Facing a Financial Squeeze: What Harvard’s Response Can Teach the Rest of Us
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Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I'm your host, David Stein. Today is episode 524. It's titled, Facing a Financial Squeeze. What Harvard's response can teach the rest of us? Last month, representatives of the Trump administration from the General Services Administration, U.S. Department of Education, and the U.S. Department of Health and Human Services sent a

a letter to the president of Harvard University, Dr. Alan M. Garber. The letter stated that Harvard, in recent years, failed to live up to both the intellectual and civil rights conditions that justify federal investment. Harvard University, including its medical school, receives billions of dollars in federal grants.

The letter demanded reforms on the part of Harvard as it relates to governance and leadership, its hiring practices, its admissions practices. It demanded changes regarding its programs, its approach to student discipline and accountability, protections for whistleblowers and adaptability.

additional reforms related to transparency and monitoring. The editorial board of the Wall Street Journal, which tends to skew very conservatives, said that these demands by the Trump administration were de facto federal receivership. In other words, the federal government taking over Harvard University. Harvard, in turn, responded with its own

own letter that said over the past 15 months, the university has undertaken substantial policy and programmatic measures, new accountability procedures, and discipline adjustments in order to combat hate and bias and enhance safety and security measures. The letter said Harvard's a very different place today from where it was a year ago.

At that point, the letter said that Harvard felt that the federal government's demand invaded the university's freedoms that have been long recognized by the Supreme Court as well as from the First Amendment of the Constitution.

They concluded the university will not surrender its independence and relinquish its constitutional rights. Neither Harvard nor any other private university can allow itself to be taken over by the federal government. Trump administration then froze $2.2 billion in grants for Harvard University and asked the Internal Revenue Service to strip Harvard of its

its not-for-profit status, which is laid out in Section 501c3 of the tax code that states that corporations organized for educational purposes are entitled to tax exemption as long as they are operated on a non-profit basis and don't participate in political campaigns. This disagreement between the Trump administration and Harvard University, as well as other universities, will be resolved in the

the courts. In the meantime, Harvard has seen a big blow to its budget. Harvard's annual operating budget is $6.9 billion. What we want to look at then is given this financial crisis that Harvard is facing, what are they doing and use that as kind of a comparison to how we could respond if there's a major financial crisis that we're facing? Be

be it a loss of a job, loss of other income. That's what Harvard is facing right now. And it's getting a lot of pressure to draw from the endowment. Harvard has a $53 billion endowment. 70% or more is invested in

in private capital, private equity, leveraged buyout funds, venture capital funds. So it's fairly illiquid. But that $53 billion is made up of about 14,000 restricted funds, which just can't be tapped immediately. But there's still about $9.6 billion in the endowment that is unrestricted, that potentially could be accessed.

What are they doing? Well, the first thing Harvard is doing is it's reducing its spending. Harvard Medical School leadership told employees that the school is preparing to make staff reductions and cuts to programs. The HMS executive dean for administration, Lisa M. Muto, said, I know this news is sobering. I know that many of you have been expecting this news. So to actually be clear and transparent about it is difficult for all of us. They will have to reduce spending.

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Find your next great hire on LinkedIn. Post your job for free at linkedin.com slash david. That's linkedin.com slash david to post your job for free. Terms and conditions apply. The second thing they're doing is potentially tapping the reserves. And it's been highly controversial in that endowments, university endowments, are set up to have a set spending rate. The idea is to maintain a

intergenerational equity to make sure that the funds are there to serve the current university needs, but also the university needs 100 years from now. And as a result, there's set spending that universities spend each year. Last year, on average, it was around 4.7%. Yet, some of the endowment is for reserves. Business professor Howard Bonneman

