Endowment Hardships and the Power of Nice
by Jeb Breiding on November 14, 2009 in HKS News, News
Harvard recently reported that the value of its endowment declined by $11 billion, or 27 percent of the total. This is the equivalent of 35 years’ worth of tuition from the combined 20,230 undergraduate and graduate students. For the University, this represents the most severe financial setback in its 373 year history and will undoubtedly have serious consequences. The ambitious Allston Science Complex, scheduled for completion in 2011 at a cost $1.2 billion, has been put on hold. Capital spending overall has been cut by half.
For those colleges most dependent on endowment funding, like Arts and Sciences, cost cutting is already underway and is likely to be painful. The college is facing a budget deficit of $220 million and is taking measures to cut 20 percent of all costs. These cuts have manifested themselves in a variety of ways – thermostats have been lowered during the winter months from 72 to 68 degrees, free coffee is no longer available at the University’s Barker Center, courses have been cut, and class sizes are getting larger.
With salaries constituting approximately 50 percent of operating expenses, Harvard’s personnel-heavy budget leaves little room for less painful cuts, a problem which has few solutions. President Drew Faust announced recently that 1,600 employees have taken early retirement and that 275 others have been laid off. For those who remain, no bonuses will be paid for 2009 and salary increases for 2010 are unexpected.
Harvard has not been alone in suffering losses – the average university endowment fell 18 percent last year. But with an estimated $26 billion in total funding and stellar financial performance over the longer term, Harvard has the largest university endowment in the world. During the last ten years, including last year’s hiccup, Harvard’s endowment earned an impressive annual return of 8.9 percent, compared to 3.2% for its peers, a report compiled by Willshire Associates found.
The magnitude of the loss since last fall is nevertheless a severe jolt and has provoked a debate about the importance of accountability, the sensibility of expansion plans, and the need to reassess fund-raising efforts.
The decisions that led to the endowment’s loss were largely made during the tenure of former Harvard President Larry Summers, now a leading economic advisor to President Obama. During Summers’ stewardship, the endowment took on more leverage, increased its exposure to risky assets – accepting higher so-called ‘Value at Risk’ – and substantially reduced the liquidity of the portfolio. Summers also broke with Harvard’s longstanding policy of saving more when performance was good, in order to provide for ‘rainy day money’ when performance was bad.
There were also mishaps. A report by Bloomberg revealed that at one point, the endowment took a $923 million loss on a failed derivative bet that interest rates would rise. Bloomberg’s report suggested that the endowment may not have understood what it was investing in; Footnote 4 in Harvard’s latest fiscal report reveals that 64 percent of the endowment’s assets are held in Level 3 types of investments. These tend to be more obscure assets like private equity, hedge funds, and real estate whose ‘prices or valuation require inputs that are both significant to the fair value measurement and unobservable.’
Over the last ten years, Harvard’s expansion plans have grown at least as fast as it has outpaced the ability of its endowment to fund them. A total of 6.2 million square feet of campus was added from 2000 to 2008, the equivalent of about 140 football fields. Though many reasons have been given for such a plan, it also probably helped that during this eight year period, Harvard had four presidents, each of whom wished to make their mark.
Harvard’s endowment is not a single massive account, but a conglomeration of 11,600 separate funds, established over many years, and with a wide variety of purposes and restrictions. Yet Harvard centralizesits investment management of those collective gifts and donations despite their separate legal and fiscal status, which enables it to fund operating budgets at colleges that are heavy on costs, but light on recurring revenues. For example, the College of Arts and Sciences and the Graduate School of Design depend on the endowment to pay 55 and 48 percent of their budgets respectively, while HBS and HKS only draw 25 and 28 percent.
Though the aggregation, centralized management, and need-based distribution of funds worked well under normal circumstances, the drop in the endowment’s size and the restrictions on how some funds can be used has only increased the difficulty of managing the endowment over the past year.
Endowment funding has become a critical measure of a school’s vitality and stature. It enables a school to make long term investments, attract the best faculty, offer state of the art infrastructure, and attract the most desirable employers. Fundraising inevitably determines the relative bargaining strength among Harvard colleges, and can often spur internal competition.
Endowments have permanently transformed the operating model of universities. Harvard’s endowment in 1985 was $2.5 billion, and the portion of operating costs funded by it was a tiny fraction of what they are today.
The good news is that a new era of large donations to nonprofit institutions seems to be approaching. The Center on Wealth and Philanthropy estimates that up to $27.4 trillion will be donated over the next 40 years, and as the University’s premier public service school, HKS should stand to benefit from some of those funds.
The Kennedy School has the potential to be a preferred donor destination given our focus on “doing good” rather than just “making money.” But the HKS endowment is only $800 million, compared to $2 billion for the Business School and $11 billion for the College of Arts and Sciences. That is why many believe it is time for HKS to seize this opportunity to narrow this gap, and that we should put our brightest minds together to help make this happen.
In doing so, HKS should not lose sight of the fact that it has something else in its favor which engenders charity that its cousin across the Charles doesn’t have: ‘the Power of Nice.’
