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Endowment endurance in higher ed

In a “very low return” environment for endowments, higher ed leaders make tough decisions about spending and where to invest
University Business, April 2016
Being able to draw from the endowment is important for an institution like Berea College because of its no-tuition promise. Students are required to work as they attend school, with assignments such as greeting guests at the Historic Boone Tavern Hotel.
Being able to draw from the endowment is important for an institution like Berea College because of its no-tuition promise. Students are required to work as they attend school, with assignments such as greeting guests at the Historic Boone Tavern Hotel.

When endowment returns are way down, it’s not exactly prudent to spend the same percentage of the endowment for institutional operations each year, with the assumption that target investment payoff percentages will return.

And, right now, down they are.

Endowment investment returns fell from an average of 15.5 percent for Fiscal Year 2014 to 2.4 percent in FY2015, according to the 2015 NACUBO-Commonfund Study of Endowments released in February.

That’s not as low as in FY2012—when the average return slipped into negative territory, at -0.3 percent. Yet the very challenging environment investors faced in 2015 will most likely continue for the next several years.

William Jarvis, executive director of the Commonfund Institute, blames the downturn on a number of factors, including an economic slowdown in China, no or low growth in Europe and Japan, and a drop in commodities prices.

“All of this ricochets through the emerging markets, too,” Jarvis says, referring to developing countries that offer portfolio diversification and the potential for above-average investment returns.

On average, academic institutions spend between 4.5 and 5 percent of their endowments each year. In doing so, the financial decision-makers hope to preserve the purchasing power of endowments to support scholarships, endowed chairs, facilities upgrades and other initiatives.

To fund that spending, the target investment return rate at most schools is between 7 and 7.5 percent. The average annual return for the 10-year period ending with FY2015 was 6.3 percent, down from 7.1 percent the prior year.

In other words, says Jarvis, “we now have a tension, a conflict between what schools tell us they need to have and what the market has been providing over the long term.”

The average spending rate for institutions dropped from 4.4 percent in FY2014 to 4.2 percent in FY2015, which the study attributes to the income-averaging methods schools use to calculate annual future spending.

And while the spending rate declined, 78 percent of the 812 colleges and universities reported spending more in dollars from their endowments this year. That is, they are spending smaller percentages of larger endowments.

It seems counterintuitive to spend more when returns are down, but one advisor cautions against putting too much weight on a single year’s results.

“One year doesn’t show a trend or a pattern,” says John Griffith, endowment specialist at Hirtle Callaghan, a Philadelphia firm that acts as a chief investment officer for universities. “A more powerful number is the 10-year average of 6.3 percent,”—not reaching the targeted 7 to 7.58 percent return, but much better the outcome for FY2015 alone.

Still, John Regan, chief investment officer at Permanens Capital in New York City, says it’s time to examine how much can be spent from endowments. Considering the ever-important investing mix is also key to a sustainable endowment.

Spending levels check

“Returns will be going down, not up, over the next few years. Schools will need to take a hard look at endowment spending levels,” says Regan.

Stuart Mason, chief investment officer of the University of Minnesota, says conversations with peers at other schools have given him the impression that institutions are looking at lowering the percentage of the payout from the endowment from between 4.5 to 4.7 percent, to the low 4 percent range.

“The goal is to lower the payout so you’re not eating into the core if you’re unable to make that 7.5 to 8 percent target return rate,” he says.

The University of Minnesota’s current payout rate for its $1.3 billion endowment is 4.5 percent of a rolling 60-month average of the endowment’s market value. It earned 5.7 percent in FY2015 and 20.4 percent in FY2014.

Alternative strategies

Minnesota can maintain those spending levels because its investments are doing well.

“We tend to be in the upper quartile of our peers because we have relatively high levels of our endowment allocated to private fund structures,” Mason says, referring to investments that don’t typically mature for at least 10 years. They include real estate, venture capital, distressed debt and commodity-related investments such as minerals and mining.

The university invests about half of its endowment in these private fund structures, which Mason says offer potential for a higher return than do stocks and bonds. For example, the university’s venture capital portfolio has generated almost 25 percent annually over the past 10 years while the stock markets have produced about 5 percent during the same period, he says. “The negative is that we can’t get the money out of them if we need it.”

Because Berea College in Kentucky doesn’t charge tuition, it relies in part on its $1 billion endowment to enroll its students, all of whom are low-income. Berea also has invested more aggressively in private fund structures to generate revenues in “a very low-return environment,” says Jeff Amburgey, vice president for finance.

The NACUBO study found alternative strategies, such as private fund structures, accounted for 57 percent of the allocation at institutions with larger endowments, but just 11 percent at schools with the smallest endowments.

Berea’s investment return has been lower than the NACUBO study average the past few years, mostly because of an over- allocation to developed international equities, emerging market equities and commodities, Amburgey says.

Because of the decade-long maturity rate, it’s too soon for the school to benefit from what it anticipates will be a higher return on investment than alternatives that include stocks and bonds.

Outsourced CIO

Interest rates hovering near zero have driven colleges like Berea to outsource its chief investment officer function. In the NACUBO study, 43 percent of respondents have substantially outsourced investment management.

“The firm’s staff can provide the expertise that we can’t afford in-house,” says Amburgey of Hirtle Callaghan, Berea’s investment manager. “They have a fiduciary responsibility to the college and are held accountable. Berea’s investment committee has the ultimate authority and responsibility, but isn’t making the day-to-day decisions.”

An institution outsources when its financial managers don’t have the expertise to invest in alternative strategies. Perella Weinberg Partners, headquartered in New York City, manages endowments for about two dozen universities or foundations.

“Hedge funds, private equity, venture capital, real estate and other options are much more complicated and more difficult to research,” partner Trey Thompson says.

Social change

Thompson is also seeing a trend among institutions starting to think about how or whether they should use their endowments to affect social and environmental change, known collectively as ESG—for environmental issues, social responsibility and corporate governance.“Rarely does a meeting go by where that’s not a topic of discussion,” Thompson explains.

The NACUBO study found that 15 percent of respondents are interested in ESG-driven investments, while 25 percent exclude investments that aren’t consistent with the institution’s mission.

ESG investment decisions tend to be driven by the institution, rather than financial advisors.

Unity College in Maine follows an ESG strategy without suffering financially. In 2012, it became the first academic institution to divest from fossil fuel-related investments. Melik Peter Khoury, Unity’s president and former chief financial officer, says it has been a sound ethical and financial decision.

“We are meeting our investment policy and expectations and are able to beat the market a bit, so our trustees are happy with the decision,” Khoury says. The return on the school’s $14.3 million endowment in FY2015 was 5.5 percent.

For those considering this option, he recommends creating a long-term plan to reach the goal. The process is less complicated today than it was when Unity made its decision to divest, he adds.

“When we started, most of the investment firms didn’t have fossil fuel-free portfolios. We found a firm that would work with us company by company, but now there are indexes that make it easier,” Khoury says. That firm is Spinnaker Trust of Portland, Maine.

Importance of patience

Looking to the future, Amburgey of Berea College stresses that institutions need patience because the overall market isn’t expected to see a significant upswing for some time. “In today’s environment, it’s very hard to get returns that are consistently above and beyond inflation and cover the endowment draw,” he says. “We’ll have to be patient and monitor our draw.”

“There’s a lot of stress and a lot of concern,” adds Mason of the University of Minnesota. “While that doesn’t make for easy sleeping at night, there’s also a lot of opportunity.”

Sandra Beckwith is a Western New York-based writer.

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