Oct. 16 (Bloomberg) — Harvard University, the world’s richest school, paid almost $500 million to investment banks to escape interest-rate swaps that backfired, according to the school’s annual report released today.

Harvard paid $497.6 million during the fiscal year ended June 30 to get out of $1.1 billion of interest-rate swaps intended to hedge variable-rate debt for capital projects, the report said. The university in Cambridge, Massachusetts, said it also agreed to pay $425 million over 30 to 40 years to offset an additional $764 million in swaps.

The swaps began losing value last year when benchmark interest rates fell in the global credit crisis, forcing the school to post collateral to the banks that sold the swaps, said Daniel Shore, Harvard’s chief financial officer. Harvard sold $2.5 billion in bonds, in part to pay for the swap exit, even as the school’s endowment recorded its biggest loss in 40 years, the Harvard annual report said.

“When we went into the fall, we had some serious liquidity management issues we were dealing with and the collateral postings on the swaps was one,” Shore, who is also Harvard’s vice president for finance, said in an interview today. “In evaluating our liquidity position, we wanted to get some stability and some safety.”

Swaps are a type of derivative where two parties agree to exchange payments tied to a financing, typically a variable-rate for a fixed-rate payment. The terminated swaps include three tied to $431.7 million of bonds the university sold in 2005 and 2007, the annual report said.

Kapolei, Hawaii: Six months ago, Island Pacific Academy was like many start-up independent schools. Even though it had enrolled 650 students PK-11 in four years of existence, it struggled to meet the debt service on a $20 million bond issue amidst rising costs and the stagnant enrollment of the current recession.  Today, the School has cash reserves and completed the purchase of its property. The debt remains, but the debt service is more manageable, given the school’s comparatively low tuition and enrollment.  How did they do it?

“Bond math 101″, says Nick Prassas, financial advisor to the School.  “Two years ago, the School sold a bond issue at par, at a fixed interest rate of 6 3/8.  When the credit crisis hit, interest rates spiked higher.  Higher interest rates, lower bond prices.  The School was able to negotiate the repurchase of its bond issue from bond holders for 65 cents on the dollar.”

Of course, the School still needed $13 million to buy back their discounted bonds.  That source of funds:  federal stimulus dollars from the United States Department of Agriculture.

“We were at the right place at the right time,” says Stuart Hirstein, Associate Headmaster and Chief Operating Officer.   “The USDA, which provides rural community facilities financing, became one of the conduits for disbursing federal stimulus funds. The agency, having guaranteed a loan for the School several years ago, was already familiar with our financial profile.  We made our request just as stimulus funds were being allocated.”

The USDA funds came in the form of a direct loan, and a loan guarantee.   The direct loan carries an interest rate of 4.5%, repayable over forty years, instead of the customary thirty.

“It sounds straightforward, now that we’ve closed the transaction,” says Dan White, Headmaster of the School. “The USDA program is designed to support new community initiatives.  Fortunately, IPA had received a five-year grant from the Hawaii Community Foundation in their Schools of the Future program. The Schools of the Future process will, in fact, transform our school and represent a genuinely new initiative. Putting the deal together, though, required long hours and hard work by several knowledgeable people.”

The notion of a school capitalizing on the USDA stimulus program to buy back their own bonds at a discount, just one year after selling them, is novel.

“Obviously the recession provided fertile ground for thinking outside the norms of independent school finance,” added Prassas. “Everything we hear, though, about independent schools in the post-recession world would suggest that the old norms are not likely to return.”

“The schools of the future—15 to 20 years down the road—might well look very different than today.  Why wouldn’t school financing evolve in a similar fashion?” asked White.“We still need to make enrollment targets,” continued White. “The debt service is still a huge chunk each month.  We continue to be frugal; we have to be. But we have a huge asset—our land—that we did not have before, and there is great security for the school in that fact.”

