12-8-09: Princeton: Inside the Vault: Risky Business

Every year, it takes $1.3 billion just to keep Princeton running. The University depends on that money to keep the lights on in dorm rooms, pay faculty and staff and serve food in the dining halls.

And every year, the University depends on the endowment to foot just less than half that bill. But in January 2009, the University decided that it would instead fund part of its budget by selling $1 billion in bonds — essentially borrowing money from the investors who bought the bonds. Doing so, the University contended, would preserve the long-term financial stability of the endowment and the institution.

The Princeton University Investment Company (PRINCO) has long stood by that philosophy. PRINCO president Andrew Golden pointed out that the University has existed for more than 250 years and is unlikely to go anywhere any time soon. Golden is a protege of the revolutionary head of Yale’s endowment, David Swensen, who held that universities should forego the appeal of short-term cash in favor of the long-term returns of riskier investments.

“We’re trying to invest so that, 100 years from now, Princeton has the same financial strength as it does today,” Golden said.

Since Golden took the reins in 1995, the proportion of University funds invested in private equity has risen considerably. The illiquid nature of private equity investments means that investors can’t cash in their investments for quite a while. It is typically not possible to sell shares in a small company until those shares begin to be traded on the stock market, which could take years. In return for waiting, though, investors can make huge profits.

These sorts of investments correspond to Golden’s focus on the long term. Though they do not offer the same access to cash from year to year that more liquid assets like stocks and bonds do, they often pay out much more in the long run.

And the growth of the endowment enables the University to take on more ambitious projects. Having a large endowment means that a university can channel more money into all aspects of its campus, leading to better professors, better facilities and better dorms.

For most of Golden’s tenure, that strategy has paid off: The value of the endowment has more than quadrupled under his leadership.

If PRINCO had instead adopted a more conservative investment strategy 10 years ago, focusing on highly liquid assets that offered great short-term flexibility, the endowment would be worth less than half of what it is worth today, Golden said.

He estimated that, instead of having the fourth-largest university endowment in the world, Princeton would have an endowment worth only $4.5 billion, putting the value of the University’s endowment just below that of Cornell.

Therefore, Golden discouraged focusing solely on the performance of the endowment last year.

“A year is not an appropriate time period to evaluate an endowment program,” he said. “The secret to our success involves being willing to have an embarrassing year like we just had. If you’re not willing to lose that much money, you can’t make as much money as we’ve made over the past decade.”

Over the past 10 years, PRINCO easily outperformed the S&P 500, one of the most popular barometers of the U.S. stock market. On average, the endowment grew by 9.7 percent annually, while the S&P 500 posted yearly declines of 2.2 percent.

“That’s outstanding performance,” said James Clark Jr. ’60, an experienced investor and retired general partner at the investment firm Tweedy, Browne.

But Tad LaFountain III ’72, a former endowment portfolio manager for the University of Richmond, wanted to put those 10 years in context.

“With a university that celebrated its 250th anniversary 13 years ago, 10 years in the Princeton environment isn’t a long time,” he said. “When it’s offered as a long-term perspective, it’s not.”

“To brag about the performance over the past 10 years and state that the last 18 months has been an aberration is breathtaking,” he added. “The last 10 years have been the aberration.”

LaFountain said he was most troubled by the disconnect he saw between the purpose of the endowment and the way its funds were invested.

The University operates strictly on a year-to-year basis, a very short timeframe when it comes to investing. Therefore, the clash between the University’s short-term needs, which this year forced it to borrow for the first time in 15 years, and Golden’s long-term focus has disturbed some.

“What [Golden] says makes an awful lot of sense until you match that with the rationales of the very investment pool that he’s talking about,” said LaFountain, who was named by The Wall Street Journal as the best stock picker in the semiconductor industry in 2001.

The University has a “$1 billion annual budget that depends on income from that pool for nearly half,” LaFountain added. “So how can [Golden] talk about long term when there is this relentless appetite waiting to be fed like clockwork?”

In tough economic times, the University needs money more than ever: The shuttered Forbes dining hall on Saturdays, the shortened hours at Cafe Vivian, staff layoffs and the cuts to departmental budgets are evidence of that.

“Our mission is to … earn high returns in the fat-calf years so that we can continue to spend in the lean-calf years,” Golden said. But in a lean year like this one, people like LaFountain question whether the long-term strategy is really in the University’s best interest — the $12.6 billion the University holds in reserve serves no purpose if not to support Princeton’s academic mission in tough times.

Yet Clark maintained that the long-term strategy is a perfect fit for the University, citing the long time horizon as one of the key advantages that institutional investors have over traditional Wall Street investment companies.