Buncis of Eastern Michigan University, he has audited the finances of several universities, said, this is exactly what reserves are for, to deal with temporary unexpected declines in

in revenues or increases in expenses. As long as Harvard are not asked to take out a billion dollars per year for many years, they can easily afford this on a one-time basis. Harvard typically pulls about $2 billion from its endowment each year, and now they have these federal cuts of a couple billion dollars, and they'll have to work it out. So potentially they can tap

those reserves or some of those reserves. The other thing that Harvard and other universities are doing is they have issued bonds. They're borrowing against the value of

of their endowment, their endowment assets to the tune of hundreds of millions of dollars. And this is the same way that as individuals, if we are experiencing hardship, we can use our emergency savings to address the financial need. But in some cases, we might want to borrow against some of our assets. Perhaps we borrow from a home equity line for our house.

Sometimes individuals will borrow from their 401k plan, but debt can be helpful, needs to be used prudently, but when there is a financial crisis and that's what Harvard is doing and that's what we can do. Third thing that Harvard or other universities are doing is they can sell applications.

Yale, for example, is exploring the sale of some of its private equity investments. And we'll look at this more closely in this episode, how endowments are invested. But these Ivy League schools, the largest endowments in the world, tend to be the most illiquid with 70 to 80 percent in private assets.

assets. And what we're seeing in recent years, the amount of distributions coming from a venture capital fund or a private equity fund is much lower than it has been in the past. So one report from Cambridge Associates that said cash distributions from private equity over the past three years has been half the long-term average.

Given that these university endowments use that cash from these private investments to help fund their spending, there's been a shortfall. And so what they're doing is sometimes they're selling some of those private investments in the secondary market and sometimes investing.

That's not a terribly liquid market, so they have to mark down or take a haircut on those sales. But they can also borrow against those private equity funds. They're called net asset value, NAV loans. Typically, they're four to five years.

And so that's another thing that universities can do when they get into a cash crunch. So stepping back, we can do it. They can do it. We can tap reserves when we have untapped reserves.

We can have unexpected expenses. We can reduce other expenses to meet the need. We can borrow against assets we might have, or we can sell assets to raise liquidity.

Professionally, I used to advise on university endowments and foundations. Worked with the University of Puget Sound for many years. I worked for Texas A&M University System for a number of years. Worked with Texas Tech, some other private colleges. And I learned a lot about endowment management, how universities are run. Each year, there is a major study put out by

by NACUBO, which is the National Association of College and University Business Officers. And that's done in conjunction with Common Fund, which is an asset manager that traditionally has worked with university endowments.

They surveyed 660 university endowments and foundations. Aggregate total assets, about $870 billion. The average size is $1.3 billion, and the median is $234 million. And so this survey was for performance ending June 30th, 2024, and they conducted the survey in the fall last year, completed it December 16th, 2024.

It's some fascinating data. These endowments that universities use, about 48% of the spending, and on average, last year they spent 4.8% of the endowment assets.

About half of that money went for student financial aid. Another 18% went to academic programs and research, 11% for endowed faculty positions, 7% for campus operations and maintenance, and 17% for other purposes. But half is going to student aid to help students afford to go to the universities.

Nakuba is an interesting study because we can get an idea, well, how do universities invest? What have their returns been and have their returns been sufficient to support that 4.8% spending rate?

I'll link to the study in the show notes, but I was most focused on the longer term returns because that will take into account volatility and you get a better sense for the long-term investment returns. And we'll compare that to the stock and bond market. So the average annualized return for university endowments for the 20 years ending June 30th, 2024 was 6.9%. If we compare that to

to the overall global stock market. That return was 8%. U.S. market returned 9.7% annualized. And the U.S. bond market, as represented by the Bloomberg U.S. AdWords

aggregate bond index, that return was 3.1% annualized. So I wanted to back in to what would the stock bond allocation be, a balanced portfolio made up of just stocks and bonds in order to get a 6.9%

annualized return, which is what the average university endowment did over the past 20 years. And it turns out that you would have to be invested 78% in stocks and 22% in bonds. So that's a fairly aggressive portfolio, which means if we look at, and we will look at the allocation of university endowments, their investments outside of the bond market to diversify into other

areas boosted the returns because your typical endowment is not invested 78% in stocks. Before we continue, let me pause and share some words from this week's sponsors.