About a month ago, I attended a financial sustainability lecture from a prominent association.  There was (I felt) a pointed lack of specificity, aside from the generic conventions applicable from a previous era, but rather more of an uplifting tone that “this too shall pass.”  But while I suppose it is human nature to seek the positive in a difficult environment, I also believe it is disingenuous to stare down at the broken glass and exclaim it is half-full.

Independent schools simply must be realistic about the current environment.  The educational bubble has burst.  Bloomberg had a wonderful article, entitled “Colleges Flunk Economics Test as Harvard Model Destroys Budget,” which can be read here.

As a banker, money manager, and private school parent, I believe there are certain truths that are self-evident:

• The educational dollar is no longer inelastic.  Parents (in the aggregate) cannot afford the expense of essentially nineteen years of private education.  They cannot be counseled or somehow convinced that tuition loans are anything other than a very short-term solution. Lowering tuition sounds logical, but is a slippery psychological slope.  I know several schools who have raised tuition, and increased financial aid as a short-term tactic.  Ultimately, educational value must be realized and families who can, pay.
•  As such, the top third of private schools have the cache and/or the capitalization to survive the transition.  The bottom two-thirds can no longer count on a rising tide.  Many will not survive.  It is unjust to suggest otherwise.
• Meaningful fundraising from private school parents is different than for other not-for-profit organizations. Parents are already resentful at the tuition we have to pay.  Asking for even more money is a much greater challenge that the school must acknowledge and accommodate.  Successful fundraising must break the model, become more entrepreneurial.  The same whiny nag will not produce the raw dollars.
• Debt is a valuable tool, but one nonetheless crudely applied by commercial and investment bankers who are essentially financial product vendors.  The capital markets are resourceful and complex.  A financial advisor who is not simply a bond or swap shill can be invaluable.  Again, the top one-third of schools have all the options.  The others have to be smarter.
• I met with a school with $40 million in debt -and 150 student enrollment.  I have met a school so leveraged with variable rate debt, there was a cash-flow crisis if interest rates rose above 2%.   And they are looking for an interest rate swap.  Harvard’s debt problems are well-publicized, and yet they had 17 debt advisors.

And so, I do not often know where to begin.  The paradigm must change, but I am afraid it will only do so when it is too late, when critical options begin to disappear.  This blog has quite a few subscribers, but no comments on any of the topics.  And without feedback, I am unable to address the questions and topics that most weigh on the minds of independent school stakeholders.  And so I ask, if there is any value to this blog, that readers participate.

At our table, the range of comments among the other parents were, in no particular order:

• I only hear from the school when they need money.
• I’ve been paying tuition from my home equity line of credit.
• There’s a good charter school across town.  It’s cheaper to move than pay tuition for three kids.
• I cannot afford to pay for this AND college.
• They nickel and dime us for everything.
• This school gets enough of my money.
• The school will pay for an attorney to draft my will if I leave them a bequest.  Yeah, right. I’ll pay for my own attorney.
• The school has an endowment.  They don’t need my money.
• They’ll just blow my donation.
• My kid graduates this year.  Why do I care?
• I made the mistake of donating a few years ago.  Now they pester me every year for a bigger donation.

However unjust, independent schools are not generally perceived to be a particularly sympathetic beneficiary; certainly not among any of the parents I talk to.  As such, fundraising without regard, or at least some appreciation, of such donor sentiment would arguable fall flat in the current environment.  And yet I get plenty of passive, feel-good requests in the mail.  I don’t even look at them.  They go right into the garbage.

There is an entire fundraising industry, of established strategies and tactics, that I do not always understand.  I have a much simpler benchmark:  me.  I am as typical a potential donor as anyone.  A worthy fundraising tactic is one I might personally (as a donor) respond to, versus tactics that I routinely ignore or which annoy me. In other words, common sense.

Bloomberg article can be read here.

There have been a number of bubbles over the past decade that we now know about. Unfortunately, we are also about to find out if there was an education bubble.

