Princeton's Unobservable Assets

As an amateur investor, I follow with amazement the major university endowments, and how many of our ancient institutions jumped on the "Yale model" bandwagon about 10 years ago.  This model calls for an emphasis on "alternative investments," meaning highly leveraged bets that asset values would continue to rise over the long term, leaving the portfolios illiquid in a market downturn.  As has happened.

This investment strategy was sold to trustees as being perfectly suited for well-off universities, because a nonprofit institution with deep financial pockets can easily fund its operations, so the thinking goes, without having to rely on traditional stock and bonds for a steady income from stock dividends and bond interest.  After all, nonprofits don't pay taxes or dividends to investors.  The "Yale model" theorized that big endowments can afford to tie up their capital in 20-year, higher-return investments, such as private equity shares in middle-class residential housing projects in Brazil, funded with massive debt.

Universities trumpeted their stellar returns in the 2000-2007 era, and for the most part defended "alternative investments" when the markets, and returns, collapsed.  Shirley Tilghman of Princeton offered a typical defense in 2009:

Had we adopted a more traditional approach, our endowment would be about half its current size and we would not have been able to lead the country in eliminating loans for students on financial aid; we would not have been able to expand the size of our student body to make a Princeton education available for more students; nor would we be able to make the critical investments we currently make in the research and teaching missions of the University.  In other words, our pre-eminence has depended upon the risk/reward profile that Princo [the University's investment arm] has adopted.

Buying lottery tickets might pay off, but a fiduciary would not allow it, because the "risk/reward profile" jeopardizes the security of the endowment income.  This is exactly what has happened.  The Princeton endowment is stuffed with unmarketable assets, now that the "alternative investments" bubble has burst along with the debt bubble.

The school administrations that have adopted the "Yale model" violate so many basic principles of prudent investing and common sense that it's hard to list them all.  These academic leaders:

  • Brag about how much money their endowments make in the market.
  • Ignore the detrimental effects of volatility on compounded average rate of return.
  • Rely on a few blockbuster years for long-term growth.
  • Teach students that keeping up with the Joneses, or the Yales, is noble.
  • Promote the idea that you can pay the rent by spending the short-term capital gain.
  • Commission new buildings on campus that advertise glitzy sculpture over functional efficiency.
  • Flock all at once like birds on a wire to the same types of leveraged assets, as in 2006/07, thereby helping to create a bubble in private equity.
  • Populate governing boards with conflicts of interest in the form of Wall-Streeters who market alternative investments, thereby weakening the oversight of investments.

Whatever happened to teaching prudence, caution, frugality, humility, and practicality?

This appalling recklessness was reinforced recently, when something just popped out at me in rereading Princeton University's 2010 Treasurer's Report, in an auditor's note on page 29.  The note shows that 82% of investments fall into a category called "Level 3 -- Significant Unobservable Inputs."

I looked up what the Financial Accounting Standards Board means by Level 3:

The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date.  In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions.  However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

That sounds clear.  Level 3 refers to something illiquid, with little certainty about the valuation.  What would this investment fetch if they tried to sell it today?  Good question to ask.

Having dug further into this, I learned that FASB's standards call for financial reporting to refine what has generally been called "fair value."  In other words, the FASB now encourages the asking of that good question.  If an endowment holds a share of Exxon, it's easy to determine "fair value."  The stock trades on the NYSE, and one can look up the market quotation.  An asset like an Exxon share is Level 1 -- very liquid, and easy to measure its value accurately.

Level 2 applies to assets and liabilities not traded in any active market, and therefore its value can't be observed.  However, fairly reliable "inputs" can be observed, such as the 10-year Treasury bond, which give a good indication of the value of an asset based on interest rates, as an example.  Hence, one step down the reliability scale.

The lowest level is Level 3. This is where Princeton has 82% of its endowment.  Level 3 applies when the method of valuation uses "unobservable" inputs.  Level 3 would include highly leveraged "alternative" investments, such as hedge funds and private equity partnerships, as examples.

Many jokes could be told about how the brilliant minds at Princeton use "unobservable" inputs to calculate a net endowment value of $14.4 billion while not being able to park their bicycles straight.  But the issue is serious, and I fear that these endowments will crumble in time and be propped up with government support, making a badly compromised academy even more subservient to debt.

George W. Ford blogs occasionally at