For the nation’s best endowment managers, it was clear years ago that something in the credit markets was off. Debt was too cheap and the economy’s brisk growth was bound to peter out.
The Yale University Investment Office prepared by betting against the market and shorting stocks that were backed by sub-prime mortgages.
“This bubble was not something that should have surprised people,” Yale’s investment czar, David Swensen GRD ’80, said last spring in a guest lecture to economics professor Robert Shiller’s class. “I thought the University positioned itself well to take advantage of this really not surprising collapse of housing prices.”
But the magnitude of the ensuing collapse caught major universities by surprise. Across higher education, schools are bracing themselves for fiscal belt-tightenings of their endowments. The richest — Harvard and Yale — are no exception. The question is whether their endowments, declining at the fastest rate in years, can continue to support the universities’ operating budgets.
Swensen, who declined to comment for this article, earned his reputation as an “investment guru” by diversifying Yale’s endowment investments and raking in billions in returns. But in the current financial crisis, every kind of asset has suffered, and money managers have virtually nowhere to turn.
But that may be beside the point, seven analysts interviewed said. The key, they said, is to judge endowments not based on year-to-year returns, but on their ability to support university budgets.
“The income from the endowment supports the programs of the University,” Provost Peter Salovey said Friday. “It’s not as if we’re ever going to liquidate the endowment. The value on any given day is not crucial — it’s long-term performance and our ability to draw cash from it.”
Yale, like other universities, needs that cash now more than ever, as the sputtering economy pushes down other sources of revenue such as grants and donations. Endowments are hoarded during boom years in order to be drawn from during downturns, said Perry Mehrling, an economics professor at Barnard College.
Through the past several years of double-digit returns, universities resisted increasing their endowment payouts in order to smooth spending and save up for tough times. Now that tough times are here, Mehrling said, decreasing endowment payouts would be inconsistent.
But with returns slipping into the negative — and spending from the endowment on the up — university budgets run the risk of badly damaging endowment returns for the future.
The problem is the potential for the combination of negative returns and increased spending to quickly deplete assets.
“If you’re spending too much, you can have a tipping point, where there’s no coming back and you just run the endowment into the ground,” said Richard Anderson, an endowment consultant for institutional fund consultant Hammond Associates.
To prevent that, some universities, including Yale, build caps into their spending rules. Yale determines endowment spending through an equation that considers inflation and the average endowment performance of the past several years. That formula smooths spending over time, shielding the budget from sudden jolts in the market.
Yale last adjusted its spending rule in January to accompany its financial aid initiative. Endowment payouts typically hover around 4 or 5 percent of the fund’s total value.
The only time Yale’s endowment payout ever topped 6 percent was in the early 1970s, when inflation soared and market returns dropped. In order to support operations, the University eroded the real value of the endowment.
With other revenue streams drying up, some endowment managers have taken drastic steps to give their universities cash to fund annual budgets. With the values of relatively liquid equities plunging, some reports have circulated that Harvard, among other schools, is dumping assets at basement prices to free up endowment funds.
Harvard spokesman John Longbrake said the school does not comment on investment strategy.
Anderson said he knows of an Ivy League endowment, which he declined to identify, that has had to sell five or six hedge funds to stay liquid.
To avoid selling equities at discounts, analysts said, managers could borrow against their assets, but tight credit markets make this difficult.
All that leaves managers like Swensen with few options. With the entire financial world reeling, hardly any assets are profitable.
Some opportunities exist in distressed credit — buying troubled equity stakes at huge discounts and improving them. But that strategy requires highly skilled managers, said William Jarvis ’77, managing director of the non-profit Commonfund Institute in Wilton, Conn.
Harvard President Drew Faust’s Nov. 10 memo on the economy ominously cited a Moody’s financial report projecting a 30 percent decline for university endowments over the coming year.
If such losses materialize, even the wealthiest schools could risk draining their endowments.
“The endowment is supposed for last for future generations and sustain us for a long time,” Longbrake said. “If you factor in inflation and starting eating into the principal, that’s a problem.”
But with both Harvard’s and Yale’s endowments coming off of years of double-digit growth, even a few cycles of losses would still leave the schools in better financial shape than they were 10 years ago. If the current crisis is just a market correction, Yale should have the ability to lean on its endowment for a few years, at least.
“The whole point of an endowment is to buffer the university from the day-to-day vicissitudes of the market,” Mehrling said. “The right way to use an endowment is to stabilize spending in order to protect the university against a rainy day.”
“Guess what?” he added. “It’s raining.”