Fueled by endowment gains and tuition increases, universities in recent years have gone on a building, faculty and program expansion spree. I have personally seen it in the law school realm. Instead of the historical 12-credit loads, the norm over the past few years in law schools has trended towards nine to ten credits. This allowed for more research, but also meant that the faculty needed to expand to continue offering the same course levels. Salaries also rose as law schools and other areas of universities competed for top talent.

But the same forces buffeting the general economy are affecting the university.

Yale recently froze all faculty salaries for employees paid more than $75,000, and Harvard froze all faculty salaries at its arts and sciences school. The big private, elite universities appear to be particularly at risk. To understand why, let’s take a look at the Harvard endowment.

Steven M. Davidoff, writing as The Deal Professor, is a commentator for DealBook on the legal aspects of mergers, private equity and corporate governance. A former corporate attorney at Shearman & Sterling, he is a professor at the University of Connecticut School of Law. His columns are available at The Deal Professor blog.As of June 30, 2008, this endowment stood at $36.9 billion, and last year, it paid out $1.6 billion to Harvard. The Harvard endowment has grown at a torrid pace in recent years — it was just $22.6 billion in 2004 — fueled by portfolio gains and especially a 28 percent, 10-year return on its private equity portfolio. That compares to a total portfolio five-year return of 17.6 percent as of June 30.

But like everyone else, the endowment was hit by the downturn. It has not announced definitive 2008 results, but Harvard has said that it expects returns to be down by about 30 percent. I think the situation is much worse than that. In 2007, approximately $5.16 billion of Harvard’s total portfolio was in private equity, and by my estimate, a total of $11.2 billion, or 26 percent, in all kinds of illiquid assets (the others being real estate and land). Here, this figure is for all of the general investment assets managed by Harvard. That figure was $43 billion as of June 30, 2008, with the bulk being the $36.9 billion endowment.

The 2007 figures and allocations for the entire $43 billion portfolio are disclosed in the endowment’s 2007-2008 year-end report.

Calculating the losses in year-end 2008, I estimate that Harvard’s total private equity portfolio declined 40 percent to around $3 billion. I assign such a figure because I mark-it-to-market — and right now, these illiquid assets are hard to sell and even harder to price. In the long run, these investments may pan out, but for the short term, these private equity assets are at best mispriced.

Applying these calculations through the total endowment as of this date should give about $25.5 billion split with 23 percent to 24 percent in illiquid assets, or about $6 billion. For these purposes I have assumed that all of Harvard’s hedge fund holdings ($8.3 billion as of June 30, 2008) are liquid. This is unlikely because of the many hedge funds that have imposed lock-downs on capital withdrawal. And my aggregate number here is in line with the 30 percent decline Harvard has stated it thinks should occur.

This is where the problem lies. Harvard pays out its endowment on a three-year basis. So for the next three years, I estimate it will still pay out on average about $1.5 billion. This may actually be low, as Harvard seeks to keep spending stable and help out colleges, such as the Harvard Divinity School, that rely heavily on the endowment.

However, if you do the numbers calculating a zero percent return on liquid assets (stocks, etc.), a negative five percent return on illiquid ones (private equity, etc.), and an annual donation rate of $500 million, you get the following allocation:

2010 2011 2012 Liquid assets (in millions) $16,972 $14,472 $11,972 Illiquid assets 7,229 8,368 9,449 Total 24,202 22,840 21,422 % illiquid 29.87% 36.64% 44.11%If you change the returns to five percent for liquid assets and zero for illiquid ones, you get the following:

2010 2011 2012 Liquid assets (in millions) $17,946 $16,343 $14,661 Illiquid assets 7,531 9,031 10,531 Total 25,477 25,374 25,191 % illiquid 29.56% 35.59% 41.80%In either case, illiquid assets rise to approximately 41 percent to 44 percent of the endowment. This is the general point of these numbers: Even as you adjust them, Harvard is about to go from an asset illiquidity level of 26 percent (and a target level of 31 percent) to a much higher level.

