Moody's Investors service report "Liquidity and Credit Risk at Endowed U.S. Universities and Not-for-Profits," offers an important analysis of why the financial practices of many US higher education institutions have forced them to take on a large amount of debt, while they continue to cut their budgets. While many people know that states have reduced their funding for schools, and in turn, these universities have increased tuition and decreased enrollments and class offerings, what most people do not understand is the role played by risky investments in tying up the funds of these institutions. As universities have moved more of their investments into real estate, private equity, and hedge funds, they have reduced their access to cash, and now during the budget downturn, their only option is to take on more debt.
According to Moody's, universities have been seduced by the high returns non-traditional assets offer long-term investors: "Since the 1980s, U.S. colleges and universities have benefited greatly from above average returns in equity markets and falling interest rates, leading boards to approve ever higher endowment allocations to public equity, private equity, hedge funds and real assets as well as lower allocations to fixed income. Investment performance of most endowments over this period consistently exceeded target benchmarks, especially among funds that followed the most illiquid and long-term strategies, thereby encouraging further allocations to these illiquid strategies." The problem with this type of asset allocation is that it ties up most of the institution's funds into illiquid assets, and when there is a fiscal downturn, there is not enough money for the school to pay its operating costs.
High Debt and Inflated Budgets
When investments result in a high return, universities increase their spending and compensation packages, but when investments show a loss, the only way the schools can pay for their inflated budgets is by making more risky bets and taking on more debt. Moreover, Moody's reports that these universities are not only investing their endowment funds, but they are increasingly placing their operating cash into illiquid asset allocations: "As high returns from long-term endowment investments continued and short-term returns on cash balances dwindled with declining interest rates, many boards increasingly moved more operating funds into the long-term pool of endowment investments--expecting that future operating cash needs could increasingly be funded from positive returns on long-term investments." In other words, in the search for high returns, universities are now betting everything on high-risk investments.
Driving the universities' constant need to take on more debt is the fact that schools never have enough funds: "Over the last 15 years, debt issuance by universities has grown rapidly. This increase in borrowing was driven by a combination of factors, including lower interest rates, catch-up on capital spending deferred during the demographically weak 1985-1995 period, competition among institutions for the best qualified students and state-of-the-art facilities, expanded research funding from the federal government, and rising demographic demand as more students enrolled in higher education over the period." All of the driving forces in higher education call for a constant increase in spending, and this means that schools need to turn to borrowing and risky investment strategies in order to compete with the other institutions for the best students, faculty, grants, and facilities: "As universities expanded their research, educational, and student-life facilities to meet rising demand for their services, they developed more ambitious strategic and capital plans. To fund these plans, they faced strong incentives to maximize financial assets invested in high-performing endowment pools in order to increase their resources to a greater level over the long-term. Long-term investment management became, in effect, a core business line of the university because it was generating institutional resources much like private fundraising and student tuition." It is important to stress that not only private schools but also public universities have turned to endowments and other long-term investment strategies to meet their expanding budgets.
Increased Endowments Increase Debt
One of the paradoxes of this new way of financing higher education is that universities are so afraid of losing an opportunity to earn a high rate of return in their investments that they do not use their endowments to support their budgets, and instead, they simply borrow money and raise tuition to cover their increased costs: "This dynamic led naturally to institutional preference for more borrowing to pay for capital projects due to the high opportunity cost of pulling funds out of the strongly performing endowment. Utilizing more low cost debt to pay for capital expansion, rather than liquidating high returning investment assets, seemed an obvious way to maximize long-term institutional benefits for students, faculty, donors, government, and alumni." While schools spend a tremendous amount of money and time raising endowments and managing their funds, they often resist spending their returns on the core mission of education and research.
Before the most recent market crash, many universities were gaining an average of over 10% on their endowment investments, and since they could borrow money at 3%, they figured that they would simply take on more debt as they increased their returns: "As many endowments sought to maximize annual endowment returns, already averaging well in excess of 10%, they sought to minimize the cost of borrowed capital even lower than the 5% widely available for long-term fixed rate tax-exempt debt. The simplest way to achieve a stable but lower cost of capital was to issue variable rate debt at 3% or less, and then "synthetically" fix the long-term cost of the debt through an interest rate swap with a counterparty. Beginning in 2001, short-term tax-exempt rates declined well below 3% and consequently variable rate borrowing and use of swaps increased rapidly." Credit defaults swap seemed like a good idea at the time, but once the market started to tank, the universities were asked to quickly come up with huge amounts of cash to cover the collateral. Likewise, at the same time these universities were having to pay millions in their swaps, the issuers of private equity and venture capital were also demanding universities to come up with large sums to cover their deals.
During the global fiscal crisis, universities found that they needed a great deal of unrestricted funds, but most of their cash had either been lost or was tied up in long-term investments. As most of the large endowments lost between 25% and 30% of their value in 2009, a major source for operating cash disappeared, and schools had to cut their budgets and take on more debt. These universities had literally gambled away their students' tuition dollars and the gifts of their benefactors, and the result is a major restructuring of higher education: "Many institutions have looked internally to alleviate liquidity stress through liquidation of endowment assets, reclassification of the restricted nature of gifts, and cuts in operating and capital budgets." The big question is what will universities do now that some of their investments are showing a high rate or return.
If the University of California is any indication of how universities are dealing with these new financial realities, it is clear that these schools have not learned any lessons. While the UC is reducing enrollments and faculty positions, it continues to increase its holdings in private equity and real estate; meanwhile, the university has taken on a record level of debt as it continues to pursue expensive capital projects. The future for higher education appears to entail more buildings, fewer faculty, decreased enrollments, high debt, risky investments, and a staggering lack of financial foresight.