Coping with the endowment crisis: with high-flying days over, new strategies are emerging to protect and build assets.

Endowment managers have put in some long days this year--hours spent investigating new investment opportunities to offset heavy Losses resulting from over-reliance on stock and bond markets during the past few years. Then there's the angst over spending plans, now that the yield on investments is modest at best. And there's the painful task of cutting administrative costs, which some are doing by reducing staff and outsourcing endowment management, and by recommending spending cuts across the board. Finally, there's the push to find new donors and the reaching out to past gift givers to convince them to replenish the coffers.

Endowment trends--and the financial markets that affect them--are changing fast and furiously, says Louis Morrell, VP/Investments and treasurer of Wake Forest University (NC). This is why he reads at least 60 newspapers and magazines each month, to scope out the financial trends at home and abroad. His motivation isn't to time the market--never a wise move, he says--but to be informed and to plan for long-term growth. Like so many portfolios, Wake Forest's endowment enjoyed major gains from the stock market's dot-com boom. It grew from $410 million to $969 million during the past five years, enjoying returns that climbed to 22 percent and higher. (The average annual return during the late 1990s and 2000 was 17 percent.) Morrell and others like him do not expect to enjoy these types of returns any time soon. It's time for serious homework.

DOWN FOR THE COUNT

The statistics back up such drive in endowment offices. According to survey results compiled by the National Association of College and University Business Officers (www.nacubo.org), earnings on endowment investments were down in 2001 by an average of 3.6 percent. That represents a drop of 14.5 points from the previous year. In 2002, endowment returns suffered an additional loss of 6 percent--their worst performance since 1974, according to NACUBO reports. Data compiled by the fund-consulting firm Hammond Associates (www.haifc.com) estimates that endowment earnings are down another 5 percent for the first half of 2003.

The group hardest hit has been the smaller-sized endowments. Those institutions with endowments of less than $25 million suffered a 6.6 percent earnings drop in 2002, according to statistics released by TIAA-CREF (www.tiaa-cref.org), while colleges and universities with endowments of $1 billion or more felt an earnings dip of 3.8 percent. There could be several explanations for the disparity. One is the basic way that arithmetic works, according to the Hammond report, "The Crisis in Endowment Spending." "Arithmetic isn't fair, it favors them that's got," writes Dennis Hannon. Smaller endowments feel the losses more intensely because a, say, 5 percent loss to a smaller fund represents a larger percentage to the fund overall, and requires more to be spent out off the principal, or to be raised with new funds, to cover the loss.

Then, too, smaller endowments tend to comprise fewer alternative assets and are more likely to be managed in a passive manner, given the constraints of endowment and the staff size, according to other TIAA-CREF information.

Bottom line: An endowment valued at $100 million in 2000 was worth about $75 million at the end of last year, and is worth slightly less than that today. The drop in total value is traced to the loss in earnings, which has forced more schools to dip into the principal to cover costs. On average, these "small [endowment] category" schools spent as much as 6.3 percent of their endowments in 2002, according to NACUBO. By comparison, the larger-category schools spent 4.7 percent of their endowments last year.

In addition, Commonfund (www.commonfund.org), the endowment consulting firm, reports that 12 percent of the 637 institutions that it polled had invaded the corpus of their endowments, leaving many under water. Managing such troubled endowments is tricky, adds Judy Van Gordon, treasurer and chief investment officer for the University of Colorado. This summer she and colleague Loren Loomis Hubbell treasurer and vice president for Finance and Administration at Mercy ColLege (NY), spoke about such specific challenges at a TIAA-CREF endowment workshop. The two presenters explained that UMIFA (the Uniform Management of Institutional Funds Act), which was first promulgated in 1972, limits an institution's ability to spend from an endowment that is under water. "This is a quandary for an institution," says Van Gorden, who adds that UMIFA is in effect in all but three states: Alaska, Pennsylvania, and South Dakota.

During these tough times, many endowment managers have taken to poring over all the terms of the gifts they have received. While many institutions have interpreted UMIFA as allowing them to pay direct and administrative fees on endowments, even if they are under water, Van Gorden advises endowment managers to research the issue thoroughly and seek informed Legal advice. Nothing upsets a donor more than seeing a generous gift used for general purposes and not used for specific goals, such as Launching a new bioengineering program, or improving the library or the medical school.