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The average stock investment for all endowments is around 30% of assets are invested in stocks. Typically, larger endowments will have less in stocks. So I took a look at, well, what's the average allocation for endowments with assets less than $250 million? On average, they're about 50% to 60% in stocks, so not the 79% that you would need to generate a 6.9% return. If we

If we look at endowments less than $250 million, on average, they have 20 to 30% in fixed income. So your typical smaller endowment is stocks and bonds make up 70 to 90% of the allocation. For all endowments, which is skewed by those greater than a billion dollars, they on average have 10% in fixed income. So just stocks and bonds only makes up about 40%.

What else are endowments invested in? Well, about 10% of all endowments is real assets, about 5% to 8% of those less than $250 million. And most of those real assets would consist of real estate. All endowments have about 18% and what are known as marketable alternatives, commonly known as hedge funds. Smaller endowments have anywhere from 4% to 8% in hedge funds. And then a

other alternative investments, including private equity venture capital. All endowments, again, skewed by the largest endowments, have about a third in other alternative investments apart from real assets. Endowments less than $250 million have about 5% to 10% in other alternative assets. And so these portfolios are diversified with public and private assets. Larger endowments have more in assets

private assets, they earn what's called an illiquidity premium, additional return for less liquid assets. And that diversification into alternative assets did boost returns over the past 20 years with the hedge funds or private equity generating more than the bond market and in some cases more than the stock market, enough to bring up the overall return to 6.9% annualized.

Now, when we think about that, the average university endowment, the returns are not double digits by any means. The overall return is less than the stock market, more than the bond market. And as we saw, equivalent to about 78% in stocks, 22% in bonds. But in reality, they have less in each of those categories and they've diversified into other areas.

That additional diversification can reduce volatility, partly because private assets aren't valued on a daily basis, tends to be monthly, quarterly or annually. So just how they're valued tends to be less volatile, but it does provide some diversifying return streams. Now, again, these larger endowments have so much more in privatization.

private equity. Harvard, for example, its endowment has 39% of it in private equity, 31% in hedge funds, only 11% in public equity. And again, the

these larger endowments, the cash being generated by these private assets is less. And in some cases, they're selling them or a portion of them, or they're taking out loans against those to get the liquidity they need. It's somewhat of a cash crunch. And if you layer on top big federal budget cuts, that's a concern. Now, there's some other interesting things on

on university endowments that I learned from the NACUBO study. We've done podcast episodes in the past on sustainable investing, ESG, environmental, social, and governance. According to the NACUBO survey, 51% of endowments factor in responsible investing

in their manager due diligence and evaluation process. That's down from 52% two years ago. And reasons university endowments give for not being more active in the ESG space is 36% say they're invested in pooled vehicles, so they're not separately managed accounts, so they can't do it that way. Another 34% are concerned about potential adverse effects

impacts to returns. The idea that ESG investing potentially will lead to lower returns, so they've been unwilling to pursue it. Another 31% are worried about potential conflicts with the university's mission or fiduciary duty. And those are the main reasons, performance concerns, mission concern, or they're just using primarily pooled vehicles, although there are pooled vehicles that do invest in ESG. I would also say the political environment for

ESG has changed over the last couple of years. Another interesting thing I learned from the NACUBO study, and this surprised me, is there's something called OCIO services or outsourced CIO services. And when I was at my previous advisory from FEG Advisors, we launched a early version of OCIO. This would have been in

in 2003. It was based on some research I'd done in terms of a portfolio approach and investment philosophy. It was controversial at our firm at the time because up until then, we hadn't taken on discretionary investment authority. We only made recommendations to our university endowment clients and other clients in the

form ADV that the federal government requires, you file, an advisory firm files for the SEC or the state, there's a box that you check to say, do you do discretionary asset management or is it non-discretionary? And we had always done non-discretionary. And so we debated internally whether

whether we should be willing to do that. And we did. And the product did well. It's expanded to include private capital and it's done very well for FEG. And what I didn't realize is 44% of endowments now use OCIO for at least a portion of their investment management.