The reason the illiquid part grows is future investment commitments by the endowment to private equity and real estate partnerships. The 2007-2008 report did not disclose these commitments, but the 2006-2007 report stated they were $8.17 billion through 2017. Assuming that this commitment stayed the same or went down by no more than $1 billion in 2008 (Harvard last year said they were going to grow the portfolio), Harvard is going to have to follow through on about $7 billion to $8 billion in commitments in the coming years.

In the numbers above, I estimated that Harvard has to cough up about $1.5 billion a year over the next three years on these commitments. The reason was aptly stated by Blackstone Group Chief Executive Stephen A. Schwarzman last Friday, as he referred to the buyout firm’s large supply of “dry powder.” This powder is uncommitted funds, and private equity hopes to use these funds to take advantage of distressed opportunities. Moreover, funds are not flowing back from private equity firms, as they are holding their portfolio companies for the long run.

So, my numbers are rough, very rough estimates — but the problem is apparent. In the short term, unless it boosts its liquid returns, Harvard is going to have to raise a lot in donations or eat up its liquid assets to fund university obligations and its private equity commitments. This results in a spiraling decline in Harvard’s liquid assets as each year they go lower to meet these needs and more and more assets become tied up in private equity. This assumes the markets stay where they are in the next three years — there are scenarios where liquid assets do worse (like yesterday), or better, of course.

This is likely why Harvard recently sold $1.5 billion in debt, and unsuccessfully tried to sell $1.5 billion of its private equity portfolio. It needs to cover short-term funding obligations rather than liquidate illiquid assets at fire-sale prices. In essence, Harvard is more like a hedge fund than ever — trading for short-term gain with the same risks involved.

Other universities may be in worse positions. Duke, for example, sold $500 million in bonds, and Princeton $1.5 billion. Again, the reason appears to be to fund liquidity.

The result is twofold. First, private equity may not have as much dry powder as people believe. Private equity investors, known as limited parters, or LPs, are likely to strongly resist meeting all of their commitments. This may lead to a renegotiation of some funds as private equity seeks to accommodate their clients.

Private equity was historically viewed as the savior to higher education, but it now may mean its trouble.

Second, there is education itself. To paraphrase “Top Gun,” “their mouths were writing checks their brains couldn’t cash.” Universities expanded rapidly during the past few years on the basis of endowment growth. But not only is that growth gone and endowments fallen, the numbers may be far worse because of how much these entities depend on private equity.

In the long term, this should all rebalance and dry powder gains may compensate, but as Keynes said, “in the long run, we are all dead.” The Yale model assumes that endowments have perpetual life, but they also have short-term funding commitments.

Universities and endowments are surely hoping the situation is not as bad as the above might suggest. The likely result is pain at the university and for faculty, as many of these institutions go through their own “deleveraging.”

The Wall Street Journal

Colleges and universities led by Stanford, Harvard and Columbia raised a record $31.6 billion in fiscal year 2008, but their fund-raising outlook has darkened amid the economic crisis.

A survey of 1,052 institutions conducted by the nonprofit Council for Aid to Education shows college fund raising rose 6.2% last year. But that predated the sharp stock-market decline that began last September because most academic fiscal years end June 30. Fund raising in academia is highly sensitive to stock prices because many donors, for tax reasons, give appreciated stock instead of cash.

Ann E. Kaplan, who directs the study, said she has spoken with about 20 institutions recently and all indicated difficulty in fund raising this year, saying they “hit a wall” in January. Ms. Kaplan said she wouldn’t be surprised if the current year ended up being worse than fiscal 1975, when contributions fell 3.6%, the biggest drop in half a century. Institutions have already reported to researchers that some multiyear donations have been renegotiated to give philanthropists more time to honor their pledges.

The recent numbers suggest another challenge for higher education, as even the wealthiest schools are suffering painful budget cuts after steep losses in their endowments.

Any decline in giving would follow a decade of dazzling generosity to colleges. Over the past 10 years, contributions to colleges have risen at a 5.7% annual clip.