Traditionally, about 40 percent of an institution's endowment is open to unrestricted spending, which means the other 60 percent is earmarked for specific initiatives. To get closer to that 40 percent of unrestricted spending, and avoid any confusion about targeting of funds, some treasurers have asked donors to release restrictions on their gifts. This, to allow endowments to be spent in various ways for a period of time. The intention is to get the focus back on the Long-term intentions quickly, says Van Gorden.

ALTERNATIVE INVESTMENTS

The volatile market conditions have created a good deal of industry buzz, which is why, these days, endowment managers are hearing terms such as "alternative investments" and "hedge funds" more often, and why they are getting more calls from fund managers pitching these options.

It is also why many have already reallocated their investment percentages, pulling more money out of the U.S. stock and bond markets and investing it in alternatives--hedge funds, international markets, timber, and real estate. According to The Commonfund Benchmarks Study, released earlier this year, such alternatives now account for 32 percent of endowment portfolio assets, up from 26 percent in 2002 and 23 percent in 2001. Equity holdings account for 25 percent of endowment investments, down from 30 percent one year ago. Investment in large cap growth stocks dropped from 26 percent to 22 percent.

William Spitz, Vanderbilt University's (TN) treasurer and vice chancellor for investments, is encouraged by alternative opportunities, but does urge some caution. "Certainly a tot of money is chasing this stuff because it is what has done well over the past few years," he says. Spitz concedes that he has invested in a number of alternatives, including timber, energy, and some arbitrage strategies. Other investments, such as real estate and Treasury Inflated Projected Securities (TIPS), may be overrated, he adds.

"Remember, these are illiquid assets. You can't just decide to put 8 percent of your holdings in real estate," says Spitz. Real estate is the type of investment that builds over time. "If you decide it isn't as attractive as it used to be, you can't just get out. You're Locked into it for a while."

There is validity in adopting investment strategies, but, say most experts, beware: There is no silver bullet. Clearly there are glimmers of hope for investors, says Lyle Brizendine, VP of Institution Trust Services for TIAA-CREF (www.tiaa-cref.orq).

GOING BACK TO THE WELL

Knowing there are no foolproof formulas for building investment income, Brizendine is encouraging endowment managers to create new fundraising tools. It may seem a futile exercise to go to new and past donors during an economic slump, but he notes that charitable giving to colleges and universities has remained at encouraging levels.

Statistics from Commonfund back him up. This group reports that donor giving to IHEs throughout Last year either remained stable or increased for nearly two-thirds of the institutions followed. In fact, close to 24 percent of the schools surveyed said that gifts had increased. Spitz also notes the trend; he observes that almost every school is starting a capital campaign, is in the middle of one, or is just completing one.

Although it remains to be seen if gift giving will remain generous for 2003, many endowment managers are gleaning hope from these and similar findings. New investment strategies are being coupled with strategies to increase gifts, including some new and innovative planned giving programs.

For starters, more schools are seeing the need to have at Least one full-time planned or major gifts officer, notes Brizendine. This is an individual who liaisons with the chancellor, president, chief development officer, business officer, and other leaders to target how new gifts should be used. The list of targeted goals can be quite limitless--scholarships, endowed chairs, new programs--and there can be many layers of legal complexities, but the effort to find and budget a qualified individual to deal with these issues can be well worth it.

There are many generous and affluent alumni, friendly business owners, and philanthropists still in a position to give, who need to be identified and targeted by the institution and approached with specifics about what they can do. Brizendine concedes that even the wealthy don't feel as well off in the current market, but statistics show that as of 1998 (the Last reporting), individual wealth in the U.S. was placed at $32 trillion. He references a Boston College study in noting that older Americans will transfer as much as $12 trillion via gifts and estates during the next 20 years. Charities should receive an estimated $1 trillion. Brizendine's argument: There is no reason that colleges and universities shouldn't be in that group of beneficiaries.

Universities can tap these assets with planned giving programs that ensure some cash flow year to year. Aside from urgings to include an institution in a will or trust, some officers are developing new gift-giving tools. Doug Phillips, senior VP for Institutional Resources at the University of Rochester (NY), has created a Donor Advised Fund (a relatively new planned-giving tool) that allows donors to contribute tax-deductibLe funds in an ongoing fashion that specifically support "charities" at the university.

The fund, stiLt in its infancy, requires a minimum donation of $25,000. It is now managing an estimated $1.25 million in assets, says Phillips. The fund's assets are invested in U.S. equities, international equities, hedge funds, private equities, venture capital, bonds, and some alternative investments not mentioned above. The interest earned is in the tow single digits, he says, white noting that the modest, positive gains have been reinvested in such university initiatives as the art gallery, the medical center, and the graduate school of business.