Most investment firms must report performance statistics to their investors every three months. If a fund performs poorly, investors may begin to pull their money out, which could bankrupt that fund. Universities don’t face that same restriction: The only investor in PRINCO, for example, is the University. That means PRINCO can pursue higher, long-term returns without worrying that its investors might withdraw their funds after a poor quarter.

“You don’t have to play the flavor- of- the- month game,” Clark said, paraphrasing Warren Buffett. “It allows you to be greedy when others are fearful and … to be fearful when others are greedy.”

Like Golden, Clark urged people to look at the 22.7 percent drop in the value of the endowment more critically. The claim that the University had lost a quarter of its endowment was a “misstatement,” he said.

“There’s a real significant difference between if the endowment is down 23 percent and they haven’t sold anything and if they have,” he said. “The danger is that people panic, and they go sell their one share, and then it’s a permanent loss.”

Because the University continues to own many of the assets that declined in value, it still stands to earn from them if their prices go back up in the long run.

That’s the reason Vice President for Finance and Treasurer Carolyn Ainslie gave for the University’s decision to borrow money this year: Those potential long-term gains prompted the University to borrow money by issuing bonds — and commit to paying interest on $1 billion — instead of selling endowment assets at unusually low prices.

“It’s basically math,” Ainslie said. “By borrowing at rates that are even a little over 5 percent, if you can raise money in the endowment that can earn at least 8 percent, it makes sense.”

Golden said that so far, it did. “The endowment’s performance has been far greater than the interest costs on those bonds,” he explained.

Clark called the University’s decision to issue bonds in January “smart,” but added that he has some doubts.

“They were able to solve the problem by borrowing $1 billion, but the fact that they needed to borrow $1 billion, that’s the issue I would have,” he said.

LaFountain said he was concerned with the long-term problem of paying back the bonds, plus interest.

“[The University has] made a bet that they can pay them back with the same asset pool that has denied them sufficient liquidity for current needs,” he explained.

He noted that, besides the $2.5 billion that the University has in debt through bonds — the $1 billion issued this January plus another $1.5 billion, issued previously — the University’s Fiscal Year 2008 financial statements list an additional $6.1 billion in unfunded commitments. These are contractual obligations for future funding.

In other words, the University has committed to supplying third parties with $6.1 billion in cash, “generally … over a period of 10 years,” according to the report. Taken together, those commitments represent 68 percent of the endowment.

LaFountain said this combination of debt and unfunded commitments could hurt the University’s ability to stay liquid, or have enough cash to pay its bills. That could force the University to borrow more money, which would push it further into debt.

“The University is an institution,” he said. “Its brand equity that has been built up over 260 years gets put at risk when it’s shown to be an improper steward of resources.”

But Golden pointed to Princeton’s Aaa rating from the credit rating agency Moody’s, which rates companies and other institutions on their ability to meet their debt obligations in the future. Aaa is Moody’s highest credit rating.

“There weren’t so many risks that Moody’s was concerned about the endowment,” Golden said, adding that University was “sufficiently liquid to fulfill all of our obligations.” That Aaa rating isn’t easy to get: Moody’s downgraded Dartmouth from Aaa to Aa1 earlier this year due to its issuance of debt.

“I have no concerns about liquidity,” Ainslie said. “Given that we’re not asking [Golden] for cash right now, we have no comprehensive liquidity issues right now.”

Ainslie also said there was tremendous market confidence in Princeton’s finances and ability to meet its debt obligations, adding that investors often ask the University if it will be issuing bonds. That sort of demand was evident when Princeton issued its bonds back in January.

“When we issued the $1 billion, we decided to do so at 8:30 a.m.,” she said. “By 9 a.m., we had offers [to buy the bonds] for $4 billion or $5 billion.”

Ainslie said the University could have liquidated endowment assets in January to pay for this year’s operating budget, but it chose not to because borrowing “would be better for the University in the long run.”

“It looks like it has been exactly the right thing to do,” Ainslie added.

Nonetheless, the University couldn’t sell nearly half of its assets, even if it wanted to. That’s because more than 50 percent of the endowment is invested in illiquid assets, which sacrifice the convenience of a quick and easy sale for higher returns in the long run. This sort of portfolio offers the prospect of better returns, but it also comes with a great deal of additional risk.

This is the second article in a five-part series on the University’s endowment and investment practices. In tomorrow’s paper, senior writer Chetan Narain looks at PRINCO’s private equity holdings.

http://www.dailyprincetonian.com/2009/12/08/24676/