Tuesday, April 27, 2010

It's not easy making up $11B in endowment value

Yes, it's come down to this -- Harvard now begging its alumni to send their spare change to Cambridge to help it recover the $11B (or 27%)  in endowment value it lost last year.  Okay, that's just a little bit of an exaggeration - they're asking for more than just spare change.  But the impact of the downturn in Harvard's endowment is being felt across the university.  It's easy to take potshots at what Boston Globe columnist Alex Beam used to lovingly refer to as World's Greatest University, or WGU for short (not to be confused, of course, with the Western Governors University, a somewhat less-prestigious on-line university).  But maybe some of those potshots are deserved.

Harvard flew high in the 1990s and in the early part of the current century, when it often earned annual returns in the high teens, with an endowment heavily-invested in private equity and other alternative investments.  It is easy to simply write off last year's plunge as the inevitable result of the crows coming home to roost - that in return for earning double-digit returns all those years, the university exposed itself to such high betas that it ran the risk of a large downturn at some point.  And in fact, Harvard Management Company has trumpeted this perspective, arguing that if it had invested its endowment more conservatively all those years, and had earned returns much closer to market benchmarks, then it would never have grown as spectacularly as it did: "Harvard's long-term performance remains strong, even after the severe market correction experienced in fiscal year 2009. The 10-year annualized return is 8.9% versus 1.4% for a typical 60/40 stock/bond portfolio." That 8.9% still sounds good, but keep in mind that just two years earlier the 10-year annualized return had been 15%.

But this just may be a bit of Monday morning quarterbacking on Harvard's part.  Yes, by investing in risky instruments with higher betas, Harvard did earn larger returns.  And it turned around and took those earnings and plowed them into the operating budget (Harvard subsidizes about 40% of its operating budget through endowment earnings).  But it took this action with likely little forethought to what would happen to the operating budget if those endowment earnings plummeted, as they did last year.  The result is that Harvard now has a mess on its hands, as signified by large holes in the ground across the Charles River in Boston where it has halted construction on the Allston campus (see these articles from Harvard Magazine, "Allston Development on Ice" and "Arrested Development").  Harvard also had to borrow $2.5 billion in December 2008 in order to meet cash needs and to meet calls on private equity investments.

It will take Harvard a long time to return the endowment (and its subsidy of the operating budget) to levels it enjoyed just a couple of years ago.  And hopefully Harvard's endowment managers (and those of other universities who made similar investing decisions) will have learned a valuable lesson about the downside of risky investment instruments.

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