How the Financial Crisis and Great Recession Affected Higher Education

Jeffrey R. Brown,Caroline M. Hoxby

• Publisher: University of Chicago Press
• Year: 2014
• ISBN:
  9780226201979
• Topic: Betriebswirtschaft
• Subtopic: Business allgemein

The recent financial crisis had a profound effect on both public and private universities, which faced shrinking endowments, declining charitable contributions, and reductions in government support. Universities responded to these stresses in different ways. This volume presents new evidence on the nature of these responses, and on how the incentives and constraints facing different institutions affected their behavior.The studies in this volume explore how various practices at institutions of higher education, such as the drawdown of endowment resources, the awarding of financial aid, and spending on research, responded to the financial crisis. The studies examine universities as economic organizations that operate in a complex institutional and financial environment. The authors examine the role of endowments in university finances and the interaction of spending policies, asset allocation strategies, and investment opportunities. They demonstrate that universities' behavior can be modeled using economic principles.

1

Endowment Management Based on a Positive Model of the University

Caroline M. Hoxby*

1.1 Introduction

In this chapter, I propose a positive model of the university in which many apparently peculiar features of universities—such as endowments and tuition subsidies—are generated by the internal logic of the model. The model proposes a specific objective function for universities and demonstrates how it is enforced. That is, the objective function leads to actions that reinforce the initial selection of the objective function. The model offers important predictions for the decisions that universities should make on many fronts if they are behaving in accordance with it. In this chapter, I focus on the implications for financial decisions, especially universities’ endowment spending rules and portfolio allocations. The model is designed to explain America’s great private research universities and very selective liberal arts colleges and—with modest adaptations—institutions that are partly controlled by the state such as America’s and Britain’s great public research universities. The model is designed to explain them precisely because many people find them hardest to explain, even enigmatic. An ancillary benefit of the model is that it provides a justification for the existence of all of the aforesaid institutions by assigning them a unique role in the creation of intellectual capital. A simpler version of the model could explain most other colleges and universities, and this is a topic to which I return briefly.

A very brief intuition into the model, laid out in section 1.3, is as follows. Each university maximizes its contribution to society’s intellectual capital by making two types of investments: (a) investments in advanced human capital embodied in people and (b) investments in new knowledge embodied in research. These investments have peculiar properties that make them unlikely to be financed by conventional means. In making these investments, universities play a role that closely parallels that of a venture capitalist. They invest not only money, but also expertise and infrastructure. The university gets what is essentially an equity stake in its intellectual capital investments. Collecting these (equity-type) returns is a key difficulty for universities, and it is in overcoming this difficulty that universities (a) generate an endowment, not merely gifts and grants for current use; and (b) reinforce the initial choice of their objective function so that the model is, as a logical matter, closed.

This chapter draws heavily upon Hoxby (forthcoming) in that the model of the university is the same. However, those chapters present empirical evidence that justifies how the model characterizes universities. They also explain how universities evolved over decades into the institutions that they are modeled as being. In this chapter, I present the model without much empirical justification and without history. Hoxby also examines the implications of the model for universities’ policies on tuition, admissions, and a variety of other outcomes. In this chapter, I touch on these policies briefly and focus on the implications for endowment management.

The papers to which this study is most closely related are Hansmann (1990) and Merton (1993). The Hansmann paper is a masterful review of many explanations of why universities have endowments and what each justification implies for endowment management. He carefully analyzes and rejects both the intergenerational equity model of Tobin (1974) and extensions of the intergenerational equity model that presume that there will be an increasing cost of education for succeeding generations. The latter type of model produces spending rules along the lines of the Stanford Rule (Merhling, Goldstein, and Sedlacek 2005). Hansmann also analyzes several partial explanations for endowments and their management rules—for instance, programming models—such as Grinold, Hopkins, and Massy (1978)—which do not maximize an objective function that values education and research but merely assess whether a rule can attain a metric such as maintaining a certain ratio of expenses to endowment. Hansmann even carefully assesses casual explanations for endowments such as the character and incentives of people who serve as university trustees.

