By Thom Ryan · On March 30, 2017
Most major universities maintain sizeable financial reserves, which are more commonly known as endowments. These endowments are typically comprised of a diverse portfolio of financial assets which are predominantly funded through alumni donations and other charitable giving campaigns. Similar to pension funds who aim to grow assets for the purpose of funding pension liabilities, endowments adhere to a strict set of long-term guidelines regarding asset allocation, risk levels, and targeted returns with the purpose of growing investment funds for the university’s overall operating budget.
Now fixtures at most universities, who on average rely on endowments for at least 10% of their operating budgets, endowments have become critical in funding research, academic programs, school facilities, extracurricular activities, and financial aid. Yet, over exposure to risky assets prior to the financial crisis, sky-rocketing management fees, and questionable ethical practices have contributed to growing criticism of their investment models and even called into question their purpose entirely.
The Yale Model
Despite a myriad of investment approaches across various institutions, the Yale endowment has emerged as a clear leader. Under the leadership of David Swenson, who has held the role of Chief Investment Officer for thirty years and pioneered what is now referred to as the “Yale Model” for endowment fund investing, Yale’s endowment has enjoyed unprecedented success with annualized returns of 14.5%. The handsomeness of the Yale endowment’s returns are especially impressive when compared to the underperformance of its peers, who have struggled to perform. Harvard for example, has struggled to live up to its world class pedigree, posting the second worst annualized returns over the past 5 years out of all Ivy League schools. And it’s not just endowment funds who have struggled to meet targets; hedge funds and asset managers have experienced massive capital outflows of late due to lacklustre performances. This monetary exodus, fueled in part by the increasing difficulty to beat market returns as well as investors turning to more cost effective, passive funds such as ETF’s, has left managers questioning traditional approaches.
Given such adverse industry wide conditions, why has Yale been so successful? The Yale Model focuses on a more diversified, and sometimes controversial, approach to investing. First, the majority of investment decisions are outsourced to external fund managers (Yale itself only employees a staff of thirty), a decision that itself has generated significant criticism. According to the New York Times, Yale paid approximately $480 million to private equity fund managers as compensation in 2015 (about $137 million in annual management fees, and another $343 million in performance fees, also known as carried interest) to manage about $8 billion, or one-third of Yale’s endowment. By contrast, of the $1 billion the endowment contributed to the university’s operating budget, only $170 million went towards funding tuition assistance, fellowships and prizes, calling into question whether or not its endowment is adhering to its mandate of by and large, serving students.
Part of the problem can be attributed to increasingly large charitable gifts to elite universities, which are incentivized by favourable tax treatment. In 2014 and 2015 alone, hedge fund manager Kenneth C. Griffin and Stephen A. Schwarzman, the chairman and co-founder of the private equity giant Blackstone, each gave $150 million to Harvard and Yale respectively, with John A. Paulson (another hedge fund manager) topping them both with a $400 million to Harvard. While these donations are undoubtedly beneficial, some have suggested that they highlight an increasingly conflicted relationship between asset managers and university endowments.
Most endowment funds, including Yale, compensate asset managers based on what is called the “2 and 20” model, which refers to a 2% annual management fee and a 20% share of the investment profits, or carried interest. Carried interest is highly beneficial from a tax perspective since most institutional investors, especially universities, are afforded a tax-exempt status. As tax-exempt vehicles, fund managers carried interest is subsequently taxed at lower capital gains rates as opposed to ordinary, more egregious income tax rates. Since endowments support the expansion of knowledge, it makes sense that they are exempt from taxes. Still, critics argue that their over consumption of alternative asset managers, which results in more capital deployed towards compensation and less deployed towards students, should be grounds for concern.
As public disdain for private equity and hedge fund managers continues to intensify, many university endowment funds have become increasingly scrutinized and even pressured to sever ties with alternative asset managers entirely. Multiple student unions at varying universities, including the likes of Queen’s, Yale and Cambridge, have voiced concerns about the social implications of private equity and fossil fuel investments with varying success. In early 2016, after substantial pressure from student groups, Yale’s endowment fund unwound a $10 million fossil fuel position, while Queen’s –where natural resource companies play a larger role in employing students post-graduation- chose not to divest of fossil fuels. But the fossil fuel industry is not the only source of moral discomfort among students. Fees aside, many students feel squeamish about the common private equity business model of over-leveraging, stripping down companies, and destroying jobs in the name of increasing efficiency and profits.
Despite well-meaning intentions, these criticisms are misplaced. Decisions on asset allocation, specifically divestment from fossil fuels, do little to further concrete change in climate policy. Emission production is largely driven through the use and consumption of fossil fuels; for example, fossil fuel firms contribute only one quarter of emissions to Canada’s greenhouse gas emissions.
Moreover, as Vanguard’s Bill McNabb points out, lowering an oil companies’ share price may be counterproductive to climate change progressivism since cheaper valuations makes companies more vulnerable to private equity takeovers, ultimately reducing the transparency and oversight that is required of public companies.
Understanding this, the University of Toronto employed a more holistic approach towards calls for divesture in 2015. Rather than blanket divestiture, the university specifically outlines how both the endowment and the university as a whole approaches investments, research and energy consumption — noting that this approach will be more effective to meet both the endowment’s fiduciary duty to the university as well as addressing the reality of climate change.
Furthermore, while there are certainly grounds to argue that universities have lost sight of the idea that students, not private equity funds, should be the primary benefactors of endowment funds, severing ties with fund managers is not the solution. As Yale’s returns illustrate, premium fees do in fact translate to premium returns. For the past twenty years and under the careful stewardship of David Swensen, Yale’s private equity portfolio has generated a return of 36% per year. Critics also incorrectly gloss over Yale’s generous financial aid policy as well as fact that its endowment is largely responsible for funding things that benefit students indirectly, like buildings, faculty salaries and research. For example, in the 2014 fiscal year, Yale’s endowment provided over $830 million for expenses that included funding recruiting top professors, subsidizing research and facility maintenance. As for the stripping of assets and the job displacement associated with private equity, it can hardly be viewed in a vacuum. Many industrial and manufacturing companies have offshored jobs and technological innovation has reduced the need for bloated workforces. Often, failing companies need to be slimmed down in order to preserve their existence entirely, and it should be viewed as a necessary evil to keep companies afloat in an increasingly competitive global market.
With or without blanket calls for divestiture, which do little to impact climate change, the world is trending away from reliance on fossil fuels. Meanwhile, having a robust and diverse investment strategy, has enabled many universities’ to provide funding for research and innovation at unprecedented levels, which ultimately can have a more substantial social impact on issues like global warming or job displacement due to automation. Returns from these investments undoubtedly are put towards a net societal positive which is improving higher education. For students concerned with making a difference, it is important to have an open mind to endowment funds and even more important to make the most of the learning opportunities that they provide.