Donors send routine lists of charities to support. Those who participate are the types of donors who would probably be giving generously to charities anyway for altruistic and tax break reasons, explains Phillips.

RELATED ARTICLE: Rethinking the spending plan.

Institutions are guided by spending rules that ensure neither too much nor too little of an endowment will be spent during any given year. "The most common guideline is 5 percent," explains Judy Van Gorden, treasurer and chief investment officer for the University of Colorado.

Even in the troubled economic climate of the past three years, the 5 percent spending rule has held up for many schools, largely because endowments have enjoyed healthy "average" market values. That's because many endowment managers base decisions on the past 12 financial quarters (some of which came before the dot-com bust that contributed to the recession), explains Van Garden. With this as the case, the endowment picture is still positive for many schools.

Still, to offset the 5 percent in spending, endowment managers aim to earn it in investment return annually, plus another 2.5 percent (for inflation) and an additional 1 point or more to cover fund management expenses. In essence, most are looking at a 9 percent investment return each year, to feel comfortable spending 5. Earning 9 percent was easy during the boom years, and such gains are still keeping many endowments afloat. But a rude awakening is on the horizon say analysts.

William Spitz, Vanderbilt University's (TN) treasurer, suggested that attendees at NACUB0's annual July meeting rethink the 5 percent spending rule. For him, the math is simple. "If returns aren't the 9 percent they have been, but are 7 percent, and you are still spending 5 percent, then you are losing 2 percent in real value," he notes. (Spitz keeps Vanderbilt's percentage at 4.5.) A cut in endowment spending will force belt tightening across campus, he adds, noting that administrative costs are usually the first target.

Most schools have been forced to cut costs. Outgoing Wellesley College (MA) President William Reed told the media last year that he didn't know of a school that wasn't going through some cost-reduction program, and added that Wellesley was reviewing staffing levels spurred by the 6 percent drop in its $1.1 billion endowment. Illinois Wesleyan University froze 2002 departmental budgets to make up for the 22 percent drop in earnings on its $136 million endowment.

Still, Perry Mehrling, economics professor at Barnard College (NY), cautions against kneejerk reactions. "Everyone is concerned that endowment returns are down, and so they feel they need to cut spending. I think this is a mistake." Mehrling, who has studied foundations and endowment spending for TIAA-CREF, and who authored the study "Spending Policies for Foundations," agrees that the corpus of an endowment should be protected, but urges institutions to be honest about how they define endowment principal. Many endowments, he says, have "quasi-endowment" money sitting in accounts. This is money that has accumulated because endowment managers have been paying out less than the total return for a long time, especially during the bull years. "These were very good years, and nearly all endowments were enjoying double-digit returns. There are substantial resources in these endowments that have built up. Now that it's bad times, it is time to draw them down." Quasi-endowment money shouldn't be defined as principal, and shouldn't be protected as such, he says.

RELATED ARTICLE: Small endowment strategies.

Tips to help smaller schools level the investment playing field

There are several effective strategies for investing a small endowment (under $100 million) to help it not just survive the down economy, but to contribute to the growth of the institution.

"The big news is that the gap between investments available to large and small endowments is narrowing," says Dennis Hammond, managing director of Hammond Associates (www.haifc.com). "In the past, only the big guys could get into the alternative strategies because they have huge minimums and limited access. Now that's going to change with 'fund-of-funds,'" he says.

These types of funds, which invest in other existing funds, are more secure because of the reduced risk of the multiplying factor, and so are attractive options for smaller endowments.

"If you are a small endowment, most of the money managers offer commingled or mutual funds for smaller accounts," Hammond says. "With fund-of-funds plans, there has been much greater access to alternative investment strategies for smaller endowments. They can have the same type of asset allocation that a large billion-dollar endowment has."

It works like this: A school with a $50 million endowment wants to invest 10 percent, or $5 million, in hedge funds. They invest that in two or three fund-of-funds. Each fund-of-fund in turn invests that money into 25 to 35 underlying funds. "At the end of the day, your $5 million has been adequately diversified among 90 or more underlying subfunds," says Hammond. "You have very low probability of a huge blowup with this money. Is that risky? No, it's just prudent."

A big school with a billion dollar endowment, can take the same 10 percent allocation--or $100 million--and parse it in chunks of $5 million to 20 different funds, and get adequate diversification. "But a smaller endowment, with only $5 million, will end up with more different slices than the big guy will, because they're getting 35 different funds for each fund-of-fund. They diversify well," he says. The down side? With their additional fees, fund-of-funds are initially more expensive. Jack McCarthy of PricewaterhouseCoopers (www.pwcqlobal.com) suggests some other strategies that may help smaller endowments.