Following his review—which I do not imitate in this chapter, partly because his review is so masterful and partly for reasons of length—Hansmann concludes:

The argument that has been offered most frequently in recent years to explain the accumulation of endowments—that they are a means to inter-generational equity—is unpersuasive. More compelling reasons to accumulate endowments are that they serve as a financial buffer against periods of financial adversity, that they help to insure the long-run survival of the institution’s reputational capital, that they protect the institution’s intellectual freedom, and that they assist in passing on values prized by the present generation. It is not clear, however, that these are today the reasons why endowments are accumulated. Nor is it clear that the sizes of existing endowments, and the ways in which they are managed, are well chosen to serve these goals. In particular, prevailing endowment spending rules seem inconsistent with most of these objectives. We cannot say, from the arguments and evidence surveyed here, that the endowments of the major private universities today are either too big or too small. It does appear, however, that surprisingly little thought has been devoted to the purposes for which endowments are maintained and that, as a consequence, their rate of accumulation and the pattern of spending from their income have been managed without much attention to the ultimate objectives of the institutions that hold them. (1990, 39–40)

In other words, Hansmann concludes that there is not a satisfying, positive model of universities in which endowments play a logical and necessary role. He does not himself propose one.

In many ways, Merton takes off where Hansmann ends. Indeed, his paper begins with part of the above quotation from Hansmann. Merton’s key contributions are (a) to focus attention on the nonendowment sources of cash flow for universities (tuition, gifts, and so on), and (b) to solve the problem of how to manage an endowment given these nonendowment sources of cash flow and flows of expenses. Merton treats the cash flow and expenses as exogenous because “that abstraction does not significantly alter the optimal portfolio allocations.” Merton’s article is a great contribution that is not only useful to the broad scholarly community, but that is specifically helpful to this study because it allows me to focus on questions that he leaves unresolved.¹

I focus on what the university’s objective is; why that objective generates sources of cash flow like gifts, tuition, and grants; why endowments exist; and how the endowment and cash flows are interdependent. Essentially, my model sets up the structural version of the university’s investment problem. For each problem there exists a reduced-form version that can be written strictly in terms of cash flows. This reduced-form problem is solved in Merton’s paper—except for some issues that I take up later.

In addition to the closely related papers by Hansmann and Merton, there is a rich but less related literature on the management of endowment portfolios (the types of securities in which they should invest) and on spending rules (the amount of the annual return on the endowment that should be spent rather than saved in the endowment).² Many of these papers provide important estimates of elasticities or other parameters—for instance, the sacrifice in average returns and decrease in risk that universities experience when they invest more of their portfolio in bonds. Or, to take another example, Brown, Dimmock, and Weisbenner (chapter 5, this volume) estimate the response of donations to the rate of return on the endowment. However, as noted by both Hansmann and Merton, this rich array of papers tend to take no stand on why endowments exist or the purpose they serve and instead rely—explicitly or implicitly—on a rule of thumb such as needing to maintain a perpetual level flow of expected real income. Thus, the body of papers referenced in this paragraph, although terribly useful given an objective function and reduced-form rules based on it, are logically posterior to this chapter.

This chapter contrasts with the small existing literature that does propose objective functions for universities—most notably prestige.³ These papers strike me as unsatisfactory in that prestige is a fundamentally incomplete explanation. The authors never demonstrate why institutions should compete on the particular metrics of prestige—endowments and admissions thresholds—that the authors choose. They never explain why endowments or admissions thresholds exist in the first place so that they could be grounds for prestige competitions. Indeed, saying that universities compete for prestige seems merely to be conceding that there is no positive model of universities, with the result that universities must necessarily be said to pursue essentially superficial goals that happen to have predictive power.

The structure of the remainder of the chapter is as follows. In section 1.2, I review the venture capital problem because it clarifies important features of the university’s investment problem. In section 1.3, I lay out a positive model of the university. Section 1.4 presents a less abstract, more down-to-earth portrait of a university than is described by the model. In section 1.5, I describe the implications of the model for endowment spending and portfolio allocation. This is where Merton (1993) plays an important role. Finally, in section 1.6, I conclude by explaining what the model has to say about some questions that commonly arise.

