Financial future holds plenty of risk

I was disappointed to see the headline “Seeking financial stability in an uncertain economy” (Notebook, July 15), because our endowment’s problems are not due to something so common as an “uncertain economy,” which occurs frequently throughout history, but to a new-style “Yale-model” investment strategy that has led the University into a serious financial crisis that President Tilghman said in a March interview with Charlie Rose on PBS “will have a tremendous impact on the University.” 

But when I read in the article’s subhead that Princeton has begun a “review of [its] investment strategy,” I had hopes for a thoughtful account of different strategy options, with introspective commentary from University leaders and helpful analysis by independent investment professionals. 

Did I miss something, or is there a lack of useful reflection and self-analysis here?

Astonishingly, the article quotes Princeton spokespeople as boasting that they “side-stepped domestic stocks” in favor of foreign and emerging market stocks. Does this make sense? Stocks are only 23 percent of the endowment’s portfolio, so unless foreign stocks have really soared it would be hard to argue how this could be a feather in Princeton’s cap. Indeed, a five-minute look at The Wall Street Journal’s online market data shows the opposite. Over the past fiscal year (July 1, 2008, through June 30, 2009), the S&P 500 (domestic stocks) outperformed the both the Dow Jones Ex-US index and the MCSI World index by 5 percentage points. 

As any casual reader of investment news is aware, Princeton and most of our main competitors bet the ranch on something called the Yale model, loading up on “alternative investments.” The assets in these investments are highly leveraged with debt. They are not at all similar to publicly traded stocks, which may be volatile but at least can be priced, and therefore sold, on any trading day. Compared to stocks, “alternative investments” carry much higher risk, are based on assets purchased with borrowed money, are difficult to sell in a down market, and are almost impossible to price because there are so many would-be sellers of these assets and so few buyers.

Princeton’s endowment is about 75 percent alternative investments. To put a net value on an endowment using this investment policy is to guess. Any legitimate discussion of investment strategy has to grapple with this fundamental point: Private equity partnerships, leveraged buyouts, hedge funds, commercial real estate, timber, oil – the whole collection of alternative investment – cannot be priced accurately, especially now that so many universities have adopted the same Yale model strategy and purchased the same types of assets, many of which were purchased between 2003 and 2008 when the market was over-heated, and now want to sell. These are illiquid, hard-to-price assets that do not yield significant cash flow and therefore do not allow the endowment to function in the way it should. Over-reliance on these investments destroys the time-honored principle of annual compounding of interest and dividends, and is at odds with prudent fiduciary management. 

An analysis of how Princeton seeks financial stability should note that in June, President Tilghman reported that she expected the University to pay out 6.7 percent of the endowment’s estimated net value of $11 billion to the operating budget, or $737 million. 

Add to that the approximately $1.2 billion we owe next year to the partners of various private equity pools (called “cash calls”) and approximately $200 million owed for debt service, and you have a total cash need for FY2010 of about $2.1 billion. That means 19 percent of the endowment’s net value will be required for cash payments going to operations, private equity partnerships, and debt service.

When you view the University finances from the standpoint of “seeking financial stability,” the road ahead is fraught with dangers and risks.

“Is Princeton insolvent?” might be an idea for the headline of a future endowment article in the Princeton Alumni Weekly.