Big Squeeze on Ivy League Endowments

FOR YEARS, TOP UNIVERSITY ENDOWMENTS at Harvard, Yale and Princeton were the envy of the investment world, thanks to the outsized returns they generated from significant investments in nontraditional assets such as private equity, real estate, hedge funds and commodities, and low exposure to U.S. stocks and bonds.

Now that widely imitated asset- allocation strategy, dubbed the Yale model because of the enormous success of the Yale endowment under the 24-year leadership of David Swensen, is facing its sternest test amid the bear market of the past 12 months. Harvard and Princeton are assuming their endowments fell about 30% for the fiscal year ending June 30, while Yale is projecting a decline of 25%.

The outlook is challenging for the big Ivy League endowments because many of their investments are in illiquid private- equity and real-estate funds or commodity-related assets such as timberland, whose estimated value might not reflect today's steeply discounted market prices. Yale and Princeton, for instance, have invested roughly half their endowment assets in private-equity deals, real estate and commodities, a far cry from the 65%-to-35% blend of stocks and bonds favored by many individuals. If the three Ivies valued such assets at market-clearing prices, their endowment losses for fiscal 2008-09 could approach 35%.

It is tough for outsiders to assess the big university endowments, given limited public disclosure, and endowment directors at Harvard, Yale and Princeton declined to speak with Barron's. The endowments reveal their asset allocations, but not individual investments or outside managers. Most of their assets are farmed out, with endowment pros like Swensen overseeing the selection process while monitoring risk and results.

We have assumed that private-equity, real-estate and commodity investments lost about 50% in the past year, based on market benchmarks. Major commodity indexes are off 50%, as are independent oil and gas stocks. The MSCI index of real-estate investment trusts has lost 45%, and private-equity investments are trading for 50 cents on the dollar, or less. The Standard & Poor's 500 index has fallen 27%.

Timberland, for instance, looks significantly overvalued and could drop sharply as investors "race to the exits," Barron's Roundtable member Oscar Schafer said in our midyear update two weeks ago ("Too Far, Too Fast," June 15).

OTHER MAJOR ENDOWMENTS, including those of Stanford, the University of Michigan and the University of Virginia, also have allocated a significant portion of assets to so-called alternative investments. Stanford has less exposure than the biggest Ivies, however. It is projecting a 30% loss for the current year.

Barron's was among the first to identify university-endowment problems, in a cover story last fall ("Crash Course," Nov. 10, 2008), and the financial pressures on both the endowments and schools have worsened significantly since. We correctly predicted the major endowments could be down 25% or more in the current fiscal year, even as some endowment chiefs were insisting any losses would be much lower.

The endowments may end up trailing the stock market in the coming year because of the lag in marking down illiquid asset classes. As we argued last fall, it is probably time -- and now, past time -- for the big endowments to exit some of their illiquid investments and buy stocks and bonds, both to take advantage of market opportunities and gain greater financial flexibility.

In the near term, however, endowment holdings may become more skewed toward illiquid assets, as they are tapped to ease strained university budgets and fund new investment commitments to private-equity and real-estate managers that were made when the markets were stronger. Endowments normally recycle distributions from existing private-equity and real-estate funds into new investments, but the bear market has slowed such distributions to a trickle. Institutional investors who walk away from private-equity commitments usually pay a steep price, which could include forfeiting existing holdings.

Liquidity problems are affecting Harvard, which ended its 2008 fiscal year with the country's largest university endowment: $36.9 billion. Harvard lost two key internal bond managers last week amid reports the managers were unhappy that the endowment had grown more conservative in its investments, limiting their ability to buy riskier bonds. Such caution isn't surprising, however, because liquidity problems last fall, prompted by market declines and the need to post collateral to offset losses on an interest-rate swap tied to a university bond offering, nearly forced the endowment to sell private-equity interests at distressed prices.

To give themselves financial breathing room and forestall asset sales, major universities sold sizable amounts of debt last year. Harvard issued $1.5 billion; Princeton, $1 billion, and Yale, $800 million. Harvard's debt now exceeds $5 billion. Even while borrowing heavily, many big universities have been sellers of stocks, bonds and other liquid assets in the past year.

Despite their investment losses in the past year, major university endowments still have a stellar long-term record. For the 10 years ended June 30, 2008, the Yale endowment gained 16.3% annually, while Harvard rose 13.8% a year and Princeton, 14.9%. The Standard & Poor's 500 logged an average annual increase of just 2.9% in that span.

Yale's endowment grew to $22.9 billion from $6.6 billion in the decade, while Harvard's expanded to $36.9 billion from $13 billion. The Princeton endowment rose to $16.3 billion from $5.6 billion. Harvard's strong performance in the past 10 years relative to that of the average nonprofit investment pool translated into a staggering $23 billion of added value.