Introit

Portfolio Challenge: End of Fiscal 2011

Although I havn't reported in some time on my "porfolio challenge" (aka an independent school endowment held entirely in gold bullion, just for the fun of it), I wanted to provide a year-over-year comparison, given that we recently closed the fiscal year 2010-11.

The stats from June 30, 2010 (one year ago):

June 30, 2010 marked the end of the first fiscal year of my portfolio challenge. As a reminder, my fictitious endowment for Independent Academy is based on holdings of 2,500 troy ounces of gold. My figures from the past year are as follows:

Starting Dollar Value as of 6/30/2009: $2,321,250   (New York close of $928.50/oz.)

Dollar Value as of 9/30/2009: $2,515,000    (New York close of $1,006) +8.3% from 6/30/09

Dollar Value as of 12/31/2009: $2,741,250   (New York close of $1,096.50) +18.1% from 6/30/09

Dollar Value as of 3/31/2010: $2,781,500   (New York close of $1,112.60) +19.8% from 6/30/09

Dollar Value as of 6/30/2010: $3,106,000  (New York close of $1,242.40) +33.8% from 6/30/09

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At that time, we did the following:

1. Annual Draw. As promised we will take 4.5% of the US Dollar value of the corpus and sell that many ounces of gold. Based on a New York Spot close on 6/30 of $1,242.40, our endowment was valued at $3,106,000.

SOLD: 112.5 oz = $139,770

Endowment Balance = $2,966,230 [2,387.5 oz. of gold bullion]

2. Annual Purchase, based on 15% of Annual Fund donations. Our Annual Fund brought in $500,000, 15% of which equals $75,000.

BOUGHT: 60.4 oz. of gold

Endowment Balance = $3,041,230 [2,447.9 oz. of gold bullion]

June 30, 2011 marked the end of the second fiscal year of my portfolio challenge. As a reminder, my fictitious endowment for Independent Academy is based on holdings of 2,447.9 troy ounces of gold. My figures from the past year are as follows:

Dollar Value as of 6/30/2010: $3,106,000  (New York close of $1,242.40) +33.8% from 6/30/09

Dollar Value as of 6/30/2011: $3,672,584  (New York close of $1,500.30) +18.2% from 6/30/10

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A return of 18% is pretty good, given the state of the economy! Independent Academy has done well. Now, two matters remain before we launch into the third fiscal year of an endowment based entirely on gold bullion.

1. Annual Draw. As promised we will take 4.5% of the US Dollar value of the corpus and sell that many ounces of gold. Based on a New York Spot close on 6/30/11 of $1500.20, our endowment was valued at $3,672,584.

SOLD: 110.2 oz = $165,266

Endowment Balance = $3,507,018 [2,337.2 oz. of gold bullion]

2. Annual Purchase, based on 15% of Annual Fund donations. Our Annual Fund brought in $500,000, 15% of which equals $75,000.

BOUGHT: 50 oz. of gold

Endowment Balance = $3,581,277 [2,387.2 oz. of gold bullion]

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Looking Ahead to FY 2011-12

1. Our ounces of bullion are diminishing, yet our dollar value of the endowment corpus is increasing. Don't you find that interesting? The dollar buys less than it did, which you can see in our purchases of bullion: we're not buying as many ounces as before.

2. It may make sense to change our policy, so that we always maintain a "balance" of 2,500 troy ounces of gold. However, word to the wise: that may become prohibitively expensive.

3. If you haven't believed me before, in terms of my own work and presentations on endowment -- including paying special attention to inflation, can you see it now? How do schools deal with that?

Core Inflation and Tuition-Setting

Great article by Lorenzo Bini Smaghi (member of the executive board of the European Central Bank) in the June 2, 2011, edition of the Financial Times: "Ignoring the core can keep inflation at bay."

[N.b. My question to schools is at the very end of this post. However, please read through the next section, to see what I'm driving at, so that the question will have context.]