Still, the survey demonstrated a sharp divide among the haves and have-nots in higher education. The top 20 institutions received 27% of all gifts, with many smaller colleges showing declines in giving. Ms. Kaplan said the wealthiest colleges tended to benefit from successful billion-dollar-plus capital campaigns. But since the money in such efforts tends to flow into endowments, where it is invested, she noted that much was likely lost in the market downturn of recent months.

For the fourth straight year, Stanford University, which has long benefited from its ties to Silicon Valley, topped the annual fund-raising list, receiving $785 million in its 2008 fiscal year, ended in August. Stanford was followed by Harvard’s nearly $651 million, Columbia’s $495 million and Yale’s $487 million.

Lisa Lapin, a Stanford spokeswoman, said the university is in the midst of a five-year, $4.3 billion fund-raising campaign, which ends in 2011. The Palo Alto, Calif., institution’s big haul represents a decline from 2007 and from 2006, when it raised $911.6 million, a record for any college in a single year. Ms. Lapin said the school has “seen some slowdown in philanthropic support during the past several months, possibly due to the constraints on the economy and the current level of financial uncertainty.”

In line with other wealthy schools, Stanford has said its endowment, which stood at $17.2 billion on Aug. 31, is expected to decline 20% to 30% this year. The university is planning steep cuts to its $3.5 billion budget over the next two years and has already had scattered layoffs and suspended some major capital projects. Ms. Lapin said income from the endowment makes up 28% of Stanford’s budget, while annual donations comprise only 5%, so “any changes in giving would have little impact on the university’s operating budget.”

A fundraising infrastructure is important not only for fundraising, but as the foundation for board committees and endowment funds.  Fundraising should be developed like an investment proposition to a venture capitalist; instead it is often conducted like a spoiled child nagging his mother.

Ok, I’ve made my point.  But I have been in enough board meetings in which fundraising was the primary topic, the results were consistently disappointing, and yet there was insufficient critical thinking to advance the discussion and start doing what works.

This is the first in a series of posts on fundraising.  It is the popular topic, now that endowment balances have fallen and the debt markets have become inhospitable.  The primary objective, at least initially, is a change in perspective.  As such, I will reprint a few of my older posts, and approach the topic in different directions.  Perhaps one of the stories will ring true enough to act as a catalyst for change.

The Dream of the White Knight

I was a substantial contributor to my children’s private school. So much so that my name is displayed prominently on a wall in their main building, among a select group of other major donors. The headmaster was receptive to my invitation to lunch.
I asked about the direction of the school. The headmaster talked about the funding needs of future projects, and the desire to create an endowment fund. I talked about planned giving and the value of a charitable remainder trust for owners of appreciated real estate.

The headmaster nodded approvingly.

I volunteered to organize a planned giving marketing program. The school was located in an affluent area, and many of the parents and patrons had the kind of tax problems that planned giving vehicles could directly address.

The headmaster’s attention wandered.

This marketing program would demand a degree of commitment from the headmaster and the staff. I explained that the participation of the board of directors was crucial, and that I was happy to prepare a presentation. The headmaster said:

“Can’t you just write another check?”

No, I could not. I never wrote another check to that school again.

Many independent schools flourish because of sound planning and a cultivated depth and breadth of support. Many more fail to reach their potential because they lack very basic financial planning principles and procedures.

In my experience (as both advisor and board member), the greatest impediment to financial planning is The Dream of the White Knight: that wealthy donor who appears on our doorstep, enthralled with the sheer goodness of the mission, and solves our financial burdens, with few strings attached.

The Dream is a common “virus” among not-for-profit organizations. White knights are certainly an integral component of not-for-profit funding. Sometimes, thought, our White Knight wants collateral and a 14% investment return.

The danger of the The Dream is when it evolves into the predominant form of financial planning. It is intoxicating because it suggests that the otherwise messy aspects of finance, such as soliciting a diversified base of new donors or making debt service payments, can be tidily sidestepped.
And of course, The Dream is kept alive because every now and then a major donor does indeed appear.

Ultimately, the cost of The Dream is a complacent, financially fragile organization that does not develop the discipline and foraging skills necessary for long-term financial management.