Endowment explained: What the University does with $9.7 billion

By Michael Sugerman, Daily Staff Reporter
Published November 26, 2014

The University’s most recent Report of Investments, released at the October Board of Regents meeting to reflect numbers as of June 30, 2014, shows an all-time high level of endowment funds: $9.7 billion. That’s nearly quadruple its value 15 years ago.

The annual report analyzes the University’s investments using a great deal of financial jargon that, to the finance novice, amounts to little more than gibberish.

The following is a look at what exactly the endowment is, how it works and why it is important for students. The University also has a complex mechanism for how it invests its endowment funds — choices that have a direct impact on student life.

The endowment

As defined by Rafael Castilla, the director of investment risk management in the University’s Investment Office, the endowment is a pool of capital that can indefinitely support the University if properly managed.

“You can think of it, in a way, as this giant bond … which pays out a certain amount of interest every year to the University,” Castilla said. “It’s one of various funding sources.”

The endowment’s investment return in 2014, according to the report, was 18.8 percent — meaning that the total endowment grew by 18.8 percent.

It’s worth noting that the endowment does not grow alone by compounding upon itself; the University’s fundraising campaigns also play a significant role.

Take the current effort, The Victors for Michigan campaign, which aims to raise $4 billion. Rather than giving gift money directly to students, the funds are generally invested. The proceeds from those investments can continue to fund scholarships for years.

University spokesman Rick Fitzgerald said the destination for individual donations depends on the donor.

“For example, having just talked with development, we know that, toward that $1 billion goal for student support, donors have given about $400 million so far, so almost halfway to that goal,” Fitzgerald said. “Most of that is donations that are gifts that will go into the endowment, so that they’ll be invested.”

Donations outside that fundraising push may be invested directly into specific projects, such as University alum Charles Munger’s $110 million donation, which allocated money for the construction of graduate student housing.

Castilla and Fitzgerald said, on average, the University spends 4.5 percent of investment proceeds, leaving the rest to grow the endowment.

As to why the endowment has grown so quickly, even in just the last year, Castilla said it’s a matter of compensating for the decrease of public funds.

“Once upon a time, many decades ago, the University of Michigan was mainly funded by the state,” Castilla said. “The composition of that funding has changed over time. Everybody knows that the state has cut back on funding over time, but the cost of giving an education has gone up also.”

The state of Michigan provides 16 percent of the University’s general fund budget, according to University budget reports. In comparison, it was 78 percent in 1960, so the drop has provided the impetus for the need to expand the endowment, raise tuition and encourage donations.

As recently as 1990, tuition and fees and state support provided equal contributions to the University.

For this reason, expanding the endowment has been critical for funding all facets of the University. Fitzgerald said if the endowment didn’t grow, costs like tuition would increase at higher rates.

Some might say the constantly expanding endowment is a sign that the University operates like a private company, rather than a non-profit, public educational institution. Fitzgerald said the opposite is true.

“It’s really acting like a prudent investor for the funds that have been provided by the donors,” Fitzgerald said. “And we want to maximize those donor dollars to do the most good across campus for the educational benefit of our students as possible.”

Castilla also underlined that, while the University has the highest endowment of any public institution, it’s 94th on a per-student basis.

“One thing to keep in mind, and a lot of people don’t realize, but I think it’s really important to understand … although the dollar amounts seem very large, the University is so large that if you look at it on a per student basis, we’re really only roughly speaking about the 100th largest endowment in the country,” Castilla said.

The investments, pt. I: private equity and “strategies”

Beyond the role and meaning of the endowment, a quick glance at the investment report doesn’t necessarily articulate how the University invests its money.

The firms listed in the long term portfolio are scattered across the nation and globe, though many seem to be in Palo Alto, New York and China. Adding to this confusion is that the companies are all focused in capital, management and equity, not typical “stocks.”

That’s because they’re not stocks at all. Castilla highlighted that the University never directly invests in individual stocks, bonds, mutual funds and other types of properties.

Instead, its system of investing has numerous layers, and the easiest way to explain the format is that the Investment Office gives money to other firms to invest on the University’s behalf.

“What we do is we pick managers in certain sectors,” Castilla said. “We give them pieces of the endowment, and then they make the specific investments.”

“We’re saying, here’s some U of M money; you invest it in these kinds of companies that you’re really good at investing,” Fitzgerald said. “All of these companies that are listed in the report are investment companies that work in a particular area.”

Broadening the scope of this technique, the University chooses from five “super strategies:” Venture capital, private equity, natural resources, real estate and absolute return. Within each strategy, the University picks firms, or “managers,” that refine those areas of investment into even more specific “asset classes,” or smaller markets.

Often, the larger managers will hire smaller ones within a more refined asset class, and this second set of managers will finally invest the University’s original funds in specific stocks.

The goal is for managers with niche areas of expertise to use their market knowledge to invest the University’s endowment in the most efficient way possible, yielding the highest returns with the least risk.

Overall, these allocations of money to private equity firms comprise the University’s long term portfolio, which makes up a large portion of endowment spending.

The investments, pt. II: public equity and internal funding

Castilla said the long-term portfolio is often seen as synonymous with “endowment.” However, he added, a portion of the endowed funds are invested in public markets as well. These investments are liquid, and referred to as marketable securities.

As indicated in the investment report, around 27.5 percent of these marketable securities are invested in the public stock market. The University’s top investment: $13 million in Apple, Inc.

The University has also begun investing in itself. In November 2011, the University established the Michigan Investment in New Technology Startups program, which allows the Investment Office to invest in startups “based on technology that was licensed from the University of Michigan,” according to the MINTS website.

All of the University’s investments, and those who the University hires to invest on its behalf, are held to the Uniform Prudent Management of Institutional Funds Act, passed in 2006. This mandates that the University can only authorize “costs that are appropriate and reasonable” associated with making these investments.

“We think of it as investing for return to support the mission, which, in the case of the University of Michigan, happens to be education and research,” Castilla said.

Parameters for divestment

The University also has a set of individual standards for divesting funds, which Fitzgerald said are stringent and rare in application.

“The bar is set intentionally high ... to somewhat insulate the investment office from the political winds that could change from one direction to the other,” he said. “So the bar for considering divesting is set intentionally very high and requires this broad pervasive sentiment throughout University community to even be considered.”

This consideration operates through the Board of Regents, Castilla said. The regents have voted to divest twice. In 1978, the University divested from South Africa during apartheid and in recent years, divested from tobacco companies.

Fitzgerald added that divesting on the sole basis of political sentiment would both infringe upon the Investment Office and harm University projects.

“If we were to shift our investments based on the political perspectives of this group or that group, we’d essentially be undermining the performance of the overall goal ... (to) maximize the return so that those disbursements can help pay for endowed scholarships and the operations of the University,” Fitzgerald said.