This is a detailed response to key passages from President Tilghman’s Sept. 29, 2009, letter to the University community.
“... [T]he exercise of reviewing virtually everything we do for cost-savings and efficiencies has strengthened us as a University. There were things we were doing not because we should, but because we could ... There were staff positions that could be consolidated or redirected toward higher priorities. There were services that had become obsolete, such as television hookups in every classroom and postage meters in many departments. By eliminating or cutting back on such services, we achieved significant savings without affecting the operation of the University.”
Cutting costs is definitely the right thing to do.
“To preserve the long-term purchasing power of the endowment, we chose not to transfer funds from the endowment to the operating budget last spring. Instead, working capital for operating expenses was provided by a combination of other resources, including proceeds from a taxable bond offering last January.”
There is nothing wrong with borrowing $1 billion to pay expenses, if Princeton can afford the borrowing costs. (Sometimes it is wise to pay your American Express bill with your Visa card, although doing so doesn’t make you more liquid.) Right now the service on the total debt is costing $200 million per year. That would be OK if the assets not being liquidated are earning more than that. The point is the endowment is tied currently to a policy portfolio of great volatility and illiquidity, thereby forcing the University to choose between adding to the debt-servicing costs or selling assets at a loss. This is a structural problem that needs to be addressed.
“That [borrowing] has proved to be a wise and prudent decision, given the recent recovery in the markets.”
If the markets were certain to be on the road to recovery, you would be correct. But the S&P 500 is still a long way (almost 20 percent) from reaching the June 30, 2008 (PU fiscal 2008) level. It is by no means certain that we will not be re-testing the market lows of earlier this year, nor is the long-term outlook for the stock market necessarily positive, given the recent asset bubble, the extraordinary levels of debt in the economy, and the current easy money policy of the Federal Reserve, which are fueling the markets and are unsustainable long term.
In addition, Princeton is not in a position to take advantage of the recent market increase by liquidating stocks at the current price and taking profits, because it is not vested strongly in the markets to begin with. Stocks are only 23 percent of its portfolio as of the last report. And alternative investments cannot be sold easily.
“With regard to the issue of risk, our policy of broad diversification of asset classes, including relatively illiquid asset classes such as private equity, independent return [hedge funds] and real assets, has, until last year, provided effective hedges against risk, as the values of asset classes tended to rise and fall independently of one another. Last year when the sub-prime mortgage crisis sparked the near collapse of the world’s financial markets and we came face-to-face with a once-in-70-year recession, that lack of correlation disappeared, and all investment classes except fixed income experienced significant losses. From this we were reminded that there is no investment approach that could fully protect an endowment against the severest of global downturns, and at the same time provide high enough returns over the long term to enable us to preserve the purchasing power for future generations.”
Princeton’s endowment policy is not diversified in the sense of being hedged against downside risk. A diversified portfolio would have at minimum 65 percent in a combination of bonds, high dividend stocks, and commodities. Princeton is invested 75 percent in very risky and illiquid alternative investments that have never been able to preserve value in a downturn, because they only came into prominence in a period of asset inflation (1982-2007). The reason they blow up is leverage. If you buy assets with borrowed money, your performance looks like a grand slam home run on the upswings and disastrous on the downturns.
It is true that hedge funds theoretically provide “effective hedges against risk.” At one time, many years ago, hedge funds performed this function of capital preservation through short- or long-selling. More recently, however, most hedge funds have functioned as generic strategic investment funds, borrowing heavily from banks to fund many kinds of investments, which, as predicted by many, has resulted in very painful bankruptcies.
The explanation you are providing here is that no one can protect against a “black swan,” or catastrophic, event, except by being in fixed income. There are many financial firms whose investments were hedged successfully in 2008 and also have excellent 10-year returns, including firms with giant balance sheets such as PIMCO and Travelers.
“The linkage between risk and returns is made crystal clear by the fact that universities that employed a more conservative approach to investing may have had losses that were significantly lower than ours last year, but they also had much lower annualized returns over the last 10 years. Had we adopted a more traditional approach, our endowment would be about half its current size and we would not have been able to lead the country in eliminating loans for students on financial aid; we would not have been able to expand the size of our student body to make a Princeton education available for more students; nor would we be able to make the critical investments we currently make in the research and teaching missions of the University. In other words, our pre-eminence has depended upon the risk/reward profile that PRINCO has adopted. It is important to remember that even after successive 8 percent reductions in endowment spending this year and next, the payout per unit of endowment in FY11 will still be more than 37 percent above the FY06 payout.”
Princeton is spending beyond its means. That is why the University has had to reverse course and put a stop to the budget growth, which accelerated in the 2000-2008 period. That is also why the payout will continue to be unsustainably high for years to come. If the endowment were half the size it is purported to be today, what would be wrong with that? Wouldn’t a $6 billion endowment consisting of prudently selected assets and yielding 7 percent-8 percent per annum ($450 million) be exactly what the University needs? It is unlikely that the current endowment generates that much income.
Obviously, the extra benefits and features purchased over the past decade would have been foregone, but in retrospect, those purchases were paid out from a net valuation based on frothy but only temporary prices – a leveraged mirage. One way to value the current endowment portfolio is to hire an outside auditor to monitor valuations and performance, as CalPERS is now doing.
“The economic crisis has brought into sharp relief the importance of maintaining sufficient liquidity within PRINCO to supply the budget with operating funds on a quarterly basis. The pressure on liquidity was exacerbated by having a significant percentage of PRINCO’s resources in illiquid investments, and the looming (but largely unrealized to date) prospect of significant capital calls from its external managers that we would be legally obligated to meet. The endowment has had more than ample liquidity to support the operating budget and meet its contractual obligations, even in the current circumstances, but as I noted above, providing that liquidity would have required selling equities at unattractive prices. In light of this past year’s experience, the directors of the PRINCO Board, together with the members of the Finance Committee of the Board of Trustees, are reviewing our overall investment strategy and considering ways to further buffer the University from future severe downturns. The early stages of the review
suggest that marginal, not radical, changes may be warranted.”Translation: Princeton University fully understands the severity of its illiquidity problem. We need an investment portfolio that will generate sufficient cash for operations. Right now, the endowment is not performing that function. Therefore, we are going to re-do the strategy, with all of the fiduciary officers taking part in the process, so that the investment strategy serves the operational needs, short- and long-term. We are not ruling out making radical changes to our investment portfolio.
This last paragraph from President Tilghman is encouraging.