Question

Jarvis University (JU) is a private, multiprogram U.S. university with a $2 billion endowment fund as of fiscal year-end May 31, 2019. With little government support, JU is heavily dependent on its endowment fund to support ongoing expenditures, especially because the university's enrollment growth and tuition revenue have not met expectations in recent years. The endowment fund must make a $126 million annual contribution, which is indexed to inflation, to JU's general operating budget. The U.S. Consumer Price Index is expected to rise 2.5% annually and the U.S. higher education cost index is anticipated to rise 3% annually. The endowment has also budgeted $200 million due on January 31, 2020, representing the final payment for construction of a new main library.
In a recent capital campaign, JU only met its fund-raising goal with the help of one very successful alumna, Valerie Bremner, who donated $400 million of Bertocchi Oil and Gas common stock at fiscal year-end May 31, 2019. Bertocchi Oil and Gas is a large-capitalization, publicly traded U.S. company. Bremner donated the stock on the condition that no more than 25% of the initial number of shares may be sold in any fiscal year. No substantial additional donations are expected in the future. Given the large contribution to and distributions from the endowment fund, the endowment fund's investment committee has decided to revise the fund's investment policy statement. The investment committee also recognizes that a revised asset allocation may be warranted. The asset allocation in place for the JU endowment fund as of May 31, 2019, is given in Table 28E .
a. Prepare the components of an appropriate investment policy statement for the Jarvis University endowment fund as of June 1, 2019, based only on the information given.
Each component in your response must specifically address circumstances of the JU endowment fund.
Table 28

Jarvis University endowment fund asset allocation as of May 31, 2019
b. Determine the most appropriate revised allocation percentage for each asset in Table 28E as of June 1, 2019. Justify each revised allocation percentage.

Answer 1

a. OBJECTIVES

1. Return

 

 

The required total rate of return for the JU endowment fund is the sum of the spending rate and the expected long-term increase in educational costs:

Spending rate = $126 million (current spending need) / ($2,000 million current fund balance less $200 million library payment)

= $126 million/$1,800 million = 7 percent

The expected educational cost increase is 3 percent. The sum of the two components is 10 percent. Achieving this relatively high return would ensure that the endowment's real value is maintained.

2. Risk

 

 

Evaluation of risk tolerance requires an assessment of both the ability and the willingness of the endowment to take risk.

Ability: Average risk

·   Endowment funds are long term in nature, having infinite lives. This long time horizon by itself would allow for above-average risk.

·   However, creative tension exists between the JU endowment's demand for high current income to meet immediate spending requirements and the need for long-term growth to meet future requirements. This need for a spending rate (in excess of 5 percent) and the university's heavy dependence on those funds allow for only average risk.

Willingness: Above average risk

·   University leaders and endowment directors have set a spending rate in excess of 5 percent. To achieve their 7 percent real rate of return, the fund must be invested in above-average risk securities. Thus, the 7 percent spending rate indicates a willingness to take above-average risk.

·   In addition, the current portfolio allocation, with its large allocations to direct real estate and venture capital, indicates a willingness to take above-average risk.

Taking both ability and willingness into consideration, the endowment's risk tolerance is best characterized as above average.

 

CONSTRAINTS

 

 

1. Time Horizon.

 

 

A two-stage time horizon is needed. The first stage recognizes short-term liquidity constraints ($200 million library payment in eight months). The second stage is an infinite time horizon (endowment funds are established to provide permanent support).

2. Liquidity.

 

 

Generally, endowment funds have long time horizons, and little liquidity is needed in excess of annual distribution requirements. However, the JU endowment requires liquidity for the upcoming library payment in addition to the current year's contribution to the operating budget. Liquidity needs for the next year are

Library payment +$200 million

Operating budget contribution +126 million

Annual portfolio income -29 million

 

 

Total +$297 million

Annual portfolio income =

(0.04 × $40 million) + (0.05 × $60 million) + (0.01 × $300 million)

+ (0.001 × $400 million) + (0.03 × $700 million) = $29 million

3. Taxes. U.S. endowment funds are tax-exempt.

4. Legal/Regulatory.

 

 

U.S. endowment funds are subject to predominantly state (but some federal) regulatory and legal constraints, and standards of prudence generally apply. Restrictions imposed by Bremner may pose a legal constraint on the fund (no more than 25 percent of the initial Bertocchi Oil and Gas shares may be sold in any one-year period).

5. Unique Circumstances.

 

 

Only 25 percent of donated Bertocchi Oil and Gas shares may be sold in any one-year period (constraint imposed by donor). This constraint reinforces the need for diversification of the portfolio. A secondary consideration is the need to budget the one-time $200 million library payment in eight months.

 

b. U.S. money market fund: 15% (Range: 14% - 17%)

Liquidity needs for the next year are

Library payment +$200 million

Operating budget contribution +126 million

Annual portfolio income -29 million

 

 

Total +$297 million

 

Total liquidity of at least $297 million is required (14.85 percent of current endowment assets). Additional allocations (more than 2 percent above the suggested 15 percent) would be overly conservative. This cushion should be sufficient for any transaction needs (i.e., mismatch of cash inflows/outflows).

 

Intermediate global bond fund: 10% (Range: 10% - 20%)

To achieve a 10 percent portfolio return, the fund needs to take above average risk (e.g., 10% in global bond fund and 20% venture capital). An allocation below 10 percent would involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy. An allocation in the 11% to 20% range could still be tolerated because the slight reduction in portfolio expected return would be partially compensated by the reduction in portfolio risk. An allocation above 20% would not satisfy the endowment fund return requirements.

 

Global equity fund: 15% (Range: 15% - 25%)

 

Bertocchi Oil and Gas common stock: 15%

There is a single issuer concentration risk associated with the current allocation, and a 25% reduction ($100 million), which is the maximum reduction allowed by the donor, is required ($400 million - $100 million = $300 million remaining).

 

Direct real estate: 25% (20-30%)

To help fund short-term outflows, exposure to real estate will be decreased. This is a moderate decrease since divesting more than 2/5 (35% → 25%) of the $700 million allocated to direct real estate would be difficult given general illiquidity of the direct real estate market.

 

Venture capital: 20% (15%-25%)

To help fund short-term cash outflows, exposure to venture capital will be reduced. This will be a modest decrease since divesting more than 1/5 (25% → 20%) of the $500 million venture capital allocation would be difficult given lock-up periods, contractual agreements and general illiquidity. An allocation above 25 percent would involve taking unnecessary risk that would put the safety and preservation of the endowment fund in jeopardy. An allocation below 25 percent would not satisfy the endowment fund return requirements.

 

The suggested allocations (point estimates) would allow the JU endowment fund to meet the 10 percent return requirement, calculated as follows:

Asset	Suggested Allocation	Expected Return	Weighted Return
U.S. money market fund	0.15	4.0%	0.600%
Intermediate global bond fund	0.10	5.0	0.500
Global equity fund	0.15	10.0	1.500
Bertocchi common stock	0.15	15.0	2.250
Direct real estate	0.25	11.5	2.875
Venture capital	0.20	20.0	4.000
Total	1.00		11.725%

 

 

The allowable allocation ranges, taken in proper combination, would surpass the 10 percent return requirement, maintaining a long-run, above average risk approach to its portfolio.