At the peak of the dot-com boom, Stanford appeared to be prospering. Enriched by its relationships with Silicon Valley entrepreneurs and venture capital investors, the University attracted $242 million in endowment gifts in fiscal year 1999-2000, an all-time high. Meanwhile, Stanford’s investments performed spectacularly. Between August 1995 and its peak in March of 2000, the market value of the endowment more than doubled, surpassing $8 billion.
Then, the bubble burst, both the Dow and the NASDAQ plummeted, and the U.S. economy entered a recession it still hasn’t shaken.
Mike McCaffery, MBA ’82, began his job as president and CEO of Stanford Management Company, the primary investment arm of the University, in September 2000. By then, the markets were in free fall. That same month, John Etchemendy, PhD ’82, took over as provost, Stanford’s chief academic and budget officer. Ever since, the two men have watched and worried as the battered economy dragged Stanford’s endowment down with it.
The endowment is a corpus of money held in reserve to protect the long-term health of the University. The principal is invested so as to increase the endowment and to provide returns each year that can augment Stanford’s operating budget. Lately, though, the endowment has been shrinking. As of August 31, the “merged endowment pool”—the portion of the endowment that is actively managed—stood at $7.35 billion, down roughly $500 million from the 2001 fiscal year and about $1.3 billion off its peak in 2000. It’s the first time since Stanford began recording annual performance in 1964 that the University’s endowment has lost value in consecutive years.
Stanford isn’t the only school hurting. Among the country’s 20 largest university endowments, only a couple produced positive numbers last year, and those were tiny gains. Most had losses larger than Stanford’s.
Stanford asked McCaffery and Etchemendy to discuss how the weak economy, the market upheaval and the declining endowment are affecting University planning and programs.
Stanford: Maybe we should start by having you talk about this year’s budget. How does it look?
Etchemendy: The general funds budget going into FY03 is balanced, though it required about a 5 percent budget cut to balance it. We are now beginning the yearlong process of determining next year’s budget [fiscal year 2004, which starts in September 2003], and in order to get to a balanced budget, we are again going to have to make significant budget cuts. I hope it will be only 5 percent, but depending on various factors, it could approach a 10 percent cut.
How seriously will those cuts affect University programs?
Etchemendy: This year’s budget reductions, coming as they did on the heels of an unprecedented string of strong years in which both endowment and research income grew substantially, were a modest retrenchment. They forced us to cut back in areas that had perhaps expanded unnecessarily, or to cull functions that were no longer necessary. A tight budget year can actually be good in that respect. But a series of tight years—of cutbacks on the order of 5 percent—becomes much more problematic.
Do you foresee layoffs?
Etchemendy: Since the University’s budget is mostly people, at a certain point, hiring freezes or even layoffs become unavoidable. It is too early to tell whether we are reaching that point in the coming budget year.
Is there any truth to the notion that humanities disciplines are more vulnerable during a budget crunch?
Etchemendy: This is actually a myth. Humanities departments are relatively inexpensive to run, and so are less vulnerable in tough economic times than the much more expensive science and engineering programs. For example, the recruitment of a new humanities faculty member costs us a salary and housing assistance—a fair amount, but not nearly as much as a science faculty member, who requires not only a salary and housing assistance but also laboratory renovation expenses, equipment, research start-up funds and so forth. It is not uncommon for “start-up packages” in the sciences to run more than a million dollars. So in tight budget times, it is much more likely that the University will be forced to slow down its hiring of science faculty than of humanities faculty.
What are the various sources of income that affect the budget?
Etchemendy: Most people are aware that private universities rely heavily on endowment income to fill the gap between, for example, tuition and the actual cost of a university education. We also rely on annual expendable gifts [gifts not restricted to specific purposes] to close the tuition gap. [For fiscal year 2002, expendable gifts totaled about $130 million.] When the economy is bad, people often feel that they can’t afford to give as much. Any changes in annual giving are felt immediately by the University.
But there are other ways in which the economy has an immediate effect on the budget. For example, the income from the Stanford Research Park [which houses corporate tenants] and the income from what we call the “expendable funds pool” are both affected by the economy and by investment returns.
How much does the University get from its endowment each year?
McCaffery: The stated payout from the endowment is 5 percent, and that fluctuates very little from year to year because of a smoothing formula we use to reduce volatility. What that means essentially is that we take the gains in the good years and spread them out. Sixty percent of this year’s payout came from last year’s returns, and 60 percent of last year’s payout came from the returns of the year before. In any given year, the payout is being affected by three to four years of past investment performance. It is designed that way to avoid spikes up or down.
The money from the boom years is still providing a cushion?
