Endowment Returns Still Uncertain Going Forward

Endowment Returns Still Uncertain Going Forward

The Stanford Management Company reported a strong 22.4 percent return on its investments for fiscal year 2011, but challenging market conditions continue to test growth.

This 22.4 percent gain represents returns from the university’s primary investment pool, the Merged Pool, which totals $19.5 billion and includes most of the university’s endowment and expendable funds.

Peer institutions have reported similar figures of growth in 2011, although Stanford reported better returns than both Harvard and Princeton, which posted 21.4 percent and 21.9 percent gains respectively.

The Stanford endowment, which comprises $16.5 billion of the Merged Pool, posted a 19.5 percent gain. This marks the second consecutive year of growth, after a 25 percent loss in fiscal year 2009 and a 14.4 percent gain in 2010.

According to John Powers, president and CEO of the Stanford Management Company (SMC), spending of these returns is restricted and only about 5 to 5.5 percent actually contributes to the university’s operating budget.

“The whole notion of the endowment is that it exists in perpetuity,” said Powers. “In 1991, the endowment was at 1 or 2 billion, so reinvesting contributes dramatically.”

The volatility of the market also significantly impacts investment returns, which are climbing again after the recessional dip.

Powers attributed the strong returns in fiscal year 2011 to the SMC’s investment strategies as well as improving market conditions.

“We took advantage of opportunities we thought would emerge after the market crash of ‘08-‘09,” Powers said. “Given a clearly rising tide, we performed better than our fair share in a rising market.”

Investment returns are a major source of funds for the university, along with research grants and tuition paid by students. These three main sources are affected by economic conditions, with financial need increasing and sponsored research decreasing during the downturn.

Payout from the endowment is equal to approximately 25 percent of consolidated revenue.

“When investment returns are strong, this source of revenue increases, and vice versa,” said Randy Livingston, CFO and VP of Business Affairs at Stanford University. “Sponsored research is an equally important source of revenue that is significantly impacted by Congress’ Federal budget negotiations.”

According to Livingston, the university budget generally trends upwards by about four percent per year, net of inflation. The long-term increase in budget has been driven by increases in sponsored research funding, the graduate student population, the number of students housed on campus, and the clinical revenue generated by School of Medicine faculty physicians, as well as strong investment returns resulting in growth of endowment payout.

Recession Response

Responding to the 30 percent decline in investment income in 2009, the university made significant budget cuts particularly in the area of unrestricted funds. By downsizing operational costs and eliminating jobs, most of the reduction occurred in fiscal year 2010 with follow-up cuts in 2011.

“The university made dramatic budget cuts in response to the drawdown of the endowment, greater financial aid needed for students, reduction in charitable giving as well as concerns about decreases in the availability of grant funding for research,” Powers said.

Stanford’s need-based financial aid program has also taxed the general fund. The program became more generous, promising to meet students’ full financial need. For families making less than $60,000/year, this means the expected parental contribution is $0. Families making less than $100,000/year will be expected to pay expenses less tuition.

“Because we meet full need, financial aid expenses tend to increase, as we’ve seen in the past couple of years,” Warner said. “We ended up having to put more money into financial aid than we would have forecast back in 2008 because families’ circumstances changed.”

The university continues to embark on ambitious construction projects, such as the construction of a new Chemical Engineering/Bioengineering building and the Bing Concert Hall. These endeavors are largely funded by private donors.

“Our general approach is to look to donors and friends of the university to support big capital building projects,” Warner said. “Typically while the construction is financed privately, the university’s general fund covers the costs of ongoing maintenance and utilities to actually run the building.”

Because of the endowment payout smoothing methodology, the results of year-to-year investment returns are distributed rather than having an equally large, immediate impact.

“One year of strong investment returns don’t directly translate into an equally large increase in endowment payout,” Livingston said. “However, strong investment returns over several years do result in strong payout growth – this is what we experienced during the 1990s and from 2003 to 2007.”

According to Livingston, this formula provides some protection from moderate investment downturns, but there are other measures to turn to should the economy worsen, like budget cutbacks.

Future Expectations

According to Powers, the SMC is more conservatively positioned than in late 2008 when markets were extremely turbulent. He said that he expects conditions to remain volatile in the near future.

As the university is currently beginning the budgeting process for fiscal year 2013, it’s still too early to tell whether spending cuts will be necessary going forward, he said.

In order to better buffer the university budget against a 2008-09-magnitude downturn, the university has made changes in financial practices, according to CFO and VP of Business Affairs Randy Livingston.

“The University’s investment portfolio has been structured to provide somewhat better downside protection from a scenario similar to 2008-09,” Livingston said.

“If we have a dramatic downturn, similar to 2008-09, then we will decrease endowment payout which would force budget cutbacks,” Livingston said. “Hopefully, that won’t happen.  But, we are concerned about the global economic environment and the potential for another investment swoon.”

Following the recession, the university temporarily suspended the smoothing formula and took a 25 percent reduction in the two-year payout of the endowment with 10 percent reduction in 2010 and a 15 percent reduction in 2011.

The strong growth in 2011 relieves some, but not all concerns about this fiscal year, according to Warner.

“We did have a good year in the endowment performance last year, and that’s helpful going forward,” Warner said. “On the other hand there’s a lot of controversy about research and research growth in Washington.”

The economic difficulties faced by the university in recent years draw comparisons with previous recessions. According to Warner, who has been in his position for close to 20 years, the period of 1989-92 was more difficult in many respects.

“We went through controversy with the federal government over research funding, and sustained damage from the Loma Prieta earthquake, so it was kind of a perfect storm at that time,” Warner said. “We made a lot of budget cuts and increased payout rates to generate enough cash to cover expenses.”

Having experienced almost two full economic cycles in his 10 years at Stanford, Livingston said he has modest expectations for growth.

“I arrived at the tail end of the dot-com venture capital bubble, and the subsequent bust in 2001-03,” Livingston said. “We then had tremendous growth from 2003-08, followed by the 2008-09 downturn.  We’re back in an up cycle now, but all of the financial leadership is very cautious about the outlook.”

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