Wednesday, December 03, 2008

The Best Aren't the Best Forever

by Andrew Gillen

Felix Salmon clarifies some of the real reasons university endowments are dumping private equity stakes:
The problem with private equity funds is not that they're illiquid, or that they're long-term: endowments can cope with both of those quite easily. Rather, it's that they're highly levered, which means that they can go to zero quite easily. And once they've hit zero, they don't ever recover.

Leverage is fantastic on the way up since it multiplies gains, but downright brutal on the way down, since it multiplies those too.

The common 2 and 20 fee structure (2% of assets and 20% of gains above some benchmark), is not very attractive at the moment either. After all, who wants to pay 2% for the privilege of watching their portfolio shrink?

These funds were the cream of the crop of the financial world. When things were going well, their past performance eased worries, allowing them to increase leverage, which increased performance... But that all came to a screeching halt when the market stopped going up.

Hmmm...Perhaps it's just because a reporter called yesterday about the Tuition Bubble paper I wrote a few months ago, which compared the housing bubble to what I called a tuition bubble, but I see some similarities here. Replace leverage with prestige, and equity funds with the top schools in the country, and you've got a very similar situation. These schools rely heavily on their prestige (leverage) to succeed. Their performance appears to justify their high tuition (2 and 20 fees). As long as nothing damages their prestige, they are in a virtuous cycle of prestige leading to more money leading to more prestige...

Q: Is there anything that could damage the prestige of these institutions?
A: Value added assessment of the education they provide. While some of the top schools are doing a good job, I have little trouble imagining some are resting on their laurels.

Even at our best schools, we do not currently have value added assessment, as this quote from William R. Fitzsimmons, dean of admissions at Harvard shows:
At Harvard we get terrific students, and we turn out terrific students later on. Is that due to Harvard or is that due to the students to begin with? Who knows?

Given that value added analysis could upset the virtuous cycle, it should come as no surprise that top schools energetically resist it. As Kevin Carey notes, "When the conventional wisdom says you're the best, you have no interest in proving otherwise." Their best interests "lie in using whatever means necessary to prevent the release of any information that would upset the status quo." A proposal a few years back that would have moved us one step closer to value added failed when
lobbyists for private colleges put on a full-court press to block the proposal, pressing Congress to prohibit its creation and publicly denouncing it as "Orwellian" and "an assault on Americans' privacy and security in the shadow of the Fourth of July."

Value added assessments will not be blocked forever. And on the wonderful day when it comes, schools that perform poorly will shut down because no students will want to attend a school that doesn't provide value. Schools would be well advised to make sure they will perform well on this measure by ensuring they are providing value for their students, which means shifting away from the sorting/screening and entertainment functions that seem so dominant today, and towards a system that focuses more on educating and guiding students.

Luckily, as these universities ditch high fee funds relying on leverage, they are getting a glimpse of what lies in their future if they cease to earn their prestige, and rely on their illustrious past to carry them forward.


RWW said...

Andrew, that is really a well written, coherent, and thoughtful piece. Your segue into "value added" is quite striking. I can't argue any of your points. Very well done - informative.

The only thing I might have a small problem with is Salmon's definition of "liquidity". But that's a minor debate for another day and other person.

RWW said...

An Oldie But Goodie from May 2008

By Glenn Beck

Editor's note: "Glenn Beck" is on CNN Headline News nightly at 7 and 9 ET and hosts a conservative national radio talk show.

NEW YORK (CNN) -- There is an industry in this country that is making billions in profit while average Americans are struggling to fill up their gas tanks.

Glenn Beck says universities should share the wealth from the tax break on their endowments.

It's an industry that made an average profit of nearly 17 percent in 2007 while most Americans could barely keep up with inflation.

It's an industry whose members paid a grand total of zero dollars in tax on their endowments last year.

Are you outraged? Are you ready to call on Congress to investigate or demand that a "windfall" tax be placed on these egregious profits?

Well put down the phone because the industry I'm talking about is Higher Education. And make no mistake, it is an industry.

The top five college and university endowments reported a combined value of over $100 billion at the end of 2007. That's five funds, a hundred billion in cash. Not a nickel in tax. Not an ounce of outrage.

Harvard University, which has the largest endowment in the country, has a total of $34.6 billion. To put into perspective just how much money that is, consider that the largest charitable foundation in the world, the Bill & Melinda Gates Foundation, has a total endowment of $37.3 billion.

But while their financial statements may look similar, their missions aren't. The Gates Foundation is working to cure malaria, develop new tuberculosis vaccines, and stop the spread of AIDS. Most of our colleges and universities are only working to spread the radical political views of some of their professors.

Let me be clear: I have absolutely no problem with Harvard or any other school having billions in cash. In fact, good for them!

I have no problem with Harvard posting an unbelievable 23 percent rate of return on their money last year. The truth is, I'm jealous of it.

I have no problem with the fact that if you project Harvard's endowment out using their historical rate of return they would have over half a TRILLION dollars in 20 years.

I don't even have a problem with Harvard not paying one dime of tax on any of that money.

What I do have a problem with -- and it's a big one -- is how Harvard spends that money. Or, maybe it would be more accurate to say how Harvard, doesn't spend that money.

Schools with large endowments (at least $500 million) reported spending an average of 4.4 percent of their stockpiles in 2007.

Meanwhile, those same schools made an average of over 19 percent on their money.

But I also have another problem, and that is how these sanctimonious institutions who are so good at complaining about the injustices of our government are nothing but really highly educated hypocrites.

For what's been estimated to be about $300 million a year (less than 1 percent of their endowment's value) Harvard could completely waive tuition, room and board for every single one of their students. Instead, they announced an increase in those fees of about 3.5 percent for next year. Being a student at Harvard will now cost a staggering $47,215 a year.

Doesn't Harvard know how many millions of Americans are struggling to afford college? Don't they want to pay their fair share and help those who are less fortunate?

Some politicians in Massachusetts who can't stand to see so many billions dangling just out of their reach, have proposed a new tax on large university endowments. They don't have a cute name for it yet, so let's call it an "endowment windfall tax."

Under their proposal, all endowments over a billion dollars would be taxed at 2.5 percent, a rate any wealthy individual or corporation would salivate over. The tax would net the state over $1.4 billion a year, which is a lot of money considering that Boston currently receives about $1.8 million a year from the school.

So how did Harvard, which is basically the Exxon-Mobil of higher education (minus the accusations of price-gouging), react to that proposal? In a word, conservatively.

"You'd be taxing success here," Kevin Casey, Harvard's associate vice president for government, community and public affairs complained in a quote that will soon be framed and hung in my office. "Over time, this would put us at a real competitive disadvantage, which would drastically hurt the Commonwealth."

No Kevin, you're looking at it the wrong way. These politicians aren't trying to hurt you, they're just trying to level the playing field. Greater Shrewsbury Liberal Arts Community Technical College for Women down the road is struggling and here you are making billions. If they could just redistribute some of your profits to GSLACTCFW then everybody would be happy.

Does anyone else find it ironic that universities overflowing with liberal professors (a 2005 study revealed that 72 percent of professors view themselves that way) embrace conservative values only when it suits them?

As a conservative, I don't believe in taxing anyone just because they have a lot of money or are an easy target. That applies to individuals, businesses and universities. I believe that taxing success discourages success, and that's not what America stands for.

But I also believe in something else: consistency and accountability. And that's where most of our colleges and universities fail miserably.

Besides, Harvard, you're in the wealthiest 1 percent. Isn't it time to help those who are less fortunate?