McCaffery: That’s right. In 1999, the endowment was up 36 percent; in 2000, it was up 39 percent.
So the smoothing formula limits exposure to severe budget cuts when the endowment loses value over the short term. But, presumably, weak returns would eventually overcome the formula and reduce the payout. What kind of performance do you need to prevent that?
McCaffery: If we assume no new gifts to the University, we would need a return of about 9.25 percent to maintain the current purchasing power of the endowment. That means that if we assume a 5 percent payout every year and adjust for inflation, investment performance lower than 9.25 percent reduces the value of the endowment in real terms. We call that 9.25 figure our “hurdle rate.”
Can you make that this year, given the state of the economy?
McCaffery: I don’t want to sound overly optimistic, because this keeps us awake at night; but we think we have an excellent shot at meeting our hurdle rate over multiple years with the portfolio we have now. But it is extremely difficult to project short-term returns, particularly in an environment that is as volatile as the one we have seen the last two years. We are much more confident than we were a year ago, both about our portfolio and about the market environment. The key right now is true diversification, and we have that.
How does the University plan ahead when market volatility creates so much uncertainty?
Etchemendy: Thanks to the endowment smoothing rule, and the diversified investments represented in the endowment, the effects of market volatility are less than they might otherwise be. Note that we are talking about single-digit cuts in the budget, which are much less than the recent drops in the stock market. The smoothing rule and other techniques that we use to buffer the effects of volatility reflect the fact that the University must husband its resources conservatively, preserving them for the benefit not just of current students but of future generations of students as well.
How much risk do you take in the University’s investments?
McCaffery: Part of our job at the management company is to assess Stanford’s appetite for risk and design an investment strategy that meets the payout expectations while keeping risk at an acceptable level. We look for a package of assets that gives us a high probability of meeting our hurdle rate and a low probability for capital losses. In other words, what are the chances that we wake up one morning and Stanford has lost 10 percent of its endowment value, or 20 percent? And we sit down with Isaac Stein [chairman of the Board of Trustees] and President Hennessy and the members of the management company board and show them various scenarios, and we say, “How do you feel about that?” One of our goals is “multigenerational equity,” which essentially means that the endowment is there in perpetuity. We are constantly running Monte Carlo simulations, but we would never take the University’s money to Monte Carlo.
Despite the recent downturn, Stanford’s endowment is more than $7 billion. That seems like a lot of money even for a complex institution. Why is it not enough?
Etchemendy: Seven billion dollars sounds like a lot of money, and it is. But it is not a lot when it comes to maintaining a world-class university the size and strength of Stanford. Our endowment return covers only about 15 percent of our expenses in a given year. In contrast, peer universities’ endowments are covering between 25 and 40 percent of their expenses. This means Stanford has to work much harder than, say, Harvard or Princeton to raise annual sources of income to cover its expenses. For example, we use half of all of the annual gifts to The Stanford Fund to help cover financial aid expenses. At Princeton, which has the largest endowment per student [$1.2 million, compared with Stanford’s $508,000], financial aid is entirely endowed. And on top of that, they could afford to do away with student loans a couple of years ago and replace them with university grants paid by those endowment funds. This means that their annual gifts can go entirely to programmatic enhancements rather than financial aid.
Is Stanford maintaining its competitiveness with Harvard and Princeton in attracting students and faculty?
Etchemendy: Remarkably enough, yes, in spite of their much larger financial resources. Right now, we are offering what is arguably the finest undergraduate education in the world, and this is partly reflected in the number of students who choose to come to Stanford rather than Harvard or Princeton in spite of somewhat better financial aid packages that they might receive at those schools. We also do very well with faculty recruitment. No university consistently out-competes us.
Could Stanford close the gap with those schools with better investment performance?
McCaffery: Trying to catch up with Harvard and Princeton through investment alone would be a major mistake. The idea that we could close the gap by outperforming them year after year is really far-fetched. It would require taking substantial risk that is contrary to the philosophy of ensuring that the endowment is there in perpetuity.
Silicon Valley has been hit particularly hard by the bursting of the Internet bubble and the subsequent recession. Is the same true for Stanford?
McCaffery: Stanford’s portfolio was weighted to early-stage technology venture capital in the ’90s, which was understandable, given our location and our network. As a result, we were more vulnerable when the market went the other way, but it’s not as bad as people assume. To be fair, it served Stanford well. Between 1995 and 2000, Stanford invested roughly $500 million in venture capital. At the market’s peak, that $500 million was worth $3.8 billion. When the numbers are finally in, we think that the value will be about $2 billion. So, although for the past couple of years we have reported paper losses of $1.8 billion, we actually realized a gain of $1.5 billion over the cost of that original investment. Would I take that again? Any day of the week.
