Editor’s Note: Today’s story — a look at the financial investments that make up the University’s endowment, the individuals that manage it and the kinds of strategies they employ — is the first in the Daily’s four-part “Anatomy of an Endowment” series. Subsequent stories in the series will try to answer other important questions about the endowment, like why more endowment funds can’t be used for financial aid, how the global financial crisis will impact the endowment and how the University’s investors take into account social responsibility and ethics when investing the endowment’s funds. By the end of the series, our goal is to have dissected, described and analyzed in simple terms a massive, intricate financial portfolio — one that is critical to the University’s success.

It’s often said that the University of Michigan, the state’s flagship institution of higher education, is about as close to a private school as a public university can get.

On the one hand, this can be attributed to the University’s impressive alumni base and the fundraising success that comes with such a vast alumni network — both characteristics of elite private universities.

But declining state funding has pushed the University further in the private direction. Since the 2002 fiscal year, annual appropriations funding from the state government has decreased almost $97 million when measured for inflation.

As a result, the University has been forced to rely more than ever on its multi-billion-dollar endowment to fund its academic departments, provide financial aid for students, pay for other University operations and essentially keep the University in business.

Yet despite the endowment’s increasingly vital importance to the University, very few people understand what the endowment is, what it’s comprised of, how it functions, who manages it and, most of all, how decisions are made concerning how much of those billions of dollars can be spent at any given time.

“Almost the entire public doesn’t understand what endowments are,” said University President Mary Sue Coleman in an interview last fall. “Very, very intelligent people, you know, some of our donors will say to me, ‘Well, why don’t you just spend more of the endowment?’ And I say, ‘Wait, wait, wait. Let me explain it to you.’ ”

Given the dire financial situation facing the state, many wonder how reliable a source of funding state appropriations will be for the University moving forward. And with the endowment compensating for dwindling state funding, it becomes increasingly important that students, faculty, administrators, alumni and everyone else connected to the University understand how the school’s multi-billion-dollar financial backbone actually works.

BILLION-DOLLAR ‘BUCKETS’

Though referred to in the singular, the University’s endowment — temporarily valued at $6.5 billion as of Dec. 31 — is actually made up of over 6,000 different investments.

These investments are organized into asset classes — groupings of similar kinds of investments — or “buckets,” as University Chief Investment Officer Erik Lundberg often calls them.

The first and most recognizable bucket is the endowment’s equities or stock holdings, which made up just over 20 percent of the endowment as of Dec. 31, according to a February investment filing.

The University invests in both domestic and international stocks — the kinds any investor could buy on, say, the New York Stock Exchange. The stocks include online shopping site Amazon.com, oil corporation Exxon Mobil, American automaker General Motors, British military contractor BAE Systems and telecommunications giant AT&T, according to the latest equities data dated June 30. (For a complete listing of the University’s endowment equities information for the past five fiscal years, click here.)

So far this fiscal year between July 1 and Dec. 31, the endowment’s equities recorded staggering losses of nearly 37 percent while also posting losses of 6 percent last fiscal year. The University’s investment team has also sought to decrease the amount of stock holdings in the endowment, according to the June 30, 2008 Report of Investments created by the University Investment Office.

The next investment bucket in the endowment is “fixed income,” or otherwise known as bonds. These investments, which comprised almost 9 percent of the endowment as of Dec. 31, are essentially loans on which the University collects interest and, at the end of the loan term, is repaid the principal amount.

Bonds have posted minor losses this fiscal year of almost 1 percent as of Dec. 31. In the 2008 fiscal year, however, bonds recorded gains of 5.1 percent. Like stocks, endowment investments in bonds have also decreased due to the limited gains to be made compared to other types of investments in the endowment’s portfolio, according to the 2008 Report of Investments.

“Absolute return,” the next asset class, is a much more complex grouping of investments. Rather than focusing on a single type of investment, this bucket is grab bag of a number of different investments and strategies employed by University investors and the outside funds with which they work. This bucket includes investments in Treasury bills, high-yield bonds and debt securities of struggling companies as well as corporate events like mergers or company restructurings. The goal for this bucket is to try to post positive gains each quarter — not incredibly high, but always making gains — regardless of how the financial markets are performing.

One strategy used in “absolute return” is “long-short” investing, in which investors buy stocks (otherwise known as taking the long position) known to perform well and sell stocks (known as the short position) performing poorly. As long as the purchased stocks outperform the sold stocks going forward, the investor will gain from the strategy.

Having posted a 10-percent gain in the previous fiscal year, positive returns had almost always been the case for “absolute return” until the current fiscal year as of Dec. 31, in which it has recorded losses of nearly 21 percent.

The endowment also has a “cash” bucket containing cash holdings, which comprised over 3 percent of the endowment as of Dec. 31.

While stocks, bonds and “absolute return” investments are considered liquid assets — meaning they can be converted more quickly and easily into cash — the rest of the endowment consists of illiquid assets, which are often investments in longer term partnerships and agreements.

Venture capital and private equity investments — together making up almost 23 percent of the endowment as of Dec. 31, according to the February investment filing — are two types of illiquid investments.

In the case of venture capital and private equity, the University’s investment team meets with fund managers and investors, learns about their investment strategies and decides whether or not to work with that fund. If the University decides to work with these groups, its investors commit initial money to the fund. Unlike stocks or bonds, however, venture capital and private equity commitments usually span multiple years and sometimes more than a decade, meaning University investors can’t simply yank their money out of a fund if they so desired.

