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Endowment Declines 22 Percent through October 31

12.2.08

Going beyond the disclosures made on November 10 and November 18, the University on December 2 released new information to deans and financial administrators indicating that the value of Harvard's endowment had declined 22 percent through October 31. (It was valued at $36.9 billion last June 30, the end of fiscal year 2008.)

Moreover, according to the memorandum from President Drew Faust and Executive Vice President Ed Forst, "even that sobering figure is unlikely to capture the full extent of actual losses for this period, because it does not reflect fully updated valuations in certain externally managed asset classes, most notably private equity and real estate." (Managers of such assets report to Harvard Management Company regularly but at infrequent intervals, and the valuation process obviously is more complicated than for securities readily traded on public markets, like corporate stocks and Treasury bonds.) Accordingly, the expectation is that when reports are received on these latter asset classes, "the endowment will realize further declines in value." In total, that explains why the University's budget planning envisions a scenario with asset values decreasing 30 percent, approximating the 30 percent decline in endowments generally that Faust cited (from an external rating service) in her message to the community on November 10.

For at least 40 years before the current one, the memorandum notes, Harvard's worst investment loss was a negative 12.2 percent return in 1974 (when the endowment totaled less than $1 billion and accounted for a much smaller portion of the University's operating revenues; in fiscal year 2008, endowment distributions for operations totaled $1.2 billion, or 34.5 percent of revenues).

Beyond losses in value from negative investment returns, the endowment will be further reduced by current-year distributions for operating and capital purposes. Those latter figures might total $1.4 billion and $0.2 billion respectively. As a hypothetical exercise, that implies a combined decline in the endowment's value--including both the negative investment returns of 22 percent to 30 percent, and the funds distributed this year--from $36.9 billion to a range of $24 billion to $27 billion by year's end. Using the Corporation's long-term guideline of distributing approximately 5 percent of endowment value annually, such declines imply theoretical reductions in yearly spending power of nearly $500 million to about $635 million (but in fact it will likely authorize a higher spending rate in the near future; see below for more about the decisions the Corporation faces).

Accordingly, University leaders are being advised "not merely to contemplate changes at the margins," but to plan for significant budget reductions.

Even slowing spending will present real challenges: revenues were $2.6 billion in fiscal 2004, $2.8 billion in fiscal 2005 (up 7.8 percent), $3.0 billion in fiscal 2006 (up 7.1 percent), $3.2 billion in fiscal 2007 (up 7.0 percent), and just under $3.5 billion in fiscal 2008 (up 8.5 percent). Throughout this period, the driving engine for the $200-million-plus average annual increases in revenues has been income distributed from the endowment for operating purposes, which rose from just more than $800 million in fiscal 2004. (During the same period, investment income on working-capital investments--not endowment funds--distributed for operations has also soared, rising more than 50 percent to $175 million in fiscal 2008. Thus, the flow of operating funds made available from investments has accounted for fully half the University's revenue gains since fiscal 2004.)

Although the Corporation will determine in coming months how much to distribute from the endowment for operations in the fiscal year starting next July 1, and will approve University and school outlays then, Faust indicated that the magnitude of the decline in the endowment's value is too large to cushion against the prospect of significant budget cuts (even though the memorandum indicated that, inevitably, spending from the endowment next year will be at a "higher percentage" than in the recent past).

Instead, the central administration and the schools are proceeding under budget guidance that incorporates the estimated 30 percent decline in endowment asset values and a different--perhaps sharply different--trajectory in distributions of funds. (Reports of November 12 and November 19, respectively, describe the implications for each of Harvard's schools, and for the Faculty of Arts and Sciences in particular; the latter had originally been planning for a $100-million increase in endowment distributions for fiscal 2010, at which level it would still have run a budgeted operating deficit.)

Given the very volatile financial markets, the memorandum outlines a new element of Harvard's financial strategy. First, taking advantage of the University's top-tier (Aaa/AAA) credit rating and the historically low interest rates, Harvard will issue "a substantial amount of new taxable fixed-rate debt." Forst said the pace and extent of the borrowings will depend on the terms and structure of debt that can be sold in the market over time. (Taxable bonds and notes outstanding as of last June 30 were reported as $1.3 billion; tax-exmpt debt issued at fixed rates totaled $1.1 billion.) The aim is to accumulate cash "to fund ongoing operations and critical academic and research priorities," according to the memorandum--in essence, to maximize financial flexibility during a period of disrupted markets and recession that is of uncertain depth and duration.

Second, to reduce the risk in the cost of renewing its short-term debt against the backdrop of very volatile markets, the University intends now to replace those borrowings with longer-term tax-exempt debt instruments. According to the University financial report for fiscal 2008, variable-rate notes and commercial paper outstanding totaled about $1.6 billion as of last June 30; the exact amount outstanding now has not been disclosed, but is presumably somewhat greater.

Although the decision to borrow to build a pool of liquid funds and the likely willingness to spend above the long-term endowment distribution rate "will help," according to the memorandum, these steps "do not obviate the need to reduce expenses," beginning now. Faust and Forst's memorandum indicated that they were working with each school to focus on "a range of capital and operating budget-reduction scenarios." Major capital plans, including for Allston campus development, are being "reconsider[ed]," with implications for project priority and pacing, and "a hard look" is being taken at hiring, staffing levels, and compensation.

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