Introit

Role of Equities in Endowment (2013)

Some twenty years ago, David Swensen's thinking on diversification changed how Yale invested its endowment. As John Authers points out in this weekend's (October 26-27, 2013) Financial TImes, "Mr Swensen argued that he was most likely to find value away from the public markets. [...] He moved out of bonds and cash, and into hedge funds, private equity and real assets such as forestry. Yale now holds about 6 per cent of its assets in US equities. This reaped impressive investment returns for decades, and many endowments imitated it."

Authers goes on to illustrate that Yale, like everyone else, lost money (lots of it!) during the financial crisis. Interestingly, due to how it is diversified (as noted above), it has not seen the flattering returns of the S&P 500 index, though. And that's not a bad thing...Yale's endowment returned 12.5% last year, with its diversified model of looking for value in private markets. Yet, the main thrust of his article ("This is no time to get off the equity train") is that the notion of portfolio diversification hasn't worked terribly well over the past five years, mostly because large institutional investors diversified out of stocks, sometimes by a wide margin. Consequently, not having as much at stake in equities equated to a reduced return.

He is very supportive, though, of Yale's strategy of diversification, to the point that he supports endowment managers considering the application of the Yale process when purchasing assets, while being clear that managers shouldn't strive to imitate the portfolio's holdings. Basically, "look for assets that may be inefficiently priced and would not fall with equities."

What I appreciate is that Authers is looking ahead to the time when stocks lose their momentum, as is inevitable.

I don't hear this kind of talk from many, so it's refreshing to consider it.

Portfolio Challenge: End of Fiscal 2012

It is time for the annual report 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 2011-12

The stats from June 30, 2011 (one year ago):

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

A return of 18% was pretty good, given the state of the economy. Independent Academy did well. There remained two matters to address before entering the 2011-12 fiscal year.

1. Annual Draw. Per the original agreement of the Portfolio Challenge, 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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2011-12 Portfolio Challenge Results

June 30, 2012 marked the end of the third year of my Portfolio Challenge. My figures from the past year are as follows:

Dollar Value as of 6/30/2011: $3,672,584  (New York close of $1,500.20) +18.2% from 6/30/10

Dollar Value as of 6/29/2012: $3,817,372  (New York close of $1,599.10) +3.9% from 6/30/11

*close was 6/29 instead of 6/30 because the 29th was the last business (trading) day of month.

A return of 3.9% is quite modest, compared with some of the gains in domestic equities. At one point, gold had touched $1,900, but it has since pulled back from those highs. Nevertheless, our corpus is worth more in dollars than it was one year ago. This report marks the third year in a row that our endowment has been in positive territory, and that is good news. Now let's turn our attention to the Annual Draw and the Annual Purchase, per the original Portfolio Challenge.

1. Annual Draw. The agreement calls for a draw of 4.5% of the US Dollar value of the corpus, meaning that we will sell the corresponding troy ounces of gold to cover the amount in dollars. Based on the closing New York spot price of $1,599.10 on 6/29/12, that means we need the equivalent of $171,782, or 107.4 troy oz. of gold.

2. Annual Purchase. Again, per the agreement, we are funneling 15% of Annual Fund dollars into gold purchases for the endowment. Our Annual Fund saw a 5% increase this year to $525,000. Fifteen percent of that figure equals $78,750.

BOUGHT: 49.2 oz. of gold.

Endowment Balance = $3,724,304 [2,329 oz. of gold bullion]

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THOUGHTS

Last year, I mentioned that it might make sense for the board to consider a constant endowment balance of 2,500 troy ounces. Any purchase of gold at the end of the fiscal year would have to bring the balance back up to 2,500 ounces, so that that amount (weight) would be consistent over time.

On March 23, 2012, the Board voted unanimously to approve this measure, recognizing that it would need to re-think how Annual Fund dollars are deployed. Clearly, given the dollar's continued reduction in value versus gold, more Annual Fund dollars would have to be spent in order to maintain an endowment corpus of 2,500 troy ounces of gold. However, the Board believed that the concept of intergenerational equity called for this kind of stewardship. It stood to reason that, if the US dollar (the currency our families use to pay tuition) is losing value, then it is the school's responsibility (via stewardship) to think long-term about the financial stability of the education it offers families.

With this measure in mind, we need to add 171 troy ounces of gold to our corpus, to return to the level of 2,500 ounces. That will cost us $273,446 from the Annual Fund, meaning that we had to allocate 67% of our Annual Fund to endowment purchases. So, the new balance is 2,500 ounces with a value of $3,997,750 on 6/29/12.