“So the investment period is for four years,” Lundberg explained. During that period, the fund or group will “go out and buy a company, or they’ll go out and start companies, or they will go out and sponsor entrepreneurs and help them grow their companies. … And when the company’s ready, they’ll take it public or they’ll sell it to another company, and then we get our money back. But it may take 10, in some cases up to 15 years, from when the fund starts until it ends.”

Historically, the venture capital and private equity buckets have reaped rewards for the endowment, reporting 3- and 5-year returns anywhere from 16 percent to 26 percent, according to the 2008 Report of Investments. Not surprisingly, the University’s investment team has sought to increase the percentage of the endowment made up of venture capital and private equity investments.

But venture capital and private equity, too, have suffered losses of 3 percent and almost 10 percent, respectively, as of Sept. 30. (The most recent data for the endowment’s illiquid assets is Sept. 30 because of a lag time in calculating illiquid asset values; liquid assets, on the other hand, are easier to calculate.)

The last two illiquid buckets in the endowment are real estate and energy investments, which together comprise around 27 percent of the endowment as of Dec. 31, according to the February investment filing.

Real estate investments involve endowment funds being invested in real estate managers throughout the United States and the world who identify property development opportunities such as buying office and residential properties and then improving and reselling them for a profit.

Though profitable in past years, real estate investments included in the endowment have suffered losses of about 7 percent as of Sept. 30.

The final bucket is the endowment’s energy investments. The largest portion of the energy bucket, Lundberg explained, is investments in companies that buy oil and gas fields that are declining in production and use advanced extraction methods to make those oil and gas fields produce more.

“They maybe drill a few more wells, but the whole idea is there’s proven oil and gas reserves in there, and their goal is to get out more than what the seller could’ve gotten out knowing what they do,” Lundberg said.

Though the energy bucket had posted a 13-percent loss as of Sept. 30, the endowment’s energy investments reported an astounding 61 percent return in the 2008 fiscal year, on the back of record oil and gas prices in the first half of 2008. On top of that, the energy bucket has recorded 3-year returns of 47 percent and 5-year returns of 56 percent, according to the 2008 Report of Investments.

THE UNIVERSITY’S FINANCIAL GUARDIANS

Other colleges and universities with multi-billion-dollar endowments often employ massive investment teams — Harvard Management Company, which oversees the school’s endowment, pension assets and other investments, employs over 200 people, and the University of Texas System’s management company has almost 60 employees listed on its website.

The University of Michigan Investment Office, located in downtown Ann Arbor, is a bit more tight-knit.

The University’s investment team consists of 12 financial analysts and three administrative staff members. Heading that team is Lundberg, a Norwegian native and former analyst and investment strategist for phone company Ameritech, who started the University Investment Office in 1999.

Prior to the onset of the current financial crisis last fall, Lundberg and his team had enjoyed impressive returns over the past decade, having helped, alongside impressive University fundraising efforts, to grow the endowment from $2.5 billion in 1999 to $7.6 billion by June 30.

As a result, Institutional Investor magazine named Lundberg one of its “Excellence in Investment Management” award winners in 2007. Lundberg also earns one of the top base salaries at the University, having made $426,000 in 2006 and 2007 and $491,000 in 2008, according to annual University salary data.

Although the investment team oversees the direction, strategy and performance of the school’s endowment, University analysts don’t actually do the buying and selling. Instead, outside investment groups, who partner with the University Investment Office, make the actual investment transactions.

“Our job is to put together the composition of the aggregate portfolio, like deciding how much we should have in stocks and bonds, and then all of these different asset classes,” Lundberg explained, “and then go out and say (to outside investment groups), ‘Populate that (strategy) with the best of breed out there.’ ”

Coming up with the most profitable investment strategy isn’t solely the responsibility of the University’s investment team, either. As Lundberg said, “It’s not just me sitting in my corner office here looking at the world saying, ‘Hey, this is what we should be doing.’ ”

Integral to the investment team’s strategy is the advice of the University’s Investment Advisory Committee. An eight-member group of investment veterans, the committee’s members include directors at institutions like Goldman Sachs and Bain Capital and individuals whose specialties range from venture capital to private equity to other kinds of investments. (Click here to learn more about the eight members.)

Committee members meet with the University’s investment team several times a year, offering advice on what kinds of investments they think would benefit the endowment and other strategic advice for investing the University’s money.

The Investment Advisory Committee has been widely praised. After participating in one of the committee’s meetings, Charlie Munger, the vice chairman of the venerable Berkshire Hathaway Corporation and a former University student, said it was the best investment committee he had ever seen of its type, recalled committee member Sanford Robertson.

Lundberg also praised the committee, describing it as “a very good sounding board, (offering) very good advice, sound advice.”

Lundberg also emphasized that other parts of the University help with various aspects of managing the endowment. The University Controller’s Office, for example, continually tracks the endowment’s investments for the Investment Office, Lundberg said.

“We rely very heavily on other parts of the University to do our job,” he said.

—–

Daily reporters Andy Kroll and Kyle Swanson will be taking questions all week about the series and about the University’s endowment, in general. Click here to access their Q & A.

Leave a comment

Your email address will not be published.