Universities choose growth over disclosure in endowment investment

Su-Kyong Park, VP of Content, and Leanna Bornkamp, Co-Editor-in-Chief

On November 5, a set of over 13 million leaked confidential documents related to offshore investments was made public by the International Consortium of Investigative Journalists.

Dubbed “the Paradise Papers,” this trove—the second-largest data leak in history—contains information related to offshoring conducted by corporations, politicians, and other global players, operating in dozens of countries. Also on the list are many U.S. colleges and universities: leaked documents illustrate their attempts to avoid scrutiny on investments by offshoring endowment-related financial ventures. These universities have enjoyed soaring endowment growth in recent years as a result, but they appear to have done so at the unmistakable expense of transparency and U.S. tax revenue.

The Paradise Papers have illuminated some of the creative investment strategies used by higher education institutions to grow their endowments. The scope of these enormous investments, generally considered a U.S.-only phenomenon, creates immense pressure to continuously reproduce meteoric growth for the sake of protecting the interests of the initiatives they fund. To do so, colleges and universities are increasingly focusing on higher-risk investment opportunities, via private equity and hedge funds.

To understand the rationale motivating the offshoring strategy, it’s important to understand the financial structure behind it. Put simply, an endowment is a donation provided to a non-profit institution, with the assumption that the donation will be used in perpetuity. This is usually achieved by investing the original gift, preserving the donation itself as a principal and spending down the earned interest (often only for the use expressly prescribed by the donor). College and university endowments are frequently used for operating expenditures like salaries for staff and faculty or research funding; in some institutions, funds are allocated for scholarships. Harvard University is the wealthiest U.S. college with an endowment of $37.1 billion, followed by Yale University at $27.2 billion and Stanford University at $26.7 billion.

In general, endowment earnings—boasting median returns of 12.7 percent in 2017, according to Cambridge Associates—have traditionally been tax-exempt. But as investment strategies deviate from their passive norm, investments in private alternatives have left endowments vulnerable to less-favorable tax treatment. According to the New York Times, when schools expand endowments through investments “unrelated [to their] core educational missions, they can be required to pay a tax that was intended to prevent nonprofits from competing unfairly with for-profit businesses.” Therefore, by moving risky-but-profitable investments offshore, educational institutions can hide their participation in controversial industries, as well as shelter their returns from taxes levied on investment income earned within the United States.

Blocker corporations, oft-exploited by private equity and hedge funds with investments in offshore tax havens, add a shield to these ventures. By “establishing another corporate layer between private equity funds and endowments,” according to the New York Times, taxable income is effectively blocked from flowing into endowments. Rather, this tax would be owed by the blocker corporations and, because these corporations are established in no-tax or low-tax jurisdictions like the Cayman Islands or the British Virgin Islands, universities can dodge the tax man.

The revelations detailed in the Paradise Papers coincide with Congress’ increased scrutiny of university endowments, reflected most recently in the tax reform bill currently in the Senate. When the Paradise Papers became public, Republican members of congress plunged into endowment examinations with renewed vigor. The currently proposed House Republican tax bill would tax wealthy colleges’ endowment returns at 1.4 percent of net investment income, increasing revenue by $3 billion between 2018 and 2027. Wealthy colleges are defined by schools with assets of more than $100,000 per student; small schools and state schools would be exempt.

These wealthy universities have criticized the bill as myopic.

“[Endowments support] substantial student aid and student service programs, and provide funding for instruction, research, and for building and maintaining classrooms, labs, libraries, and other facilities,” said Mary Sue Coleman, president of the Association of American Universities. Cornell University claims the proposed tax “has no clear policy objective other than raising revenue.”

Many universities fear these taxes will force endowment rates of return to stagnate or even to decline, leading an operating cash flow crunch. In fact, for colleges like Princeton University and Amherst College, endowment returns represent at least half of their operating budgets.

Most universities normally spend between 4 and 5 percent of the endowment’s total asset value per year, according to the National Association of College and University Business Officers (NACUBO). NYU, the 30th wealthiest U.S university by endowment size in 2016, distributes approximately 4 percent of its endowment to its annual operating budget.

NYU’s Total Combined Endowment Fund (of $4.1 billion, as of August 2017) is managed by the NYU Investment Office, headed by CIO Kathleen Jacobs. With an objective to provide current financial support to NYU’s operating budget and to preserve the fund’s long-term purchasing power, NYU’s endowment is “actively managed and relies on a globally diversified, equity-oriented approach.” Relative to its benchmark of 5.9 percent return, the Main Endowment has returned an average of 7.4 percent annually over the last fifteen years. Furthermore, the endowment has grown by approximately 9.0 percent annually during the same time period, net of spending and other distributions.

NYU, although not found in the Paradise Papers, has previously invested in industries some find less-than-savory (e.g. fossil fuels). NYU Divest, made up of students, faculty and alumni, has been campaigning for five years for fossil fuel divestment. They have also organized protests, including a 33-hour occupation of the executive elevator in the NYU Bobst library in April 2016. Many students believe investment in fossil fuels runs counter to the university’s goal of pursuing sustainability and promoting green energy in the face of climate change.

In June 2016, the University Senate passed a resolution proposing that, while no new investments in fossil fuel-related companies would be added to the endowment, NYU would not liquidate its current investments in the category. In order to divest from fossil fuels, the Senate argued, the fund would have to liquidate nearly 40 percent of its private equity investments despite the fact that a meager 4 percent (or $139 million) of the endowment is related to that category. NACUBO estimates that about 54 percent of endowments are tied up in alternative and illiquid investments. The statistic is muddied further when those alternative investments are revealed as part of index funds or other diversified investments that don’t afford investors the opportunity to unbundle securities within the package.

One can see the merits of utilizing offshoring tactics to ultimately protect the financial security of sustained charity—it’s a means to an end, per se, for the benefit of an educated society. When laid out against an endowment’s long-term obligations, however, such divestment and related restructuring doesn’t seem all that insurmountable. At what cutoff do we consider an endowment’s surplus to be ample enough to protect the promise of interminable payouts? If an endowment’s current value exceeds the present value required to ensure payouts ad infinitum, is this enough of a cushion that the endowment is considered secure, at least temporarily? Perhaps it is in these moments of fleeting safety—of 13 percent median growth—when controversial ventures can be liquated, when mitigation of aggressive offshoring tactics can be achieved. But in order to take the plunge into such scrupulous territory, the powers that be in higher education would need to admit when enough was actually enough.

Rather than holding our breath for that, we may be better off predicting when the median will hit 14 percent.

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