Smaghi makes a potent argument against the use of core inflation (what we in the US refer to as CPI) as an accurate measure for forecasting economic trends and making monetary policy. "For core inflation to be a good basis for forecasting headline inflation, the variations in the prices of agricultural and energy products have to be temporary, and should on average not differ from other prices. If that is not the case, core inflation is neither a good estimate of underlying inflation, nor a good forecast of future inflation."

He points out that a study of the data since 1999 shows that "the global index of energy and raw materials has more than doubled, as has that of food prices. These increases have not been short-lived at all, but have had a lasting effect."

His thesis, well-argued, is that the philosophy behind the measure of core inflation (the CPI) is predicated on short-term fluctuations in food and energy, but that these longer, secular movements to the upside render core inflation an impotent metric.

Looking ahead, he says, prices of food and energy commodities are expected to only increase, which will skew the measure of core inflation even further. "For central banks around the world, this means that core inflation is no longer a very useful indicator for monetary policy, and should probably be abandoned. It may have taken a while to realise this but, as the Romans used to say, errare humanum est, perservare diabolicum -- to err is human, to persist in erring is diabolical." (Ah, Latin!)

To come to it, then, here is the question: if core inflation (CPI) no longer has the "accuracy" it once had, should we continue to use it as a guide to setting tuition in our schools?

Thoughts?

*I've been writing about core inflation as deletrious to endowments as well. Please check out the category "Endowment" here at Introit (categories are on the right vertical bar). If Smaghi's argument is valid, then my concern is even greater than before, in terms of maintaining intergenerational equity.

Query: Where's Your Risk?

I'm working on a visual design of a risk management nexus, a document is that is meant to serve schools in assessing their risk(s). It is more or less complete (I think...), and my plan is to release it on Introit in the next month or so. Before doing so, however, I'd like to ask readers to identify what they would look at, when it comes to determining the risks a school faces in its operations. I don't want to leave out any areas that are of critical importance!

What do you feel are the most important areas for assessing a school's operational risk?

Please click on "comment" and share your thoughts.

Caveat Emptor!

Buyer beware!

From a perusal of many independent school websites, it seems clear that the financial crisis that began in Fall 2008 spurred donor interest in providing money to schools for the purpose of financial assistance for students. To be sure, such funding is a noble objective, and schools should be glad for the gifts.

Yet a number of schools should remain cautious about employing too many of those dollars. The reason? Those funds could leave just as easily as they arrived. Donors are making these gifts on an annual basis (or even on an as-needed basis), not by means of a longer-lasting vehicle, such as a planned gift.

If a school is accepting, let's say, $100,000/year from a wealthy alumnus to provide financial assistance, that represents a good chunk of change for most schools. Such schools are able to stay afloat financially--and keep enrollment at certain levels--precisely because the alumnus is giving that gift. What happens, though, when that gift goes away? How does the school absorb the $100,000 in its already-weakened operational budget?

So I say: caveat emptor!

Despite the best intentions of all donors and schools, this financial arrangement promotes a certain level of risk for the institution. The intentions are the very best, but the model is flawed. The best case scenario would be for the school, before entering into such an agreement for funds for financial assistance, to work with the donor to set up a planned gift that will continue to provide such funding in perpetuity. In other words, unless a school and its prospective donor can set up 1) an endowed financial aid fund or 2) a charitable trust (lead, remainder, or dynasty), the annual gifts for financial aid should be counterbalanced in the annual operating budget. Do not back out those amounts from the budget!

Caveat emptor!

Removing Volatility from the Balance Sheet

The Financial Times carried a fascinating article earlier this month that, among other things, addressed the volatility on many companies' balance sheets, emphasizing that the volatility needs to be removed.

That sounds highly corporate and perhaps un-school-like, but the reality is that many schools are facing an analogous situation: families who are in serious arrears on their tuition payments, or who have paid nothing at all toward the current year. Another layer might be that donor who made a substantial pledge, but who hasn't followed through with a single dime.

For independent schools reliant on tuition payments and pledge payments (isn't that just about everyone?), non-payment = volatility on our balance sheets. We might have swings of several hundred thousand dollars--or more, in certain scenarios. Like banks who are working with the "have-not" companies described in the FT article, how long can schools continue the process of what the FT author terms "extend and pretend" or "delay and pray"? In other words, how long can schools continue to extend payment schedules, pretending that the cash is actually in-hand? That formula doesn't work for very long, and the school ends up being hurt financially.