So they're outsourcing. In many cases, they'll hire an advisor that'll do manager selection. They'll do some perhaps adjustment to the allocation within the confines of an investment policy statement. But it's very common. In fact, 60% of...

endowments with 100 to 250 million in assets use OCIO services for at least a portion of the endowment. And I had no idea it had gotten that big. And that's a big change in the last 20 years. And a final slide from the NACUBO study I found was back in the early 2000s, I guess the late 90s, one of my clients was Wright State University in Dayton, and they had a

student had a class that managed a small portion of the endowment. And it was done as a student managed portfolio. They were researching stocks. They presented to the investment committee about once a year. And so it was a fascinating exercise. I didn't have that opportunity when I was studying undergrad or graduate school. But it turns out 36% of

Yeah.

by the sophistication of their portfolio, the student-led portfolio. And they're, for example, they're invested in CLOs. Most people...

People don't have any idea what a CLO is. And so that's been a fascinating development. So that's an overview of how university endowments are investing. There's one element, though, on returns that it's important to recognize in terms of what's the target rate of return. The average, based on an Akubo study, is 7.2%. As they do their asset allocation, on average, university endowments are targeting 7.2%.

They're trying to achieve a return that's 4.7% greater than inflation. So we have the 7.2% target return back out 4.7%, which essentially is their spending rate. And then that should at least equal inflation. And when we think about the return over the past 20 years, 6.9% return with

an average 4.8% spending rate, at least last year, if we block that out, that equals 2.1% return. That's less than the 2.6% inflation rate over the past 20 years. So the spread above inflation was only 4.3%, less than the amount spent last year, which means that

on average, endowments didn't generate enough return to maintain what's called intergenerational equity, that the real value of the endowment slipped a little bit over the past 20 years. When we look at the target, their idea is, well, let's get 7.2%, and then that'll help support the 4.7% to 4.8% spending rate. But we've seen that endowments have fallen short on average. Now, again, some would have done a lot better

Some worse, but it's not like there's a huge excess. There is a process for determining a target asset allocation. Sometimes that is they set the target. They'll outsource to an OCIO manager. They'll decide how much stocks, bonds, additional asset classes, how much public or private assets.

And they generated just under 7% over the past 20 years annualized. They're targeting around 7.2% with a spending rate of 4.7% to 4.8%. Now, as retirees, if we're retired, we typically start out spending 4%, for example, but then that's increased by the rate of inflation. So that 20, 30 years down the road, you're spending...

10, 12, 13% of assets in order to reduce it to zero. An endowment doesn't want to reduce it to zero. And so they maintain a

a steady spending rate, generally speaking, in order to maintain the real growth net of inflation and spending of the endowment or at least maintain the real value over time. And that's what allows that intergenerational equity that future generations can spend the same amount on an inflation adjusted basis as those generations

And that's why when we look at the crisis, financial crisis that Harvard is facing, some other universities are facing due to federal government cuts, freezing of grants, it's not necessarily just as simply we'll just take it from the endowment because of the underlying math of how endowments work. Now, that doesn't mean nothing.

that they won't. I have worked with higher educational institutions that had a higher spending rate for a time because there was a crisis and then they spent the money and eventually were able to work down to a more sustainable spending rate. And that's what endowments do. And that's what we can do. We can be flexible. If there is a financial crisis, we can perhaps spend more than we would sell some assets, borrow money, but these are not permanent things we can do. We make the change,

meet our needs, and then work to get to a more sustainable footing in terms of our allocation, our return to spending, and levels of debt. That's episode 524. Thanks for listening.

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