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November 9, 2012
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Education: Endowment Yield is Long-Term Stability

Patience, compound interest turn Kentucky college donations into a firm foundation for the future

By Frank Goad

Amidst the very public howling over tuition increases, budget cuts and the rising cost of a college education, at most schools there also are little-talked-about but vital financial efforts going on in departments referred to as Advancement or Development.

Personnel in those departments across Kentucky work to nurture the link – or to re-establish the connection – between the school and its alumni and friends, to help them understand the need and convince them to financially support the institution now or after they’ve breathed their last.

Higher education depends on donors. Any of us with a college diploma likely receives appeals from our alma mater. Our checks support the school’s general fund for operations, scholarships, capital improvements, payroll and other day-to-day things. Lasting, ongoing long-term benefit comes, though, when contributions go to toward an institution’s endowment, which is one of the most remote and least understood parts of higher ed funding.

Besides their major endowments, many schools have a variety of smaller, department-specific endowments whose proceeds are restricted to certain functions. These allow the schools to pay top teachers or recruit outstanding students in one field.

The chart below shows that Kentucky schools reported more than $3.6 billion in their endowments to the National Association of College and University Business Officers (NACUBO). These are large numbers of dollars and might prompt some to call the school where their child matriculates and ask why they’re not using this money to lower families’ outlays. Some of this money is used for scholarships, but its prime purpose is to maintain a firm financial foundation for the school’s future.

Endowments are an important part of a school’s stability and its ability to serve students for many years to come; creatures from the realm of compound interest, they are not a dollars-in, dollars-out proposition.

The accompanying chart shows the Kentucky results of NACUBO’s survey in the United States and Canada. Some private Kentucky schools are not included; only about one-third of schools in the United States have endowments and some who do did not report to NACUBO. The commonwealth’s larger schools do have endowments, and that is a sign they are carefully planning for the future of Kentucky’s higher ed system.

These endowments are considerable sums of money – a couple are approaching $1 billion. However, Kentucky’s largest endowment ranks only 79th. The No. 1 reporting school, Harvard University, has an endowment reported for 2011 to be $31.7 billion, nearly 10 times the total of all Kentucky schools that reported. That’s larger than the Commonwealth of Kentucky’s entire 2012 operating budget of $28.3 billion, which includes federal funds and all categories of spending (“Budget In Brief”).

Even among the big schools, Harvard is an outlier. The next largest reported endowments were Yale University’s $19.4 billion; the University of Texas System’s $17.1 billion; Princeton University’s $17.1 billion; and Stanford University’s $16.5 billion. For comparison and perspective, Johns Hopkins at 25th in size has $2.6 billion.

It’s big business.

Only a fraction of earnings are spent

The most important thing to remember about endowments is that the principal is there to generate interest, whose proceeds can then go to pay expenses. Most colleges have an average “spend rate” of 4-5 percent of their endowment’s annual earnings, and dip into principal only in dire emergencies. Endowment earnings that are spent commonly contribute to a school’s operating or capital requirements and are used to develop facilities and programs that attract and serve students. Some schools do, indeed, use a portion of the funds for scholarships.

Besides their major endowments, many schools have a variety of smaller, department-specific endowments whose proceeds are restricted to certain functions, such as endowed chairs for professors, scholarships and fellowships. These allow the schools to pay top teachers or recruit outstanding students in one field, such as medicine or math, or to support specific types of research.

Endowments are separate from donations to a general fund, for scholarships, activities, programs or school-based charities.

“Endowments create a sustainable foundation for institutions,” said Kelly Wesley Taylor, a principal in Lexington-based Trek Advancement, a company that works with schools to improve donor relations and donations. “They provide critical support to meet the fixed needs and emerging opportunities that allow them to deliver on their mission to educate current and future generations. They need to be a driver for growth and advancement to enable the school to stay relevant and educate future generations of students. They ensure that their educational missions are accomplished.”

To do this, you must make the donated money last.

