Harvard Endowment Down 22%

Harvard University has reported that its endowment fell 22% in the four months since June 30.

When I was in college, I would often hear my fellow students complain about how stingy the university was.  "We have a multi-billion dollar endowment, why don't we spend more of it?"  was the common refrain. 

"You idiots don't understand!" I would stew to myself (I never actually argued out loud, especially to a girl.  I didn't talk to a girl at all until second semester senior year).  "You can't just spend all of the endowment now!  Don't think of it as $XX billion you can spend, think of it as an asset that produces an annual cash flow stream that you can spend.  In a world of perfect foresight, you'd smooth your spending perfectly, spending the same amount on an inflation-adjusted per-student basis every year between now and the end of the world.  In the real world you don't have perfect foresight--you don't know how well the endowment will perform or how many students will exist in the future or how available alternative forms of income will be--so you make an educated guess on how much to spend today (at my alma mater it was called the spending rule).   When you spend too much today you're taking it away from future students, who have as much right to benefit from the endowment as you do!"  I did a lot of stewing in those days, as you can see. 

That was then.  Today the thing to keep in mind is that it works in reverse too:  when you spend too little today, you punish the present to benefit the future.  Not only that, but harsh cutbacks in financial aid, staffing, and other spending can do long-term damage to the school's reputation.  I don't know all the details, but unless President Faust is simply trying to talk down the budget expectations of the various deans, which is the eternal task of a university president, that's the risk Harvard faces.

The $8.2bn decline in the endowment's value looks large and is large, but it's not as large as it looks.  First, as Felix Salmon points out, the total value is just back to what it was in 2006--two "lost years" is not a big deal if you're 372 years old and consider yourself immortal.  In addition, the pain such a decline will inflict on annual spending, present and future, doesn't have to be that bad:

The endowment's value as of June 30 was $36.9 billion.  Suppose the spending rule percentage, absent any market value decline, would have been 4.5%.  Therefore the total annual spending would have been $1.66 billion. 

Now suppose that come June 30 of next year the endowment declines by the 30% estimate Harvard is assuming, to $25.8 billion.  If the spending rule remains constant at 4.5%, then annual spending would decline by an identical 30%, to $1.16 billion.  That's $500 milllion less spending.  If you've ever tried to cut $500 million from a university's budget you know how miserable life can be.  And if you'll permit me to get on my high horse, it's not the tenured professors who will really suffer.  It's the secretaries and staff, construction workers, part-time faculty, and others who truly depend on the school for their livelihood.  It would be somewhat ironic for an institution that very publicly (and admirably) dedicates itself to the betterment of humanity as a whole to refuse to take care of its own. 

But what would happen if instead of maintaining a constant spending rule of 4.5% in the face of the decline--spending $1.16 billion--the university decided instead to maintain the actual dollars spent at $1.66 billion?  (On the new lower denominator of $25.8 billion, that would increase the spending rule percentage to 6.43%.)  The $500 million in "excess" spending can be thought of as dipping into principal, which in certain old Boston families is worse than adultery, but in this case represents only 1.9% of the new principal amount of the endowment.  That would be the penalty imposed on future generations, and that's the number to weigh against the pain current budget cuts would cause. 

I suspect that the real problem Harvard faces is a simple cash crunch.  It committed to spending a large percentage of its operating budget--i.e. predictable, recurring, difficult-to-take-back obligations--with endowment income, but chose to fund those obligations not with similarly predictable and recurring cash flows but with their polar opposite--hedge fund, PE and VC fund LP interests.  This would explain its recent fire sale of PE fund interests, its move to issue new bonds, and its decision to reduce the risk of the endowment portfolio.  As David Swensen has shown, embracing volatility and illiquidity in pursuit of superior long-term returns is worth doing.  But there is a price.

 

Comments

[Tom Chechatka]

I see your point. Since Harvard is "embracing volatility and illiquidity in pursuit of superior long-term returns," there's no harm committing "adultery." Obviously, there are complexities of the "embrace" being compounded these days by fear. All the more, too, considering the deep involvement of the lender of last resort we presently are needing. Though serving to alleviate fear in the short-term, the potential added risk, long-term, that volatility and illiquidity would just blow out should the lender of last resort fail, further complicates the issue you raise.

Or does this consideration only all the more support your case? After all, you can't spend it when you're dead...

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