It is a cycle we cannot afford. As a restructing specialist quoted in the article says, "Eventually, gravity takes over."

Is it easy, though, in such a people-centric enterprise, to cut loose those families who haven't paid? Can schools afford it? Can schools afford not to?

Endings - Happy and Sad

Happy Endings: another NAIS Annual Conference, a chance to meet new people -- including a number of folks in the Aspiring Heads fellowship, an opportunity to reconnect with familiar faces and ongoing acquaintances, a learning opportunity in many sessions, a chance to see a unique community on the harbor across the bridge from Washington, D.C. Also happy: looking forward to the next NAIS Annual Conference I can attend, even if it's not next year's in Seattle. Though the quality of the overall conference can vary from year to year, I find the connections, reconnections, and session attendance very stimulative and often generative. It rejuvenates me, serving as a remind of why I love independent education.

Sad Endings: speaking with two people from two very different schools, both of which are closing at the end of this school year. At one, the entire administration has been let go already, as the school doesn't have the funds to pay them for the remainder of the year. What is more, the bondholders (the school had debt, which is no surprise to readers of my posts on debt issues) want the property sooner rather than later, so the school has had to accelerate its academic calendar in order to graduate the students before the bondholders take over the property. At the other, the decision to close was announced in recent weeks, and they are in closing mode, which will take the next six months or so. It is difficult to imagine the emotional drain on a leader who, with the board, must shut down operations, place students in other schools, and assist faculty and staff with job searches, etc. The silver lining, perhaps, is that the pain resulting from closure has an end-point in sight; at other schools that are struggling to stay afloat -- usually due in part or exclusively due to debt issues, the pain will continue in the form of more rounds of downsizing, reduction or elimination of benefits, salary reductions, and the like. Death by a thousand cuts; a kind of torture that prolongs the feelings of wounded-ness rather than provide for well-being and sobriety.

Gaudeamus igitur?

Gaudeamus igitur. Latin for "let us rejoice, therefore."

The gut-wrenching economic scenarios we've seen played out on the world stage since 2008 have brought about any number of editorials, television appearances, blog posts, books, (insert other media here) that underscored the need for fiscal responsibility and concrete plans for the financial sustainability of all institutions.

For schools, financial sustainability means a plan that allows for all expenses to be paid by means of revenue from tuition, fees, investment income, and philanthropy. If those four factors do not provide consistent, forecastable, adequate revenue for a school, then that school is not financially sustainable. In other words, admission and enrollment cannot be forecast with any reliable accuracy, which means that tuition and fees cannot be forecast with any reliable accuracy, which means that annual budget construction is nauseating and painful, with reductions in personnel and/or programs occurring every year.

In the face of such uncertainities, then, it seems remarkable that schools that are struggling to remain financially viable/sustainable--which, by the way, tend to be schools with heavy debt loads--are finding success in renegotiating the terms of their debt with banks.

The argument of the pragmatist might be that the continued operation of the school is in the bank's best interest because the bank doesn't want to own a school building. That can be a piece of real estate that is difficult to sell. So, the bank agrees to refinance the school's debt. The refinancing scheme is the thing that is actually in the bank's best "interest," since it will earn more interest on a longer amortization period. A school that owed $10 million at 7% over 20 years (total repayment = $18.6 million) now refinances that same amount at 4% over 40 years, making for a total repayment of $20.1 million.

Top Advantage: significant decrease in cash flow needed to meet debt repayment

Top Disadvantage: the school is locked into debt repayment for almost half a century.

Is that responsible? Is that sustainable?

There are other disadvantages, to be sure, and some superficial advantages, but there remains the underlying issue of a school's ability to enroll and retain students, ensuring tuition payments. If a school has been unable to forecast admission and enrollment reliably, why should a bank engage in the arduous process of refinancing a school's debt, when the refinance mechanism itself is predicated on a school's ability to repay the debt via its operational budget...yet the school cannot forecast reliably, for whatever reasons?

