The Holistic Endowment
Managing your institution’s endowment as a balance sheet can open doors to a full set of strategic choices, tools, and investment solutions—and to better risk management.
By Judith Van Gorden
The challenge for managing endowments is no different, says Tilman. In viewing college and university endowments as balance sheets and leveraging state-of-the-art approaches employed in other financial sectors, he suggests, the objective can no longer be an optimization of risk and return characteristics of a portfolio, but, rather, of the implicit balance sheet. “Observing other industries, their successes, and their ability to withstand market crises—and to manage their businesses proactively and efficiently across economic cycles—could benefit higher education,” he says.
Tilman and his team work closely with members of the Bear Stearns investment strategy committee to develop a comprehensive outlook on the economy and on financial markets. These views are then used in the course of the firm’s strategic advisory work for some of the world’s largest and most sophisticated financial institutions and institutional investors, including banks, insurance companies, pension plans, endowments, money managers, government-sponsored enterprises, and central banks. “Given the movement of many institutions toward a highly integrated strategic management function,” says Tilman, “our work—when offering advice or designing solutions for our clients—blends macroeconomics, market strategy, investment theory, product development, applied corporate finance, and risk management.” Further, he says, “We see potential applications of these broader strategic conversations to the unique challenges facing college and university endowments.”
Bottom-line question: How easy would it be for higher education institutions to move in the direction of managing their endowments as a balance sheet? “I think it requires a somewhat different mental approach,” says Tilman, “where currently unrelated activities across various functions of a college or university are integrated.” There also has to be internal buy-in that such integration is beneficial. “Implementation,” he says, “requires pulling together decision makers, systems, and data and instituting an asset liability committee-like process—certainly a nontrivial endeavor.”
In an interview for Business Officer, Judith Van Gorden, senior vice president and chief financial officer at the Arizona State University Foundation, Tempe, engages Tilman on his outlook and its key implications for individuals with endowment management responsibilities.
What are the potential applications of your work with financial institutions, corporations, and institutional investors worldwide to the challenges facing higher education endowments?
We have worked fairly extensively with various players in the pension and endowment industries in recent years. However, when preparing a presentation for NACUBO’s 2007 Endowment Management Forum, we decided to step back and present a deliberately external view on the problems facing endowments. By departing from the traditional language of portfolio theory and focusing on holistic balance sheet management frameworks firmly grounded in modern enterprise risk management, we tried to bridge the two currently parallel worlds.
The urgency to expand frameworks, tools, and solutions for endowments comes partly from the low-return environment. First, interest rates are stabilizing at levels below historical norms. Second, despite the dramatic market volatility during the ongoing credit and liquidity crisis, an argument can be made that globalization, inflation targeting, use of structured products, foreign currency regimes, and financial innovation have resulted in secular compressions of risk premia in many asset classes. If one subscribes to this notion, the question of whether your current investment strategies are capable of satisfying liabilities in perpetuity must be addressed as rigorously as possible.
What insights have you gleaned?
When we looked at endowments, we asked, “If an expert in bank or insurance asset liability management was brought in to look at current endowment practices, what would he or she see?” Our immediate reaction was that endowments are, in many ways, not stand-alone portfolios. In reality, they are balance sheets. On the left side, you have current assets along with future expected contributions to the endowments and investment returns. These expected future contributions have a certain value and certain assumed behavior over time. Some academics have argued that the inclusion of their assumed properties into portfolio optimization is important and can sometimes change “optimal” strategic asset allocations materially.
We observed that the same rationale should apply to the implicit liability side of this balance sheet—that is, expected future payouts of various sorts. First, there are fairly fixed payouts that are supposed to occur in perpetuity—for example, 5 percent expected distribution or payout per year. This [represents] a well-defined, albeit implicit, liability. In addition—especially in times of hardship or market declines—there could be potential distributions of endowment to the debt service and other expenses of higher education institutions. So, in fact, this situation does not describe a stand-alone portfolio, where risk and return trade-offs ought to be optimized. Rather, this is a mini-balance sheet, where the objective is asset and liability management. An endowment constitutes a subset of the balance sheet of an institution and arguably is a balance sheet in its own right.
What benefits do you foresee by transitioning from portfolio theory language to that of balance sheet management?
First, it allows a manager to formally separate liquidity risk from market risk, both of which are embedded in endowment asset liability management. Currently, liquidity risk gets a lot of attention, because it is indeed very important to have enough liquidity to satisfy various kinds of short-term liabilities. However, the issue of liquidity management is different from answering market risk- and asset liability management-related questions, such as: What is the nature of my exposures to adverse market movements? What are the implications of the low return environment for my institution? And, to borrow a term from pensions, what is my current hypothetical funded status—that is, the ability of my current assets, their expected investment returns, and additional future contributions to satisfy liabilities in perpetuity?