* Look at endowment spending and ask what you can't afford to do. "It definitely has an impact on the overall budget," McCarthy says. "A number of schools such as Dartmouth and Stanford have quite publicly said that they are tightening their belts."

* Reconsider your spending policy. Universities typically experience higher inflation in their budgets than the broad consumer price index. What you can spend is equal to the return, less inflation. "If you have a spending policy of 5 percent, maybe you should have a spending policy of 3.5 percent so you can preserve some of those gains and allow them to be at play," says McCarthy, "because when you spend gains you are actually liquidating and spending the cash. Leave that money at play so that when the markets rebound, you'll have better opportunity for long-term preservation of the endowment."

* Adopt multiple spending formulas. For IHEs trying to provide needs-blind financing for student tuition and fees, it may be wise to have a more aggressive spending formula for unrestricted endowment funds. "They might keep the 5 percent formula for scholarship funds, in the hope that they can replenish those funds in other ways going forward, but lower their spending formula for the rest of the funds to 3.5 percent," McCarthy says. "Put it where it's needed most. Affordability of higher education is a central issue because tuition continues to rise at two to three times the rate of inflation."--Tim Goral

RELATED ARTICLE: Help wanted.

With so much at stake, choose the right endowment specialist.

Managing money is part skill, part science. And with multimillion or even billion dollar endowments at stake, it's not a job to be taken lightly. According to the 2002 NACUBO Endowment Study (see chart), outside help is now widespread across the endowment spectrum. Surprisingly, even at the highest endowment level, consultant use is common; 55 percent of the responding schools with endowments of more than a billion dollars used consultants. "The smart thing for a smaller endowment to do is to hire an external consultant, or a manager of managers like Commonfund or TIAA-CREF, to help with the endowment decisions," says Dennis Hammond, who offers these tips for finding the best consultant for your IHE.

* The right person for the job. "There are many kinds of consultants," Hammond says. "The biggest crowd is the consultant to pension funds, but pensions funds don't necessarily behave like endowments, so be aware of the particular type of expertise a consultant brings to the table."

* Compensation consideration. Investment consultants often fall into one of two categories: Soft-dollar consultants who take compensation from commission on trades, or hard-dollar consultants who get paid a fee directly from the endowments. "My opinion is that a board wants to hire a hard-dollar consultant, simply because the soft-dollar mechanism is fraught with too many conflicts of interest," says Hammond. "Soft-dollar consultants are less likely to recommend index funds because they don't trade; they recommend active managers instead. And if they are recommending active managers, they will more likely recommend those who trade frequently to make sure there is enough money at the end of the quarter to pay their bill. Soft-dollar consultants will also want to make sure the commission rates paid on the trade are high enough to support whatever rates they are charging." These things work to the detriment of the client, he says. "As an endowment, you don't necessarily want active managers in every asset class, and you certainly don't want high-turnover active managers with high commission rates. Those don't benefit the school." Instead, specify that your consultant be paid an agreed-upon fee. "Too often, we see soft-dollar consultants who are getting paid on trades, but they are also getting paid by the same money managers on trades other than those of the endowment," says Hammond. "The problem is, you can have a consultant getting commissions from a money manager that he's referred to you on your account, but that same consultant is also getting paid many times over in commission from the same money manager on others' accounts. That creates an impediment to the consultant being honest with you about whether or not the manager is doing a good job."--Tim Goral

% of Institutions Employing Consultants

Pool Size                    %

Over $1 Billion             55
$501 Million-$1 Billion     85
$101 Million-$500 Million   81
$51 Million-$100 Million    79
$25 Million-$50 Million     73
Less than $25 Million       63

Source: 2002 NACUBO Endowment Study

Note: Table made from bar graph.

ENDOWNMENT MANAGEMENT RESOURCES

Brakeley, John Price Jones

www.brakeley.com

Cambridge Associates

www.cambridgeassociates.com

CIBC Oppenheimer

www.cibcopco.com

Commonfund

www.commonfund.org

Computer Fin. Modeling Workshops

www.formodel.com

DiMeo Schneider & Associates

www.dimeoschneider.com

Fund Evaluation Group

www.feg.com

Hammond Associates

www.haifc.com

TIAA-CREF

www.tiaa-cref.org