Yet the stories are out there of schools that have successfully obtained longer amortization periods, when it is clear from their plummeting enrollments that the market is sending a message regarding the viability of those schools. Not only longer amortization periods, but sometimes lines of credit are added onto existing debt loads, with the line of credit being used to pay for the ongoing, usual expenses of the school such as payroll, vendor payments, and the like. In other words, some schools are given lines of credit in order to meet their normal monthly bills because their annual budget has failed.

Failure, then, is being rewarded with positive reinforcement. It is being promulgated and encouraged. All in the name of meeting "financial sustainability" through the ruse of cash flow.

Such an approach to "financial sustainability" is dangerous. It will culminate in further economic malaise in the credit markets, when it becomes apparent that such schools, even with renegotiated debt terms, will be unable to meet the new terms, as their enrollment of full-paying students continues to decline.

Philosophically, should we (independent school folks) be happy about all of this, as (apparently) are the boards of these schools that have "increased" their cash flow?

Gaudeamus igitur? For real?

Longevity and Risk

There is a direct correlation between the current economic circumstances and an increase in the longevity of employees at independent schools. Simply put, due to economic uncertainty (read: portfolio losses in 2008-09), employees who might otherwise retire are staying put longer, meaning that trustees and heads of school are seeing salary-benefit costs remain at high levels, if not increase, due to the way that compensation systems are structured currently.

My question is this: how much risk is involved in this scenario? In other words, in a worst-case scenario of the economy heading downward again and long-tenured faculty remaining on staff (i.e. postponing retirement yet again), what would the effect be on school budgets? If budget reductions simply had to be made, where would the flexibility be with regard to this piece of the pie?

To mitigate risk, should schools offer 'early retirement packages' to long-tenured employees over the course of, say, the next two years? Would a cost-benefit analysis of such a plan yield results that would support such an action? Would such a move allow schools to hire younger teachers at a lower pay rate, free up cash flow, and keep tuition increases low?

Is it worth board-level discussion?

Longevity is something to be desired, as it produces consistency and, quite often, a remarkable product (i.e., our graduates). However, is there also a downside risk to be acknowledged in terms of budget constraints?

On Non-Tuition Revenue Sources

Marc Frankel wrote a great post earlier this month at Triangle Associates. Marc disusses how schools are looking to new sources of revenue with more vigor than ever before, but, as he cautions, be realistic about how much revenue those sources will generate. As he points out, if you try to incorporate vendors into your strategy, be aware that they will probably pass any increases (i.e., what they will pass on to your school in the form of non-tuition revenue) on to other customers, some of whom are your parents, most likely.

Marc's post came to mind when I read an article on entrepreneurship in the Oct 20 (2010) edition of the Financial Times. Peter Marsh highlights a veteran of the UK's technology sector named Stan Boland. Boland has had exposure to a wide range of company cultures, including top jobs in finance and technology, enabling him "to build deep knowledge in a range of diverse topics from loan finance to high-speed telecommunications protocols." Boland has a handy list of do's and don'ts, and I find the list to dovetail nicely with the increased attention given to non-tuition revenue sources in independent schools. In my estimation, schools need to be very careful when pursuing these sources; not every school will be successful in creating ones that generate significant revenues. What is more, these opportunities will require plenty of creativity, in keeping with my most recent post.

Stan Boland's do's and don'ts

DO

• Find great people who share the same passion to build a new company [think: non-tuition revenue source] and who operate at the top of their profession. If you cannot find them, don't do it.
• Find great investors who are networked, will generate good ideas and don't tell you what to do. It has to be advice, not instruction.
• Get in front of customers.
• Reply quickly to realistic business ideas. You can always think about it some more later.
• Make work a fun place. Create open spaces and operate flat organizational structures.

DON'T

• Discuss the possibility of failure. It will transmit to the team and customers in a nanosecond.
• Build a business with the aim of selling it.
• Run out of cash. Make sure you plan ahead and raise more capital than you need.
• Ignore market shifts. The value of a small business is its ability to adapt to the needs of customers ahead of its rivals.

