Thursday, June 3, 2010
A report by the Tellus Institute argues that risky investment strategies by big nonprofit endowments played a role in making the economic crisis worse.
The report studied the investment strategies at six privately endowed New England colleges and universities: Boston College, Boston University, Brandeis University, Dartmouth College, Harvard University, and MIT. The report finds that the aggressive investment strategies used by the managers of the endowments at these institutions exacerbated the economic crisis. Here are a few of the reports' conclusions:
- By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets. Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling markets, magnifying volatile price declines even further. The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
- College governing boards have failed to guarantee strong oversight of the Endowment Model by relying heavily upon trustees and committee members drawn from business and financial services, many from the alternative investment industry. . . . To take only one example, Dartmouth’s board has included more than half a dozen trustees whose firms have managed a total of well over $100 million in investments for the endowment, over the last five years. Even when there are not potential conflicts of interest, the oversight abilities of many trustees and investment committee members seem to have diminished because of their professional connections to the shadow banking system or their corporate directorships.
- Although they had little responsibility for endowment management or oversight, students, faculty, staff, alumni, and local communities are bearing the brunt of the Endowment Model’s consequences: from widening pay inequity to demoralizing layoffs, hours and benefits cuts, and hiring and pay freezes; from program cuts to reduced student services; from construction delays and stalled economic development to forgone tax revenues. Because these six schools are among the very largest employers in their communities, the widening pay gap between over-compensated senior administrators and more modestly compensated staff not only distorts pay structures on campus but also deepens social inequality within surrounding communities.
Perhaps more surprising is that the report directly attacks tax-exemption as part of the problem. In essence, the report argues that tax-exemption and its related tax benefits (e.g., the contributions deduction) facilitated the risky investment strategies. Again, a few quotes:
- As major property holders in their communities, the six schools in our study own tax-exempt real estate worth more than $10.6 billion, yet collectively they made negotiated payments in lieu of taxes (PILOTs) totaling less than 5% of the $235 million in taxes they would owe if they did not have the privilege of their tax-exempt status. Some schools make no PILOTs whatsoever.
- Gifts to endowment are tax-deductible to donors, and investment gains and income that endowments generate are tax-exempt. Endowment managers can therefore rapidly trade without considering the potential tax consequences of their investment decisions.
- Tax-exempt bonds have allowed colleges to borrow at low interest rates while keeping their endowment assets fully invested in high-risk, high-return investments. Endowments pocket the difference in yields tax free, while investors in tax-exempt bonds also receive favorable tax treatment on income. Congressional leaders and the Congressional Budget Office are exploring how colleges benefit from this indirect tax arbitrage when they use tax-exempt bond proceeds for operating expenses in order to use other investments to chase higher rates of return. Because of the excessive levels of illiquidity in their investment portfolios, colleges have increasingly turned to the bond markets for cash.
Not surprisingly, the report recommends wholesale changes in endowment investment strategies. "Endowments need to foster greater resilience in times of crisis by investing in assets with greater liquidity and lower volatility, and a portion of excess returns generated during good times needs to be set aside in rainy-day funds for the bad. But more fundamentally, endowments need to pursue “responsible returns” that remain true to their public purpose and nonprofit mission as tax-exempt institutions of higher learning. By integrating sustainability factors into investment decisions and becoming more active owners of their assets, endowments can begin to seize the opportunities of long-term responsible stewardship."
While I don't necessarily agree with all the points made in the report, it does generate a lot of food for thought. For example, the decline in value of endowments has been reported to death, but the press has generally ignored the collateral consequences (layoffs, salary reductions, etc.) that the endowment "crashes" caused in their local communities. On the other hand, the big profits made in the boom years almost certainly helped create a boom in the local economies at the time. So, I wonder: should tax-exempt organizations adopt more conservative ("sustainable" in the words of the report) investment strategies because of their quasi-public role? I frankly don't know about this one; I'll have to cogitate on it some . . .