To address the increased credit risks and benefits associated with the differing investment strategies adopted in higher education, Moody’s Investors Service has retooled its rating process to pay more attention to an institution’s investment management and governance practices. According to Moody’s, the execution of better investment management generally correlates well with higher credit ratings.
Moody’s makes other observations in its report, including:
- Increasingly, management teams and governing boards are establishing governance and management structures aimed at improving endowment returns. No one approach constitutes an industry “best practice,” notes Moody’s, which cites the need to tailor endowment management strategies and policies to the individual institution’s financial and human resources.
- A clean audit opinion is not sufficient evidence of an institution’s appropriate oversight and risk mitigation efforts. In fact, specific practices that may mitigate credit risk could increase the difficulty of passing certain audit standards that relate to evaluating the fair value of alternative investments. Citing the findings of the 2006 NACUBO Endowment Study, Moody’s calls for more frequent and professional oversight of the investment function when alternative investments represent a growing share of all investments.
- Not all institutions can make available the appropriate level of oversight and risk management needed to pursue more complex diversification strategies. Larger endowments with more diverse allocations have a greater likelihood of justifying the additional cost of new investment oversight functions. Among endowments of at least $400 million, for example, the trend is to establish investment management as a separate own business function, with its own governance and management teams. Such separation is rarely possible for institutions with smaller investment pools and more limited economies of scale. Still, their boards have taken action to improve management policies, make better use of consultants, and clarify the distinct responsibilities of board and management.
Looking at its database of financial metrics, Moody’s compared investment returns to growth in financial resources over a five-year period. Two significant findings emerged from this analysis. First, the wealthiest institutions generate a higher return on financial resources from gains on investments. Second, investment income represents a larger share of total financial resource growth at these wealthier institutions.
At the larger endowments, the need for additional financial management staff often drives the creation of a separate investment management function. Or, a new expertise may be needed to monitor the risks accompanying a more complex investment strategy. In addition, despite viewing investment management as distinct from other financial management functions, many institutions have improved balance-sheet management by linking asset and liability strategies.
Typically, smaller endowments cannot create a dedicated investment staff. Still, a growing number have strengthened their investment practices in several ways, such as enhancing board oversight, adopting enhanced written investment policies, and addressing new audit concerns regarding valuation of alternative investments.
“Border” endowments—those between $100 million and $500 million—typically offer the most challenges. Finding it cost prohibitive to hire a chief investment officer, the governing boards often devise hybrid solutions to meet the institution’s investment management needs. Primarily, they transfer some investment management responsibilities to the investment committee of the governing board, in lieu of the full board. Additionally, they often contract with consultants specializing in private investments, thereby providing the additional oversight needed with such difficult-to-monitor investment classes. In general, these endowments rely extensively on external consultants.
Staff Resource: Anna Marie Cirino, associate director, financial management policy