This list represents good advice for independent schools that are looking to build significant sources of non-tuition revenue. The opportunities are great, but schools need to be prepared to "do it right."

Effects of Inflation on Independent Education: Prepare Now

The consensus appears to be that the Federal Reserve is intent on creating inflation as a means of staving off the threat of deflation. With all the talk of QE-2 (not the ocean liner, but rather, Quantitative Easing Part II), we as independent schools ought to be planning for the consequences.

What are those consequences?

• Higher prices for basic necessities (food, clothing, shelter) for families
• Basic necessities will cost schools more as well; dining plans will have to increase in price
• Utility costs will increase
• Increased prices (price appreciation) will bring pressure to bear on governing boards to increase faculty and staff salaries, as a means of keeping up with overall price appreciation for families
• Tuition increases will become a super-sensitive lever for schools. We will face internal and external price appreciation, yet be scrutinized by families who are price-sensitive (since many schools are at the price-saturation point already), and who will expect any tuition increase to be equal to or less than CPI.

The question becomes: "how do we plan for high inflation?"

First, we need to speak with those individuals who were heads of school during the inflation of the late '70s and early '80s. They lived through a significantly inflationary period. Almost any one of them will say that a 7% increase for faculty was unwelcome, as it was too low, relative to overall price appreciation. Their experience of having lived through it would be some source of comfort, perhaps, for school heads and boards.

If your school is already at the price-saturation point for your market, what is the board's plan to counter the effects of inflation that is being created on purpose by the Federal Reserve? For example, your school's endowment will suffer, since a high rate of inflation means that any return you might have will be forced into negative territory in actual dollars.

What to do in the meantime? (Figure 18-24 months for inflation to begin to take hold)

1. Endowment -- a) consider whether to decrease your annual draw to a minimal percentage; b) start raising more money for overall endowment; c) be sure that your portfolio includes weightings in areas that will weather inflation, such as commodities, precious metals, and perhaps foreign currencies.
2. Annual Budget -- construct a rubric that will allow your school's commitment to salaries to mimic a marathon: in other words, create estimates of what your competitors will be able to afford to pay faculty in the event of high inflation, over the long-run (say, five years). If your belief is that they will suffer enrollment declines in the event of high inflation, then it stands to reason that they will be unable to offer salary increases that keep pace with inflation. So, will your school be able to offer such increases, i.e., in keeping with CPI? If not, what metrics will you use to determine what your school will be able to afford? Think of it in terms of five years, so as to stretch out faculty salary dollars. Make sure that your faculty will come out ahead of the faculty at competitor schools, and you can use this data to provide some confidence to your faculty during inflationary times. It goes without saying that you should consider avoiding taking on any new debt, unless the opportunity of a lifetime is staring you in the face.
3. Classroom Materials -- prepare faculty with the  mindset of "making do" for a period of several years, cutting down on classroom materials expenses. In terms of textbooks, consider going to all electronic books, which are significantly cheaper.
4. Bricks and Mortar -- give serious consideration as to whether to expand your physical plant. In the event of high inflation, will your school be able to bear the increased costs of additional plant, let alone concomitant price increases in utilities, building materials, and such?
5. How We Do School -- is there a way that we can continue to provide high-quality education, yet by means of a different  model, one that allows us to contain and reduce costs? Where will the price-conscientious families go during a period of high inflation, if they're still willing to pay for an independent education? Do we touch the sacred cow of "18 max in a class"?

As a reminder, "inflation" means "an increase in the supply of money." We have inflation already, as evidenced by the M2 Chart below. The gray area shows how much the M2 increased during the 2008-09 recession (via quantitative easing):

What schools should be anticipating next is price appreciation, as a result of inflation. Did you notice that the M2 continues to increase in the "post-recessionary" period in which we find ourselves?

I'm concerned that schools are still dealing with the effects of the Great Recession, but are about to be whalloped by a significant increase in prices across the board. Families that are already price-sensitive may become even more so.