In the credit-industry equivalent of a thriller, Moody’s Investors Service on June 14 released “Liquidity and Credit Risk at Endowed U.S. Universities and Not-for-Profits.” The report, by Moody's vice president Roger Goodman and analyst Stephanie Woeppel, in effect dissects the trends during the past 10 years that put Harvard and peer institutions under pressure—and in some cases, in institutional danger—when the financial markets seized up in 2008 and in the ensuing recession.
Beyond clarifying what risks the institutions assumed (the dry language about "liquidity" concerns events that, in a business context, result in an organization's default on its loans, and in the worst case, bankruptcy), the report suggests changes that will affect how Harvard and other universities manage their finances in the future. Among the implications may be modified endowment-investment policies, suggesting lower rates of return.
A Gathering Storm
The Moody’s analysts point to two fundamental trends:
• “Since the 1980s, U.S. colleges and universities have benefited greatly from above average returns in equity markets and falling interest rates, leading boards to approve ever higher endowment allocations to public equity, private equity, hedge funds and real assets as well as lower allocations to fixed income. Investment performance of most endowments over this period consistently exceeded target benchmarks, especially among funds that followed the most illiquid and long-term strategies, thereby encouraging further allocations to these illiquid strategies.”
Harvard's evolution. To cite the data published in the University's annual Financial Report for the fiscal year ended June 30, 2008, the "policy portfolio" (the broad asset guidelines) employed by Harvard Management Company (HMC) called for:
•Publicly traded equities to make up 58 percent of investment holdings and private equity (venture capital, principally) 12 percent in fiscal 1995; by fiscal 2009, public equities were 33 percent of the policy portfolio and private equities 13 percent.
•During the same interval, bond holdings declined from 22 percent to 13 percent of the policy portfolio; "real assets" (commodities, timber and agricultural land, real estate) increased from 13 percent to 26 percent of the portfolio model; and "absolute return" (hedge funds)—not a part of the portfolio until the late 1990s—were allocated 18 precent of the model holdings in fiscal 2009.
•Overall, highly liquid, public securities decreased from 80 percent of policy portfolio holdings in fiscal 1995 to 46 percent in fiscal 2009; the proportion devoted to illiquid holdings increased from 25 percent to 57 percent. (Totals equal more than 100 percent because HMC also borrowed, leveraging up the portfolio to boost returns.)
The largest endowments led this shift, and were its biggest beneficiaries, Moody’s reports, citing Yale’s 15.9 percent compound annual endowment growth rate from 1988 to 2008; that growth led the Yale endowment to increase tenfold, even as spending from the endowment to support operations grew. Given the allure of high returns, Moody’s says, “many boards increasingly moved more operating funds into the long-term pool of endowment investments—expecting that future operating cash needs could increasingly be funded from positive returns on long-term investments. As a result, relative institutional cash liquidity declined significantly even as universities became wealthier.” (emphasis added)
Harvard's evolution. As is now known, the University invested a significant portion of its liquid funds in the endowment. As previously reported, in the fiscal 2009 annual financial report Harvard disclosed $1.8 billion in losses incurred in the “general operating account”—the principal cash funding mechanism for University operations—where assets, invested like the endowment’s, absorbed proportional declines in value.
At the same time, Moody's observes, institutional ambitions and the sheer financial allure of maximizing attractive investment returns, while taking advantage of relative low borrowing rates, led to greater use of debt, thus:
“Over the last 15 years, debt issuance by universities has grown rapidly. This increase in borrowing was driven by a combination of factors, including lower interest rates, catch-up on capital spending deferred during the demographically weak 1985-1995 period, competition among institutions for the best qualified students and state-of-the-art facilities, expanded research funding from the federal government, and rising demographic demand as more students enrolled in higher education over the period.
“As universities expanded their research, educational, and student-life facilities to meet rising demand for their services, they developed more ambitious strategic and capital plans. To fund these plans, they faced strong incentives to maximize financial assets invested in high-performing endowment pools in order to increase their resources to a greater level over the long-term. Long-term investment management became, in effect, a core business line of the university because it was generating institutional resources much like private fundraising and student tuition.”
Harvard's evolution. At the end of fiscal 1998, Harvard had $1.14 billion of bonds and notes payable. A decade later (before the extraordinary borrowing in fiscal 2009—see below), the principal amount outstanding was $4.09 billion.