Of course, one must be careful in how implicit liabilities of endowments are integrated into strategic asset allocation decisions. On the one hand, distributions—which are often formulated as a percentage of assets—can and do decline when asset values fall. Financial modeling techniques can address this cash flow variability and come up with an appropriate measure of the average duration of liabilities across a large number of asset- and inflation-dependent scenarios. While an endowment’s distributions may decline if asset values fall, other adverse impacts on the balance sheet may surface.
For instance, it may become more difficult for a college or university to satisfy its liabilities during hard times because donations decline. Asset losses in an endowment, especially if they exceed losses of peers, may also affect future donor contributions. Connections between various parts of endowment and institution balance sheets are nontrivial, which is yet another argument for why they should be part of an integrated framework.
As an additional benefit, fixed or floating funding, hedging, and other corporate finance choices faced by institutions can also become a part of this balance sheet management framework. So, in many ways, the set of issues becomes somewhat similar to that of integrating a pension balance sheet into that of a corporate sponsor, subject to unique circumstances and a different setting for college and university endowments.
Would you say that it is timely for higher education institutions holding endowments to broaden their thinking?
I believe so. Apart from secular trends, we appear to be in economic-cycle highs in terms of interest rates, with many market participants anticipating that the Federal Reserve will start cutting interest rates. As treasurers are formulating fixed and floating decisions for college and university debt portfolios, this could be an opportune time to couple funding, hedging, and asset reallocation decisions to address certain dominant asset liability management mismatches.
Does the fact that the financial institutions and corporations you work with are public companies cause them to have different sensitivities about these issues than the higher education sector?
Absolutely. Because we deal with a wide range of financial institutions—including public, private, and mutual funds—we get to see pronounced behavioral differences. This is one of the central points of a forthcoming book on strategic management of financial institutions that I’ve co-written (2008, Oxford University Press). Lower sensitivity to the volatility of earnings (returns) remains one of the major competitive advantages of endowments. This is one of the reasons why—despite the fact that the nature of asset liability management exposures of endowments is similar to that of pensions—certain pension hedging solutions may not directly apply to endowments. What sets endowments apart is that their objective is to enable higher education institutions to function and fulfill their missions indefinitely. While risk tolerance is an important consideration, minimization of earnings volatility is not necessarily a part of this objective.
Would an institution that employed this process be looking at the individual components separately and trying to maximize on those components? Or would it look at all the variables at the same time and essentially seek an optimal solution?
I think this argues for a fairly integrated solution. The kind of frameworks that we and others in the industry advocate are actually modifications to the optimization problems currently in place as opposed to being an entirely different set of practices and implementations. We’re simply pointing out that current thinking is that of maximizing expected returns of portfolios subject to various risk limits and diversification considerations. We argue that these optimizations need to be expanded to include information on other assets and implicit liabilities, with objectives being asset liability management-driven rather than portfolio-driven.
In reaction to the significant downturn in the markets earlier this decade, institutions have diversified more heavily. It appears that endowment portfolios that were diversified into hedge funds and alternative assets fared significantly better, and it’s now standard practice to reduce volatility experience in the future by diversifying…
That is correct. And, I think the movement toward alternative assets is consistent with some of the themes we are advocating. Expectations of differential returns between equities and fixed income have declined, so existing large allocations of equities are going to earn less. Expansion of the investment universe and of alternative assets is the attempt to remedy this situation. Through the latter, endowments and other entities can get access to the full power of dynamic management and the cutting-edge structured products and derivatives. Static buy-and-hold asset allocations and business models are unlikely to produce adequate returns going forward, given changed market realities.
In terms of better diversification achieved in recent years, it’s certainly a positive. However, I would venture a guess that the total asset/liability risk profile of endowment balance sheets may not have changed materially. It used to be a combination of equities and fixed income vis-à-vis long-duration, fixed-income liabilities. Today, it’s a combination of alternative investments, hard assets, equities, venture capital, and fixed income against long-duration, fixed-income liabilities. While the portfolio has changed and hopefully has become more diversified, the overall risk due to significant asset and liability mismatches may not have necessarily changed dramatically.
To finance their capital needs, higher education institutions are using more variable rate debt as an alternative to using the more traditional fixed-income instruments. Typically, the conceptual framework incorporates an implicit hedge with the investment portfolio. How do funding activities fit into your concept?
Colleges and universities, similar to financial institutions and corporations, are faced with ongoing choices of funding with long-dated debt versus funding with short-dated debt. Historically it was beneficial to fund yourself short because the shape of the yield curve was, on average, upward sloping. Many debate the validity of this statement in the world of globalization and inflation targeting. Irrespective of secular or tactical market views, these decisions must be part of a comprehensive framework that manages liquidity, funding, and market risks.
