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More on Endowment Risk

The Times Dealbook is running an intriguing article on the college endowment bubble, even if it doesn't make the connection to the larger tuition and student loan bubble that MetaEzra first made last spring.

It's a nice follow-up to yesterday's discussion on the relative value of endowment dollars, and suggests that college endowments may have taken on a bit more risk than they could afford to over the last decade. The basic point is that investments in illiquid private equity, real estate, and hedge fund interests will cause further degradation of an endowment's value as the liquid portions of the fund need to be sold to fund current revenue needs:

In the short term, unless it boosts its liquid returns, Harvard is going to have to raise a lot in donations or eat up its liquid assets to fund university obligations and its private equity commitments. This results in a spiraling decline in Harvard’s liquid assets as each year they go lower to meet these needs and more and more assets become tied up in private equity. This assumes the markets stay where they are in the next three years — there are scenarios where liquid assets do worse (like yesterday), or better, of course.

This is likely why Harvard recently sold $1.5 billion in debt, and unsuccessfully tried to sell $1.5 billion of its private equity portfolio. It needs to cover short-term funding obligations rather than liquidate illiquid assets at fire-sale prices. In essence, Harvard is more like a hedge fund than ever — trading for short-term gain with the same risks involved.

It's impossible to tell how much more dire Cornell's situation is than Harvard -- a similiar percentage of Cornell's endowment (33 percent) is thought to be locked up in real estate and private equity. On one side, Cornell depends a lot less heavily on investment revenue, but on the other side, Cornell has a lot less in liquid assets to burn through to support its operating budget.

It's no use speculating though, and at the end of the day, I think the basic philosophy of an endowment may need to be re-examined. Endowments have tried to 1) provide a steady stream of income to their institutions, 2) act as a reserve to depend upon when other revenue sources are in decline, and 3) serve as a source of future revenue growth.

But the last point seems antiethical to the first two given the amount of risk it can introduce to a university's operating basis, the results of which are currently coming home to roost. Because its associated spending on research, faculty, and financial-aid is often vital to the long-term health of an institution, endowment income should be a source of income stability and its principal should serve as a counter-cyclical hedge. It shouldn't be seen as a source of revenue growth for a university.

Some may see that as a problem -- why shouldn't an endowment enjoy the gains of the market? But don't forget, a university can effectively "outsource" its market risk in a risk-free fashion to its benefactors -- those alumni succesful in the market will naturally want to endow professorships, develop research programs, and build residence halls in their name. So much like a retiree's nest egg, I think stability can be a feature, not a bug.

Matthew Nagowski | Posted on March 03, 2009 (#)

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