Ivory-Towering Infernos

The Economist
Dec 11th 2008

America's universities have seen billions of dollars go up in smoke

HARVARD will have to take a "hard look at hiring, staffing levels and compensation", wrote Drew Faust, the university president, on December 2nd in a surprise letter to Harvard deans. The Harvard endowment, which was worth $36.9 billion at the end of June, has since lost at least 22%, says Ms Faust. The university should brace itself for losses of 30% in the fiscal year to next June, she adds, although even that may prove far too optimistic. Its ambitious plans for new buildings on the other side of the Charles river seem likely to be scaled back, or at least slowed down.

Harvard is not alone. At Stanford University, the president, provost and other senior executives have taken a 10% pay cut. There is speculation that its endowment, which at $17 billion in June was third only to Harvard's and Yale's, has performed horribly since then. Many smaller endowments--only six were bigger than the $8 billion that Harvard says it has lost so far--have suffered too. Williams College has seen its endowment plunge by 27%, from $1.8 billion to $1.3
billion, while Wesleyan University's has tumbled by 24% to $580m.

But all eyes are on Yale, the inventor of an investment strategy that in recent years has been imitated by many other universities and some charitable foundations. Richard Levin, Yale's long-serving president, is expected to make an announcement soon about the performance of its endowment and the implications for Yale's budget (its new campus alone is said to be costing around $1m a day to build). In the meantime there is much debate in faculty clubs and among charitable trustees about whether to persevere with the "Yale model". This is ironic, for it is at times like these--when most other investors are desperate for liquid assets--that the model is supposed to come into its own.

The creator of the Yale model is David Swensen, who was persuaded by James Tobin, a Nobel-prize winning economist, to become the university's chief investment officer in 1985, when the endowment stood at just over $1 billion, and increased it by June of this year to $22 billion. As Mr Swensen explains in his influential book, "Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment", which was published in 2000, the "permanent" endowments of universities (and of some charitable foundations) meant that they could be the ultimate long-term investors, able to ride out market downturns and liquidity droughts.

By investing heavily in illiquid assets, rather than the publicly traded shares and bonds preferred by shorter-term investors, an institution with an unlimited time horizon would earn a substantial illiquidity premium. By 2006, Yale was aiming to invest a staggering 69% of its endowment in illiquid alternative asset classes such as hedge funds, private equity, property and forests. Others followed. According to "Secrets of the Academy: The Drivers of University Endowment Success", a new study by Josh Lerner, Antoinette Schoar and Jialan Wang in the JOURNAL OF ECONOMIC PERSPECTIVES, Ivy League endowments increased their allocation to illiquid assets from 9.3% to 37.1% between 1993 and 2005. On average, universities raised their allocation from 1.1% to 8.1%.

Until this year, the strategy paid off handsomely. For the 1,300 endowments studied, the median annual real rate of return was 6.9% between 1993 and 2005, while the 20 best performers generated average real annual returns of more than 9%. That was better than most other institutional investors. Between 1996 and 2005, about 5% of university and college endowments did better than the top percentile of American corporate pension funds.

Until this year the main complaint about endowments was that they were performing too well. High returns were leading to such huge bonuses for endowment managers that less well-paid university staff protested. After two Harvard endowment managers each earned about $34m in 2003, the university agreed to cap future compensation at $25m. That may have contributed to the decision of Jack Meyer, who had enjoyed a long and successful run in charge of the endowment, to leave in 2005. His successor, Mohamed El-Erian, left after barely a year, in which the endowment grew by 23%.

So what has gone wrong? The sort of carnage that has hit the markets this year must have been worse than anyone, including Mr Swensen, thought possible. Some endowments are believed to have failed to arrange credit lines to manage the risk of an extreme financial crunch. Others may have underestimated the downside risks of the Yale model, and used money they did not really have. Universities typically spend around 4.5-5% of the value of their endowments each year. Spending is usually based on averaging the value of the endowment over three years. This method may have led them to spend too much when times were good.

POISON IVY
The model may also have been adopted by endowments that were too small for it. "You need to be very big and very diversified, and to be sophisticated enough to understand the risk management of complex investments," says Anthony Knerr, who advises universities on funding strategies. Some of the hardest hit may be smaller endowments that adopted a "Yale-lite" strategy that they did not really understand. They may also have been unable to invest in the best hedge funds and private-equity firms, which have (until now) been able to pick and choose between investors.

Even the biggest Ivy League endowments are finding their private-equity investments a source of worry. They suspect that the values put on their portfolios by private-equity firms may have to be cut sharply before the end of this fiscal year. Moreover, many private-equity firms are now demanding that endowments and other investors hand over the capital they promised during sunnier times, cash the universities would rather keep.

Harvard is rumoured to be trying to raise around $1.5 billion by selling some of its limited partnerships in private-equity firms, fuelling speculation that the university is facing a cash crunch. Some close to the fund say that it may instead be gearing up to buy assets. This should be just the time when long-term investors that can afford to be illiquid and have money to spend make a killing. If he has enough cash, Mr Swensen may even now be preparing to splash out on assets that will never again be so cheap. This may yet prove to be the Yale model's finest hour.