1.2 The Venture Capital Problem

It may appear to be a digression to review the venture capital problem and how it is solved before moving to universities. However, it is efficient to conduct this review because it is easier to see the structure of the problem when it is presented in its more abstract form, without all of the details that often confound analysis of universities. Although economists who work on the venture capital problem usually lay it out in a fairly different way from the presentation here, the fundamental problem and aspects of the solution I present draw heavily upon this literature.⁴

1.2.1 Problematic Investment Projects

There exists a set of investment projects with the following characteristics:

• They are brought forward by a person (or persons) whose unique capacities are necessary for the success of the project. For instance, this person could be someone who has the idea for an invention. Hereafter, I call this person the “agent.”⁵

• To be successful, the project requires assets—usually described as expertise and infrastructure—whose building or adjustment costs are convex in the per-period increase in their amount or diversity. This is just to say that it is expensive to build the relevant assets very quickly, especially if one does not already have a foundation of closely related assets. For instance, the project may require expertise in finance, marketing, the law, certain engineering, or some other body of knowledge. The infrastructure required may be the plant and equipment necessary to construct and test a prototype of the invention. What is important is that the project requires assets that have costs that are convex in the way described. Hereafter, I use the phrase “convex adjustment costs” to refer to such costs.

• Unless an assessor has expertise in areas related to the agent’s unique capacity, his estimates of the potential profitability of the project will be extremely imprecise.

• The project is risky. This almost goes without saying since (a) it depends on the existence of the agent who could, say, be killed in an accident; and (b) something about the project must be advanced if only an expert can assess its potential profitability.

These conditions generate a problem. The agent cannot get financing for the project from a bank or raise money in some other conventional way because (a) the bank or other conventional financier has insufficient expertise to assess the project and cannot build this expertise without incurring prohibitive costs, and (b) the agent’s costs of building the expertise and infrastructure himself are prohibitive. Even if the agent were able to get financing from a bank, he might substantially underfinance the project because he is risk averse and his investment would entail a great deal of undiversified risk.

1.2.2 The Potential for a Venture Capital Solution

Venture capitalists are a potential solution to this problem. They are modeled as people who have a pool of financial capital to invest and who have already built expertise and infrastructure in areas relevant to certain types of projects. A venture capitalist invests not only money but also expertise and infrastructure. Using his expertise, he selects projects whose expected rate of return exceeds a threshold based on the opportunity costs for his financial capital, expertise, and infrastructure. In return for making an investment, the venture capitalist gets what is essentially an equity position in the project (more on this below).

The venture capital problem exists precisely because the costs of building expertise and infrastructure are convex as described. This has a few implications. First, a venture capitalist’s portfolio is necessarily limited in its breadth and size by the cost of building diverse expertise and infrastructure. His portfolio may contain many projects and be much more diversified than any one of these projects, but it will be far less diverse than, say, a market index fund. Second, the venture capitalist will want to finance a stream of projects over a number of years—not finance a single generation of projects and then get out of the business. This is because the costs of building expertise and infrastructure are convex in the speed of doing it. Thus, the venture capitalist’s investments in expertise and infrastructure are more likely to pay off if he builds them gradually and employs them for several generations of projects. Third, the venture capitalist has strong incentives to maintain his expertise and infrastructure, as opposed to letting them depreciate. He will fear situations in which his returns from projects are insufficient to support maintenance-type investments in his expertise and infrastructure. For instance, a venture capitalist who was short on current income might lose his experts to other employers. If much of this were to occur, his ability to continue his venture capital business would be in doubt. Thus, venture capitalists may wish to have a smoother stream of investments than an investor in financial markets. Fourth, the cost structure implies that projects will crowd one another out at the margin. That is, two projects may have similar potential profitability and might each pass the venture capitalist’s threshold if each could use his existing stock of expertise and infrastructure. However, neither project might justify the venture capitalist’s quickly building enough new expertise and infrastructure to accommodate it. The potential for crowding out means that venture capitalists will acquire a good deal of information about an agent before making an offe...