Question

In 2009, in the wake of the financial crisis, some endowments indicated that they had increased their asset allocation to private equity. Explain.

Answer 1

Over the last two decades, wealthy colleges and universities placed an increasing share of their endowments into high-risk, high-return, largely illiquid investments. During the boom times, this “Endowment Model of Investing” generated impressive financial returns. Then came the financial crisis, and in the space of a year, investment losses destroyed tens of billions in endowed wealth at colleges and universities.

Some reasons are as follows:-

1. Investment risk-taking has jeopardized the security of endowment income.

• For the past two centuries, endowment management has centered on protecting the principal of endowed gifts and generating reliable income. Investments were traditionally made in relatively transparent, liquid securities such as publicly traded equities, bonds, and money-market instruments. But in the last 25 years, many universities have embraced a new model of investing that relies on radical diversification of endowment portfolios into illiquid, riskier asset classes: private equity and venture capital, hedge funds, and various “real assets,” such as oil, gas, and other commodities, private real estate and timberland.
• By taking on higher financial risk, endowment managers generated high returns for a time— but at the cost of intensifying colleges’ exposure to the rampant volatility of the global capital markets.
• Resulting investment losses, endowment declines, and liquidity squeezes have jeopardized the very security of income that has traditionally defined what an endowment is.

2.  Endowments helped enable the financial crisis.

• The role of nonprofit institutional investors in heightening risk in the capital markets requires much closer scrutiny. Given the scale of capital under their control and the academic credibility they lend to high-risk investment strategies, the influence of college endowments on financial markets is considerable.
• By engaging in speculative trading tactics, using exotic derivatives, deploying leverage, and investing in opaque, illiquid, over-crowded asset classes such as commodities, hedge funds and private equity, endowments played a role in magnifying certain systemic risks in the capital markets.
• Illiquidity in particular forced endowments to sell what few liquid holdings they had into tumbling markets, magnifying volatile price declines even further.  
• The widespread use of borrowed money amplified endowment losses just as it had magnified gains in the past.
• The seeming success and sophistication of the Endowment Model also encouraged other institutional investors and their advisers—smaller endowments, pension funds, foundations, investment consultants, and asset managers—to imitate these high-risk strategies and place more assets into the shadow banking system

3. Conflicts of interest on governing boards weaken independent oversight of investments.

• There has been a predominance of business and finance professionals on college boards and the numerous potential conflicts of interest that arise when the investment firms of trustees from the finance industry provide investment management services to the very institutions on whose boards they serve.
• Even when there are not potential conflicts of interest, the oversight abilities of many trustees and investment committee members seem to have diminished because of their professional connections to the shadow banking system or their corporate directorships.
• By working in bailout banks, venture capital, hedge funds, private equity, and other alternative asset management firms, many trustees may be de-sensitized to the risks associated with exotic, illiquid investments that they deem normal business activities. And the College governing boards have failed to guarantee strong oversight of the Endowment Model by relying heavily upon trustees and committee members drawn from business and financial services, many from the alternative investment industry

4. The rise of the CIO has ratified a culture of risk-taking and excessive compensation.

• The complexity of investments under the Endowment Model has spawned a new class of highly compensated investment officers on campus.
• CIOs and investment officers from investment banks and consulting firms are now wooed by colleges with some of the highest compensation packages in the nonprofit sector.
• The increasingly intertwined worlds of higher education and high finance reflect how the culture of stewardship in nonprofit endowment management has been eroded by a Wall Street culture focused on profitable investment returns as if they were central to colleges' institutional missions.