University Debt

Bloomberg has a story on the University of Chicago's big debt expansion. Obviously, it's a topic around faculty lounges too.

A few thoughts. Why does a university simultaneously borrow $3.6  billion but have $6.7 billion Invested? If borrowing is such a big deal, why not just spend the endowment on new buildings?

Answer: universities can borrow at municipal rates, free of federal tax to the lender, if they are building something. Borrowing at tax-free rates makes financial sense, even you just stuff the marginal dollar into endowment. Of course the endowment is not invested in Treasuries -- universities don't do simple tax arbitrage. So the model is more that of a leveraged hedge fund -- borrow at low tax-free rates, up to the limit imposed by tax law, and invest in high risk, (hopefully) high-return projects like hedge funds, private equity, real estate etc. The fact that investment returns are also not taxed makes this a doubly advantageous strategy. Donors: if you give now, your gift grows tax-free, while if you earn the rate of return and then give the money to the university, you pay taxes on the intervening returns.

Borrowing long term is an exceptionally good deal right now. "...borrowing costs remain close to five-decade lows.  The institution sold $149 million of federally tax-exempt bonds last year, including a portion maturing in October 2052 that priced to yield 3.5 percent, Bloomberg data show"

Short-term rates are even lower, but raise the prospect of rollover risk. You have to sell new debt to pay off the old debt, which might be at much higher rates, and markets might not sell it at all. Ask Greece. I've been advocating the US government dramatically lengthen its maturity while the getting is good, and the same principle applies to a university. These low rates are, apparently, locked in for a generation. Only a decades-long deflation will make them seem a bad idea.

So, it's really not about the borrowing -- the U of C could just spend the endowment, but it makes more sense to borrow against the endowment instead. It's about the building.

Here is what I think is happening: The U of C's leaders think there will be about 5 big, global, high-prestige, science-oriented, big-idea-generating research universities left in 20 years. The gap between those and second-rate schools will grow, especially as the top 5 educational content goes online. Who wants to take an online class from the #11 university? We want to be one of the big 5. We're behind, especially on the transition from arts and humanities to science and engineering. And if research funding moves from government to billionaires, scale and rank will be even more important. This is the "ambitious program to improve campus life while bolstering highly regarded academic programs." Harvard (5.7) and Stanford (4.8) have more debt than us (3.6) and Yale (3.6) the same, an indication of who is in this race, and that they're ahead of us.

If the ratio of debt to endowment is high, the U of C doesn't have a problem of too much debt. It has a problem of too little endowment.  This is something that the development office would like you to help with, very much, by the way. There are buildings still left to name! Bloomberg suggests that some competitors have a better idea: "relying more on fundraising and less on bond financing." Hmm. Last time I talked to the development people, they were not sitting around having margarita parties and turning down checks because we'd rather borrow the money.

But left with a choice, do you want to leave a mediocre university with a great endowment and credit rating, or a great university with a mediocre endowment and credit rating, our leaders are making a big, bet-the-company move, of the type that we write about in case studies when it works out. 

Endowments are a bit of a puzzle anyway.  Imagine this is a corporate finance case class, and we're looking at a company that has billions of dollars of extra cash squirreled away. We would say, there is a company with no good ideas. The rate of return to investing internally and expanding is obviously worse than the rate of return they see in markets.  I also observe that high-endowment universities seem to be proportionally more inefficient, with much more staff, and internal bureaucracy. It takes a lot more paperwork to get expenses reimbursed when I travel there. They don't pay higher salaries to their faculty, which is, of course, the number one most important thing for a university to do! Endowment seems to be to universities as oil is to third world countries. You can either read that observation as confirmation of poor internal prospects, or verification of the corporate theory that internal funds get misused by managers. In corporate classes, we say the company should just return cash to shareholders.

Now, universities don't have shareholders, and they don't pay taxes on their investments -- a big advantage over the long run -- so operating an endowment makes a lot more sense. Still, Chicago has always been lean, efficient, under-endowed, attentive to the bottom line, and it's pretty clear we'll be that way for a few more decades! It's also clear our leaders see a high rate of return to investing internally, which is a good sign for any business.

Well, what about the bond rating? I find it a bit curious that bond rating agencies worry about lending to an institution with twice as many assets (endowment) as debt, before you count up the value of the buildings that the bonds finance. But that's their business. This all seems second order. We can always sell endowment to build buildings if we want. The rating causes a lot of on-campus grumbling, and it generates pressure for the parts of the university that generate profit surplus, like the business school, to keep doing so. But perhaps that grumbling will apply necessary pressure for other parts of the university to become as efficient.

Disclaimer: I have zero inside information, all of this is personal opinion only and based only on reading the same public sources you do.

Update:  Chris Hrdlicka and Thomas Gilbert at the University of Washington have a nice recent paper analyzing university endowments. "We show that a risky and large endowment signals a combination of three university characteristics: low productivity marginal internal projects; self-interested stakeholders resisting productive expansion; or binding constraints on maximum endowment payouts."

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