Harvard Borrows $2.5 Billion: The Costs and Rationale
The University moved quickly to sell new bond issues, to refund existing short-term debt, to increase financial flexibility, and as it turns out to extricate itself from expensive interest-rate swap agreements.
Moving promptly to tap the credit markets for additional financial resources--as signaled in the strategy outlined by President Drew Faust and Executive Vice President Ed Forst on December 2--the University sold $1.5 billion in taxable bonds on December 5, according to reports by Bloomberg and the Wall Street Journal, and $1 billion in tax-exempt bonds on December 10 (up from an initial projection of $600 million), Bloomberg also reported.
Size and Structure of Offerings. According to Bloomberg, the taxable bonds were offered in $500-million blocks of 5, 10-, and 30-year bonds, with yields 3.35 to 3.375 percentage points higher than U.S. Treasury bonds of similar maturities. The University subsequently confirmed that it had been able to price the bonds at yields of 5.03 percent, 6.06 percent, and 6.53 percent, respectively--implying annual interest costs of $88 million, before principal payments.
The tax-exempt offering, Bloomberg reported, ranged from 6-year bonds yielding 3.15 percent to those maturing in 2036, which yielded 5.8 percent. The University declined to offer any details about the pricing or principal amounts; it seems reasonable to estimate additional annual interest costs of $40 million to $50 million for these bonds, again before principal payments.
(For perspective, in the fiscal year ended June 30, 2008, according to the University's annual Financial Report, interest expense--not all of which is necessarily current cash payments--was $146.1 million, and projected annual principal payments were $17 million to $22 million per year through fiscal 2012; as of last June 30, total bonds and notes payable were $4.1 billion.)
Servicing the debt. The University has not commented on its plans for servicing the added annual interest and principal payments. However, a possible hint arose at the December 9 Faculty of Arts and Sciences (FAS) meeting. A questioner from the floor asked whether the administrative assessment for the "strategic infrastructure fund" (SIF, an annual one-half percent levy on endowment capital accounts, created early in the decade to offset central expenses for work on Allston campus planning and development; see discussion here) would be altered--presumably, reduced or suspended. That assessment yielded $168.4 million in fiscal year 2008, and had grown as the endowment appreciated. As the pace of Allston work is rethought--as Faust has said is in prospect--reducing or suspending the assessment would lessen demands on schools' endowments. The issue had been raised previously at the FAS meeting of November 18, from which Faust had been called away on other business; on that occasion, FAS dean Michael D. Smith said that the SIF and everything else was "on the table."
Responding on December 9, Faust said the SIF would continue and that, depending on the pace of Allston work, the University might decide that there were other necessary uses for the monies the assessment generates. Even if it were reduced in line with diminished endowment values, the assessment could conceivably generate significant sums to defray the costs of servicing the newly incurred debt, or other needs paid for through the University's financing structure.
Reasons for the Financing Strategy. In describing the taxable offering, Faust and Forst said taking advantage of the University's top-tier (Aaa/AAA) credit rating and the historically low interest rates would enable the University to accumulate cash "to fund ongoing operations and critical academic and research priorities"--in essence, to maximize financial flexibility during a period of disrupted markets and recession that is of uncertain depth and duration.
There may be several possible rationales for the borrowings.
• Endowment. One reason such flexibility may be desirable is that endowments like Harvard's, which have significant investments in illiquid assets (private equity, real estate, venture capital, some forms of hedge funds; see "Investment Philosophy" at the website of Harvard Management Company--HMC), depend on those outside partnerships to make distributions from their successful investments to fund both future investments and the endowments' own distributions to their parent universities for operating use.
But such investment distributions have slowed to a trickle in the current volatile financial markets. Many investment-management partnerships have even closed off distributions to reduce pressure to sell assets at distressed prices and to protect other investors in their funds. At the same time, such investment partnerships have contractual rights to call on their limited-partner investors, like Harvard and other institutions, to advance capital for new investments.
The University has declined comment on such matters as they may affect the Harvard endowment, but the subject has been covered in the financial media, in stories relating in general to hedge funds and private-equity firms, some of which have university clients (see, for example, this December 8 dispatch from the New York Times). In addition, the University of Virginia Investment Management Company has explicitly discussed its own situation relating to capital calls by and liquid distributions from its outside investment managers (see the CEO's letter of November 26). In the current environment, if the University has other sources of liquid funds available, it might enable HMC to pursue longer-term investment strategies than would otherwise be the case.
• Credit-Swap Losses. A second reason, alluded to in Faust and Forst's description of the planned long-term tax-exempt financing, was to reduce the risk in the cost of renewing its short-term debt against the backdrop of very volatile markets; indeed, at various times recently, the markets have frozen up completely, making it impossible or prohibitively expensive to refinance even very short-duration debt instruments. (According to the University financial report for fiscal 2008, variable-rate notes and commercial paper outstanding totaled about $1.6 billion as of last June 30.) Faust and Forst wrote, "We also intend to convert a substantial amount of existing short-term tax-exempt debt into bonds with longer maturities, so we can reduce our exposure to volatility in the credit markets and provide a measure of greater predictability in a time of extraordinary flux."
The preliminary official statement for the sale of tax-exempt bonds through the Massachusetts Health and Educational Facilities Authority details a specific potential use of the offering proceeds (for both the taxable and tax-exempt bond sales): to "finance certain swap termination payments."
