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Pastimes : Unusual Bubbles

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From: Sam Citron3/4/2009 10:08:35 AM
   of 3
 
Harvard, Private Equity and the Education Bubble [NYT]
Andrew Sorkin/ DealBook

There have been a number of bubbles over the past decade that we now know about. Unfortunately, we are also about to find out if there was an education bubble.

Fueled by endowment gains and tuition increases, universities in recent years have gone on a building, faculty and program expansion spree. I have personally seen it in the law school realm. Instead of the historical 12-credit loads, the norm over the past few years in law schools has trended towards nine to ten credits. This allowed for more research, but also meant that the faculty needed to expand to continue offering the same course levels. Salaries also rose as law schools and other areas of universities competed for top talent.

But the same forces buffeting the general economy are affecting the university.

Yale recently froze all faculty salaries for employees paid more than $75,000, and Harvard froze all faculty salaries at its arts and sciences school. The big private, elite universities appear to be particularly at risk. To understand why, let’s take a look at the Harvard endowment.
Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.

As of June 30, 2008, this endowment stood at $36.9 billion, and last year, it paid out $1.6 billion to Harvard. The Harvard endowment has grown at a torrid pace in recent years — it was just $22.6 billion in 2004 — fueled by portfolio gains and especially a 28 percent, 10-year return on its private equity portfolio. That compares to a total portfolio five-year return of 17.6 percent as of June 30.

But like everyone else, the endowment was hit by the downturn. It has not announced definitive 2008 results, but Harvard has said that it expects returns to be down by about 30 percent. I think the situation is much worse than that. In 2007, approximately $5.16 billion of Harvard’s total portfolio was in private equity, and by my estimate, a total of $11.2 billion, or 26 percent, in all kinds of illiquid assets (the others being real estate and land). Here, this figure is for all of the general investment assets managed by Harvard. That figure was $43 billion as of June 30, 2008, with the bulk being the $36.9 billion endowment.

The 2007 figures and allocations for the entire $43 billion portfolio are disclosed in the endowment’s 2007-2008 year-end report.

Calculating the losses in year-end 2008, I estimate that Harvard’s total private equity portfolio declined 40 percent to around $3 billion. I assign such a figure because I mark-it-to-market — and right now, these illiquid assets are hard to sell and even harder to price. In the long run, these investments may pan out, but for the short term, these private equity assets are at best mispriced.

Applying these calculations through the total endowment as of this date should give about $25.5 billion split with 23 percent to 24 percent in illiquid assets, or about $6 billion. For these purposes I have assumed that all of Harvard’s hedge fund holdings ($8.3 billion as of June 30, 2008) are liquid. This is unlikely because of the many hedge funds that have imposed lock-downs on capital withdrawal. And my aggregate number here is in line with the 30 percent decline Harvard has stated it thinks should occur.

This is where the problem lies. Harvard pays out its endowment on a three-year basis. So for the next three years, I estimate it will still pay out on average about $1.5 billion. This may actually be low, as Harvard seeks to keep spending stable and help out colleges, such as the Harvard Divinity School, that rely heavily on the endowment.

However, if you do the numbers calculating a zero percent return on liquid assets (stocks, etc.), a negative five percent return on illiquid ones (private equity, etc.), and an annual donation rate of $500 million, you get the following allocation:
2010 2011 2012 Liquid assets (in millions) $16,972 $14,472 $11,972 Illiquid assets 7,229 8,368 9,449 Total 24,202 22,840 21,422 % illiquid 29.87% 36.64% 44.11%



If you change the returns to five percent for liquid assets and zero for illiquid ones, you get the following:
2010 2011 2012 Liquid assets (in millions) $17,946 $16,343 $14,661 Illiquid assets 7,531 9,031 10,531 Total 25,477 25,374 25,191 % illiquid 29.56% 35.59% 41.80%



In either case, illiquid assets rise to approximately 41 percent to 44 percent of the endowment. This is the general point of these numbers: Even as you adjust them, Harvard is about to go from an asset illiquidity level of 26 percent (and a target level of 31 percent) to a much higher level.

The reason the illiquid part grows is future investment commitments by the endowment to private equity and real estate partnerships. The 2007-2008 report did not disclose these commitments, but the 2006-2007 report stated they were $8.17 billion through 2017. Assuming that this commitment stayed the same or went down by no more than $1 billion in 2008 (Harvard last year said they were going to grow the portfolio), Harvard is going to have to follow through on about $7 billion to $8 billion in commitments in the coming years.

In the numbers above, I estimated that Harvard has to cough up about $1.5 billion a year over the next three years on these commitments. The reason was aptly stated by Blackstone Group Chief Executive Stephen A. Schwarzman last Friday, as he referred to the buyout firm’s large supply of “dry powder.” This powder is uncommitted funds, and private equity hopes to use these funds to take advantage of distressed opportunities. Moreover, funds are not flowing back from private equity firms, as they are holding their portfolio companies for the long run.


So, my numbers are rough, very rough estimates — but the problem is apparent. In the short term, unless it boosts its liquid returns, Harvard is going to have to raise a lot in donations or eat up its liquid assets to fund university obligations and its private equity commitments. This results in a spiraling decline in Harvard’s liquid assets as each year they go lower to meet these needs and more and more assets become tied up in private equity. This assumes the markets stay where they are in the next three years — there are scenarios where liquid assets do worse (like yesterday), or better, of course.

This is likely why Harvard recently sold $1.5 billion in debt, and unsuccessfully tried to sell $1.5 billion of its private equity portfolio. It needs to cover short-term funding obligations rather than liquidate illiquid assets at fire-sale prices. In essence, Harvard is more like a hedge fund than ever — trading for short-term gain with the same risks involved.

Other universities may be in worse positions. Duke, for example, sold $500 million in bonds, and Princeton $1.5 billion. Again, the reason appears to be to fund liquidity.

The result is twofold. First, private equity may not have as much dry powder as people believe. Private equity investors, known as limited parters, or LPs, are likely to strongly resist meeting all of their commitments. This may lead to a renegotiation of some funds as private equity seeks to accommodate their clients.

Private equity was historically viewed as the savior to higher education, but it now may mean its trouble.

Second, there is education itself. To paraphrase “Top Gun,” “their mouths were writing checks their brains couldn’t cash.” Universities expanded rapidly during the past few years on the basis of endowment growth. But not only is that growth gone and endowments fallen, the numbers may be far worse because of how much these entities depend on private equity.


In the long term, this should all rebalance and dry powder gains may compensate, but as Keynes said, “in the long run, we are all dead.” The Yale model assumes that endowments have perpetual life, but they also have short-term funding commitments.

Universities and endowments are surely hoping the situation is not as bad as the above might suggest. The likely result is pain at the university and for faculty, as many of these institutions go through their own “deleveraging.”

Final note: If anyone wants to see my underlying numbers and stress them, e-mail me at dealprof@nytimes.com and I will send them to you.
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