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Managing money during volatile times

Colleges and universities are still trying to find equilibrium in a volatile economy
University Business, May 2015
Finance professor Jeffrey R. Brown's new book is "How the Financial Crisis and Great Recession Affected Higher Education," with co-editor Caroline M. Hoxby, a Stanford economics professor
Finance professor Jeffrey R. Brown's new book is "How the Financial Crisis and Great Recession Affected Higher Education," with co-editor Caroline M. Hoxby, a Stanford economics professor.

The Great Recession of 2007-08 had a profound impact on both public and private universities.

In How the Financial Crisis and Great Recession Affected Higher Education (University of Chicago Press, 2015), Jeffrey R. Brown, a finance professor at the University of Illinois at Urbana-Champaign, and co-editor Caroline M. Hoxby, a Stanford economics professor, examine universities as complex economic organizations that operate in an intricate institutional and financial environment.

Despite increased enrollments, universities faced declining state support and weakened endowments. As a result, they were forced to curtail hiring, freeze spending and eliminate programs, while increasing tuition at rates that far outpace inflation.

“All schools suffered during the recession,” Brown says. “The difference is that endowment-dependent schools have since rebounded nicely, but public support has continued to decline.”

I was a bit surprised to read how deeply the recession impacted nearly every aspect of higher education.

It sure did. That’s what motivated us to write the book. There’s no doubt that this was a shock of rather immense proportions. And it affected different schools differently.

In the case of the large, well-endowed private institutions, they witnessed really unprecedented shocks to their endowment values. The publics were dealing with a different set of problems, which is declining state support, and then partially offset in some cases by the federal government’s attempt through the stimulus to get some more money into their hands.

During the recession, 48 states cut their higher ed spending. Yet now, in the midst of the slow recovery, some states, such as Illinois and Wisconsin, plan to make even deeper cuts.

As the federal government stepped up its spending, states took it as an opportunity to scale back on their financial aid. So the net effect to the university was much smaller than was intended by the federal stimulus.

But these are big cuts, and part of the issue is pensions. In Illinois, for example, there is no doubt that direct funding and direct appropriations to public higher education have been falling dramatically. And if the governor gets his way with his proposal, it’s going to be a 31 percent cut.

For The University of Illinois system, this will take state funding from about 15 percent down to only about 10 percent of its budget. That number is down from something like 70 percent of the budget 40 years ago.

But what people miss is that the legislators will say, “If we think more holistically about our contributions to higher education and include in that the state’s direct cost of providing pension benefits and retiree healthcare benefits to public university employees, those things have been exploding.”

When you look at the sum of those two things, the state has a legitimate argument that they haven’t been really cutting funding, they’ve just been shifting it from direct appropriations to benefit costs. Effectively, the dollars that are direct to university to pay for salaries, research, and things like that are being crowded out by pension and retiree health obligations.

Those, in turn, have grown so large, primarily because of many decades of insufficient contributions on the part of the state. They’ve done it over many decades by not paying their bills, by not funding the pensions, not funding healthcare.

And now that we have to pay the piper, the past fiscal indiscretions are coming back to haunt us in the form of reduced direct appropriations to universities. So it really is a much longer-term problem.

You wrote, “Many observers outside the academy were surprised by how difficult the financial crisis was for Harvard, Yale and Stanford.”

Yes. We learned a number of important things. One is that endowment investment strategies have become too divorced from the use of the endowment. That’s because there are effectively two different financial teams. And, while I’m sure they communicate, they are not fully integrated.

So you’ve got an endowment investment team on one hand, and then you’ve got the university finance officers on the other. The big lesson here is that you really need to think about these things in an integrated way.

To be clear, they benefited enormously from that in terms of really high rates of growth in their endowment during all the good times. What we discovered during the recession was that not only did they lose a lot of money being in these risky assets, but they ran into some liquidity problems where they just simply didn’t have the cash on hand, so to speak, to be able to fully fund the activities that they were now committed to funding.

To me, one huge lesson from all of this is somebody needs to be thinking in a holistic, integrated way about how the endowment fits with the rest of the university’s portfolio, both in terms of other revenue sources and in terms of the spending needs that the endowment is used for. When endowments take big shots, it has real implications on hiring and on other parts of the university operations.

At the University of Illinois we very highly value the concept of shared governance. I dare say that the average faculty member probably has very little idea how a university endowment is invested and how it’s managed. And yet, when things go badly, it has a direct effect on their ability to deliver the educational services that they intend to deliver.

How did smaller endowments fare? Was it more of a burden for them?

Even a school with a small endowment, if it was still large relative to their spending, or if the loss that they experienced was a large loss, then it still could be a large financial shock relative to their annual budget.

And we really did see significant adjustment costs, I guess you could call them, across a wide range of schools. But obviously, those that had tiny endowments aren’t going to be as affected by the endowment shock.

We often talk about the new normal in higher ed. Do we even know what that is?

To me, the term “new normal” almost makes it seem like we have just settled into a new state of the world, a new equilibrium, and it’s different from the old one, but it’s going to be stable. I don’t think we’re there at all. If there’s a new normal, it’s continued volatility and uncertainty about our funding models going forward. And it’s especially true in public where there’s enormous variation.

I would not be the first to point out that there are some small private institutions that don’t have big endowments, and some public institutions that are almost completely reliant on general state funding. I believe we’ll see some of those institutions fail. They’ll either merge or get absorbed, or just go away.

I’m not predicting widespread shuttering of education. But I think there is going to be some of that. The institutions that will survive and thrive are the ones that can figure out how to diversify their revenue base, get smarter about risk management, and who can grow their endowments and then invest them in a way that provides some degree of insurance or protection against negative financial shocks.

What is the takeaway for administrators? How can they better safeguard their institutions going forward?

I think the uber message of this whole book is the importance of a comprehensive look at risk management. Finance guys like me are always thinking about correlations. You need to think about all your revenue streams—whether that’s grants and contracts, tuition dollars, state support, endowment income, and so on—and how they correlate to your spending priorities. You need to adjust your investment decisions accordingly.

For example, if you are thinking about embarking upon a new initiative—you are going to start a new school within your university, a new college—you better be thinking hard about how the financial future of that new school is correlated with the rest of your portfolio of both academic and financial programs. You need to into it with your eyes open as to whether this new initiative is something that is diversifying you or whether it is actually increasing your risk.

If I were a university president, I would want to see much closer integration, not just the occasional conversation, but much closer integration of the university’s strategic priorities with its endowment investment and payout policies. To me that’s a really clear takeaway from all of this.

Tim Goral is senior editor.

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