While extreme, note that it is a one-time "charge". In other words, Independent Academy had to make up for three years of not observing the policy of a stable corpus of 2,500 ounces. Had that policy been in place and the Academy had had a balance of 2,500 ounces on 6/29/12, the Annual Draw would have been $179,899, or 112.5 ounces of gold, and the corresponding Annual Purchase would have equaled 112.5 ounces of gold, or $179,899, representing 34% of Annual Fund dollars.

TRENDS/ISSUES

• With gold continuing to climb against the dollar, it will take more dollars to maintain the corpus of 2,500 ounces. That means that, each year, a growing percentage of the Annual Fund will need to be used to keep the endowment at stable levels.
• Because gold continues to climb against the dollar, the purchasing power of the 2,500-ounce endowment will continue to increase.
• The numbers end up being easy to deal with, in terms of annual purchases, etc. The draw is fixed at 4.5% (which may not be tenable over the long haul, by the way; it may have to be reduced), and it will always equal 112.5 ounces of gold to be sold, followed by 112.5 ounces of gold to be purchased.
• What other things should the Board begin planning for? I would like to hear from readers!

 

External Risks to Schools and Doomsday Scenario

Risk management has been on my mind all week, irrespective of whether I wanted it to be! Apart from the drama with Greece and the larger questions being posed vis-a-vis the global financial system (the potential fallout from which we should be considering), the FInancial Times ran a fascinating story on Wednesday (June 13, 2012) regarding the recent disclosure by JPMorgan that it had a trading loss of some $2 billion in April.

The article would be useful reading for school leaders and trustees, in terms of seeing through the lens of risk management. I have heard the assertions that being "mission-focused" and "on message" all the time is the best form of risk management. Vital though those pieces are, external risk events--the ones that we simply cannot control through our mission-focused discourse--are things we need to consider, and this article provides us with a no-nonsense approach (financial modeling).

"In March, Gregory Baer, deputy general counsel, presented a plan to policy makers and bankers illustrating the results of a hypothetical $50bn loss. It showed the bank would fail, shareholders would be wiped out and Jamie Dimon, chief executive, would be fired" (16, emphasis mine).

Tom Braithwaite, the author of the article, goes on to say that "the presentation, given at a Harvard Law School event, is also an unusually frank acknowledgement that there are limits to the capital buffers of even healthy banks. In the doomsday scenario [...], a $50bn loss would trigger 'a run on the bank,' with $375bn of funding, including bank deposits draining away. The government would then step in and mark down the bank's assets, leading to an additional $150bn loss. Shareholders would be wiped out but senior creditors would be transferred to a new bridge company that allows 'critical activities to continue to operate smoothly.' Their debt would be restructured into equity."

Let's consider how such a scenario might look in terms relevant to independent schools:

1. A significant event occurs, and a large percentage of parents immediately stop paying their tuition payments; what's more, pledge payments from major donors cease, and the remainder must be written off. The endowment corpus shrinks substantially, more than 25%, and perhaps as great as 50% to 75%.
2. The school undertakes yeoman efforts to collect tuitions due, stating that the funds are needed to continue to operate the school through the remainder of the school year.
3. Other parents panic, thinking that the school will be unable to keep its doors open, and they begin to contact other schools for immediate transfer; or, if they're generous, they look for admission elsewhere for the next fall. This is the equivalent of the 'run on the bank.'
4. A strong percentage of parents accept offers of admission to other institutions, whether mid-year or for the following year, and the school can no longer count on those tuition dollars.
5. The trustees step in, and, based on reduced enrollment projections, outline faculty and staff cuts. Unless the Head has been doing something egregious, it is unlikely that the board will fire the Head, as s/he will need to implement the massive reduction plan.
6. Any debt that the school has been carrying will now be revisited by the lending authority. It is likely that this scenario is causing debt covenants to be breached, and the lending authority may alter its terms altogether, if the school is unable to meet debt service, up to and/or including seizing the school's facilities as collateral assets, to meet the debt.
7. During all this turmoil, what happens to the school, as a corporation, let alone to all the students, families, faculty, and staff?

In the JPMorgan illustration, or as we saw during the 2008 crisis, the government stepped in and loaned money to recapitalize the banks, restore confidence, etc. However, in the case of independent schools, what happens? Do you have donors who would step in, capitalize the running of the school for the remainder of the year, pay off all debts, and fund a major marketing campaign for the next 2-3 years?

My point with this post is not to scare anyone; rather, it is meant to serve two larger purposes:

1. to illustrate bluntly what is indeed possible, should a major risk event occur
2. to suggest strongly that schools should be engaged in risk management--modeling for external risks in particular

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?