Federal funding cuts are forcing university endowments, often consistent allocators to private equity, to reexamine their portfolios and liquidity positions, an equation that could be further muddied by the threat of a raise to the endowment tax.
The Trump administration’s proposed cuts to student aid and loan programs, research grants and university funding, including to specific Ivy League institutions, will have a direct impact on the finances of a number of universities across the US. The administration plans to cut funding to the National Institutes of Health, which administers university research grants; slash Pell grants and student loans; and it has Columbia, University of Pennsylvania and Harvard in its sights for specific funding decreases.
Chief investment officers have been creating contingency plans to help prepare their funds for worst case scenarios, despite little optimism that endowments can cure for significant slashes to public funding, multiple advisory sources told Buyouts.
These contingencies largely rest on the objectives of increasing target rates of return, identifying and triggering liquidity options and cutting back overall spending.
But several blockages are likely to emerge for endowments looking to achieve these objectives. Overallocation to private equity, concern over excessive levels of risk and leverage and the potential for an endowment tax to further reduce spending power – along with a plethora of other challenges LPs are facing in today’s market – all play a part in endowments’ struggles when addressing funding cuts.
“As ever, there are a host of challenges when thinking about the proper strategic asset allocation, and instability within the operations of the university would be a major one,” Matt Bank, co-CIO of the outsourced investment firm GEM. “But there’s also the need to navigate an extremely volatile market environment, to continue to deploy capital into compelling opportunities, and to provide support for board and committee anxieties.”
Funding cuts
The wide-ranging cuts to university funding will likely impact most US institutions, but some will feel the pressure even more than others.
The Trump administration aims to slash $400 million in funding to Columbia and $175 million to the University of Pennsylvania and is reviewing $8.7 billion in federal funding grants to Harvard, leaving those institutions, representing three of the largest endowments in the world, particularly vulnerable.
Research universities that rely on federal grants for their operations are also likely to suffer under the weight of broad-based cuts. It was recently reported that $800 million of funding to Johns Hopkins, which received direct funding from the USAID program, was shut off as part of the Department of Government Efficiency’s dismantling of federal programs writ large.
Universities at large are also concerned about what the future holds for federal student loans.
“The Department of Education came out initially and said that only discretionary grants would be affected, so Pell grants and other federal student loans would be exempt,” says Tim Yates, President and CEO of Commonfund OCIO in an interview with Buyouts. “Now it’s clear that the DoE is in what [secretary of education] Linda McMahon described as ‘the final mission of winding it down.’ So, it’s still unclear where the $1.7 something trillion student loan portfolio goes.”
Unrestricted endowment funds usually only make up a portion of an endowment’s total assets under management, and for almost all universities, endowment draws will not suffice to close the pending funding gap.
“There’s no easy answer for how to plug the hole left by federal funding at institutions for which it is a large part of the operating budget,” says Bank. “Likely, they will have to take an ‘all of the above’ approach: replacing federal grants with grants from private sources or other philanthropic organizations, drawing incremental capital from the liquid portions of the unrestricted endowment, and cutting expenses.”
Shift to liquid
Many endowments are trying to shore up their liquidity positions in the face of these cuts by increasing their exposure to more liquid asset classes such as public equities and fixed income and drawing incremental capital.
“We expect large institutions will reduce their pacing to private exposure incrementally to build more liquid portfolios,” Bank notes.
The transition to a more liquid portfolio could be a drawn out process for many endowments. According to a survey from February conducted by the National Association of College and University Business Officers and Commonfund, US endowments have a 30.9 percent allocation to public equities on a dollar-weighted average, compared with 28.8 percent allocation to venture capital and private equity assets.
This imbalance is accentuated among larger endowments. Endowments with AUMs in excess of $5 billion are allocated to public equities at a rate of 24.1 percent on average, compared to a 33.6 percent allocation to venture capital and private equity assets.
Debt issuance has also emerged as a potential liquidity tool. A recent Bloomberg report showed that Ivy League universities have raised more money through bond issuances so far this year than they have in any year over the past decade.
But some believe that this increasingly popular mode of relief isn’t sustainable.
“There’s a certain amount of just leverage that any institution, whether it’s a nonprofit or a for profit, can handle,” says Anne Duggan, a managing director at TIFF Investment Management. “You can’t increase that number indefinitely.”
Tax threat
The immediate threat of federal cuts has put endowments on red alert, but they also may face challenges further out on the horizon.
Multiple bills currently sit in congress proposing to increase the endowment tax rate from a previous mark of 1.4 percent to proposed rates of 10 percent, 14 percent or 21 percent. TIFF notes that a tax rate of 10 percent and above would prompt institutions to take measures to address the tax burden.
Other proposals have also suggested lowering the criteria for taxation to $200,000 of AUM per student, compared to the current mark of $500,000 per student. In its current iteration, the endowment tax only applies to 56 universities, including all of the 25 largest private university endowments.
While these proposals are still months away from posing a threat to university finances and are far from guaranteed to pass into law, even a more modest tax hike could have a drastic effect on endowment portfolios, especially combined with federal cuts.
While Commonfund’s CEO Mark Anson signaled that an increase in the tax rate could trigger a move towards private assets with higher returns, as reported by Buyouts. But endowment drawdowns in response to funding cuts threaten to muddle the effectiveness of this solution.
“When you take more money out of the endowment, you are required to have a higher return within the endowment to make up for the shortfall,” says Duggan. “However, the more money you take out, the harder it is to replace through performance. So there becomes this balancing act around these two components, to ensure you’re supporting the school sufficiently while still maintaining the endowment corpus.”
Beyond generating the necessary returns that will be lost from a combination of funding cuts and tax hikes, risk profiles have become tighter for universities, too.
Many universities have already reached the limits of their risk tolerances, rendering further commitments to private equity less likely, both Duggan and Yates told Buyouts.
“The two basic risks that endowments take are equity risk and illiquidity risk,” Yates notes. “One solution to an endowment tax would be increasing the allocation to private equity to generate a higher return. However, the largest endowments that are currently subject to the excise tax typically already have healthy allocations to illiquid asset class and we are in an environment currently where some institutions are at or above policy targets because of the strong performance of private strategies and a delayed ‘denominator effect’.”
These factors, along with the stagnated exits, drying liquidity and overall macroeconomic instability that all other LPs have been subjected to over the last two years, are likely to challenge the investment operations and strategies of endowments across the country.
“We are living through some seismic shifts in the global order that will impact every part of endowment and university management, so it’s critical to stitch together finance, investment and key leadership functions at these institutions in more strategic ways to enable closer and deeper collaboration,” Bank says.
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