Thursday, March 20, 2014

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."


  1. I have not read the trust deeds for the endowment but I suspect that the endowment contains restrictions on the use of principal and that is the real reason the University is borrowing rather than dipping into the general endowment.

  2. This post just got emailed out to the listserv at the business school where I work, subject: "U of C borrowing analysis from an insider". I guess not everyone reads to the end...

  3. See the recent AER paper:

  4. I think it says something interesting about the current recession and the effectiveness of monetary policy that a large, sophisticated, credit worthy, tax exempt, borrower like University of Chicago is only now, after years of low interest rates, thinking of borrowing money to invest in the future. No wonder the recession has continued as long as it has (and obviously tax policy has no first order impact on U of C decision making).

    1. Absalon,

      Chicago's debt has grown $1.2 billion in the last four years (50%). Maybe you should read the linked (original) article.

  5. The idea of arbitraging the advantage of a tax-free municipal rate comes up from time to time, Decades back the City of Los Angeles would borrow a bil at the start of the fiscal year, and ram it into into higher-yielding assets, and draw it down over the year. They got away with this for a while, but then somebody somewhere clamped down on it.

    Dr. Cochrane is not alone in wondering why universities seem to build up more and more staff and inefficiencies...and I am sure he suspects the lack of immediate market discipline plays a role.... evidently staff to faculty ratios keep ballooning...

    Maybe the U of C needs new buildings. But Cochrane's post raises the question; What if instead the U of C said, "Well, let's refurbish what we have, and start a 100 Minds program. We will get the best 100 minds on the planet. Use the money for that."

    Or start some sort of X prizes, that will be awarded to super tech achievers, on the condition they spend a year or two on campus....

    I am too old for college, and I disagree with Dr. Cochrane on many issues. But I would rather take a class from Dr. Cochrane in a drafty tent than a lesser professor in a gilded palace....

    1. "But I would rather take a class from Dr. Cochrane in a drafty tent than a lesser professor in a gilded palace...."

      Would be nice to have a similar comment on my job performance review!

  6. Just a note to the donors of the world, to correct a minor error on Prof. Cochrane's part:

    If you invest your money now, and realize a taxable return, you will pay taxes. Then, when you give your appreciated portfolio to the University, you will get a deduction that includes the increased return. Apart from the timing difference (which, for the moment, at below-zero real short-term rates, is not terribly significant), you will not be in a worse position for having delayed your donation. Furthermore, in reality, especially if you have made significant equity investments, a good deal of your appreciation will be in the form of unrealized gains that (unless you are a securities dealer) you will not have recognized for tax purposes yet. If you donate those investments to the University in kind, your charitable deduction, which offsets your ordinary income, will equal the full fair market value of the investments, but you will never pay the capital gain tax on the unrealized gains. So you actually have an incentive to time your donation to a period when you have lots of unrealized gains and lots of ordinary income to offset.

    (As always with taxes, the above should come with 20 or 30 caveats for people in special circumstances. Consult your tax adviser!)

    Also, to put some numbers on Prof. Cochrane's point: In FY 2013, the University paid interest of $28 million (net of derivative gains) on average debt of $3.6 billion. Its endowment return for that year was 6.6% (below its 10-year average annual return of 10%). So the University earned a bit more than $200 million extra by borrowing rather than consuming endowment. That's like getting a free building in your cereal box.

  7. Isn't there some kind of legal restrictions on university endowments (501C's) acquiring debt? I thought it revoked their tax exempt status or something.

  8. Great business model, Medical Foundations and the like do the same thing, borrow at low municipal rates and invest the money in medical starts-ups and higher expected return enterprises and can make a nice spread on the difference.

  9. Had a case competition in business school very similar to this except the borrower was a large not for profit hospital that had an investment portfolio larger than their borrowings. Same answer. Borrowing tax free and investing in high returns project is a no brainer.

    Its kind of funny to think that the hospital in question and UoC are really hedge funds that happen to provide services like healthcare and education on the side

  10. The March 2014 AER has a paper I co-authored with Steve Dimmock, Jun-Koo Kang and Scott Weisbenner showing that many universities appear to operate consistent with a desire to preserve the size of the endowment for its own sake. Rather than using the endowment to smooth spending, they tend to cut endowment payouts relative to their own spending rules at precisely those times when any smoothing story suggests they should be doing the opposite. The effect is largest for those schools where the size of the endowment was hovering around its value at the time the university president took office. I think it is pretty clear that whatever endowments are maximizing, it is not the excellence of the university.
    Jeff Brown

  11. We have a fairly new paper on University endowment asset allocation and spending using a formal model that shows that a university might want to borrow to invest more aggressively in a risky asset. In this case, the key insight isn't what Professor Cochrane mentions about a "tournament" between universities, but rather an option effect on donations. In our model donations increase when the investment opportunities are better or the endowment performance improves. We also relate this to optimal spending policies and find that smaller endowments ought to vary their spending rates more than larger endowments over the investment cycle. The link to the paper can be found by clicking my name.


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