You are absolutely correct in pointing out that, if an institution’s debt is floating and it finds floating rate assets to match it, this hedges part of the asset liability exposure. The caveat is that, even though hedge funds and other alternative investments are often thought of as earning the LIBOR rate index plus a spread, their actual return profiles may be significantly different. Many of them are absolute return vehicles. So, if “LIBOR+” alternative investments are thought to be perfectly matched against floating rate debt, the institution may be inadvertently exposed to additional market and liquidity risks. The current inverted yield curve environment is an example of such a scenario.
I think your point about liquidity is very important. Because of the nature and predictable timing of funding flows in higher education institutions, funds probably have a tendency to be quite liquid. Yet, institutions can be very reluctant to invest tuition flows and reserves—or balances that might have accumulated over the years—in something that is more endowment-like. Would that be one of the benefits of the liquidity analysis that you’re proposing?
Yes. Liquidity risk management has attracted a tremendous amount of attention in the aftermath of the 1998 long-term capital management crisis. It is certainly one of the distinguishing characteristics of the ongoing market dislocation. Modern risk management affords a very sophisticated set of tools and practices related to liquidity risk. Once an institution constructs a comprehensive picture of all asset and liability cash flows and their potential variations—contributions to the endowment, payouts out of the endowment, debt service, other expenses, and so forth—this dimension of risk can be managed effectively.
Could we back up a minute so that you can define liquidity risk?
One [might] define liquidity risk as having a significant mismatch in cash flows. For instance, you may have more cash outflows due to a combination of debt service, payouts from the endowment, and other expenses than you have income and dividends generated by your investments. Dangerous scenarios arise when liquidity risk is coupled with market risk. For example, let’s say you need to liquidate some assets to satisfy your liabilities. If this coincides with a market sell-off, you may have to sell these assets at a loss.
Liquidity risk, in general terms, could refer to adverse economic events or decisions that must be made because a misunderstood mismatch of cash flows triggers undesired actions or consequences. Funding risk—an increase in short rates beyond what you expected coupled with the fact that a large proportion of your debt is floating—goes hand in hand with liquidity and market risks. The inability to access financial markets altogether—another feature of this year’s credit and liquidity crisis—also falls under the umbrella of funding risk.
Again, for an endowment, it’s a fairly straightforward exercise to map out cash flows of assets and liabilities comprehensively across an entire balance sheet and then to stress-test them, understand exposures to different scenarios involving interest rates and other economic and market factors, and come up with a robust mix of assets and liabilities where liquidity risk is mitigated across a wide range of outcomes.
Is there an opportunity cost associated with not doing this, based on the fact that you might have to sell assets or borrow funds at inopportune times?
I wouldn’t call it an opportunity cost per se. The opportunity cost may arise, if an institution has too many liquid assets or cash, simply because liquidity risk exposures are not rigorously measured. Too conservative of a posture may diminish returns. The opposite side of the coin is not really an opportunity cost, but rather, greater risk—where you’re essentially betting on the fact that, if you have a shortfall in cash and you need to liquidate the assets, the market environment will be able to bail you out without losses.
With regard to how corporations have evolved to incorporate this full range of variables into their decision making—in a way that is perhaps more efficient and more effective than the way higher education compartmentalizes asset management and debt management. What lessons from corporate history would cause institutions to adopt these other kinds of models? And would there need to be a sense of urgency to cause this to occur?
Corporations and financial institutions, out of necessity, have moved toward a much more holistic approach to balance sheet management. They were confronted with new types of risks, lower returns, and a tougher competitive landscape. Because they needed tools to manage these risks and ensure business viability and adequate returns, they gradually integrated these activities into today’s status quo.
Some of the most exciting projects that we have been involved in have enabled us to design optimal solutions for our clients using the entire universe of available tools, including asset management, derivatives hedging, securitization, debt restructuring, capital structure optimization, and mergers and acquisitions. This is the tool box for investors and financial institutions that compete with endowments for investment returns in the capital markets. Endowments and pensions are limited with respect to available tools for balance sheet management; but, they have other competitive advantages, such as long-term investment horizon and lower sensitivity to market-to-market volatility. This argues for an increase in the importance of comprehensive balance sheet management frameworks as well as innovative investment products.
So, for institutions to adopt the balance sheet approach, would they need access to an optimization model to test the many options available to them to come up with a solution that best fits their risk profile?
Much of this technology is already at the disposal of endowments, given that endowment managers and consultants optimize asset portfolios in isolation on a regular basis. We're suggesting that the existing optimization framework be expanded such that a full set of assets and liabilities is employed along with additional objectives and constraints. From that perspective, it does appear to be a manageable task as long as new frameworks and tools are viewed as beneficial by the industry. We are excited to help college and university endowments advance along this promising path.
JUDITH VAN GORDEN is senior vice president and chief financial officer at the Arizona State University Foundation, Tempe.
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