According the annual financial reports, Harvard has entered into various "interest-rate exchange agreements" at least since the early 1990s. Their magnitude, though not their structure, is reported in the footnotes describing bonds and notes payable and the University's overall investments. Depending on their structure, on the volume of such agreements outstanding (which relates to the University's aggregate financing activity), and on prevailing interest rates, the "fair value" of the agreements--how much Harvard would receive, or would have to pay, to terminate the agreements as of the date of its financial statements--is shown each year. During the current decade, these are the reported figures for the fiscal year ended June 30, showing the "notional" amount of the agreements, and then the fair value the University would have received or (paid) to terminate the agreements on that date (dollars in millions):
The bulge in fiscal 2005, according to that year's financial report, relates to forward interest-rate agreements entered into during December 2004 to fund future capital projects, including development in Allston. The financial-report disclosures do not detail how the agreements function, beyond saying that they involve Harvard making a fixed-rate payment (determined at the inception of the agreement) to a counterparty, from whom it receives variable-rate payments in return; from those variable-rate payments, the University presumably fulfills its interest-payment obligations to the original lenders.
It is conceivable in the current environment--with short-term rates spiking up sharply at moments of brief market stress, but generally being pushed down as a matter of policy (by the Federal Reserve Board) and in response to the recession--that the bulge in financing earlier in the decade might now expose the University to higher servicing costs in the interim, or might otherwise affect the projected value of the exchange agreements and the cost to the University should it decide to exit them. The financial report footnotes indicate losses realized from monthly settling of the agreements: $15.6 million and $7.9 million for fiscal years 2008 and 2007, respectively. The larger year-end termination payment calculated as of last June 30 ($330.4 million) is shown in the table above.
The University has not commented on these matters. If it faces higher monthly settlement losses in the current fiscal year, as assumptions about interest rates have changed, perhaps for a longer period than previously expected, that might provide the impetus for taking action: borrowing long-term funds, terminating the swaps, and fixing that portion of Harvard's debt cost. In that case, the costs of the new, long-term borrowings might be at least partially offset by eliminating the monthly settlement sums under the exchange agreements.
• The Central "Bank." Although distributions from the endowment are much the most important source of investment-based revenues for Harvard's operations ($1.2 billion in fiscal 2008, when revenues were nearly $3.5 billion), they are not the only source of such funds. In fact, "income on working capital investments" distributed to support University operations totaled $175 million in that year--5 percent of total revenues, up 11 percent from the prior year. During the past four fiscal years, in fact, income distributed from working-capital investments has risen more than income distributions from the endowment (an aggregate of 56.5 percent versus 48.7 percent).
It is not precisely clear from the financial statements how such funds (presumably the "float" on tuition and fee payments, grants, the proceeds from debt offerings, and other monies collected and held centrally) are invested, at what rate of return, and with what rate of interest credited back to the schools and other units to whom the cash is ultimately due. If such funds were invested in the General Investment Account, alongside the endowment, they might be subject to the decline in value and/or liquidity constraints of those assets; FAS has noted that as of last July 1, it had held $122 million of its $138 million in unrestricted reserves in the endowment, which then decreased sharply in value.
To the extent that such funds are tied to the short-term credit markets, they might yield significantly lower returns today than in the recent past. (As of last June 30, the University's financial statements show "pooled general investment assets" of $50 billion, with the endowment accounting for the largest share of such assets, and other investments of $1.1 billion.) In either event, or in combination, these centrally managed funds might be producing less distributable income from working-capital investments than in the past; if so, that would make it attractive for the University to undertake the recent long-term bond offerings to retain a desirable degree of flexibility in financing both central administrative and school operations.
• "Underwater" Endowment Funds. Finally, the negative return on endowment investments this fiscal year has certainly left some endowment funds worth less than when they were created. In accounting terms, the book value of such accounts is less than its current market value, and so they are "underwater." Unfortunately, the legal requirements surrounding endowments mean that distributions from such funds are restricted, typically to current income. Because Harvard's endowment is invested for long-term growth and capital appreciation, not to generate current income (as from the periodic interest payments made on a bond), such underwater accounts may not be able to make full, or even any, distributions. Looking ahead, appreciation from the currently depressed asset value would not, in itself, enable distributions to resume; the market value would need to return to the book value for funds to be distributed again. For a program or position set up with endowed funds in recent years, on which current expenses are being recorded--say, for salaries--it may now be difficult or impossible to realize the expected revenue. FAS's Dean Smith referred to the problem explicitly in response to a question at the November 18 faculty meeting, and program officers in other parts of the University have begun to grapple with the issue as they draw up budgets.
Harvard has not made any disclosure about the magnitude of this challenge. It takes a considerable period of time from the receipt of a gift to its inclusion as invested assets in the endowment, and from then to the distribution of funds. Even after HMC's 23 percent rate of return on endowment investments in fiscal 2007 and 8.6 percent return in fiscal 2008, it is conceivable that the projected negative 30 percent return this year would render capital gifts from the middle of the decade underwater now, and therefore unable to make distributions to support academic operations and programs. That would add to the need for other sources of revenue "to fund ongoing operations and critical academic and research priorities," as Faust and Forst put it on December 2.
Looking Ahead. As this discussion suggests, the University may have had several reasons for its recent issuance of $2.5 billion in new debt. It has been fortunate to have a top-tier credit rating, enabling it to borrow at favorable long-term interest rates and thereby to maximize financial flexibility at a time of unprecedented market dislocations.
Depending on how quickly the proceeds are used to retire existing short-term debt and to exit interest-rate swaps, Harvard at least temporarily appears to be carrying about $6 billion of debt--approaching one-fourth of the value of the endowment if its investment return for the year is indeed the projected negative 30 percent. Whether the University's financial planners would want to assume more debt, and what the market's reaction might be, are unknowable. But those factors certainly must influence decisions looming ahead on the scale and speed of future capital investments, in Allston and elsewhere around campus, for which borrowing would customarily be employed.
If further information becomes available on any of these issues, it will be posted promptly.