(One cheeky perspective on this strategy comes from Maier professor of political economy Benjamin M. Friedman, who observed in the April 29 New York Review of Books, where he was considering two recent interpretations of the financial crisis: "The philosophy seems to be that one cannot operate a bank without having a hedge fund attached. The phenomenon was not limited to banks and insurance companies. Some years ago my employer, Harvard University, decided to become a university with a hedge fund attached. Or maybe the idea was to be a hedge fund with a university attached. Either way, the project came to a bad end. To paraphrase Nixon on the Keynesians, we're all hedge funds now.")
In practice, Moody's notes, these conditions gave rise to “institutional preference for more borrowing to pay for capital projects due to the high opportunity cost of pulling funds out of the strongly performing endowment. Utilizing more low-cost debt to pay for capital expansion, rather than liquidating high returning investment assets, seemed an obvious way to maximize long-term institutional benefits for students, faculty, donors, government, and alumni.”
The next step was to minimize the costs of those borrowings by resorting to variable-rate debt, and then putting in place a seemingly secure way of fixing it at a set, long-term rate through the use of interest-rate swaps. Moody’s reports a surge in such financings from 2001 on, as short-term tax-exempt interest rates fell to well below 3 percent. But of course, variable-rate debt “also carried other risks and required greater liquidity support in the event of investor puts.” (emphasis added) In many swap arrangements, the borrowers exposed themselves to collateral calls, but “institutions increasingly focused on whether their endowments were structured to maximize return and protect from investment losses—but not whether reserve liquidity would be available in a crisis.” The important, high-return work for administrators was “[o]verseeing investment strategy, asset allocation and manager selection,” while "Debt management was more typically delegated to financial staff….”
When the Crisis Struck
As the market froze in 2008, all the positive trends reversed.
Multimillion-dollar collateral calls came into play when the value of swap agreements changed (in favor of the variable-rate party, typically a bank, and against the fixed-rate player, in this instance the university borrower).
•Harvard's evolution. As reported, the University realized enormous losses on its swap agreements during fiscal 2009, making cash payments of $500 million to get out of some of the agreements, and still facing unrealized and unhedged exposures to to additional losses of $675 million as of last June 30.
Managers of private investments (private equity, hedge funds, and so on) placed calls for capital from their institutional clients, as agreed to by contract.
•Harvard's evolution. As reported, at the end of fiscal 2005, HMC had future contractural commitments to deliver funds to private-investment managers totaling $3.4 billion—a sum that ballooned to $11 billion at the end of fiscal 2008.
In turn, those demands for liquid funds cascaded through the system as some institutions ran up against the levels of liquidity required by the covenants of their bonds outstanding, as banks and other financial institutions saw their own credit ratings downgraded, and as other malfunctions undercut large swathes of the financial markets.
And of course, institutions’ ability to meet such demands dwindled as they suffered large investment losses; as they received smaller distributions (or, commonly, none) from their investments; and as the value of endowed funds went "underwater" (below the size of the gift corpus), sometimes making distributions difficult or even illegal—just when institutions had counted on them to, say, pay a professor's salary or students' financial aid.
Together, the result was “an unprecedented crisis of liquidity at many colleges, universities, and endowed U.S. not-for-profit organizations.”
The Way Forward
How have institutions adapted? Moody's cites:
•a turn to fixed-rate debt, both for new borrowing and to refund prior obligations;
•internal actions to "alleviate liquidity stress" through sale of endowment assets, "reclassification" of the restricted nature of gifts, and cuts in operating and capital budgets; and
•where necessary, renegotiating the terms of swaps, collateral, and so on.
•Harvard's evolution. During fiscal 2009, the University incurred significant new fixed-rate debt. It issued nearly $1 billion of fixed-rate tax-exempt bonds during the year, with an effective annual interest rate of 5.4 percent (well above the cost of the short-term variable-rate notes paid off in part with the proceeds), and $1.5 billion of taxable bonds at a 5.8 percent rate; total debt outstanding rose to $5.98 billion, up nearly $2 billion from the end of fiscal 2008. (Because that extra debt was on the books for only about half of fiscal 2009, when interest costs rose $58 million, it appears that the added interest expense rose by an additional amount of the same magnitude—another $50 million to $60 million—in the fiscal year now ending.)
