolution in these correlations: something for investment managers to adapt to in the medium and long term.

What no strategy could have anticipated was the sudden crisis in the financial and investment markets that prompted essentially every asset class to depreciate in concert—and that before an ensuing recession of unknown breadth, depth, and duration. At this writing, it is unknown how exactly Harvard's endowment has performed during the tumultuous months of late summer and autumn. HMC has had various hedging and insurance strategies in place to protect its assets, at least under historical conditions (described as "overall market overlay strategies, intended to serve as protection against extreme market events" in management's September report)—and they may have buffered losses.

But it would not be surprising to learn that the endowment's value had decreased significantly. At Harvard's scale, of course, a 10 percent decline represents nearly $3.7 billion: using the University's endowment distribution policy, that represents nearly $200 million of income distributable for operations each year. Clearly, the arithmetic is daunting—particularly given that operating and other distributions of perhaps $1.5 billion have been planned in the current fiscal year. Because the Corporation sets a desired "aggregate payout rate" of 5.0 to 5.5 percent, including all operating and capital distributions (see discussion here), the University could rapidly approach the upper bounds of its financial comfort zone (which generally assumes increasing endowment distributions).

Financial crises and market corrections of course can represent significant opportunities for long-term institutional investors, such as the endowment. On the other hand, even if the investment markets were, in unison, to rebound strongly (much as happened in fiscal years 2003-2007, following the slightly negative investment returns in fiscal years 2001-2002, but beyond anyone's power to forecast today), it could take a sustained period of such performance to begin to recapture the endowment value and future spending power that may have been lost in the last few months. A capital campaign could speed such a recovery, too—but given current conditions and the schedule of internal academic planning, a University fundraising effort is not expected to be launched for at least a few years.

Clearly, the Corporation and the administration face choices uncomfortably different from their options only months ago in charting the University's future financial course—and therefore its near-term ambitions for academic programs and physical expansion.

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