The long, long view is required

Managing an endowment is a very long-term proposition. Endowment managers and advisers face a much different proposition than with the investments of an average family, where the beneficiaries are looked in the eye and expect returns for their retirement or their children’s college. Endowments do serve the hundreds or thousands of people at a college today, but most endowment beneficiaries haven’t even been born, and managers must shepherd money so that it’s there for perpetuity – for those coming in contact with the school many years ahead.

Sound long-term investment strategies are crucial because today’s donation is just the seed. The compounding effect of money is so important to endowments that a drop now in interest returns or in contributions can mean millions lost in coming years.

Boards of trustees hold endowment decision making power.

“(Board members) may be investment experts, but that’s no guarantee they’ll understand the complexities of fundraising and donor relation,” said Brooks Scudder, a partner at Trek Addvancement. “A high-yielding investment idea that alienates your constituents can seriously damage years of work. Considering that it often takes two to three years to get donors to make a substantial investment in an endowment, one mistake can have a chilling long-term effect.”

It’s all about returns

The far right column in the chart shows the percentage change in each school’s investments from 2010 to 2011, which was a very good year. All schools invest in domestic and international equities, fixed-income vehicles, short-term securities and cash. Larger endowments often make more complex investments; these include venture capital, private equity real estate, commodities, managed futures, distressed debt, private equity funds that participate in leveraged buyouts, merger and acquisitions, and “marketable alternative strategies” such as hedge funds and derivatives.

Few schools manage their own investments. They hire outside firms to invest for them. The chief financial officers of the school are often the main point of contact, and the one who reports to the investment committee of the board of directors. The board confirms the final decisions about the many recommendations they receive, so its collective financially savvy is crucial.

Average U.S. endowment earns $4 million

Only about 30 percent of the 2,719 four-year colleges in the United States have endowments, and 839 schools (including some in Canada) reported back to NACUBO for its study. Of those, 73 had endowments larger than $1 billion, and 137 had less than $25 million. The average U.S. university endowment is around $90 million and generates an average of $4 million per year in income. At most schools, maintaining physical structures alone eats up most of that.

How that money is used is often based on a moving five-year average of earnings, after subtracting a portion as a hedge against inflation and the uneven nature of financial markets.

“The size of an endowment today generally reflects where the institution’s priorities are focused,” said Taylor, who worked previously in development at Harvard. “Institutions that direct attention to prepare for its long-term needs have more robust endowment reserves, while institutions that focus only on current needs are missing an opportunity to secure support for the institution in perpetuity.”

While the average return for fiscal year 2011 in Kentucky is 17 percent, the financial market’s nosedive in 2008-09 hurt investment fund values and most are still recovering. While many of the schools reported to NACUBO that they have recovered much of the ground they lost, nearly 50 percent of the endowments have less than they did before 2008. For instance, the University of Kentucky’s endowment reported $957.6 million in 2007 and was at only $915 million four years later. The average 2009 loss for schools in the study was around 23 percent, so despite recent improvement it is still in a trench.

So, how did they get into trouble?

Not long ago, many schools varied little from the 60 percent stocks, 40 percent bonds investment strategy that many individuals follow until retirement. That changed when Yale’s David Swenson started venturing into more exotic and risky investments. Harvard followed suit, and soon most universities followed, too. According to NACUBO, over 50 percent of endowment investments are in the “alternative” strategies previously mentioned, and those typically are longer-term investments.

The larger the endowment, the more of their capital is in alternative investments; smaller endowments tend to be much more conservative. NACUBO found that endowments of $25 million or less have around 10 percent in alternative strategies, while those over $1 billion average 60 percent.

Returns from alternative investments were stellar for awhile, but when it all came crashing down, those schools were sent reeling and another big market dive could jeopardize some schools. For instance, financial trouble at The Cooper Union for the Advancement of Science and Art in New York, long famous for charging no tuition, recently started charging tuition for graduate programs and is considering whether to charge tuition for undergraduates for the first time in over 100 years.

This underscores the importance of a strong financial foundation and the critical role endowments play in a school’s stability.

Part two: Next month examines how Kentucky schools’ endowments are faring and strategies being used by those responsible for guiding them.

Frank Goad is president of the Frank Communications Lexington, a marketing, advertising and social media consulting firm. He was the first employee of Lane Communications 27 years ago.

 

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