Beyond the balance-sheet restructuring, as reported, during fiscal 2009, HMC reduced its future commitments to outside investment managers by $3 billion, to $8 billion, through fulfillment of some capital calls, maturities and sales of some investment holdings, and renegotiations with fund managers—a process that may have continued during the current fiscal year. The management company also reversed its longstanding use of leverage—borrowing, to increase its investing capacity—and is now running a portfolio that maintains a positive cash position. In rising markets, that more defensive posture will be a drag on future investment returns.
And of course the University imposed freezes on compensation and most hiring, had layoffs, has offered retirement incentives, and has ramped down capital spending and frozen construction on its first Allston development, a $1.4-billion science complex. It has also renewed efforts to examine the use of endowment funds, consistent with any restrictions placed on them.
Though measures like these, taken according to each institution's circumstances, averted the failure by any Moody's-rated institution to meet financial obligations during fiscal year 2009, the reports note that these steps were "sometimes costly for affected universities." Longer term, "[T]hese events brought to the forefront the structural limitations of illiquidity in the higher education sector." Restating the problem, the Moody's analysts write,
Despite rising usage of liquidity-based debt structures and increasingly illiquid investment strategies, organizations were overwhelmingly focused on risk management of investment preservation and return strategies rather than liquidity of the organization as a whole. For example, few if any debt, investment, or financial policies set targets for liquidity that cut across endowment and treasury management. While many set targets for liquidity supporting self- liquidity debt, few broadened that perspective to incorporate risks that might arise simultaneously across the organization.
Many management teams were structurally ill-suited for unified liquidity policy formulation because they largely divorced management of treasury operations and financing decisions from investments and endowment management. This separation may have been caused by creation of separate chief investment officers or asset management companies at the largest endowments, or by the domination of investment decisions by an investment committee of the board, distinct from other finance related committees.
From a ratings standpoint, Moody's will now impose formal liquidity ratios into its analyses of institutions' creditworthiness.
From an institutional perspective, large universities like Harvard—with a large endowment that provides a significant portion of funds for operations (in recent years, about one-third of total revenues), a penchant for illiquid endowment assets, and significant debt obligations—now clearly must have organization-wide liquidity policies and oversight, integrated investment management and financial management, and better coordinated investment, capital spending, and treasury functions.
In reflecting on the 2008-2009 experience, HMC president and CEO Jane Mendillo said last year that there had been a “lack of ready liquidity in the portfolio to meet our obligations along with the needs of the University.” The changes in investment strategy noted above are meant to reduce that risk. And in reporting on the fiscal year, Daniel S. Shore, vice president for finance and chief financial officer, told the news office last autumn, “There does need to be a balance between investing for long-term returns and managing for near-term needs, and we are now more conscious than ever of that balance….”
From a financial manager’s perspective, Shore said then, the new reality means maintaining a much more flexible posture toward plans and budgets, testing diverse scenarios at different revenue levels, and helping the whole community cope with heightened uncertainty by assuring that Harvard can be kept appropriately nimble. A Financial Management Committee (expanded to tap alumni and faculty expertise, and including both University treasurer James F. Rothenberg and HMC's Mendillo) is better integrating University and endowment perspectives on risk, risk management, liquidity, and investment opportunities. It advises Shore himself, executive vice president Katie Lapp, and through them, President Drew Faust and the Corporation, where financial policies and endowment distributions are finally vetted and approved.
At a minimum, those steps align with the Moody's analysts' new belief "that a clear understanding by the board and senior management of the potential implications of their liquidity decisions is critically correlated with future institutional credit strength." As an institution, Harvard remains both dependent on endowment earnings to fund operations and obligated to service a significant amount of debt. And it still aims to renovate existing facilities, build new ones, and support critical academic initiatives. In this sense, the revised investment strategies and the new University-wide financial management policies and bodies are among the steps Harvard must take successfully to be a leader in the new financial era, as it was in the previous one that ended so distressingly in 2008.
The trends Moody's reports built momentum over two decades. Recalibrating will occur only over time, not overnight. The fiscal 2010 HMC and University financial reports will likely arrive too late to make compelling summer beach reading. But when published, they will be unusually interesting guides for judging Harvard's progress in adapting to this decade's circumstances.
