In an op-ed for The New York Times, Professor Victor Fleischer of the University of San Diego School of Law advocated minimum annual payouts from university endowments to reduce tuition and increase research support. He suggests paying out 8 percent of the endowment balance if the endowment exceeds $100 million. This is an issue worth discussing though the conclusion that endowment payouts be mandated is by no means as clear as the professor suggests.
Even more troubling is his use of the fees paid by endowments to managers of private equity and hedge funds to justify the need for the payout rule. Investments in hedge funds and other arrangements that involve high fees are generally unproductive, and we believe that they should be reduced or eliminated, both in endowments and many other portfolios. But this has almost nothing to do with the issue of current payouts from endowments.
Why is this disconnect a problem? Debt-free higher education is a live topic of discussion in the current political and policy environment, and the last thing this debate needs is a detour into a blind alley.
The professor uses Yale as his example. Its endowment is enormous, more than $24 billion, of which one-third is invested in private equity funds. Fees for its private equity investments totaled $480 million—$178 million in annual fees and $343 million in performance fees. These fees are generally in line with the most typical private equity compensation arrangements, 2 percent per year plus 20 percent of the investment profits (which explains why investment bankers bolt for managing private equity and hedge funds as soon as they can).
Mr. Fleischer argues that the endowment fund contributed only $170 million in 2014 to tuition assistance and fellowships out of the total $1 billion it paid out to fund Yale’s operating budget, and that $170 million is much less than the endowment paid in private equity management fees. His rhetorical point: How can you pay out so much to private equity fund managers while you pay so little to reduce deserving students’ cost of education?
We have never advocated going easy on financiers—including managers of private equity and hedge funds—but it is important to keep observations of the sorry states of finance and education in their proper contexts, noting that there are important intersections but avoiding illogic. Professor Fleischer wants to increase yearly endowment payouts to reduce student costs and increase research support, but another way to increase payouts, rather than mandate a certain yearly payout as he suggests, is to increase the investment earnings of endowments.
Thus, if Yale receives more benefit from the private equity fund managers than it pays out, it makes financial sense to pay the fees, earn more and then debate when and how much to disburse from an even larger endowment.
It turns out that for 2014, Yale’s private equity fund deals were not so bad overall. After fees reported by Professor Fleischer, Yale earned about 15 percent while the S&P 500 went up a little over 12.25 percent. We suspect that he has omitted the multiple pass-through extra fees and costs that research tells us adds another 2 percent to costs, which would mean that Yale only did slightly better than the S&P 500.
However, longer-term analyses show that private equity and hedge fund investments are inferior to less complex investments, especially considering the risks involved. This is why endowments should shy away from private equity and hedge fund investments. But the argument that fees paid to private equity managers are limiting the tuition assistance the endowment can provide simply doesn’t hold water.
There is another policy issue that must be considered: endowments do not pay income taxes on their earnings. This is a tax expenditure that subsidizes non-profit universities. Because the government foregoes these taxes, the effective investment earnings of endowments are greater than other investors experience. Thus, the performance fees paid to endowment investment managers are also paid by pre-tax dollars, resulting in a taxpaying investor paying about 35 percent less to private equity and hedge fund managers than university endowments pay. The endowments are indifferent, of course, because the whole transaction is outside of the tax code for them.
In an indirect way, taxpayers are subsidizing the payments to these managers. This is particularly ironic in that managers’ performance payments are treated as carried interest and taxed as capital gains rather than income from services rendered, which the payments really are. This means the tax code is doubly subsidizing private equity partners when they manage endowments.
Required endowment disbursement, as advocated by Fleischer, is a tricky area. Paying out endowment balances means that the funds are no longer accumulating at rates that are not subject to taxes, meaning that they grow faster than taxable investments, a major incentive to hold onto the money. For this privilege, the public certainly can justify the demand for proper use of the funds. But timing is complicated.
College and university endowments come in many sizes and operate under a variety of philosophies. Rules that dictate disbursement percentages to defray student costs or to increase support of research will be far more involved than Professor Fleischer’s “8 percent if greater than $100 million” proposal. This may be worth exploring, but it is not a reason to cut down or eliminate management fees. Solving the private equity and hedge fund problem and the tuition crisis are separate thorny issues that require a strict focus on the relevant arguments.
This piece was co-written with Robert Hiltonsmith.