In real estate, “location, location, location” is a long-standing mantra. In investments, it should be “liquidity, liquidity, liquidity.”
Stanford University has yet to learn that lesson. The university’s endowment has roughly $6 billion to $7 billion dollars invested in illiquid assets, according to LBO Wire. The endowment (and associated capital reserves from affiliated hospitals) was valued at approximately $14.5 billion on August 31, 2009, meaning illiquid assets make up nearly half of its total holdings.
Illiquid assets are those that cannot be immediately converted into cash. Alternative investments including buyouts, venture capital, distressed debt, oil and gas, real estate and timber (all of which Stanford has in its portfolio) fall into this category.
Despite a sizeable amount already invested in illiquid, alternative investments, Stanford reportedly remains on the hook for another $5 billion of unfunded commitments, meaning that the university still has to actually fork over the money. All in all, Stanford has more than 75% of its endowment committed to or invested in illiquids.
The endowment’s managers probably plan to use cash distributions from its investments to fund some of its future commitments. Cumulative net cash flow is the amount of capital called by a partnership less the amount distributed. For example, assume an investor agrees to commit $10 million to a private equity partnership. The private equity fund calls $2 million annually for the first five years. However, in year 4, the partnership sells some of its early investments, distributing $3 million to investors. Even though the investor has contributed $8 million by the end of year 4, due to the distribution, his cash flow has been reduced only by $5 million.
This strategy has been studied by many. In fact, certain private equity funds suggest that cumulative net cash flow will not exceed 65% of investor commitments as early investments are realized and proceeds are distributed to investors before all capital is called. However, good luck finding a limited partnership agreement guaranteeing this sort of cash flow scheme.
Capital Dynamics, a private equity fund advisor, evaluated the historical cash flow and performance of individual private equity funds. Using a Monte Carlo simulator, Capital Dynamics graphed numerous random private equity partnerships of varying vintage years. Its worst cumulative net cash flow was 80%, which happened only in a few scenarios.
A separate 2003 study of private equity funds by Ljungqvist and Richardson determined that, on average, 57% of capital committed was called after three years while 17% of capital invested was returned. After four years, 73% of capital committed was called while 34% of capital invested was returned.
For our clients, we assume the contractual worst. When determining the current exposure to illiquid investments, we include the current fair market value plus the unfunded commitment, and we seldom allow this exposure to exceed 10 percent to 20 percent of a portfolio. This ensures that we will not have a liquidity crisis.
But even if Stanford’s strategy worked, it would still have far too much of its money tied up in illiquid investments. Liquidity is particularly important for university endowments because schools rely on the endowments to pay their operating expenses. Stanford counts on payouts from the endowment for 26% of its operating budget. In the 2010 fiscal year, the endowment will distribute $830 million to the university, 6.6 percent of the year’s beginning value. Since teacher salaries and student financial aid cannot be given out in the form of real estate, distressed debt or natural resources, only liquid assets count when it comes to funding an operating budget.
The Stanford University Merged Pool (MP), which includes the endowment along with capital reserves from Stanford Hospital and Clinics and Lucile Packard Children’s Hospital, experienced a 25.9 percent investment loss for the fiscal year ending June 30.
As a result of the losses, the university has reduced its pull on the endowment by 10 percent for the current fiscal year and plans a further reduction of 15 percent for 2011. Stanford has had to implement a university-wide salary freeze, lay off over 400 staff members, eliminate many vacant positions, and postpone $1.1 billion in capital projects. The school has not yet made any reductions to student financial aid, but finding the money for it has become a challenge.
Now Stanford is having a tag sale of sorts to try to turn some of its illiquid assets into much-needed cash. Stanford Management Company has hired Cogent Partners to look for buyers for some of its alternative investments. LBO Wire reported that one person with knowledge of the sale said that the university is hoping to bring in between $400 million and $600 million.
The chances that it will get the money are not great, however. Columbia University tried the same strategy earlier this year, putting an estimated $600 million chunk of its private equity portfolio on the market. But bids were lower than the university hoped, according to people familiar with the offering, LBO Wire said, and Columbia ended up selling only a small fraction of what it had wanted to liquidate. Harvard didn’t have much luck with its sale either.
As I wrote back in July, when preliminary figures on endowments’ 2009 performance were starting to trickle in, students’ college experiences should not be dependent on the fluctuations of the financial markets. Colleges need to keep a portion of their endowments in low-risk, high-liquidity investments so that they meet their short-term needs. A higher-risk, lower-liquidity investment strategy is not a bad investment strategy, but it requires a long-term commitment.
In order for universities to live up to their students’ expectations, their investment managers need to focus on three things: liquidity, liquidity, liquidity.